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Estimated Returns from NorthStar REIT and NorthStar REIT II in Merger with Colony NorthStar Credit Real Estate

February 22, 2018

Estimated Returns from NorthStar REIT and NorthStar REIT II in Merger with Colony NorthStar Credit Real Estate

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February 22, 2018 | James Sprow | Blue Vault

On January 31, 2018, NorthStar Real Estate Income Trust, Inc. (“NorthStar I”) and NorthStar Real Estate Income II, Inc. (“NorthStar II”) merged with Colony NorthStar Credit Real Estate, Inc. (“CLNC”), with CLNC as the surviving company.

Using the original offering prices, distributions paid and the value of CLNC common stock received in the merger, Blue Vault estimates that early investors in NorthStar I earned an annualized full-cycle return (IRR excluding DRIP and before the estimated $0.73 future payout from a withheld asset) of 4.71%, whereas early investors in NorthStar II received an annualized negative 0.43% as a full-cycle return. Had the stockholders of NorthStar I received the estimated value of withheld assets of $0.73 at the time of the merger, their estimated IRR would increase from 4.71% to 5.71% (for early investors, excluding DRIP).

According to the merger agreement, each share of NorthStar I common stock issued and outstanding immediately prior to the merger was cancelled and converted into the right to receive 0.3532 shares of Class A Common Stock of CLNC, plus cash in lieu of fractional shares (the “NorthStar I Merger Consideration”). By Blue Vault’s definition of a full-cycle event, the stockholders in NorthStar I will not receive full liquidity until their interest in a promissory note that was not part of the merger is liquidated and the proceeds paid out, which may occur as late as three years or more in the future. The estimated per share value of that interest is $0.73, but both the amount and timing of the eventual liquidation are currently uncertain.

Each share of NorthStar II common stock issued and outstanding immediately prior to the merger was cancelled and converted into the right to receive 0.3511 shares of Class A Common Stock of CLNC, plus cash in lieu of any fractional shares (the “NorthStar II Merger Consideration”).

In connection with the merger, Colony NorthStar Credit Real Estate issued approximately 42.1 million shares of Class A Common Stock to former NorthStar I stockholders and approximately 40.4 million shares of Class A Common Stock to former NorthStar II stockholders.

Shares of the Class A Common Stock of CLNC were approved for listing on the New York Stock Exchange (the “NYSE”) and began trading under the symbol “CLNC” on the NYSE effective as of the opening of trading on February 1, 2018. The closing price for CLNC on February 1, 2018 was $20.40. (The highest price that day was $22.00 and the low was $19.75.) As a result, NorthStar I stockholders could sell their shares and receive $7.20 as a merger consideration on February 1, 2018, and NorthStar II stockholders could receive $7.16 on the same date, based on the $20.40 closing price for CLNC, before commissions.

Although, the dollar amount of final consideration (excluding the withheld asset described below) received by the stockholders of NorthStar I and NorthStar II was almost equal, the difference in the rates of return for the stockholders of these two REITs was significant. Blue Vault estimates that early investors in NorthStar I earned an annualized full-cycle return (IRR excluding DRIP and before the estimated $0.73 future payout from the withheld asset) of 4.71%, whereas early investors in NorthStar II received an annualized negative 0.43% as a full-cycle return. There are two main reasons for such a dramatic difference. First, the life cycles of the two REITs differed, during which the REITs paid distributions to the stockholders. Secondly, the amount of quarterly distributions paid differed. NorthStar I stockholders received on average of 8.00% in annual distributions during 29 quarters, based on the $10.00 initial offering price, whereas NorthStar II stockholders received 7.00% in annual distributions during 16 consecutive quarters based on that REIT’s $10.00 offering price.

Blue Vault estimates that investors in the middle quarter of NorthStar I’s offering would have an annualized full-cycle return of 3.71% (excluding DRIP and before the estimated $0.73 future payment from the withheld asset), and investors in the last quarter of the offering would have an annualized IRR of 1.99% (excluding DRIP). For NorthStar II investors, the annualized IRR in the middle quarter of the offering was negative 5.01% and for those investing in the last quarter of the offering, negative 19.21% (excluding DRIP). The large negative return for late investors in NorthStar II was due to the $10.00 price in Q4 2016 and the liquidity value of $7.16 in Q1 2018, representing a significant capital loss, offset to some extent by distributions per share of $0.583 during the assumed holding period.

Using the distribution reinvestment programs offered by both REITs would not increase stockholders’ returns. Calculating IRRs for the early investors based on the assumption that every quarter, when the DRIP was available, stockholders converted their distributions into additional shares (based on the effective DRIP price), NorthStar I stockholders would have a 3.85% IRR and NorthStar II stockholders would have a negative 1.21% IRR. The lower IRRs for DRIP participants is the result of the DRIP prices exceeding the eventual liquidation values.

According to the merger agreement, not all of the assets of NorthStar I were transferred to CLNC in the NorthStar I merger. Specifically, a Promissory Note in the original maximum principal sum of $150,150,000, dated April 11, 2014, was transferred to N1 Hendon Holdings, LLC (“Holdco”), a wholly owned subsidiary of NorthStar I. Following the transfer, CFI Hendon Holdings, LLC purchased from Holdco a $65 million senior participation interest in the Note (the “Senior Participation”) and Holdco retained a junior participation interest in the Note. On January 31, 2018, N1 Liquidating Trust (the “Trust”) was formed pursuant to the merger agreement for the purpose of liquidating the promissory note. NorthStar I subsequently transferred all of its ownership interests in Holdco to the Trust in exchange for 100% of the outstanding units of beneficial interest in the Trust. On January 31, 2018, prior to the NorthStar I merger, NorthStar I distributed to its stockholders, as a special dividend, all of the units, with each share of NorthStar I Common Stock receiving one unit (and holders of fractional shares of NorthStar I Common Stock receiving an equal fractional portion of a unit).

According to the Liquidating Trust Agreement,

“The Trust will terminate upon the earliest of (i) the liquidation and distribution of the net proceeds of all the assets held by the Trust and its subsidiaries and (ii) the expiration of a period of three years from January 31, 2018. Notwithstanding the foregoing, the Trustees may continue the existence of the Trust beyond the three-year term if the Trustees reasonably determine that an extension is necessary to fulfill the purposes of the Trust.”

The NorthStar I retained asset consists of a junior interest in the NorthStar I excluded asset (the promissory note) having an approximately $86.65 million principal balance, or approximately $0.73 attributable to each outstanding share of NorthStar I common stock.

Had the stockholders of NorthStar I received $0.73 at the time of the merger, their IRR would increase from 4.71% to 5.71% (for early investors, excluding DRIP). However, the return to early, middle and late investors can be calculated only on the liquidation of the Trust and distribution of the proceeds to NorthStar I stockholders based on their ownership of Liquidating Trust units.

The latest 10-Qs filed by NorthStar I and NorthStar II were for Q3 2017, ended September 30, 2017. An 8-K filed February 1, 2018, describes the merger transaction and the values of assets involved.

According to the 8-K, NorthStar I had a pro forma equivalent book value per share as of September 30, 2017, of $8.94 and NorthStar II had a pro forma equivalent book value per share of $8.89.

Using the pro forma book values per share, the merger consideration to NorthStar I stockholders was 19.5% below the pro forma book value (before the distributions available from the Liquidating Trust). The merger consideration to NorthStar II stockholders also was 19.5% below the pro forma book value per share reported as of the September 30, 2017 statement. NorthStar I and NorthStar II pro forma equivalent per share data are calculated using the pro forma per share information and applying the share exchange ratios of 0.3532 for NorthStar I common stock and 0.3511 for NorthStar II common stock, and the closing price of CLNC on February 1, 2018.

Colony NorthStar Credit Real Estate now has assets contributed by Colony NorthStar ($1.6 billion), NorthStar I ($1.5 billion) and NorthStar II ($2.0 billion), creating a publicly traded REIT externally managed by Colony NorthStar with total assets of $5.1 billion and an equity value estimated at $3.3 billion. This would rank it as the second largest CRE mortgage REIT in terms of equity value. Since the merger closed on January 31, the closing share price of CLNC has retreated from a high of $20.40 on February 1 to $19.85 on February 21, in line with a similar fall in the S&P 500 index.

 

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Gil Armour, CFP
February 3, 2016

I have been using Blue Vault Partners for the past five years.  I have found them to be a valuable, unbiased resource when it comes to evaluating and comparing non-traded REITs.  The reports help me analyze which sponsors are doing a responsible job of managing their offerings.  This allows me to limit my REIT recommendations to only the most competitive products, and then track those REITs throughout their life cycle.