Monday, August 31, 2020

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

Front Yard Residential: Internalizing Management, Covid Tailwinds

I'm slow and full warning this is a completely unoriginal idea, feel free to read better write-ups here and here, but I took a position and as part of my process I wanted to write it up.  Front Yard Residential (RESI) is a REIT that owns approximately 14,500 single family home rentals ("SFRs") primarily across the south and southeast.  Front Yard has a mixed history, it was created and externally managed by Altisource Asset Management (AAMC) to house a non-performing loan portfolio that has since morphed into an SFR REIT.  Prior to the covid-shutdown, Front Yard agreed to be bought by Amherst (PE firm that has a SFR strategy) for $12.50 per share, that deal was terminated quickly once the severity of covid came to light in what looks to be in hindsight an overreaction.  Several months later, the stock has partially recovered, Front Yard trades at ~$9.60 and seems to be in a better position than it was pre-Amherst deal, the elevator pitch:
  • Front Yard's liquidity and leverage improved as a result of the termination, Amherst paid a termination fee of $20MM in cash, plus bought $55MM of newly issued stock from Front Yard at the deal price, $12.50/share, making Amherst one of the largest investors in Front Yard with a 7.5% stake.  Lastly, Amherst also agreed to be the lender on a $20MM loan that is currently unfunded.
  • There has been a quick and dramatic reversal of the popularity of cities, now they're seen as problematic both for pandemic/distancing reasons and recent social unrest, pushing people out to the suburbs in search of affordable space and relative perceived safety.  Single family homes have been one of the largest beneficiaries of this crisis, home prices are up, mortgage rates are way down.  But for many, home ownership is not an attractive option due to a lack of savings/credit or the desire to be mobile, thus a SFR could be a reasonable option.
  • Front Yard has long been sub-scale, only recently in the last year or so did they internalize the property management function and then this month they announced the internalization of their corporate management.  The incentives are finally aligned, but it doesn't fix the sub-scale part as it is only a fraction of the size of larger publicly traded SFR peers in INVH and AMH.  The board sold it once and there's been continual consolidation in this decade long SFR theme following the housing fallout from the last recession, it seems likely that Front Yard would once again be a consolidation target when things settle down further.
Invitation Homes (INVH), which is the legacy Blackstone and Colony portfolios, and American Homes 4 Rent (AHM) are the two scaled SFR REITs, both have good investor presentations that lay out the investment thesis for SFRs:
The addressable market is large, fragment and growing which should be a tailwind for institutional platforms, part of the argument for large platforms like the SFR REITs is the professional property management, which could equal more peace of mind to the customer.
The big non-covid related tailwind is the aging of the millennial generation, the largest cohort was born in 1990 and thus are turning 30 this year, entering a time when they'll likely want more space and start families.  The downside of the model is well known, its hard to gain scale and positive operating leverage unless you have a high concentration of homes in a locality.  INVH talks about 5000 being the scaled up number in a city, back to Front Yard, they only have one market even approaching that number with 4200 homes in Atlanta, the next largest market is Memphis at 1275 homes, again highlighting Front Yard's lack of scale, it's not just about total units but the number of units in a market.  Front Yard's properties are also generally older and cheaper than their two larger peers making their problems even more challenging (higher maintenance capex as a percentage of rent, oh and of course, actually collecting rent as covid related aide starts to slow down).

Not to pile on, but the other problem with Front Yard is leverage, they're highly levered which will make it difficult for the company to reach scale given where the stock trades.  High leverage and a low stock valuation should essentially handcuff the newly internalized management from pursuing a go-it-alone strategy as additional capital raises will be difficult to justify as it no longer just raises fees for the external manager.  The only reasonable option seems like another sale.

Given Front Yard's recent troubles and warts, its hard to value it just based on a cash flow metric, single family homes are gaining in value, especially recently with record low interest rates and limited home building since the last recession crimping supply.  Front Yard puts out an adjusted investment in real estate number that lines up when they've purchased homes or made capital investments and the appreciation in the time since those investments were made.
Obviously there should be a lot of caveats when using that number, a true one-by-one liquidation of Front Yard would take a substantial amount of time and expense to complete, and some depreciation is certainly real in these rentals, but I think it provides some additional context to the valuation.  After giving effect to the Altisource termination payments of $54MM (part of that is RESI acquiring some assets from AAMC), the enterprise value of Front Yard is ~$2.1B or about an 80% of unlevered asset value, given the high leverage of $1.5B of net debt, Front Yard is trading close to 55% of levered net asset value of ~$17.50 a share.  Again, I don't anticipate an acquirer paying a full price, but given recent trends in home prices and a migration to the suburbs, I could see Front Yard being acquired for more than the $12.50 Amherst agreed to in February.

Disclosure: I own shares of RESI

Sunday, August 16, 2020

Colony Capital: SOTP to Earnings, Digital Infrastructure Pivot

Back in April, I wrote up Colony Capital (CLNY) from the perspective of buying the preferred stock (read it for some background), today I'm going to take a shot at making the bull case for the common stock.  Colony has burned many real estate and value investors by going almost straight down since it merged with NorthStar Asset Management (NSAM) and NorthStar Realty Finance (NRF) in 2016. Back then it was going to be the next Brookfield Asset Management (BAM) by managing and co-investing in publicly traded REITs and private equity style real estate funds.  Last year, Colony announced a plan to focus on digital infrastructure, here's the quick new elevator pitch for Colony today:
  • Marc Ganzi took over as CEO (from Tom Barrack who is now Executive Chairman) of the company to effectuate the company's pivot from owning/managing traditional real estate to digital real estate (think towers, data centers, fiber, etc).  Ganzi has been a deal maker in the digital infrastructure space for a couple decades, in 2002 he co-founded Global Tower Partners, a private tower REIT, and ended up selling it in 2013 to industry leader American Tower (AMT) for $4.8B including debt.  Subsequently, Ganzi founded Digital Bridge Holdings ("DBH"), a PE fund with 6 digital real estate portfolio companies, which Colony invested/acquired DBH to bring him into the fold and lead the transition.  He has a good reputation as a deal maker with a legitimate track record, pair him with the tailwind of consumer demand for data being accelerated by work-from-home and other corona trends, the new strategy seems potentially promising.
  • Colony fits the "buy on the balance sheet, sell on the income statement" thesis that many investors (including me) look for, the value of the legacy assets today cover the market cap, as the company shifts to a manager/owner of more attractive digital infrastructure properties, the stock should earn a multiple on earnings versus languishing as a discounted sum of the parts story.
  • Colony doesn't have a natural investor base, many investors have been burned by the continual strategy shifts over the years. It is a REIT that doesn't pay a dividend, is overly complex and it is in the early days of their strategy shift -- so they're still a year or two away from being picked up by tower and data center investors.  The digital REITs dominate the top holdings of REIT index funds and trade at very lofty valuations.
On 8/7, Colony reported second quarter earnings and it was the first real chance for Ganzi to articulate his vision for the go-forward version of the company, and with it, released an investor day style presentation.  It's always a bit scary (be skeptical!) when you feel like a presentation was targeted directly at you, but Colony laid out the following few slides on why to invest in Colony:

During the quarter, the company took $2+B impairments to their legacy real estate holdings ("legacy" in this context means anything not digital, which is almost all of the balance sheet assets), basically kitchen sinked to reset the table for Ganzi, Colony spun it as covid accelerated the need for them to move quickly into their digital strategy given the demand on data/technology, but it also means potentially selling legacy assets in hard hit sectors to fund that pivot at an inopportune time.

At the top of slide is the digital pieces of the business, they primarily have two balance sheet investments in two separate data center business, the first is DataBank which they purchased for $186MM from Ganzi's DBH, possibly a less than arms length transaction but its also possible that they got a reasonable deal, who knows the business better than Ganzi?  The other thing to note is they've revalued their digital investment management company, Digital Colony, in this SOTP slide for the recent capital raise they did with institutional investor, Wafra, that bought 31.5% of Digital Colony for $250MM.  After that sale and a convertible bond offering which is now above the strike price, outside of the preferred stock, Colony has a net cash position at the corporate level.

The debt at the legacy assets is all non-recourse and generally asset specific, each asset/portfolio can almost be thought of as a call option in these times, the value of hotels or senior living facilities are clearly down, but depending on the pace of the economic recovery, these values post write-down might prove to be too low on certain assets.  In my preferred stock post, I wrote off the hotel assets completely and just assumed they'd hand back the keys, and that still might be the case as some industry rags have reported.  But Colony's hospitality portfolio is really divided into 7 separate entities (6 of which are reported under hospitality, 1 of which is under "Other Equity & Debt" as it was acquired through foreclosure), some of these are very likely going back to the lender, especially the 4 that have CMBS financing where their is little negotiating that can happen with the lender as the special servicer is generally bound contractually to foreclose.  The other 3 it's a bit murkier, but there's potential value there if things recover and Colony is able to hold on for another year or two before selling.  The healthcare facilities while down, seems salvageable to me, most of the properties in here are triple net lease and while covid has destroyed the senior housing sector (who in the right mind would place a love one in a senior housing facility right now unless that was the only option?), CLNY's rent collections have recently come in at 96%.

Another chunk of the legacy book is Colony Credit Real Estate (CLNC), a publicly traded credit REIT, they both manage the company and own 36% of it.  CLNC recently brought on former Ladder Capital (LADR, disclosure, still long) executive Michael Mazzei to take over the management of the company, I have a lot of respect for the Ladder Capital management team and see this hire as an important step in the turnaround of CLNC.  Historically, CLNC was originally thrown together from a pile of CLNY assets and a few NRF sponsored non-traded REITs, non-traded REITs are generally indiscriminate in what they buy in order to fund growth and increase the management fee to the external manager.  CLNC plans to eventually internalize although that plan is on ice for now as the stock trades for roughly half of book value (book value is a decent proxy for net asset value here).  CLNC has a large CRE CLO that they manage and use as balance sheet financing, to-date all the assets in that vehicle are current, its hard to tell if servicers are advancing funds or borrowers are using interest reserves to make payments, but given all the other assets and liquidity sources in CLNC, if a loan did go into default, they'd be able to buy the problem loan out of the CLO and maintain the coverage tests and all valuable cash flow to the junior tranches which CLNC owns.  Unlike other mortgage REITs, CLNC didn't have any securities portfolios liquidated due to margin calls, and given the current support credit markets are receiving, including possibly new supportive legislation, I can see a world where CLNC trades back up closer to current book value in the next 12 months.

Elephant in the room, most of the value in the legacy portfolio is in their "Other Equity & Debt" sleeve, they've slightly improved their disclosures here but its hard to know what's what and the overall value here:
Some of this portfolio seems like nonsense in a REIT, like the partnerships with Sam Zell in oil & gas, and the rest of it sounds risky and heavily levered to commercial real estate quickly recovering from the covid-crisis.  I'm taking a bit of a leap of faith here that management has indeed brought the carrying values down to market.

Moving to the future, Colony explicitly calls out the opportunity to eventually be valued off of an earnings multiple, again, be skeptical!:

*If* Colony can meet these management projections, the stock is a multi-bagger from the mid-$2s.  I don't know the digital infrastructure space well (possibly at all), but obviously part of the trick here is buying assets in the private space below what public market investors are paying for the same assets.  The math works better at lower valuations, but it still could possibly be attractive here as the Colony gets a little added leverage by the management fees.  For example, if they only invest in 20% of the company via their balance sheet (as with DataBank) they get the benefit of their management fees across 100% of the asset, thus bringing down the proforma multiple paid.  It's not clean and what public market investors will pay up for immediately, but makes some logical sense.

Another interesting, potentially irrelevant data point, the stock was around $5 when Ganzi came on, but you can get a sense of what the business plan looked like at the time when looking at his incentive package:
In addition, in connection with entering into the employment agreement, the Company granted Mr. Ganzi a sign-on performance-based equity grant (the “Sign-On Award”) in the amount of 10,000,000 long-term incentive units in CCOC (“LTIP Units”). The LTIP Units will vest if the closing price of shares of the Company’s Class A common stock, par value $0.01 (the “Class A common stock”) is at or above $10.00 during regular trading on the New York Stock Exchange over any 90 consecutive trading days during the five-year period beginning on the Effective Date. The Sign-On Award is generally conditioned on Mr. Ganzi’s continued employment until the performance-based condition is satisfied.
A cool $100MM (not Elon Musk incentives, but still a nice chunk of change!) if he can reach the projections outlined in the investor presentation at current market multiples, which initially seem pretty out there, speculative sure, but the transformation seems possible to me.  That upside is mostly a jockey play, Ganzi isn't super well known outside of the digital infrastructure space, but he can now sort of be viewed as the new founder of "Digital Colony" (likely only a matter of time before the company adopts that name), spent the last 7 years building out DBH/Digital Colony, sure he did cash out partially when Colony bought his firm but part of the consideration was OP units at $5+ share price equivalent, plus you'd assume he's got some reputational capital behind the proforma company.  At the end of the latest quarterly call (transcript from, in a bit of salesmanship and possibly a bit (or a lot) of hubris, Ganzi compared Colony's stock price today with industry leaders like American Tower and how it once traded at $2 as well, AMT now trades at $250+.  A bit crazy, but maybe not?
Well, listen, thank you. It's been an incredible first half of the year. Once again, I want to thank our Board. I want to thank our Chairman, Tom Barrack. I want to thank our team. This is an incredible team we have here at Colony Capital. I think we unveiled some of that to you today. But this doesn't happen without a great team focused on continuing to find the right home for our legacy assets and continuing to grow our business going forward. I think we've made the case today why this is a great moment in time to buy Colony. And I'd ask all of you who've been investing in the sector for 2 decades, who've watched my career, to remember those sort of seminal moments when American Tower and Crown and SBA were all trading sort of sub-$2. Those were really interesting points in time to buy digital infrastructure. Colony today trades slightly under $2. I'd encourage you guys to look at your history books, think about this management team, think about our business model and think about where we're going.
A good question to ask is how else does Marc Ganzi get paid? He gets a few different pieces of revenue like the 10% of the incentive fee allocation, are his equity grants too far out of the money to be meaningful? He's clearly a rich guy with a big monthly budget (big polo player, owns/founded a polo club); lives in Boca Raton and is managing the business from there, town has a bad reputation among investors for businesses headquartered there.  Colony's common stock is a bit speculative from here, but I flipped my preferred stock for the common after the earnings call.  It rhymes with a few other investments over the years that have worked out well, basically a complex grab bag of assets that's moving into an easy understand company in a sector public market investors adore.

Disclosure: I own shares of CLNY