WPC - W. P. Carey Stock: The More It Drops The More I Buy

2023-10-10 08:05:00 ET

Summary

• W. P. Carey Inc. crashed recently.
• The REIT plans to spin off some assets and cut its dividend.
• We explain why we remain very bullish on the stock of the company.

W. P. Carey Inc. ( WPC ) is one of the highest-quality net lease real estate investment trusts, or REITs ( NETL ), in the world:

• It has a multi-decade track record of significant market outperformance.
• It has a strong investment grade rate balance sheet.
• It owns a portfolio of mostly industrial net lease properties.
• It pioneered the sale and leaseback model, allowing it to pick up assets with unusually strong lease terms.
• Its leases include even CPI rent adjustments, which is a big deal today especially.

But that has not prevented it from selling off with the rest of the REIT sector ( VNQ ), and just recently this selloff accelerated when it announced that it would spin off 10% of its properties, which are U.S.-based office net lease investments, into a separate REIT:

This deal has pros and cons.

The pros are that:

• It will allow it to rapidly exit its office investments, which are today hurting its market sentiment and reducing its valuation, despite only being a minority of its assets.

• It will rapidly expand its exposure to industrial properties, reaching nearly 2/3 of its assets post-merger, and the market has been granting much higher valuations to these assets.

The main downside is the following:

• As WPC spins off 10% of its assets, it will naturally lose a good chunk of its income and it will use this opportunity to right-size its dividend to a lower level in order to be in a better position to self-fund its future growth. This is very disappointing because it will break a multi-decade track record of steady dividend payments.

Overall, the deal is neutral in that you are not losing any assets. You will get the office properties in the form of shares in a separate REIT, and the dividend policy is just a capital allocation decision that has no impact on the value of the underlying assets.

Even then, the market was quick to react negatively to the news because WPC's investor base is mainly focused on its dividend.

It will likely lead to further volatility in the near term, and we, of course, can't time the market.

But let's now go 5 years into the future.

WPC will be an even higher-quality net lease REIT with no office exposure, mostly industrial properties, a lower payout ratio, and a faster growth rate thanks to its ability to self-fund its growth.

Will the market then reward it with a higher valuation multiple than today?

I believe so.

Today, it is priced at just 11x pre-spinoff funds from operations, or FFO, even as most industrial REITs trade at double that.

The dividend news will likely hurt its market sentiment in the near term as some dividend-oriented investors decide to sell the stock, irrespective of its fundamentals, but these investors will be replaced with others who are more total-return-oriented.

Agree Realty ( ADC ) also cut its dividend in 2011 and ruined its dividend track record in the process, but that did not prevent it from later earning the highest multiple in the net lease sector. The market cares about the dividend, but REITs are not bonds and most investors care even more about total return prospects, which will likely improve thanks to this transaction.

It is easy for us to criticize looking from the outside and say that the management is jumping the gun, but we don't have all the information that they have, and their track record speaks for itself.

If they want to get out of these assets fast, then it is probably the right move.

If anything, this simply says that the prospects of single-tenant office buildings are likely even worse than what most may have thought. I have long warned about these assets, and my sentiment towards them remains just as negative. Here is what I wrote about Orion Office REIT ( ONL ) back when it traded at a >2x higher share price:

"I think that single-tenant office buildings are potentially the worst possible properties to own today, and this is why Realty Income wanted to get rid of them.

They are fine investments as long as the lease has years on them, but as soon as your lease expires, they can become very problematic because they are very costly and difficult to re-lease. Typically, they require substantial capex investments and tenant improvements, and even then, they may be difficult to re-lease. Since tenants know this, they are in a strong position to negotiate lower rents on a now older building and expensive tenant improvement packages."

I learned this lesson during my private equity days when we couldn't find tenants for some of our single-tenant office net lease investments and they essentially turned into liabilities that were losing money every month.

So, am I disappointed to see WPC get rid of these assets as fast possible?

I am not. I actually think that they probably should have bitten the bullet earlier, just like Realty Income ( O ).

It won't matter too much over the long run, but the shares are now even more heavily discounted.

WPC is becoming a much better REIT and this will eventually be reflected in its valuation. Those who buy it today will likely be richly rewarded.

We believe that W. P. Carey Inc. shares have 50% upside potential and the dividend yield is likely to be around 7% post-cut.

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