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


  1. Have you checked out CSAL? 15% div yield

    1. I haven't looked at it closely, and only a little bit when it was originally spun off, but my initial reaction was the transaction was "too cute", I've been burned by similar ones before. And with virtually all of their exposure to Windstream, that's a tough place to be in the current environment and deserves a significant discount. But I should revisit, I'll circle back soon. Thanks for commenting.

  2. 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.

    While the last statement is generally correct I think it misses some important nuance. GAAP is conservative in cases where land appreciates. Buildings indeed do depreciate everywhere and I think 30-40 years (NXRT uses 30 because they have 30 year old properties) is a pretty good guess as to the appropriate rate. In cases where land appreciates rapidly and represents a large portion of the asset value (a shanty in manhattan) GAAP is going to be far too low over long periods. For Class B multifamily in Detroit, it may be too aggressive.

    NXRT's entire portfolio was acquired from in the past two years (30% of it in Dallas near the top of the oil boom), so it's unlikely that book value is dramatically understated. The stock currently trades at 1.05x BV. At your $18 target, it would trade at 1.7x book value. Why do you think that NXRT management got such a great deal in the past two years that they can flip this thing for 70% more than what they paid for it (adjusted for depreciation)?

    Just focusing on FFO, it's hard for me to think about a yield that assumes no maintenance capex (ever). When coming up with an estimate of maintenance capex it's hard for me to think of a better number than depreciation (maybe only take 90% of depreciation if you assume the land appreciates at 3% per year which is probably aggressive for Class B multifamily).

    1. Based on annualized Q3 numbers and adding back the acquisition costs line item you'd need to believe that economic depreciation is ~50% of GAAP depreciation to think the current dividend yield is sustainable (which I'm guessing one could back into by assuming land appreciates at 3% per year and the buildings depreciate over 70 years...seems aggressive to me). You could also believe in management's story of amazing rehab ROIC but that is a "trust me" story that's very hard to verify. Insider buying is a good sign however.

    2. Thanks for thoughtful comment, regarding FFO, I sometimes get criticized for relying too much on non-GAAP metrics so I thought it was helpful just to explain why FFO can be helpful in evaluating REITs.

      I very well could be too bullish on the current state, but looking out 2-3 years, NOI growth should be high. They're still buying new properties (albeit at slowing pace), rehabbing is in its early stages, and Class B supply is relatively constricted. On the Q2 2015 call management stated they expect to grow NOI 10% a year for the next three years without acquisitions. I believe the first step will be selling a stabilized property or two in the first half of the year, show the market their rehab strategy works and recycle into new properties, should also drive NOI growth. The ultimate $18 price target might not be doable in the near term unless a strategic buyer can come in and removes the external manager costs.

      Fair on it being somewhat of a "trust me" story. Management has described this as a trade, it's not a scalable opportunity that larger REITs really have the ability to do. There's no incentive fee in the management agreement, as you mentioned, high insider ownership, they're a long way from being able to raise capital, I don't see them as overly promotional. If they want to monetize their trade, seems like a sale is most likely - even if it is 12-24 months out. Thanks for reading, appreciate the comment.

    3. One more thing - Flipping it for 70% more than they paid isn't quite right, since this is a heavily leverage company, it's really more like 20-25% more than they paid. Still might be too aggressive, but if you trust their ROIC numbers in the rehab, not out of the question.

    4. regarding maintenance capex - what do you think of the argument that some of that is already expensed in the income statement?

  3. I work in this space and there are many people currently chasing these deals. Who is to say that they paid the right price? the concentration in Texas is risky because the sunbelt has historically been highly cyclical and much easier to build new construction versus other parts of the country.

    Most of their competitors metrics would also look like this is they had highly leveraged, short-term floating rate debt on their assets. Frankly, I'm surprised their dividend isn't higher currently.

    1. Interesting point on the sunbelt comment and available space comment, are we talking exurbs? Are there lots available in suburban type locations to infill Class B or lower Class A apartments? I live in Chicago, most new buildings here just go up, not out like in NXRTs markets, so I hadn't quite thought about it that way.

      Regarding the right price, I guess we'll see, their late 2013 and early 2014 properties are showing significant NOI growth after being rehabbed. We'll soon find out if they've loosened their underwriting criteria as they pushed for growth in late 2014 and into 2015.

      Their payout ratio is pretty low (~60% of FFO), I'm indifferent to dividends in general, but it's probably preferable they retain some cash to either make additional acquisitions or repay debt.

      Thanks for the comment, I've tempered my expectations a bit since writing the post.

    2. I didn't mean to be so negative. I just find there are quite a few players doing this in the PRIVATE MARKET on Class B/C properties and over the past 12-18 months people are paying prices I cannot justify. (2013 properties should be fine). There are quite a few funds established to do this marketed to institutional investors now. I'm talking about suburbs, exburbs and less downtowns. Downtowns are more of a different animal.

      I actually own a little NXRT as well but will get out when I start seeing a decline in the Sunbelt since I work in the sector. Houston is a little weak but the rest is still strong as of 1Q16.

    3. No, thanks, I appreciate the comments and perspective. I agree there is a lot of private money splashing around this sector, public REIT investors don't like Class B/C, my thesis is they'll eventually sell to those players in the private market.

  4. On the Q4 conference call just now, management stated they've entered into an agreement to sell 3 of their assets (1 in Austin, 2 in Jacksonville) at a 6% cap rate, proceeds will be used to pay down the bridge facility that matures in this summer, remainder for 1031 exchanges into other acquisitions. Good first step highlighting the value created and improving Class B market, likely will be ignored by the market, but good step nonetheless.

  5. Thanks for this post and the follow-up after Q4 cc. I came across NXRT from CFA Chicago society's events list and found your site here. I held the same view with you that the firm is planning for short/mid term sell (either properties portfolio or the whole trust) and I see both leverage and float rates debt as positive. I'd want them to keep more cash as well but I think they will have to distribute more to maintain the REITs status. This firm is really a flipper partnership under a REITs cover to me. Once the firm starts more disposition activity and the numbers make to the filings, hopefully more investors will get it.

    1. Thanks for the comment, in agreement. And hope to see you at future CFA Chicago events.

  6. Nice post - I agree 6% cap rate sales of renovated assets are Great for proving value. Hope they plan on advertising it assuming it's a gain. With the sum-of-the-parts so disjointed from the market cap, a sale seems like the obvious play. Management's ownership % tells me that they would rather the big upfront win to roll into other ideas than milking investors on a management fee (agree that it's worth a mention in your risks section though).

    To the commenter above - use big REIT Run-rate assumptions for expense drag. Over time these will be realized via sale to entities that can extract casflow close to the cap rate of the individual properties. Looking at the expense drag of a company without full scale/still renovating is a mistake in valuing. Each building's value to a top notch operator is your best baseline. JA

    1. Agreed - I've slowed down my expectations on the timing, but ultimately this will be sold as it's too small, and an unpopular model for a public REIT.