Recent market uncertainty in REITs affords income-seeking investors willing to tolerate above-average risk the opportunity to buy quality at depressed prices with attractive investment yields.
The 10Q Detective believes that an argument can be made for the purchase of shares in NorthStar Realty Finance (NRF-$8.51), a specialty finance company comprised of a seasoned executive team of real estate executives that internally manage commercial real estate projects, with a focus primarily on originating and acquiring real estate debt, real estate securities, and net lease (corporate and health-care-related) properties.
“Groupthink [is] mode of thinking that people engage in when they are deeply involved in a cohesive in-group, when the members' strivings for unanimity override their motivation to realistically appraise alternative courses of action.” ~ Yale University Psychologist Irving L. Janis (1918 – 1990)
Shares have sold off 48.9% from their 52-week high (of $18.15 a share on February 7, 2007). In our view, the stock is oversold—groupthink—as investor sentiment has failed to differentiate specialty finance companies—like NorthStar—that offer more sustainable business models and generally employ less leverage than other commercial mortgage REITs.
Even as U.S. commercial real estate values continue to soften, NorthStar’s credit portfolio qualities remain strong. As of November 2007, NorthStar experienced no delinquencies or non-performing assets.
NorthStar's real estate securities third quarter investments had a weighted average credit rating of A+/A1.
Management’s competitive advantage has been its focus on a diversified $7.5 billion commercial asset base, avoiding direct exposure to single family housing or subprime residential lending. As such, NorthStar has dodged the fixed income/equity market volatility and asset impairment charges plaguing many of its REIT peers.
NorthStar’s above-average dividend yield of 16.8% reflects the re-pricing of owning a REIT (or any security invested in debt and equity securities). Albeit we believe the uncertainty regarding loss rates is fully priced in NorthStar’s current valuation, investors ought to be cognizant that the dividend could come under pressure if operating earnings fall because of (i) a softening in commercial real-estate activity/values, (ii) slower loan originations in the current capital constrained mentality, and (iii) increases in cost of funds (due to lenders tightening their credit standards)—offset, in our view, from lessening competition for new investments (due to the insolvency of more-levered companies).
Adjusted funds from operations in FY ’08 (of $1.69 a share) are forecasted to be more than adequate to cover payout demands of $1.44 per share.
The race of man, while sheep in credulity, are wolves for conformity. ~ Academic Carl Clinton Van Doren (1885 – 1950)
NorthStar is selling for only 0.87 times adjusted book value of $9.75 a share, a 33.1% discount to other similarly focused specialty finance REITs.
While continued credit disruptions and future investment banking (and home-builder) asset impairment charges will delay a rebound in REIT valuations, we believe new investors to NorthStar are offered a current dividend payout commensurate with the requisite risk/time premium to wait out this cyclical downturn.
When investors—and the Fed—gain better visibility on a stronger outlook for the credit markets and the U.S. economy, we believe NorthStar shareholders could be rewarded with a price-to-book value multiple expansion to 1.5 times, or about $15.00 per share.
Editor David J. Phillips owns shares in NorthStar Realty Finance. The 10Q Detective has a Full Disclosure Policy.