Description

Business Description

Colony NorthStar (CLNS) is the combined entity that resulted from the Jan ’17 all equity, tri-party merger of equals between NorthStar Financial (NRF), NorthStar Asset Management (NSAM), and Colony Capital (CLNY). The entity redomesticated as a Maryland corporation, elected to be treated as a REIT, and was added to the RMZ index.

CLNS is an internally-managed REIT that benefits from having a larger, more diversified portfolio, broader-based access to multiple sources of capital, lower leverage, and a larger balance sheet. The company has $56 bn of AUM and is targeting a debt-to-capital ratio that it less-than or equal to 50%. The $15 bn of assets that sit on the company's balance sheet are ~80% RE Equity and ~20% RE Debt. Vertical allocations are slanted towards healthcare (28%), hotels (26%), and industrial (7%). CLNS will derive fee income from the $41 bn of third party AUM, including NorthStar Europe, NorthStar’s non-traded REITs, and CLNY’s credit and other vehicles.

The CLNY management team will run the combined entity with NRF / NSAM’s Founder and Executive Chairman (David Hamamoto) remaining as Vice Chairman. Moving forward, CLNS is expected to leverage its balance sheet investments with external capital on which it will receive management fees. This more asset-light model will help enhance ROEs.

The company intends pay $1.08 in regular dividend in 2017 in addition to a $228 mm special dividend to NSAM shareholders as part of the transaction.

Why Does the Opportunity Exist

In mid-'14, NRF shifted to an external management structure when it spun out NSAM. The transaction was underwritten on the thesis that the management platform provided an enormously valuable fee stream that was not being appropriately valued by the market. By externalizing this business, NRF would maximize value for its shareholders.

Skeptics have a more jaded view of the transaction, and believe that it was a means for executives to line their own pockets. Management received hefty compensation packages and structured NSAM’s 20 year iron-clad management contract for NRF so that the fees paid would go up with any capital raise, and would never go down. This created an inherent conflict of interest as NSAM was incented to solely grow assets at NRF vs drive shareholder value.

The market soured badly for externally managed REITs and NRF’s share price went with it (-60%).  Moreover, NRF was highly levered (> 70% debt-to-capitalization) compared to other REITs. This created a challenging situation at NRF as their low stock price made it hard to grow assets, which required new capital. The company needed to de-lever but was unable to do so without selling assets, and would face negative leverage through asset sales due to the management contract that never goes down. The market took a decidedly negative stance towards the NorthStar entities due to management’s previous actions and concerns around governance.

Industry observers have estimated that a sizeable portion (~1/3) of REIT investors will not buy stock in an externally managed REIT because of the conflict of interest. This viewpoint, coupled with high leverage and poor governance drove NRF’s dividend yield (LDDs) higher than comparable companies. NRF began to monetize assets to delever, and both NSAM and NRF began to evaluate strategic alternatives.

While the company has concluded the tri-party merger with Colony, the story is even more complex now as Colony was going through a transformation as well, and has little sell-side coverage. CLNS has yet to report a full quarter on a combined basis and the business model remains under transition as the company pivots from highly levered, externally managed, opportunistic debt and equity purchases to a more traditional equity REIT focused on a small handful of verticals, which outside of Healthcare and Industrials remain to be defined. Until the company completes this transition, the financials and story will likely remain complicated.

Investment Thesis

The merger with CLNY solves a number of issues within the NorthStar complex. First, it internalize the management contract and improves governance, removing two large overhangs on the stock. Continued asset monetizations at NRF, coupled with lower leverage at NSAM and CLNY, will leave CLNS with a stronger balance sheet. The company plans to have a debt-to-capitalization ratio that is less than 50%.

The management team has a significant ownership stake (Tom Barrack owns 5% of the company) and are viewed as being strong operators. As the CLNS story becomes cleaner, it should converge towards REIT comps. Aspirational comps trade at 3% dividend yields. At a 6.5% dividend yield, an investment in CLNS would generate a mid-20s IRR. If the stock traded at a 10% yield in a downside case, the loss incurred would be ~15%. With a ~8% current yield, we are being paid to wait and the company should be able to cover the dividend in the near-term as it continues to monetize assets.  

Catalyst

- CLNS reporting a few clean quarters

- Capital optimization playing through

- Sell-side coverage highlighting valuation disconnect vs. REIT peer group