NexPoint Residential Trust, Inc.

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

NexPoint Residential Trust, Inc. (NXRT) is a real estate investment trust (REIT) that primarily focuses on acquiring, owning, and operating stabilized multifamily properties, mainly in the Southeastern and Southwestern United States, with a focus on lower middle income housing.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

NXRT operates in the multifamily real estate sector, primarily targeting lower middle-income housing with a focus on properties in the Southern and Southwestern United States, a segment of the real estate market that might offer less volatility due to consistent demand.

Revenue Distribution:

NXRT’s revenue is primarily driven by rental income from its multifamily properties. The company seeks to acquire and enhance existing properties rather than engage in new construction. This involves acquiring properties that are already generating revenue and aiming to improve their performance through management practices and capital investment.

The multifamily housing sector, especially the segment targeting lower-to-middle-income renters, is influenced by several factors, including:

  • Demographic Shifts: A growing population and migration patterns can lead to increased demand for rental units.
  • Economic Conditions: Interest rates, inflation, and employment trends can affect both rental demand and property values.
  • Housing Affordability: As housing affordability declines, more people tend to seek rental properties, increasing demand for multifamily units.
Margins:

NXRT has struggled to maintain good profitability margins. Operating margins are quite volatile. Moreover, the net operating income is frequently impacted by large asset write-offs and other non-recurring expenses. This volatility also makes their cash flow projections less reliable.

Competitive Landscape:

The multifamily housing industry is competitive, with many players ranging from individual investors to large institutional funds. NXRT’s competitive advantage relies on its ability to:

  • Identify and acquire undervalued properties: that are undervalued due to their operation or market perception.

  • Improve asset performance through operations and value-add activities: like light capital improvements or better management.

However, the company faces competition from other firms that also focus on value-add activities.

What Makes NXRT Different?

NXRT differentiates itself through:

  • A focus on Southeastern and Southwestern markets: where it claims the growth potential is the greatest and value-add opportunities are present.
  • A focus on lower to middle-income housing: which is perceived as having lower volatility than higher priced units.
  • A value-add approach: where properties are acquired and have their operations improved to create a better ROI.

Financial Analysis

NXRT’s financials show a company in a transition phase, with strong growth that often come with great investments, but are also associated with big swings in the net results, making it risky for investors. The main themes from the financials:

  • Strong revenue growth: Both rental revenues and total revenues continue to rise steadily YoY, showing good growth at a basic level.
  • High volatility in operating margins: despite revenue growth, operating margins have seen huge increases and equally large drops YoY, making long term profits hard to predict.
  • Inconsistent net income: While revenue shows positive trajectory, reported net income has been inconsistent and even in heavy losses due to property write downs and costs of acquisitions.
  • Dependence on debt: The company relies heavily on leverage to finance its operations, increasing risk.
  • Decreasing FFO: Despite improvement in revenue and operations, Funds from Operations (FFO) are on a downward path.

Moat Assessment: 2 / 5

  • Moat Source: Economic moat is the sustainable advantages that protect a company against competition. At this time, the company doesn’t have any durable economic advantages.

  • Moat Rating: 2 / 5. Although NXRT’s value-add approach and a focus on certain geographical regions can create some unique positioning, the lack of a strong, defensible competitive moat makes it challenging to rate it higher.
  • Justification:

    • Weak Switching Costs: The main weakness of residential real estate is the lack of customer switching costs. It’s easy for customers to switch between apartments or move out.

    • Lack of Intangibles: Brands and trademarks, which give pricing power and customer stickiness are not applicable in the traditional real estate industry.

  • No Network Effect: The value of a property doesn’t increase as more people live or rent in other properties, so there is no network effect to make it defensible.
  • Limited Cost Advantages: While cost advantages like location or scale are present in this type of real estate business, the company has yet to show if these cost advantages are significant enough to create a sustainable advantage.

Risks to the Moat and Business Resilience

The sustainability of NXRT’s business is subject to several risks:

  • Economic Downturns: An economic downturn could lead to decreased occupancy rates and diminished rental revenue. In the recent 10Q it was mentioned that “uncertain economic conditions, increases in real estate taxes, insurance costs, and other inflationary pressures in operating costs, could have a material adverse effect on the Company”.

  • Market Competition: Increased competition from other REITs or private property investors could decrease market share and margins.
  • Interest Rate Sensitivity: Higher interest rates may lower the rate of return and also diminish property values.
  • Tenant Credit Risk: Tenants might default on their rent payments, decreasing cash flow.
  • Property and Liability Risks: Property can be damaged and the insurance for those things are also exposed to price volatility. This was explicitly mentioned in the company 10Q, as such “A decrease in the available levels of, or increases in the costs of, comprehensive insurance coverage may materially increase our operating expenses and negatively affect our business, financial condition and results of operations.”
  • Debt and Credit Agreements: The company relies heavily on debt to finance acquisitions and has been doing so at a variable interest rate, making its profit very sensitive to the current economic changes. Changes in the agreements with lenders may also greatly impact the way the business is operated, resulting in a major impact to the profitability.

Understandability Rating: 3 / 5

The core business model of NXRT as a real estate investment trust is not particularly hard to comprehend, the challenges and opportunities they face are common across the industry, but the level of detail that needs to be analyzed and taken into account to accurately predict or model its behavior makes understanding it slightly difficult.

  • Simple Concept: Investing in and managing real estate is a straightforward concept.
  • Complex Valuation: Valuing real estate assets can be complex because of the wide variety of factors influencing them. Additionally, it can be difficult to ascertain the quality of the portfolio and the management.
  • Accounting complexities: The usage of GAAP requires a fair bit of knowledge to properly understand, especially due to a significant number of non-operating items that impact the metrics.

Balance Sheet Health: 3 / 5

NXRT’s balance sheet has its strengths and some potential issues that are worth taking into consideration.

  • Strengths:
    • Growing Asset base: Their investments in real estate have grown a lot over the past years, which in turn has given a higher value.
  • Weaknesses:

  • High Reliance on Debt: The company relies heavily on borrowings to fund its activities and expansion. The 10Q highlighted this: “As of September 30, 2023 and 2022, we had $27.6 million and $164.6 million, respectively, available under the Company’s Revolving Credit Facility”.

  • Large amounts of goodwill: The companies acquisitions have led to large amounts of goodwill and acquired intangibles, further complicating the balance sheet.
  • Uncertain valuation of financial assets: The company has a significant amount of complex financial assets, whose valuation is based on projections of the market, increasing the uncertainty in balance sheet and net income projections.

Recent Concerns and Management’s Response

The most glaring issue with NXRT is related to the significant increase in borrowing costs that are affecting their financial performance. The management has stated: “To mitigate some of the effects of higher interest rates, the Company has pursued strategies such as limiting its capital expenditures and seeking out attractive financing terms.” While they are trying to mitigate the issues, it’s clear that the management has put its profitability at a major risk. They mentioned in earnings calls that they are taking proactive measures to try and reduce risk. However, these methods of limiting expenses are not always effective. Another theme in management communications is a need to reduce debt, which signals that the management understands that their high leverage is a problem. Overall, management is trying to stay positive, even though their numbers seem to signal that the company might have some troubles in the future.

Conclusion

NXRT presents a unique case in the real estate market, with a focus on lower middle-income housing and a value-add approach. While the business itself is relatively straightforward, the lack of a durable moat and reliance on acquisitions and debt make it riskier for investors. Though there is good growth and management seems to address the main issues, potential investors need to look closer into the finer details of the business before investing.