Friday, February 12, 2016

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.

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.
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.  

  • 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

Tuesday, February 2, 2016

Crossroads Capital: Busted BDC, Bulldog Pushes Toward Liquidation

The tide has just about fully washed out of the business development company sector (more on the manager/fund raiser side), most BDCs are really just leveraged loan vehicles and not "private equity for main street" as they were originally intended.  One of the few private equity like BDCs is tiny Crossroads Capital (XRDC), which has changed its name twice in the past two years (f/k/a BDCA Venture and before that Keating Capital) as it's original asset manager was purchased by an affiliate of the toxic Nick Schorsch and then recently famed closed end fund activist Bulldog Investors won board seats and took control of the company in the second half of 2015.

The grand plan was to invest in companies approaching an IPO, from the 2013 10-K:
"Our strategy is to evaluate and invest in companies prior to the valuation accretion that we believe occurs once private companies complete an initial public offering.  We seek to capture this value accretion, or what we refer to as a private-public valuation arbitrage, by investing primarily in private, micro-cap and small-cap companies that meet our core investment criteria.  Our investment strategy can be summarized as buy privately, sell publicly, capture the difference."
With the benefit of hindsight this strategy looks a bit silly, especially in the "unicorn" Silicon Valley valuation environment that's been going on for a while and is arguably the opposite of what's described above, private companies are being valued at a premium over public ones.  But in the middle of a bull market this is an easy high fee product to sell to main street retail investors looking for a way to profit from hot technology IPOs.  The slowing IPO market and high fees began to take their toll and this BDC started trading at a significant discount to net asset value before long.

Bulldog Investors, led by Phil Goldstein, is famous in the value investing community for their activism in closed end funds and other investment companies.  These vehicles often trade for a discount to NAV due to their high fees and closed end nature, there's no mechanism for investors to redeem their shares at NAV like opened end funds.  Bulldog often accumulates a large stake and then pushes for the manager to take steps to force the price back to NAV, typically first through share buybacks, if that's unsuccessful, a liquidation of the fund.

Bulldog went active on Crossroads Capital (then BDCA Venture) in March of 2015, here's the letter, calling for a sale or an orderly liquidation.  They've since bought more in the mid-$4s, now owning 11.65% of the shares.  Events didn't move quickly enough, Bulldog launched a proxy fight and gained board representation, Andrew Dakos of Bulldog was named Chairman of the Board, and the company parted ways with its external manager in October 2015.  They've since slashed operating expenses and outsourced most of the day to day administrative tasks to a third party provider.

On 1/25/16, the company announced their new strategy:
“The Company's new investment objective is to preserve capital and maximize shareholder value. The Company seeks to achieve its investment objective by pursuing the sale of its portfolio investments, limiting expenses and deploying surplus cash as appropriate, including into yielding investments to offset operating expenses.”
In the same press release they stated the current cash is approximately $1.46 per share.  So at today's $2.46 stock price, what is an investor getting for the additional $1.00 per share?  Below are their portfolio investments as of 9/30/15, its worth noting that they took the overall value down 12% from the 6/30/15 marks and will likely take something similar off for the 12/31 net asset value.
Using the 9/30 marks (additional writedowns likely), after cash you're only paying 25 cents on the dollar for the remaining portfolio ($4.02/share).  Most of their investments are in green energy and social media type private companies, not something I'm able to value but I did some light Googling and most of them seem reasonable and potentially worth something.  January was the first month in a long time where no IPO was completed in the United States, a quick liquidation of the assets might be difficult.  In the latest 10-Q:
"We further believe there may limited opportunities to sell our interests in existing private portfolio companies to third parties in privately negotiated transactions.  Accordingly, it is possible that an orderly monetization of our current holdings may take three to five years or more."
So that's base case, but I don't think it's as simple as a big discount to NAV being closed over three to five years (don't forget - outside chance their portfolio appreciates), that wouldn't be quite as interesting.  Now that Bulldog Investors is in control of the company, and armed with a $2MM buyback authorization (if fully utilized at current prices it would increase NAV by ~5%), additional buybacks could be in the cards, liquidation distributions, and other levers pulled here to generate returns for those that stick around.  I also wouldn't write off the possibility of a quick portfolio sale of the investments at a discount to another entity.  Crossroads Capital is a jockey play on Bulldog Investors being able to unlock the value backstopped by paying a cheap price for the asset base.

Why is it cheap?
  • IPO window is potentially shut for these small cap speculative technology companies, uncertain time frame for value realization.
  • The company is stopping regular distributions, the last of the retail BDC dumb money has probably sold out in the last two months.
  • Liquidations in general tend to scare off investors: there's a lot of red tape holding up dissolution, they take longer than people would think, and can have principal/agent problems (even the bare bones administrative staff at a company liquidating isn't running to lose their job).  But with the largest shareholder in control, there's some confidence that the process will be expedited as much as possible.
I'm finding quite a few of these busted small/micro cap financials with a lot of cash recently and started to develop a small tracking position bucket, I added this one to it.

Disclosure: I own shares of XRDC