NorthStar Realty Finance (NRF) pays a whopping 18% dividend yield, but should the REIT cut it? I’ve argued in previous posts that the stock continues to trade at a ridiculously low valuation – now at about five times cash available for distribution – because investors are tremendously fearful that the company will cut its dividend. But have investors punished the stock so much that a dividend cut is more than priced in? It certainly looks like it, and I think it would be quite stupid for the company to cut its payout. But let’s play devil’s advocate for a moment.
It’s clear that investors think that NorthStar Realty Finance is about to cut its dividend. There’s no way that investors would let a stock trade at an 18% yield if they think it’s sustainable. But that doesn’t mean they’re right. So they’ve discounted the stock to an absurdly low valuation. In this topsy-turvy world, would a dividend cut actually make NorthStar stock go up?
With the possibility of a dividend cut no longer on the table, sentiment around the stock might shift and cause it to move upward. And I don’t mean just over a longer time frame. It’s common for the stocks of companies that cut their dividend to a sustainable rate to actually be higher a year down the road. I suspect that if NorthStar cut its dividend, the stock could actually rally in the short term.
How much of the dividend cut has the market already priced in? If management cut the dividend in half – a very drastic measure – the stock would still be paying out a whopping 9% yield. And that dividend cut would actually set the company up to grow the dividend for years, and even at above average rates. That’s how stupidly the market has discounted the stock. The dividend could be cut in half, and at that new lower payout ratio, there’s absolutely no chance that it won’t get paid, and the stock would still yield 9%. That’s outrageous.
Why a cut won’t happen at NorthStar
I don’t actually think a dividend cut will happen, because it doesn’t solve the key issue that the company’s external management needs to solve. NorthStar Asset Management needs to get the price of NorthStar Realty Finance up in order to issue equity and grow its own fee base. It would prefer to do this while earning the very high incentive fees built into its contract with the REIT. So issuing underpriced, dilutive equity is a nonstarter. Even if cutting the dividend actually moved the stock up a little bit, the stock is so far out of range to make an accretive deal – either on a net asset basis or a cash flow basis – that it would be almost impossible to issue any stock. In fact, it looks like the stock would have to move up to around the net asset value recently provided by management, $29.07, for a deal to even begin to make sense, and even then the REIT would probably have to structure a deal with more leverage.
So here’s where it gets real.
NorthStar management has two major paths it can go down. First, it could follow the path of almost every other externally managed REIT, issue dilutive equity and continue to grow assets under management. That hurts shareholders, makes the dividend cut a certainty, even as NorthStar Asset Management grows its base fees. Of course, it would lose its high-margin incentive fees this way. But that might not matter. This strategy is a typical game plan for external REIT managers, notably RMR, which was ousted recently from one of its management contracts. NorthStar management’s track record of growing value since the company went public in 2004 is substantial, and I’m not inclined to believe, yet, that they’re willing to throw that away. This move could ultimately hurt their dealmaking.
The second path is to aggressively buy back stock, forcing the market to see the value in the stock. At the current price, the company could earn a 19% return on equity free of execution risk. In this post, I explained how the buyback made a lot of financial sense for the company. The buyback, of course, secures the dividend and actually generates substantial cash flow for the company by avoiding the dividend payout on those repurchased shares. And the company has the means to repurchase stock, hundreds of millions in cash and credit. However, it doesn’t look like it’s begun to repurchase stock.
Following this second path, management could force the market to see the value in NorthStar or otherwise continue to collect ridiculously high returns on equity – and higher incentive fees – by just committing to a policy of repurchases.
Investors have to get it through their heads that management won’t issue dilutive equity in order to pad NorthStar Asset Management’s fee income. The surest way to do that is to repurchase stock and, of course, continue to not do dilutive deals. Until we see a buyback of size – that is, an unambiguous commitment by management to creating shareholder value – NorthStar Realty Finance is dead money.
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