NexPoint Strategic Opportunities: CEF to REIT conversion, Possible NXRT Replay

Back in 2015, closed end fund NexPoint Strategic Opportunities (NHF) (then known as NexPoint Credit Strategies) spun out NexPoint Residential Trust (NXRT), a value-add class B multi-family REIT it had incubated inside the CEF, NXRT went on to 4-5x over the next several years (unfortunately I only caught about 2x of that).  Last week, news came out that NHF shareholders voted to convert the fund to a REIT, possibly setting up another similar opportunity for a multi-bagger as the valuation metric evolves from a discount to NAV story to a multiple on FFO story.

The thesis here is a bit incomplete at this stage but promising if you followed NXRT, NHF trades at $9.45 or 55% of net asset value (pre-covid that discount was more in the 15% range), as part of the conversion to a REIT they'll be selling non-REIT related assets presumably near NAV of $17.19 per share, capturing that discount by then buying distressed real estate in the post-covid fallout.  By applying a similar NXRT value-add strategy, NHF will look to sell newly stabilized assets and then recycling that capital back into opportunistic real estate, rinse and repeat, creating sort of a multiplier effect.  The new-REIT will have a pretty wide investment mandate, essentially any asset class is fair game according to the proxy although I assume they'll stay away from multi-family and hospitality/lodging as NexPoint already has publicly traded REITs that focus on those sectors.  The public REIT market likes simple stories, this doesn't appear like it will be one, at least not initially, but NHF does intend to maintain a monthly dividend, so it could entice retail investors interested in yield.

NHF's current portfolio is sort of grab bag of assets, looking at it and its seems a bit incoherent, many readers will recognize some of the individual equity names, several bankruptcy reorgs and other special situations, NHF even has 8 shares of NOL shell Pendrell for those looking to pick some up in the coming months.  They also own CLO debt and equity, which has generally held up well through the crisis and are probably worth more than where they're marked.  But 25% of the portfolio is in a wholly owned REIT they've once again incubated, NexPoint Real Estate Opportunities, which owns self-storage facilities, a Dallas office building (City Place Office Tower), a new construction Marriott hotel in Dallas and a single family rental operator.  Again, not a real coherent strategy, this idea is a bit of a leap of faith based on their past track record and we'll likely know more in the next 6-9 months through this conversion.  I picked up a smallish position with the intention to add more as the story unfolds.

Other quick thoughts:

• NHF post REIT conversion will be externally managed, the fee agreement has an expense cap at 1.5% of assets for the first year and there are no incentive fees.  This is a similar setup to NXRT, I believe some of the "investor friendly" aspects of the fee agreement are related to being a historical 40 act mutual fund and not just out of the kindness of management's heart.
• Speaking of management, James Dondero will be the CEO, he has a litigious reputation (feel free to Google), but again, hard to argue with what the team did with NXRT and he owns 11.5% of the fund/stock.
• They have a repurchase plan in place that allows them to repurchase 10% of the stock over a one year period (plan was put into place on 4/24/20), unclear if they've acted on it at all or if they would with the new change in plans.
• One big benefit of being a REIT over a CEF will be index inclusion, joining the REIT indices should improve the valuation and analyst coverage.

Disclosure: I own shares of NHF

NexPoint Residential Trust: Update, Substantial Discount to NAV

On February 22 at 5:30 pm, I'll be hosting the CFA Society Chicago's Special Situation Research Forum in the loop, the topic chosen was NexPoint Residential Trust (NXRT) which I've held since its spinoff from NexPoint Credit Strategies last April.  Some of this is a repeat from my previous post with some updated thoughts and numbers.  If you like/dislike this idea and want to join the discussion, or just enjoy talking stocks, please feel free to email me I'll add you to the attendee list.

NexPoint Residential Trust is a small orphaned Class B multi-family REIT that is externally managed by an affiliate of Highland Capital.  The REIT was started opportunistically in late 2013 inside of a Highland managed closed end fund, NexPoint Credit Strategies (NHF), as the management team saw an opportunity to buy neglected, under-invested suburban workforce apartment buildings, do some light renovations and re-lease rehabbed units at higher rates.  Highland spun-off the REIT last spring and it's since dropped ~20-30% which presumably takes raising equity off the table, and given its small market capitalization (~$235MM), once the initial rehabbing is completed management will likely look to sell the company as the private market is valuing multi-family units at a premium to the public markets.

Portfolio Overview

• NexPoint Residential owns 42 properties, consisting of 13,155 garden/suburban units spread primarily across the sunbelt (Dallas and Atlanta make up 50% of the market exposure).
• Average Monthly Rent: $796
• Occupancy: 93.1%
• 2015 NOI (run rate): $64.0-66.5 million - but ramping as they deploy excess cash to rehab
• All but one of the apartment complexes in a JV with their property manager, BH Management, where NexPoint owns 90% and BH owns 10%.  NexPoint maintains control and final say in any disposition scenario but also aligns the property manager as they're the boots on the ground in the turnaround process.
• The portfolio has significant debt (60-70% leverage ratio), more than other publicly traded peers, but still a reasonable amount and a structure most smaller/local real estate investors would employ.  Most of the debt is floating rate and on the property level, non-recourse to the parent, as management believes interest rates will stay lower for longer (appears the market agrees with them) and it allows for a simpler property-by-property sales as the mortgages can be assumed by the buyer.  The average interest rate as of 9/30 was 2.50%, most of these mortgages are pegged off of 1 month LIBOR which has gone up with the Fed Funds hike, so the current rate is likely somewhere between 2.50-2.75%.

Unlike Class A multi-family which has seen a building boom, especially in urban markets, Class B multi-family has seen little-to-no new construction in recent years.  It's just difficult to buy land and build apartments given current construction costs and make an acceptable return renting them out for $800 a month.  NexPoint Residential's properties are located in growing sunbelt markets that are seeing significant growth in population and jobs.  Lower energy and gas prices should act like a tax break for NexPoint's blue-collar commuter residents making them more attractive credits and able to endure rent increases.

A key part of NexPoint's strategy is to rehab communities by adding or improving lifestyle amenities (fitness centers, pools, clubhouses) and doing cosmetic upgrades to individual units (~$4k a piece) as they come off lease.  As of 9/30, they've rehabbed 13% of their units for $7.3 million resulting in an average rental increase of 11%, which has generated a 24.4% return on the rehab cost.  Since NexPoint is a small REIT, these incremental improvements can still move the needle fairly significantly and generate NOI growth versus new build development that exposes them to the market turning on them as they're leasing up (see HHC).

Funds From Operations

GAAP uses historical cost accounting convention for real estate assets and requires depreciation (except on land) which implies that real estate values diminish in a straight line over time.  We know that's typically the opposite, real estate values generally appreciate loosely following wage growth and inflation trends.  So the REIT industry created Funds From Operations (FFO) as a proxy for earnings that adds back depreciation expense and excludes gains from sales (since they'd be held at depreciated values) from net income.  Instead of P/E, P/FFO is commonly used in the REIT industry, but suffers from the same issues as different capital structures (like NXRT) can skew the ratio significantly one way or another.

NexPoint Residential looks really cheap on an FFO basis do their leveraged balance sheet.

* Acquired in 2015 (AEC was acquired at a 5.9% cap rate, HME at 5.6-6.2% cap rates)

If you normalize for the debt, NXRT is less of an outsider but still undervalued compared to other multi-family REITs and to where Home Properties and Associated Estates Realty Corp were bought out at in 2015.  But at under 7x forward FFO and a 7.40% dividend yield, I could see NexPoint generating some interest from retail investors looking for yield again now that rates don't appear to moving up soon.

NAV

To normalize for NexPoint Residential's capital structure, and to value the company based on a private market sale basis since any acquirer would have their own management team, capital structure, etc., an NAV calculation makes the most sense.

Below I'm assuming the company's new run rate net operating income including their November acquisition (333 unit - The Place at Vanderbilt) and historical rent increases will be just under $70 million.  Using a 6.5% cap rate, NexPoint's NAV would be approximately $18 per share, using the 6.1% cap rate that Milestone Apartments REIT recently paid for a similar Class B multi-family Landmark Apartment Trust portfolio would yield a $21 share price.  Given NexPoint's debt any small change either way in cap rates has a magnified impact on the resulting NAV.

To further that idea, I backed out what cap rate the market is currently valuing the company's assets at using the current share price and market capitalization.  Assuming my NOI projections are correct, the market is implying a 7.66% cap rate for NexPoint's assets, or a 20+% discount to what Milestone paid for Landmark in October.

Management

The market doesn't like external management structures, and for good reason, there's typically an agency problem as management's incentives are not aligned with their captive shareholders.  NexPoint's management contract is good, not great:

• Management Fee of 1.00% of Average Real Estate Assets, Administrative Fee of 0.20% of Average Real Estate Assets, and reimbursement of operating expenses but there's a total 1.50% cap on expenses paid to Highland.  The manager also has waived about $5.5 million in fees on the initial spinoff portfolio capping the fees at the same level they would have made if the spinoff didn't happen (not clear if this is a one time waiver or annual).
• Property Management Fee of 3% of monthly gross income to BH Management which works out to be another 0.50% on assets.

However, unlike many externally managed vehicles, Highland Capital and management itself purchased roughly 16% of the shares outstanding and their management contract doesn't have a termination fee.  Additionally, there are no dilutive incentive options or other forms of management compensation gravy trains that would dry up in the event of a sale.  On their conference calls management has been open about the idea of a sale if the valuation doesn't move up to peers to allow for a more sustainable, equity raise model of a typical REIT.  

Risks

• Highly leveraged (compared to peers) balance sheet with predominately floating rate debt - if short term interest rates were to rise quickly their interest expense would rise in kind.  Rising rates may at the same time lead to a fall in real estate prices which given the leverage would disproportionately impact the common stock.  Double whammy.
• External management structure - the market dislikes these to begin with and Highland Capital (via NexPoint, the adviser) recently made a play to manage the TICC Capital, a BDC that's seen activists swarming around for the management contract.  Is Highland interested in creating a platform of permanent capital vehicles?  Would they dilute shareholders and issue additional equity well below NAV to grow their management fee?
• Texas concentration - 35% of their units are located in Texas, primarily in the Dallas-Fort Worth area (2% in Houston).  Does the energy collapse hit the rest of the state and how hard?

NexPoint is too small to internalize management, the stock price is too low to issue equity, the balance sheet is too leverage for more debt, and management is incentived to sell.  I think a sale to a private equity firm or another apartment REIT is the likely end game.

Disclosure: I own shares of NXRT

NexPoint Residential Trust: New Class B Apartment REIT

A few weeks ago a reader brought to my attention a unique spinoff where a closed end fund, NexPoint Credit Strategies Fund (NHF), was spinning off an apartment REIT they had been building inside NHF, essentially they created a non-traded REIT and then floated it via a spinoff.  On Wednesday (4/1/15), the spinoff was completed and NexPoint Residential Trust (NXRT) began trading - a small cap, externally managed apartment REIT focusing on Class B & C properties primarily in Texas and the southeast.  The REIT is managed by an affiliate of Highland Capital Management, a Dallas based alternative investment manager co-founded by Mark Okada who frequently appears on financial television and actually provides intelligent, sane commentary.

NexPoint Residential's current portfolio includes 38 multi-family properties containing 11,816 apartment units, with concentration in strong growing markets like Atlanta and Dallas.  The initial plan is to target class B & C properties and add value through rehab/redevelopment of the properties.  Larger REITs typically focus on big class A trophy type assets as its more economical, moves the needle, makes for better investor presentation materials, and immediately adds to AFFO and other metrics that REIT investors direct their focus.

Being small also has another advantage, NexPoint Residential will be able to build their asset base in small increments (not unlike GPT) and fish in ponds where the largest apartment REITs and other institutional investors are precluded from playing due to their size.  They also point out that very few mid and lower priced apartments are being built in the current environment, anecdotally I can attest to that as shiny new apartment buildings are going up all around Chicago's near north and near west sides reminiscent of the mid-2000s.  The feverish pace of class A building leaves that market susceptible to supply shocks in the next recession, whereas the limited new supply in the mid to lower markets should provide a little protection to NexPoint Residential.

I found the below slide interesting from NexPoint Residential's investor presentation, obviously these kind of comparisons are cherry picked a bit, but two things stood out to me that you don't typically see in externally managed REITs: insider ownership, and a willingness to be taken over.

Highland Capital (technically an affiliate) will earn a management fee/expense reimbursement amount capped at 1.5% annual of the assets, not the equity, so there's naturally a lean towards levering up the portfolio.  The interesting part is there is no incentive payment and there's only a two year initial contract period that can be cancelled anytime after with 60 days notice, unlike others where the external entity is essentially tied permanently to their manager.  That doesn't appear to be the case here and opens up the possibility of a takeover down the road which would likely be very accretive to the acquirer given NXRT's higher cap rates and ability to strip out the 1.5% management fees.  

Additionally, management has acquired 11.5% ownership of NexPoint Residential and indicated in their presentation they "will continue to be a natural buyer" and "management does not intend to sell shares or reduce its ownership stake", not typical statements you'd see in an externally managed vehicle that was just there to generate fat fees.

So what's it potentially worth?  Management is initially guiding to FFO of $1.12/share, at yesterday's closing price of $13.70, that's a 12.2x forward multiple, well below peers:

NexPoint Residential is clearly smaller, more leveraged, focused on lower quality assets, and doesn't have the track record of its peers, but over the next year as the platform grows out and establishes itself in the market I'd expect the valuation gap to close.  The bottom few like MAA, HME, PPS, and AEC are probably the best comparables for NXRT, at a 15x FFO multiple it's worth $16.80/share or 23% higher than yesterday's close.  Not super exciting, especially in a potentially rising interest rate environment where cap rates could widen, but that also doesn't take into account asset and FFO growth which NXRT should be able to do in the next 12 months.

NexPoint Credit Strategies Fund (NHF)

A smaller opportunity might exist in NHF, the CEF parent to NXRT, after the spinoff NHF committed to maintaining its previous dividend, essentially hiking the dividend 38% given the smaller NAV base.  NHF's strategy is to provide a credit hedge fund like offering with monthly dividend payments and liquidity, their performance despite the almost 2% management fee has been strong, yet it's hovered at a 10-12% discount to NAV for a few years (one reason they did the spinoff).  Now that the yield is higher, and the spinoff has lifted some of the funds more illiquid assets from the portfolio, the discount to NAV should decline slightly.  As of yesterday's close, its trading at a 12% discount to NAV with a 9.5% yield.

Disclosure: I own shares of NXRT, NHF (likely selling NHF in the next 1-2 weeks)