NexPoint Strategic Opportunities: Exchange Offer

Back in August, I wrote up a quick post on NexPoint Strategic Opportunities ("NHF"), it is a closed end fund that is transitioning into a REIT over the next 18-24 months (they'll technically be a REIT in 2021, but won't fully transition the assets until later, quite a bit of wood to chop here before its a clean story).  To summarize the thesis, NHF is trading at 57% of NAV and they'll be selling much of those assets presumably somewhere near NAV to invest opportunistically in real estate -- there should be no shortage of attractive opportunities coming out of the pandemic -- add in some leverage and it could have quite the multiplier effect (see what the same team has done with NXRT).  And to get the negatives out of the way, NHF hasn't articulated a clear strategy at this point other than saying it will be a diversified REIT and there's the potential for double dipping on fees, much of what NHF owns today are investments that were at one time or are now managed by NexPoint/Highland, it has sort of acted as a dumping ground for them.

The stock's reaction to the conversion news has been muted and it hasn't rallied much recently in comparison to the market or other real estate assets.  The company came out with an exchange offer structured as a Dutch tender that expires 12/10, shareholders can exchange common shares for a combination of 80% in a newly created preferred stock and 20% in cash, the range is set at $10-12 and the stock currently trades at $9.50.  The $10-12 number is highly dependent on the value the market prescribes to the newly issued preferred shares, the company is trying for a 5.5% dividend rate on the prefs, that feels a bit aggressive, but more on that later.

I love the idea of the exchange, the maximum amount is $150MM on a $433MM market cap company, the exchange will essentially force a portion of the shares to be valued at NAV accruing that closed discount value to the remaining shareholders.  It also further tightens the spring when they do fully transition to a REIT, this is already going to be a levered vehicle.  But again, the 5.5% dividend yield feels a bit aggressive on the preferred shares, so thinking through the possibilities of where the preferred could trade after the exchange, I came up with a little table:

The x-axis is where the Dutch tender prices at and the y-axis is where you think the preferred shares should trade on a yield basis incorporating the 20% cash component.

I've also played around with different scenarios based on how many shares are actually tendered and what it would do to the NAV ($16.70/share as of the latest proxy) of the remaining shares, just based on the share price and my uneducated view, seems like the market is skeptical of the exchange.  The minimum amount is $75MM.

Then my last table is using the NAV in the table above, what the price/NAV ratio would be (using a $9.50 share price, or a 57% starting point):

I've spent a lot of time in the last few months on the commercial mREITs (maybe more posts to come), most of them have preferred shares that have yields well above the targeted 5.5% NHF management is shooting for and that might be skewing my view of where the prefs will trade following the conversion.  NHF is likely to be focused on either self storage or single family homes, maybe both, equity REIT preferreds in those sectors do trade below 6%.  I took a look at the holdings of PFFR, a REIT preferred index fund, and here are the names that trade sub-6.0%, some of these didn't surprise me as they're seasoned and/or loved REITs, but others were a bit surprising.  

For example, Office Properties Income Trust's (OPI) 5.875% pref trades just above par, this is an externally managed REIT of RMR Group (RMR) that has a history of abusing minority shareholders and is in the office sector.  Is 5.5% too aggressive?  Possibly, but not by that much in a zero interest rate world.

I've added to my NHF position.  I'm currently thinking about the exchange like this: I'm planning on tendering a portion of my shares somewhere in the middle of the range (could change as we get closer to the expiration date), but still leaving behind a relatively full position.  If there is enough interest where I don't get filled on the tender and it goes closer to the lower-end of the range, common shareholders should benefit as the NAV increases even more and they've obtained cheap financing.  If I get filled, I still feel comfortable that the trading price of the prefs following the conversion should result in a good short term IRR.  Either way feels like a win to me.  NHF could also bump up the yield on the preferred shares if there isn't enough investor interest (they got a rating agency to put a BBB- rating on the prefs, presumably to head off investor skepticism on the proposed dividend yield), even paying 0.5-1.0% more in yield to entice shareholders to exchange would be very accretive to the remaining common.

Disclosure: I own shares of NHF

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