On May 4, Front Yard Residential Corp. (RESI, Financial) announced the termination of the pending acquisition by Amherst Holdings. The deal was announced on Feb. 18 at $12.50 per share, valuing the equity of the company at roughly $675 million.
In connection with the termination of the merger agreement, Amherst has agreed to pay a $25 million fee to Front Yard, purchase 4.4 million shares in a primary issuance at $12.50 per share for an aggregate purchase price of $55 million and provide a $20 million committed two-year unsecured loan facility to Front Yard.
Front Yard Residential Corp is an REIT that focuses in the acquisition and ownership of residential rental properties. As of the writing of this article, it has 14,500 houses, mostly in the southern sun-belt states. Below is a list of locations of its properties.
Most of the single-family rentals exist in the sun-belt states. Below are the properties owned by its two public peers American Homes 4 Rent (AMH, Financial) and Invitation Homes (INVH, Financial).
There is significant overlap with locations. Therefore, an acquisition from one of these companies would reduce operational costs, creating synergy.
There has been plenty of scenarios like this in the past in the REIT sector. American Homes 4 Rent acquired American Residential Properties in 2016, after which it guided for the elimination of 80% of ARP’s general and administrative (G&A) expenses.
Invitation Homes acquired Starwood Waypoint Homes in 2017 and guided for $45 million to $50 million of total synergies compared to combined revenue of $1.5 billion.
The same logic should apply to Front Yard. As shown in the table below, there are three areas where Front Yard can improve its funds from operating margin:
- Net operating income margin of 57% (which is 5% lower than competitors)
- G&A, which is 12% of revenue (compare 4% for competitors)
- Management Fees paid to Altisource Asset Management (AAMC)
NOI margin
In 2019, Front Yard’s NOI margin was about 57%. In their Q1 2019 presentation, Front Yard laid out target NOI margin of 66%.
While 66% of NOI margin could be realized in the case of a merger, it might be a little too optimistic. Front Yard’s properties are smaller and older compared to those of its public peers. However, I think it’s reasonable for Front Yard to improve its NOI margin by a little bit.
G&A
In 2019, Front Yard’s G&A was about 12% of revenue. G&A is tied to scale, so it is hard to improve on a standalone basis, so I think this metric is not likely to change much.
External Manager
Front Yard is externally managed by Altisource Asset Management, to which it pays base, incentive and conversion fees. Without an acquisition deal, it’s hard to see this relationship going away.
In 2019, fees to Altisource totaled 7.0% of total revenue, which means a potentail maximum 7% improvement in the case of a merger, if the buyer's management can completely absorb Altisource's workload without hiring additional personnel.
Conclusion
Considering all of the above, if Front Yard is successfully acquired, I estimate an increase in FFO margin to 18% (3% NOI improbement + 8% G&A improvement + 7% from management cuts), bringing the total FFO margin up to 22% from the current 4%.
A sale such as the (now-failed) deal with Amherst would be the perfect solution to unlock these values. The proxy to the deal with Amherst showed projected FFO of $0.71. This translates to about 19% of FFO margin, close to my estimates of savings.
The biggest risk of investing in the stock would be the failure of a new deal to emerge. Another risk is that Front Yard does have a substantial amount of debt. At the end of 2019, it had $1.6 billion in total debt outstanding. Of that, about $150 million matures before Q2 2020.
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