No Real Excitement for Northstar Realty Europe

The pending Colony Northstar merger (described in prior articles) did not address the future of Northstar Realty Europe (NRE).  NRE claims to be undervalued for reasons similar to Northstar Realty Finance (NRF) (see NRE presentation):

• Share price ($9.86 on 10/27) is well below Net Asset Value independently assessed at $16.64 at 6/30/16.
• Quarterly dividend of $0.15 is well covered by “Cash Available for Distribution” of $0.22 in 1Q16 and 2Q16.

But the poor performance of NRF over the past two years highlights risks shared by NRE:

• Nearly perpetual contract with Northstar Asset Management (NSAM) that cannot be cancelled except for cause (defined as fraud, bad faith, or gross negligence that has a material adverse impact)
• High base management fee plus allocation of additional executive compensation.
• An incentive fee payable when “Cash Available for Distribution” exceeds a hurdle encourages taking higher risk
• The fixed base fee discourages use of capital for accretive share repurchase

NRE compares poorly with benchmarks:

• SEB ImmoInvest 2014 results (LINK).   In 2014 74% of ImmoInvest’s rents were from office property and 40% of its property was located in Germany.  This open-end investment fund has been in liquidation since the 2008-09 crash and sold a large block of property to NRE in early 2015 (Link).  The comparison of NRE against Immoinvest’s 2014 results highlights the difference in expenses incurred from an overlapping pool of assets.
• Dream Global REIT 1H16 results (LINK).  Dream Global (TSX:DRG.UN)(OTC:DUNDF) is an externally managed Toronto listed REIT with a large portfolio of office property in Germany and Austria.  The comparison highlights the difference in expenses from two companies based in North America with similar European investment strategies.

The biggest differences are the details of management expense:

• Northstar pays a base fee of $14mm (approximately 1.4% of equity) plus an additional $14mm allocation of NSAM compensation expense  (an additional 1.4% of equity) plus various transaction fees.   The compensation obligations are described on pages 23-25 of the most recent 10-Q filing.  Note that even though NRE is not a party to the Colony Northstar merger, it will still qualify as a “change of control” allowing immediate vesting of all outstanding NRE-related compensation.
• DREAM pays a base fee of 0.35% of the historical cost of properties plus various transaction related fees
• ImmoInvest pays a base fee of 0.70% of net assets

NRE’s self-defined “Cash Available for Distribution” excludes substantial compensation expense that is initially paid in shares, but ultimately has a real cash impact.  Shares outstanding increased in 1H16 even though the company spent $4.9mm on its buyback program.  The executive payout incurred at NSAM as part of the Colony Northstar merger shows that “non-cash” compensation eventually draws huge value away from shareholders.  Therefore the above table includes equity compensation in G&A expense.

NRE’s low share price is an accurate reflection of its poor return potential due to unreasonably high expenses.  It’s hard to make any argument for investing in the company as a going concern, especially relative to Dream Global.  Liquidation of NRE is not possible under the terms of the NSAM contract.  The lack of third party interest in acquiring NRF suggests there would be a similar lack of potential buyers for NRE.  That leaves a merger with Colony Northstar as the best hope for a positive NRE shareholder return.

The complexity of the management contract between NRF and NSAM was one of the main reasons that the Colony Northstar merger exchange ratios were based on prevailing market prices for the stocks rather than a valuation model.  NRF holders received no transaction premium when their stock was trading at $13.48, only 55% of the company’s most recently reported Net Asset Value.  A future merger with NRE would present a similar challenge and could result in a similar outcome, an exchange ratio based on market prices with no transaction premium.   However each of the Colony Northstar merger parties was undervalued and has since enjoyed appreciation in anticipation of the benefits from the combination.  Those benefits may already be reflected in the Colony Northstar price when it offers to acquire NRE leaving little potential for post-announcement gains. Unfortunately NRE will not really have any viable alternatives except to continue generating weak returns as it does now.