Description

Disclaimers:  

1.      Any mistakes contained in the narrative are inadvertent ones.  Please do your own research.  The author holds a position in NHF.  This is not an investment recommendation.  This investment carries substantial risks that could result in a 100% loss of principal. 

NexPoint Strategic Opportunities Fund (ticker NHF)

https://www.nexpointgroup.com/nexpoint-strategic-opportunities-fund/

Current stock price:  $11.47

Net asset value:  $19.11

NHF is currently trading at a ~40% discount to NAV ($11.47 per share vs. $19.11).

Ove the past year, while NAV has only declined 9% the stock’s price is down ~35% and the price to NAV discount stands at ~40%!  The 3- year average price to NAV discount is ~21% and the 5-year discount ~17%.  Or said differently, the price to NAV discount is very wide versus those 3- and 5-year averages.

I believe the risk/reward at the current price is very favorable.  I believe that the current valuation of the stock is very attractive and more importantly that there are upcoming catalysts that will unlock value. 

NHF is in the process of converting from a closed-end fund to REIT by end of Q1.  That is the near-term opportunity that should cause the NAV discount to tighten because at that point in time REIT dedicated investors will be able to own the stock.

“The Company is in the process of realigning its portfolio so that it is no longer an “investment company” under the Investment Company Act of 1940 (the “1940 Act”) and continues to expect the Company to be able to transition its investment portfolio sufficient to qualify as a REIT for tax purposes by the first quarter of 2021 and to apply to the Securities and Exchange Commission (the “SEC”) for an order under the 1940 Act declaring that the Company has ceased to be an investment company (the “Deregistration Order”) in the first half of 2021.”

The stock is currently orphaned as there is no natural owner of the stock because it is currently transitioning from a closed-end fun to REIT.

NHF just completed a Dutch tender of $105 mm of stock. 

https://www.nexpointgroup.com/2021/01/05/nexpoint-strategic-opportunities-fund-announces-successful-completion-of-tender-offer-01-05-2021/

Those that tendered their shares at $12 got 20% of the consideration in cash ($12 per share) and 80% in a new 5.5% preferred that traded down immediately from $25 to $22.66. But this tender was very accretive to the equity since NAV is so much higher than the tender offer.  The new preferred also allows them to put in place permanent capital (the preferred is perpetual capital) at 5.5% and create accretive leverage that will accrue to the benefit of the equity if the Company is successful in reducing the price to NAV discount or increasing NAV.

Why does this opportunity exist?  For several reasons and they are as follows:

The dividend was cut in 2020 from 10 cents a share to 5 cents a share in November of 2020 because on August 28, 2020, shareholders approved the Company’s Conversion proposal (from CEF to REIT).  So, from the perspective of shareholders -- who were/are holding the stock for dividend income -- NHF’s current dividend yield of 5% is not all that attractive.

Today, the stock is in a sense orphaned - in the midst of a transition from CEF hands to REIT hands but there are few natural holders – only “special situation” investors of which there are few.

Second, real estate values have been hit hard by the pandemic.  Equity REIT indices are down ~10-15% over the past year and mortgage REIT indices are down ~30%.

https://www.ftserussell.com/products/indices/nareit

Third, as of the end of the third quarter 17.5% was invested in office real estate and 9.6% was invested in hospitality related real estate and those two sectors along with retail real estate have been the hardest hit by the pandemic and there exists substantial uncertainly as to the pace and extent of the price recovery in all three sectors (i.e., whether the decline in value that has occurred is temporary or permanent).

I believe NHF shareholders who have not spent the time to focus specifically on the individual constituents of the portfolio have decided the real estate portfolio has been more adversely impacted than it really has.  Why?  Because NHF shareholders have not looked at the individual components of the portfolio.  Only 29.3% of the portfolio is the more adversely impacted sectors (office, hospitality, and retail and just 2.25% is in retail).  And I believe sentiment on office and hotel is close to its low and that values are likely to recover substantially especially in a market like Dallas with its diverse job base, car dependency and a more conservative corporate business culture that is less likely to see as prevalent work from home adoption than in blue/progressive cities. 

JLL in their 3Q2020 Dallas office report wrote as follows, “Dallas is ahead of many other markets in terms of workers back in the office and has recovered almost 60% of the jobs it lost in March and April.  As a car dependent market with a diverse job base, even though there is still a lot of uncertainty on the horizon there are also rays of optimism.”

https://www.us.jll.com/content/dam/jll-com/documents/pdf/research/q3-2020-office-insights/Dallas-Office-Insight-Q3-2020.pdf

Additionally, I believe what is also under-appreciated is the current strength and strong outlook for NHF’s self-storage, single family rental debt and single-family rental equity, multifamily and life science holdings.  They comprise a substantial majority of the portfolio (~65%) vs. the more adversely impacted office and hospitality and as I wrote earlier, I believe office and hotel values are likely to recover especially in a place like Dallas.

Notably, NexPoint Real Estate finance (the largest position in NHF's portfolio, ticker NREF, 12.8% of the portfolio) stock price has recovered substantially in recent months.  NREF’s largest investments are credit investments in agency K-Series multifamily debt and single-family rental loans.  Both sectors have extremely strong outlooks going forward and the risk of credit impairment to their credit positions is extremely low.

http://s2.q4cdn.com/430275602/files/doc_financials/2020/q3/NREF_Financial-Supplement_3Q2020.pdf

On NREF’s 3Q earnings call and in their 3Q2020 financial supplement, NREF provided guidance for a substantial increase in earnings from 3Q to 4Q with core earnings expected to increase from .42 cents per share to .51 cents per share which would easily cover the current dividend of .40 cents per quarter.  Commensurate with the increase in earnings, I would expect NREF to raise the dividend shortly after 4Q earnings are announced.

At the end of the third quarter the portfolio composition was as follows:

As I wrote earlier, NHF historically traded at a ~15-20% discount to NAV and so the ~40% discount today is notably wide.

NHF Premium/Discount Information as of 1/19/2021:

6 Month -44.21%

1 Year   -39.68%

3 Year   -21.41%

5 Year   -17.10%

Were mean reversion to occur and the stock to trade at the 20% discount it historically has traded at the stock would re-rate from ~$11.40 to ~$15.30 or a ~30% advance from here.

NHF’s strategy going forward (beyond converting to a REIT) is opaque.  All they have really said is they do not intend to compete with other NexPoint entities which would rule out a focus on multifamily (NXRT is the public ticker) and hospitality (NHT is the public ticker) and probably real estate credit investing (NREF’s focus).

Once NHF converts to a REIT absent the Company substantially narrowing the real estate investing focus one should reasonably expect the stock to trade at a discount to net asset value like any conglomerate or like "diversified REITs" like Colony (ticker CLNY) or going back several years before it was liquidated Winthrop Realty Trust.

As such, to avoid the dreaded conglomerate discount, I expect NHF management to substantially narrow the real estate focus by selling off a large position of the portfolio but in a methodical way to avoid a “fire sale.”

Once again, why does this opportunity exist and why is the NAV discount likely to decline but not completely absent narrowing the focus of the Company’s real estate strategy and several strong quarters (post conversion) of financial results?

The discount may also persist because NHF is and well remain externally managed by NexPoint which was NexPoint launched out of an institutional asset management group named Highland Capital Management (https://www.highlandcapital.com).

Highland has been subject to a large amount of litigation from both ex-employees and investors in their funds and candidly the litigation casts the firm in a very unfavorable light.

https://www.institutionalinvestor.com/article/b1l0wrph2lc0j6/Nothing-Can-Stop-This-Hedge-Fund-Soap-Opera

Second, as the external manager of NHF and in the manager of many other investment funds Highland has compiled at best a mediocre performance track record over the history of this REIT and as measured by the performance of its other investment funds.  Highland was notably long land and homebuilding related names prior to the financial crisis and some of its funds were down 50% in 2008 in the aftermath of the financial crisis.

Third, since 2010, the NAV performance of NHF has been very erratic.   Since the financial crisis (and notably before the financial crisis), Highland has typically been positioned aggressively (in other words running a high beta portfolio) with substantial holdings in CCC credit, post plan of reorganization (previously bankrupt) equities and increasing their holdings of various privately held real estate.  As such, there has been a lot of NAV and price volatility in the stock price performance of NHF.

NHF, as a closed-end fund, has few if any CEF comps, and the stock is really neither high yield closed end fund nor equity closed-end fund.  And as noted earlier, the investing performance of NHF since the financial crisis has been mediocre - their real estate picks have in aggregate performed very well (more on this later and the performance of NXRT) but their high yield credit (loan and bond) positions and reorganized equity holdings have performed substantially worse. 

Notwithstanding my concerns about Highland’s past behavior, I think its incentives and those of public shareholders are very closely aligned.  Jim Dondero, Highland’s CEO has a significant position in NHF.  He owns ~10% of the stock and ~4.7 mm shares.  Further, NHF can only grow (by issuing stock at NAV or close to NAV) if the corporate governance of NHF is free of conflict, if they can reduce the NAV discount that the stock currently trades at and if the investment performance of the portfolio post REIT conversion is strong as well.

I place a lot of faith in the fact that the remaining credit and reorg positions are as of now relatively small (CLOs and reorganized equity positions -- Terrestar and MGM studios) and I expect the remaining exposure to be sold in relatively short order consistent with need to do so as a REIT.  Clearly the focus going forward is real estate consistent with the REIT mandate. 

NREF which NHF has as its largest position is a publicly traded mortgage REIT and is positioned well investing in multifamily and single-family rental real estate credit.  The stock is up significantly in recent months and the company guided to 4Q core earnings of .50 a share vs. 3Q earnings of .42 cents per share.  I think the stock which is at $17.30 today is worth $18 to $20 a share based on 9-10x core earnings of $2.00 a share (run rate) and I expect the stock to respond positively once 4Q results are reported.  I am bullish on that name and the stock price outlook.

VineBrook Homes (8.9% position) the single family holding of NHF is clearly in the right sector and the Company had at 3Q end 10.9% exposure to singe family rental equity and 18.5% position in single family rental real estate.  The sector has a very strong outlook that is expected to remain strong for a considerable period of time.

https://www.multihousingnews.com/post/single-family-rentals-an-opportunity-hidden-in-plain-sight/ 

NHF has an ~11% position in the self-storage developer and preferred equity developer Jernigan Capital which was taken private by Highland/NexPoint advisors in August 2020 at an advantageous price.  Jernigan was a hybrid between a self-storage mortgage REIT and self-storage equity REIT - they provided preferred equity to self-storage developers and were developing self-storage themselves.  Regardless, as an asset class, self-storage has been very resilient in the aftermath of the pandemic and since August (the date of the take private announcement) names like Extra Space Storage and CubeSmart (EXR and CUBE) are up 10-20% (and the average mortgage REIT is up even more). 

Most importantly, Brian Mitts and Matt McGraner, the CEO and CIO of both NexPoint Residential Trust (ticker NXRT) and NexPoint Real Estate Finance (ticker NREF), are expected to play the same roles as CEO and CIO of NHF and more importantly guide the direction of the investment portfolio going forward. 

The performance of NXRT since the spinoff from NHF in 2015 is nothing short of remarkable.  The stock is up 286% and the stock has outperformed the RMZ by 256% over that same period. 

http://s2.q4cdn.com/471454804/files/doc_presentations/2020/11/2020-REIT-World-Presentation-vF.pdf

Mitts and McGraner had the insight to identify the shortage of affordable housing and specifically the opportunity to acquire Class B apartments in pro business and quickly growing secondary markets at very high cap rates and at a significantly higher cap rate than Class A assets in primary markets.  They also saw the opportunity to drive additional value in these apartment communities by renovating units at a 15%+ and in many cases 20% plus return on investment.  NXRT was pursuing this strategy as a public apartment REIT while their public REIT apartment peer group was largely focused on developing assets in gateway markets.  At the time and for a long period of time, NHF’s strategy was perceived by naysayers as an ill-advised risky strategy but their contrarian view paid off in a big way.  Since the Company (NXRT I mean) has been public, the Company has been a buyer of the stock at significant NAV discounts and issued shares when the stock was trading above NAV. 

Simply stated, I have a high degree of confidence in Mitts and McGraner to steer the NHF ship in a thoughtful fashion.  That is, I believe they will be successful in substantially narrowing the real estate focus and in doing so substantially reduce the NAV discount over time.  I expect them to institute a stock repurchase program if the NHF trades at a substantial discount to NAV.  I expect them to produce detailed explanations not only of each of the portfolio holdings but each individual positions’ net asset value and the methodology they are using to value each position holding.

In sum, I think there are multiple paths to a higher price from here, and even if all my expectations are not realized I think there are many paths for management to decrease the discount to net asset value that the stock trades at and more importantly to increase net asset value over time.

In closing, I believe NHF has an undemanding valuation and a lot of negative sentiment based on the mistakes of the past that will fade post-REIT conversion and as management clarifies the strategy going forward and narrows the investment focus.

Catalyst

REIT conversion in 1Q 2021.