Colony Northstar Credit Real Estate Might Not Be A Disaster

Several things could go right for Colony Northstar Credit Real Estate (CLNC) in coming months:

• Release of year-end results and conference call will provide an opportunity for the company to introduce itself to investors.
• $300mm share repurchase plan can begin after results are out.  At a price of $20/share, the plan could acquire over 18% of the CLNC shares issued to former investors in the Northstar REITs.
• New investments should be able to raise future earnings from 2017 FFO of $1.38/share to a run rate over $2/share by the end of 2018
• Improved understanding of the company’s potential could raise the share price close to book value of $24.58
• CLNC’s manager, Colony Northstar (CLNS), is highly motivated to make CLNC successful.

Note that this article was written based on disclosures in the S-4 merger filing with late adjustments for the 10-k filed on 3/26.

Background

Colony Northstar Credit Real Estate (CLNC) began trading on 2/1 following the merger of two private REITs (Northstar Real Estate Income 1 & 2) and a portfolio of assets contributed by Colony Northstar.   Additional details of the transaction are described in the 2/1 press release, January Investor Presentation, and merger proxy.

So far the company has not stimulated enough buying interest to meet the pent up selling pressure from investors who had been trapped in the non-traded Northstar REITs.  No new shares were offered at the time of listing so no underwriter promoted the company to investors and no analysts have yet begun research coverage.  The company approved a $300mm share repurchase plan, but it could not begin until 2017 year-end results were released.

CLNC’s press release disclosed that book value was approximately $25/share “based on the Company’s unaudited pro forma condensed combined balance sheet as of September 30, 2017, and reflecting pro forma transaction adjustments, including the impact of fair value, consolidation and various closing adjustments.”  It appears that proforma book value disclosed in the 10K was slightly lower at 12/31/17:

Some of the appealing aspects of investment in commercial real estate credit are:

• Mortgages generally cannot be prepaid so cash flow is more predictable and less sensitive to interest rates than residential mortgage credit.
• Lending is secured by physical assets.
• REITs such as CLNC have a competitive advantage in real estate lending relative to more highly regulated taxable banks.

Portfolio

CLNC will invest in a variety of income generating assets.  Lower risk holdings of property and senior securities can be leveraged 1-3X to reach targeted return levels.  Higher risk junior securities already have structural leverage so they are unlikely to be further leveraged by CLNC (table source: CLNC January presentation)

CLNC’s current portfolio (like its manager CLNS) is more complex than its targeted asset allocation.  The company’s current leverage (debt of $1.7Bn) is below the levels implied by the company’s targeted returns.

As a result of the underleveraged balance sheet, current earnings are below targeted levels, but a strong pipeline of new potential assets should expand the balance sheet and raise returns. The pipeline of investments under evaluation suggests a preference for simpler assets with no new CMBS or Private Equity (chart source: CLNC January presentation).

If CLNC successfully optimizes use of its capital through additional leverage and achieves the targeted portfolio return of 11-13% then potential annual earnings and dividends would rise to at least 2$/share:

CLNC just reported 2017 results on 3/26 including a pro-forma income statement and balance sheet filed as an exhibit.  It appears that the underleveraged balance sheet is generating FFO at a run rate of $1.38/share and that expenses are running at 2.5% of equity.  It appears that acquisition of new assets should be able to raise the FFO run rate over $2/share by year-end.  A dividend increase is very likely.

 

Peer Comparison

CLNC is the second largest Commercial Mortgage REIT and stands out for the large discount of share price to Book Value.

CLNC’s management contract terms are typical

Briefly looking at the large cap peers:

• Starwood (link to investor presentation) is the most complex business with a wide range of asset types plus a large origination and servicing business.  The company earns the sector’s highest return on equity.
• Blackstone (link to investor presentation) has a portfolio of low risk senior loans with an average yield of 5.95% at 12/31/17.  Returns are enhanced by a high leverage ratio (Assets/Equity = 3.5 at 12/31/17).
• Apollo (link to investor presentation) has a portfolio of higher risk loans with an average yield of 9.1% at 12/31/17.  Returns are enhanced by modest leverage (Assets/Equity = 2.0 at 12/31/17).

For comparison, CLNC’s 12/31/17 loan portfolio had an average yield of 8.5%.  There’s been no indication of whether the company will seek new assets comparable in risk and yield to the current portfolio.

 

Importance of CLNC to CLNS

CLNS has struggled to digest the acquisition of Northstar Real Estate Finance and Northstar Asset Management.  Successful development of CLNC would bring many benefits to the manager:

• Appreciation in the market value of the 47.4mm CLNC shares held by CLNS
• Transparency into the value of the “Opportunistic Equity and Debt” assets contributed to CLNC would make it easier for investors to analyze the value of CLNS itself.
• Management fees paid by CLNC to CLNS could grow over time through accretive issuance of shares in secondary offerings and acquisitions
• A favorable outcome for the investors in Northstar Real Estate 1 & 2 would enhance the reputation of CLNS as a responsible manager of non-traded investment companies and improve future sales.

All these benefits depend on raising the CLNC share price so the interests of the manager appeared to be well aligned with CLNC investors.

Risks

If CLNC can expand its balance sheet to achieve targeted return levels and trade in line with peers at a modest premium to book value then shares could appreciate to $25-27.50 by the end of this year and provide a total return over 40%.  Some of the significant risks to this potential are:

• More time may be needed to acquire enough new investments to raise return on equity.
• Legacy investments may perform poorly resulting in additional writedowns that decrease book value
• Financial reporting may be complex and confusing.  The merger closed in January 2018 so the reporting of 2017 year-end results was only on a pro-forma basis.  1Q18 results may not reflect a complete quarter of combined operations so investors may not see a clean set of financial statements from the combined company until 2Q18 results are reported in August.
• CLNC management may not articulate any clear strategy for managing the company and delivering value to shareholders.  Investors want to know “Where’s The Beef”, but CLNC’s January presentation was like a buffet of cafeteria mystery meat.  Page 25 shows that the 34 steps involved in the “Investment Management Process” include “Market Data” “Negotiation” and “IT Systems”.  If the numbers were great then investors would overlook this blather, but the weak share price focuses attention on the lack of substance.  More detailed facts are needed to build investor confidence.

Disclosures

The author is a shareholder of CLNC CLNS and LADR.  The author does not make any recommendation regarding any investment in any company mentioned in this article.  Investors are encouraged to check all of the key facts cited here from SEC filings prior to making their own investment decisions.

If any company mentioned in this article can point out any factual errors in the text using public information as of 03/26/18 then corrections will be made as promptly as possible.

Note that this article was written with late adjustments for the 10-k filed on 3/26.  Errors discovered by the author may be corrected at any time to avoid spreading misinformation.