Should NorthStar Realty Finance Cut Its Dividend?

NRF imageNorthStar 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.

The endgame

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.

For all of our coverage on NorthStar, click here.

5 thoughts on “Should NorthStar Realty Finance Cut Its Dividend?

  1. Let us hope they didn’t buy back too much stock. The more they wait, the cheaper the stock gets. The big question is whether the asset sales they have planned will execute at a reasonable price. The probability of a “yes” is looking more remote as buyers don’t want to get stuck with property about to get hit by a recession. The worst case scenario is they buy a boatload of shares that drop like a rock because they are stuck with property that drops in price. Due to a debt to asset ratio of 70%, all it would take for NAV to go to zero is a 30% drop in asset values. The last recession dropped CRE values down 37%. They should have sold last year instead of buying more property. Sam Zell selling apartments to Blackstone is looking more and more prescient.

    1. I really don’t see a recession on the horizon, and neither do some of the sharpest economists out there. It’s just not in the cards yet, as unemployment continues to go down, government payrolls go up, and housing investment rises. The private market is still much hotter than the public market right now as well, as battered hedge funds run away and hide.

      1. That there will not be a recession is the consensus now, so it should be a good time to sell. However, the consensus is changing, rapidly. Atlanta GDPnow for 4th quarter shows economy stalling. Once the consensus changes completely, the damage to asset prices has been done. My point is that the company cannot afford to be patient in selling because it appears quite vulnerable to a decline in asset prices.

        1. I take your point and am waiting for them to announce a deal, because the pricing on the company today would make buybacks quite favorable. I’d rather see them do this sooner rather than later. But is the consensus really not recession? How else do you explain the first two weeks of the year, among the worst ever for the market? Is it more than just hedgies bailing after a poor year (i.e. redemptions and leverage)? It really seems like the market is pricing in some significant possibility of a recession.

          1. The consensus is that stock prices were too high and are now adjusting for a slow growth environment. When the market fully prices in a recession is when a mere flush becomes Niagara Falls and the little boat at the bottom is the last place for a tourist from Peoria.

Leave a Reply