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Northstar Realty Finance Is A Value Trap Worth Avoiding

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NorthStar Asset Management (NASM) is a global asset manager that was formed through a spin-off from NorthStar Realty Finance (NRF). As a sponsor of NASM's  investment non-traded investment programs, the company seeks to leverage its resources, expertise and capabilities to provide retail investors access to alternative asset classes and investment opportunities. Recently NASM announced that it is "exploring strategic alternatives" and to me that's code for putting the company on the block or cashing outFrom the release:

The Board of Directors of NorthStar Asset Management Group announced today that it has engaged Goldman, Sachs & Co. as its financial advisor to assist NorthStar Asset Management in exploring possible strategic alternatives to maximize shareholder value.

David T. Hamamoto, executive chairman commented,

We believe our current share price undervalues the company.  Our Board of Directors and management have always been committed to acting in the best interests of our shareholders and we are aggressively seeking ways to maximize shareholder value.

Keep in mind, NRF has engaged in “value creation” activities since July 2014 when it spun out NSAM, which was followed by the spin off of NorthStar Realty Europe in November 2015. Result of the “value creation” activities:

I am sure many talented bankers helped them with these activities too. The fees paid and the time consumed has only led to underperformance. Do shareholders need more?

The second question is, is NSAM really undervalued?

Let’s take a look at it versus other asset managers, namely Blackstone (BX), Carlyle Group (CG) and Apollo Global (APO). First, on a pure price change basis.

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From this we can see that the price of NSAM has underperformed its peers, but not so significantly that we can’t ascribe the underperformance to the focused nature of its portfolio and the relative size. Given the range of dividends paid on these asset managers, it also helps to look at the “total return price,” or price that factors in all components of return, when assessing the relative performance:

On this basis, again, NSAM has underperformed, but that can be explained by the variables listed earlier and the late start to the dividend. A common multiple used for assessing the relative performance/value of the company is the price to earnings ratio. From this, we see:

NSAM has actually been afforded a higher multiple than its larger (and more established) peers. We can also look at how it trades versus book value:

Again, NSAM is right in the ballpark. As I see it, NSAM has the same woes as the rest of the “alternative asset management” industry and the strategic alternatives is no more than an exit strategy hoping that someone like Apollo will look at them as they did AR Capital.

Benefit of strategic alternatives to NorthStar Realty Finance: Zero.

Price movement in NRF since announcement: -11%

Price movement in NSAM since announcement: -7.5%

As a result of the news, Bill Stoller, a Seeking Alpha contributor,  wrote the following:

It appears to me that the most radical part of my NRF bull thesis, second order change at NSAM, has now begun to play out. A greedy white-knight like Blackstone, offering up a small premium for NSAM shares, could also result in a better outcome for NRF and NRE shareholders. NorthStar Realty Finance shares closed at $14.50 on January 11, and I believe it is time for investors to double down on this opportunity. Based upon a sum of the parts, NRF shares could be worth close to 100% more than the current share price; especially if there is a chance for them to be sold off at a profit "under new management." Blackstone's real estate mantra is "Buy it, Fix it, Sell it," a prescription for change that could be applied to good use with the NRF portfolio, and welcome news for all NorthStar shareholders. In any event, this appears to be positive news and the beginning of a new chapter in the NorthStar saga for investors.

Here is what I see as the flaw in Bill’s logic:

An acquisition of NSAM by another asset manager (or anyone for that matter) would be premised on their ability to generate fees. The only reason to buy the company is to gain a foothold in the business (traded and non-traded funds) or grow your existing business in the traded/non-traded REIT space.

This will only be done if a firm can make money, which is, of course, premised on fee income. The benefit to NorthStar realty Finance of having a new manager does not exist. Would sale warrant a renegotiation of the management agreement? From the management agreement:

Assignment. The Agreement may not be assigned (within the meaning of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) without the consent of the parties hereto.Notwithstanding the foregoing, to the extent either party proposes, or any action is taken by either party that could be deemed an assignment of this Agreement as defined under the Advisers Act (an “Advisers Act Assignment”), both parties agree to consider such assignment in good faith and to not unreasonably withhold, condition or delay such consent. The parties would anticipate that consent would be granted in the event of a proposed Advisers Act Assignment to a party with expertise in commercial real estate and, together with its Affiliates, over $10 billion of assets under management.

As I read it, the contract (management agreement) would be able to be assigned to a buyer of NSAM as long as the buyer manages $10B AUM.  A more lengthy discussion of the assignment topic from the law firm Dechert LLP can be found here. The question then becomes:  Would a “new owner” of NSAM break up or sell off pieces of NRF?  My answer:  Why would they?  They make money from the management agreement, not the share price of NRF.

Activist Investors

On the heels of the NSAM release, Jonathan Litt’s Land and Buildings (activist investor) released the following:

This morning’s announcement that NorthStar Asset Management has hired Goldman Sachs to evaluate strategic alternatives is a step in the right direction. As we have communicated to you and you have communicated to the rest of the Board, we believe the decline in the share price is likely attributable, among other things, to investors’ distaste for externally advised REITs, the substantial compensation to be paid to senior management as well as weakness at NorthStar Realty Finance (NRF).

Wait, are they focused on the right company? Has there been a ticker mix up? Let me explain why I ask these questions. We have to take this one step at a time and disaggregate this paragraph.

…we believe the decline in the share price is likely attributable, among other things,

  1. investors’ distaste for externally advised REITs.  While this may be true, this is applicable more to NRF and NRE than NSAM. In fact, being the external advisor to REITs is responsible for the majority of NSAM’s business, and without it, they have no business.  NRF (and now NRE), however, has suffered due to the fact they have an external advisor. NSAM exists because of this and NRF/NRE suffer because of this. How can L&B/Litt maintain that this is a reason for weakness at NSAM? Think about it for a second: would someone say this is a reason for weakness at Blackstone, Apollo Global or Carlyle?  Their business is being the manager of funds, and that business sector has been weak.
  2. …the substantial compensation to be paid to senior management. While management compensation may be viewed as egregious at NSAM, it is worse at NRF/NRE. NRF and NRE’s management agreement is based on equity, not performance. This means that management will continue to be paid for equity issued regardless of the outcome on the deployment of that capital. A REIT, due to the requirement that it must pay out nearly all of its taxable income, has two means of financing growth–equity and debt. For any growth/acquisitions/, a combination of the two will be used and therefore external management compensation will increase. Simply put, NRF /NRE getting bigger is NSAM getting richer.
  3. …weakness at NorthStar Realty Finance. Weakness at NRF has been caused by 1 and 2 above (as well as complexity and too diverse a range of assets).  This is a circular reference.

Benefit of L&B’s involvement on NorthStar Realty Finance: Zero

My interest in NorthStar: In May 2015, I wrote the following on NorthStar:

NRF is externally managed and the company has engaged Northstar Asset Management Group Inc. (NSAM) to provide asset management and other services pursuant to a long-term management agreement and other ancillary agreements. Last year, NSAM spun-off from NRF.

The compensation payable to NSAM will increase as a result of future issuances of equity securities, even if the issuances are dilutive to existing stockholders. In other words, I view NRF as an "asset aggregator" and not much of a "risk manager." Ask yourself what you are actually getting when you invest in NRF.

For some investors, NRF could be a good stock to own; however, to the less sophisticated investor (like me) there are many moving parts to consider with this security and I just don't see the value proposition - or the "thrill of victory is not worth the agony of defeat."

Given the reasons noted (no circle of competence, no dedicated management team, externally-advised and unproven track record), I'm not going to pursue the tempting yield associated with NRF. I'm not comfortable with the alignment of interests and there are simply too many moving pieces. NRF is a complex REIT and even if I could begin to understand how all of the pieces of the puzzle are put together, there is no way that I could ever "sleep well at night."

What has happened since (my article referenced):

Then, in November, I wrote on the preferred stock of NRF, in which I stated:

While I do not want to be an owner of this REIT, I do believe in looking at other parts of the capital structure when they look attractive. This is due to the fact that I do not believe there is a solvency issue, only a complexity issue that has recently been taking a toll on the company.

Not being comfortable with the equity, I began looking at the preferred shares. The yield on Northstar's preferreds is very attractive relative to property peers (equity REITs) and financial peers (mortgage REITs). Recently, the stock of Northstar Realty has been selling off on equity valuation concerns, which doesn't make complete sense as there is not a solvency/distressed issue. These two factors make the Northstar Series D preferred stock a BUY.

Since that time, the Series D preferred has sold off by 6% while the equity has sold off by 21% (price change). Not quite what I had hoped, but the preferred stock has fared better than the equity.

The Bottom Line: With the continued pressure on NorthStar Realty Finance and the news that its manager is pursuing strategic alternatives and an activist investor is pushing for change, has my opinion changed? No, it has not.

Where is the catalyst that will push shares higher? Strategic alternatives at NSAM won’t, land and buildings being involved at NSAM won’t and the hedge funds pounding the table won’t. I will admit that there are “real assets” backing this REIT, and those assets generate sufficient funds available for distribution (FAD) to maintain the dividend, but there is no catalyst for change.

In my opinion, Northstar Realty Finance is a "value trap."

Value Trap (Investopedia): A stock that appears to be cheap because the stock has been trading at low multiples of earnings, cash flow or book value for an extended time period. Stock traps attract investors who are looking for a bargain because these stocks are inexpensive. The trap springs when investors buy into the company at low prices and the stock never improves. Trading that occurs at low multiples of earnings, cash flow or book value for long periods of time might indicate that the company or the entire sector is in trouble, and that stock prices may not move higher.

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Disclosure: I have no ownership in the REITs mentioned in this article.

Brad Thomas is editor of Forbes Real Estate Investor and writes for Forbes.com and Seeking Alpha. He is also a frequent guest on Fox Business and he is currently writing a book, The Trump Factor, about presidential candidate Donald J. Trump.