Extremely high dividend yields are tantalizing, but also come with significant risks. While they certainly look appealing, it is important to assess whether the dividend is sustainable.

Colony NorthStar, Inc. (CLNS) has a whopping 8.3% dividend yield. Its largest shareholder, Seth Klarman’s Baupost Group, is one of the most well-known value investors around.

Seth Klarman is the Chief Executive Officer and Portfolio Manager of Baupost.

As of December 31, 2016, Baupost held 18.7 million shares, a nearly 10% investment in the company, which is worthy approximately $279 million.

Colony NorthStar was formed in 2016, as a result of a merger of three different companies.

As a result, it is not a Dividend Achiever, a group of 271 stocks with 10+ years of consecutive dividend increases.

You can see the full Dividend Achievers List here.

This article will discuss whether investors should follow Seth Klarman into Colony NorthStar stock.

Business Overview

Colony NorthStar is a real estate investment trust (REIT). It invests primarily in commercial real estate. The company has a market capitalization of $7.3 billion.

Source: March 2017 Investor Presentation, page 3

It was formed through a tri-party merger between Colony Capital, Inc. (CLNY), NorthStar Asset Management Group Inc. (NSAM) and NorthStar Realty Finance Corp. (NRF).

Colony NorthStar has 25 years of real estate investment experience, and has more than $56 billion of assets under management (AUM).

Today, the combined entity has four major investment segments, which are:

• Healthcare: (26% of AUM)
• Hospitality: (23% of AUM)
• Industrial: (8% of AUM)
• Other Equity & Debt: (43% of AUM)

The “Other Equity & Debt” segment includes private equity fund interests, single family residential rentals, CRE loans, and Direct Property & Net Lease investments.

Source: March 2017 Investor Presentation, page 5

It also has a sizable investment management business, which accounts for $39 billion of its $56 billion AUM.

Colony NorthStar’s various businesses should provide growth in 2017 and beyond.

Growth Prospects

The first growth catalyst for Colony NorthStar is its shift in investment focus. Going forward, the company plans to de-emphasize its Other Equity & Debt segment.

Instead, it plans to allocate greater investment to the other three core property segments.

Source: March 2017 Investor Presentation, page 8

Colony NorthStar expects this will help diversify the company’s portfolio and scale up more quickly.

Separately, REITs rely heavily on purchasing new properties for growth. Colony NorthStar is no different, and will finance investments by raising capital.

To that end, Colony NorthStar is targeting $2 billion of third party capital raising in 2017.

One of the most attractive areas of future investment for the company is healthcare.

Colony NorthStar has a large portfolio of healthcare-related properties, including senior housing facilities, medical office buildings, skilled nursing facilities, and hospitals.

Source: March 2017 Investor Presentation, page 11

This provides Colony NorthStar with exposure to a strong fundamental tailwind in the U.S., which is the aging population.

There are approximately 75 million Baby Boomers in the U.S., which should result in high demand for healthcare properties for many years.

Colony NorthStar’s healthcare portfolio holds 88.1% occupancy, and higher demand could yield growth in rental revenue.

Valuation & Expected Total Returns

In order to value REITs like Colony NorthStar, it is better to use Funds From Operation (FFO) instead of earnings-per-share.

The reason is that traditional earnings-per-share includes a number of non-cash items like depreciation and amortization expense.

For most REITs, this suppresses earnings-per-share too much to be relied upon as a valuation tool. Instead, FFO is a non-GAAP measure that gives a better indication of a REIT’s cash flow.

On this basis, Colony NorthStar expects FFO of $1.40 to $1.58 per share in 2017. This means the stock is valued at a forward price-to-FFO ratio of 8.7, using the midpoint of 2017 FFO guidance.

The company believes its shifting investment initiative will help it earn a higher valuation multiple.

Source: March 2017 Investor Presentation, page 9

Indeed, the stock is significantly undervalued, when stacked up against its peer group.

Aside from an expanding valuation, Colony NorthStar stock has the potential to generate strong returns for shareholders.

A reasonable breakdown of future returns is as follows:

• 4%-6% FFO growth
• 3% dividend yield

This level of FFO growth should not be difficult to reach. Colony NorthStar can generate revenue growth through new properties and rent increases.

FFO growth will be the result of revenue growth, cost controls, and share repurchases.

On February 23, 2017, the company authorized a $300 million share repurchase over the next year. This amounts to 4.1% of its current market capitalization.

When combined with its huge dividend yield, total shareholder returns could reach roughly 12.3%-14.3% annualized.

Dividend Analysis

Colony NorthStar stock pays a quarterly dividend of $0.27 per share, which means an annualized dividend of $1.08 per share.

Based on its recent share price of $12.99, the stock has a current dividend yield of 8.3%.

This is a very high dividend yield. Consider that the S&P 500 Index, on average, yields just 2%.

With a dividend yield more than four times as much as the average stock in the S&P 500, the market is expressing some concern that the dividend may not be sustainable.

The first thing to analyze is the balance sheet, to make sure the company does not have too much debt.

Source: March 2017 Investor Presentation, page 24

Colony NorthStar maintains a total-debt-to-capitalization ratio of slightly less than 50%.

Its total-debt-to-EBITDA ratio is 6.0, which is a bit high.

At the midpoint of the company’s 2017 guidance, Colony NorthStar expects to generate FFO-per-share of $1.49.

Therefore, its annualized dividend amounts to approximately 73% of the company’s expected 2017 FFO-per-share.

The payout ratio is on the high side, but is not unusual for a REIT.

While the dividend appears to be sustainable, the company carries a significant amount of debt.

As a result, investors should closely monitor the company’s progress in future quarters to make sure its debt metrics do not worsen.

Final Thoughts

Seth Klarman is a renowned value and income investor. With that in mind, it is not entirely surprising to see that Baupost Group owns a significant stake in Colony NorthStar.

Colony NorthStar stock offers an attractive blend of value and income. The shares seem to be undervalued, and the company pays a massive 8.3% dividend yield.

REITs face a unique set of risks, and investors should keep close watch on the condition of Colony NorthStar’s balance sheet.

You can read about a REIT with a lower dividend yield, but a higher dividend growth outlook, by clicking here.

But overall, Colony NorthStar stock appears attractive for value and income.