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Given the massive run in NexPoint Residential's (NYSE:NXRT) stock price, some may consider taking their profits. However, the major drivers that have fueled the run in NXRT's stock price remain in place. NXRT's concentrated investments in class B properties are situated in the best markets, and the strong returns generated from their value-add investments are resulting in accretive returns for shareholders. Meanwhile, the premium valuation and high debt levels are justified based on NXRT's superior growth prospects.
A Contrarian Approach to Market Selection
Unlike most multifamily REITs, which have much more fragmented operations with investments across many different markets, NXRT has consolidated its investments across a few core markets. NXRT's top five markets consist of more than 80% of its total apartment units. These five markets include Dallas-Fort Worth (26.4%), Atlanta (16.8%), Nashville (14.2%), Phoenix (14%), and Houston (9%). While one may argue that lack of diversification poses a major risk should its core markets begin to struggle, why this strategy will fuel future growth and superior performance is simple. NXRT is currently invested in the strongest markets in the United States. Compared with national averages, NXRT's core markets are achieving superior employment growth.
As primary markets have become more expensive, millennials and businesses have shifted their living and operating preferences to more affordable cities, resulting in larger rent gains on a percentage basis for secondary and tertiary markets. NXRT will disproportionately benefit from these positive trends, given that the vast majority of their assets are concentrated in secondary markets benefiting from these shifts.
Concentration = Economies of Scale
Consolidation of investment activity also leads to lower operating costs. Diversified operations throughout many different markets result in resources being committed to more regions where the company may hold just one or two properties. Independence Realty Trust (NYSE:IRT), a small-cap competitor of NXRT, has fragmented investments (58 properties) in approximately 20 markets in the southeast and Midwest. Simultaneously, they have had property operating expenses at 40% of their revenue for the past three years. This model contrasts with NXRT's current strategy, in which property operating expenses have been at much lower levels. Since its IPO, NXRT's property operating expenses have continued to decline as a percentage of revenue, decreasing from 29% in 2016 to 24.5% in 2018. Lower operating costs as a percentage of revenue should extend into the future as NXRT continues to concentrate its operations and achieve greater economies of scale.
Workforce Housing Remains Attractive Compared With Class A
NXRT's properties are classified as workforce housing and class B apartments, which I would argue are the most attractive apartment-class investments. Class A investors must compete with new supply and have a limited target market given high rents. On the other hand, rents for class B properties are often too low to make class B apartment development economical, making supply concerns less of an issue. Likewise, class B properties also appeal to middle-upper income families, reducing the affordability concerns posed by class C properties and the economic risk of their tenants. These favorable demographics for class B properties have resulted in much lower vacancy rates and higher rent growth compared with class A. Vacancy rates remain at 5% and rent growth projects to be in the 3% range. Management has acknowledged the attractive rent profile of class B apartments as compared with class A in the markets they are invested in during their Q4 conference call, remarking, "the rent delta between class A and B range in our markets remains historically wide just over 27%." Consequently, should renters desire to move from class B to class A in NXRT's markets, they will be significantly increasing the amount in rent they will be paying each month. Thus, NXRT's properties are largely insulated from class A competition due to the massive rent differential.
Source: Marcus Millichap 2019 Multifamily North American Investment Forecast
Attractive Value-add Initiatives in the Pipeline
NXRT has also engaged in high-return value-add initiatives. After NXRT purchases an apartment, they often redevelop and enhance the quality of their property through improvement of exteriors and common areas, improvement of interiors, and management and cost improvements. These property enhancements will continue to drive NOI growth, as NXRT can raise rents. The value-add initiatives have resulted in ROIs of approximately 25%, as well as a higher-quality tenant base. In the current pipeline, management has identified 1,110 units they plan to upgrade over the course of the next 12 to 18 months. With an average cost to unit renovation of $5,000, and assuming a 22% ROI, NXRT can generate more than $1.2 million in additional NOI from these initiatives alone. While management may purchase a property at cap rate of 5.5%, stabilized returns are likely to be much higher - in the range of 6.25%-6.5% after value-add upgrades - depending on how many units are renovated in the apartment. In boosting NOI, NXRT effectively increases the value of their properties to enable higher sale prices.
As illustrated above, NXRT's value-add strategy of creating value through their redevelopments has allowed for substantial gains on the sale of assets, in concert with their capital recycling.
Prospective Concerns- Elevated Valuation and High Debt
From a valuation standpoint, NXRT is priced at much higher levels as compared with its competitors. NXRT is currently trading at a solid premium compared with the small caps, and at a slight discount compared with the large-cap REITs. The high level of their current P/AFFO certainly reduces the prospects of NXRT being able to generate returns in their stock price that rival those they have achieved since their IPO. Despite this, I would not go so far as to say NXRT is overvalued. In order to come up with a fair valuation, growth must be factored in to illustrate how the company's metrics will compare going forward.
|Multifamily REIT valuation||NXRT||AVB||EQR||MAA||IRT||BRT||BRG||IRET|
Barring any drastic changes in its operations, NXRT should continue to trounce its competitors in terms of growth in AFFO per share. Such will be propelled by their value-add strategy and high growth markets, as they are expected to increase AFFO per share by 14% for the upcoming year.
Looking at growth from another metric compared with competitors, NXRT continues to trump its peers.
|Metric||NXRT||MF Sector Peers|
The chart above particularly illustrates why NXRT's strategy has been so effective. By investing in the top markets throughout the country and implementing their value-add program, they have been able to achieve superior rental rate growth. The concentration of the vast majority of their investments in just four or five markets has resulted in much lower operating expense rate growth as compared with revenue growth. The end result is much higher NOI growth than than their competitors, which is not expected to slow down anytime soon. New acquisitions are expected to be accretive come year two at the latest and achieve NOI growth of 6.5% through 2021. Consequently, NXRT's investments should continue to grow earnings on a per share basis at a solid rate, in contrast with the anemic growth rates of their competitors.
|Multifamily REIT valuation||NXRT||AVB||EQR||MAA||IRT||BRT||BRG||IRET|
*For NXRT, I assumed that EBITDA would be $80 million (20% increase from last year, consistent with projected NOI increase) for the upcoming year, considering they just recently took on more debt without realizing income generated from their new properties. The rest of the REITs were calculated using 2018 numbers
It is logical for NXRT to remain trading at a premium to competitors, despite its high debt burden. NXRT is leveraged to growth in their multifamily markets and has a very low weighted average interest rate of 3.28%. Taking on such high levels of debt is allowing them to fund their superior operations through a low-cost means. As NOI increases, resulting in increased values for their properties, NXRT naturally deleverages through the core strength of their operations. In contrast, NXRT's competitors' slower or anemic growth profiles illustrate that their high levels of leverage will not produce nearly the same levels of returns as NXRT, reinforcing why they are trading at a discount. NXRT's high valuation, despite its debt levels, is not indicative of overvaluation. Rather, it is the consequence of rational decision-making by investors that is justified based on NXRT's potential performance.
NexPoint Residential Trust has been one of the best investments in the stock market since its IPO in 2015. The fundamentals that propelled NXRT's surge remain intact. NXRT remains concentrated in the top secondary markets in the United States. Its investment strategy of locating undercapitalized class B properties, enhancing their value, generating greater income through higher rents, and disposing them for a profit, should continue to drive NOI and AFFO growth. The class B multifamily space contains a major competitive advantage given that it is protected from excessive supply buildup and has significant rent differential from class A assets, and that growing demand is driving historically low vacancy rates. The fundamental and demographic outlook for NXRT remains positive. However, I would argue that the return profile of NXRT is lower than it was a few years ago, considering their valuation is much higher than it was then. Consequently, I believe returns will realistically be more modest going forward. Nevertheless, a bet on NXRT's management's ability to achieve strong returns for shareholders has been, and will likely continue to be, a good one.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.