Colony Northstar Credit: Underowned & Undervalued

• Recently launched Commercial Mortgage REIT should reach earnings potential of $0.54/quarter by year-end
• Low institutional ownership will rise as the REIT gets new analyst coverage and is added to indices/ETFs
• Undervalued at a discount of 20% to NAV compared to average premium of 18% for large cap peers (Starwood, Blackstone, Apollo)
• Potential total return over 40% by year-end

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 (CLNS).   Additional details of the transaction are described in the 2/1 press release and merger proxy.  So far the company has not stimulated enough buying interest to meet the pent up selling pressure from investors who held the previously non-tradable Northstar REITs.  No new shares were offered at the time of listing so no underwriter promoted the company to investors and only one analyst (from Raymond James) has begun research coverage.

1Q18 Core earnings of $0.44/share (press release, supplemental presentation, conference call) demonstrated that the company is already earning its $0.145/share monthly dividend and is in the process of deploying its excess liquidity in transactions that will raise earnings to their full potential.  By year-end the company should reach a valuation in line with peers Starwood (STWD) Apollo (ARI) and Blackstone (BXMT).

PEER VALUATION COMPARISON

 

PEER PORTFOLIO COMPOSITION COMPARISON

The commercial real estate credit market is extremely large and competitive.  Higher yield typically compensates for risks from assets under development or in transition.  REIT portfolios vary substantially:

Asset-level risks are balanced by varying levels of leverage:

Apollo has a strategy of higher risk loans and low portfolio leverage.  Blackstone has a strategy of low risk loans and high portfolio leverage.  Starwood has a diverse portfolio including asset-light origination and servicing activities.  Colony will pursue a flexible strategy of allocating between senior debt, junior debt, and owned real estate depending on where it can achieve the highest return while recycling capital away from other assets like private equity that were held by the Northstar REITs.  On its 1Q18 conference call CLNC suggested that debt/equity could reach 1.0 by year-end which implies acquiring about $1.5Bn of assets during 2018 with a bias towards higher risk junior/preferred securities.  The call mentioned that the company has added $525mm of assets through May 10, has a pipeline of $1.4Bn assets in the term-sheet phase, and $9Bn of potential investments under review.

PEER INCOME & EXPENSE COMPARISON

 

Colony’s 1Q results demonstrated it is well-positioned for success, but the company is not yet at a normal steady state of operations:

• Income Statement includes 3 months of activity from assets contributed by CLNS and two months of the Northstar REITs after the merger became effective on 1/31
• Base management fee covers only the two post-merger months
• G&A expense was far below the combined 2017 level of the predecessor entities reported in the pro-forma financial statements.  If CLNC continues to show significant savings in this area then it could contribute to a superior bottom line.  For comparison Colony Financial reported $11.4mm of Administrative Expense for the full year 2014 on $2.9Bn of equity.
• Normalized Operating Income equal to 9% of equity would equal $2.14/share or $0.54/quarter.  This calculation is probably more conservative than the company’s presentation of “Core Earnings” which excludes equity compensation.

Other observations from the table:

• Apollo does not charge an incentive fee, but its base fee is also applied to preferred equity
• The different asset mixes and leverage of ARI and BXMT led to almost the same portfolio return
• Starwood’s diverse business produces the highest portfolio income, but also incurs the highest overhead
• If CLNC can expand its balance sheet as planned and raises returns to a level comparable with ARI and BXMT then it will achieve comparable profitability

PEER INVESTOR BASE COMPARISON

Colony issued 83mm Class A common shares to the holders of the Northstar REITs and retained 44mm Class B shares in exchange for its contributed assets.  Institutional ownership of the CLNC Class A shares is well below the level of peers:

Significant new demand for CLNC shares should emerge as the stock is added to indices and ETF portfolios.  Active asset managers are likely to raise holdings as analysts initiate coverage.  In addition to Raymond James analyst Stephen Laws who published a $22 target in March, Steve Delaney (JMP Securities), Ben Zucker (BTIG), Jade Rahmani (KBW), Randy Binner (B.Riley), Doug Harter (Credit Suisse), and [Julian in for] Jason Arnold (RBC) all participated in the recent earnings conference call.

While institutional demand for CLNC has not yet developed, former Northstar REIT investors have been disappointed by the apparent loss in value of their investment and some have been dumping the CLNC shares they received.  Prior to the merger the Northstar REITs appeared in account statements at their estimated book value, but now the CLNC shares appear at a much lower market value.

Each share of NREI2 valued at $9.10 one year ago has been exchanged for CLNC shares with a current market value of $6.69.  It looks like a disaster and it’s no wonder that investors are confused and upset.  A portion of the decline is attributable to a decrease in the value of the assets held by the Northstar REITs between the last valuation date and the merger.  A larger portion is a result of the discount to book value at which the CLNC shares are currently trading.  This article offers reasons for optimism that the discount will disappear, but CLNC has not clearly made the same argument.

INVESTMENT CONSIDERATIONS

Stabilization of CLNC’s portfolio should lead to returns and valuation in line with peers.  Possible sources of outperformance:

• CLNC’s flexible strategy might generate higher rates of portfolio income than the 11.7% earned by BXMT and 11.9% earned by ARI
• CLNC may maintain better than expected control over overhead expense (including stock based compensation)

Possible sources of underperformance:

• CLNC’s flexible strategy might flex in the wrong direction and underperform peers
• CLNC returns could be depressed by worse than expected returns from “non-core” assets such as private equity interests.

It’s possible that valuations for the entire sector could decline due to changes in interest rates, property markets, and the economy.  Peers could move to CLNC’s valuation rather than the other way around.

Dividends transfer value rather than creating value so the article focuses on assets and income rather than yield.  Managements exercise some discretion in opting to distribute dividends in excess of the minimum REIT distribution requirement so investors should be cautious in comparing dividend yield from one company to another.  If CLNC’s income rises as expected then the company is likely to increase its dividend rate later this year.

CLNS has characterized CLNC as a “Core Business” that it expects to grow over time.  In addition to potential  appreciation of its 44.4mm Class B shares and 3.1mm OP Units, CLNS would also benefit from CLNC earnings in excess of the threshold for its incentive fee, and increased base management fees that would be paid if the company can raise capital through accretive issuance of new shares above book value.

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 and other sources prior to making their own investment decisions.