2024-01-11 11:38:53 ET
Summary
- W. P. Carey shocked the market in September 2023 with a strategy to optimize its portfolio, including a 20% decrease in the dividend.
- The market reacted negatively to the dividend cut, causing many dividend-income investors to exit the stock.
- I elaborate the key drivers behind this decision and contrast and compare them with Realty Income's financials to determine whether the underlying dividend is not at risk.
Back in September 2023, W. P. Carey Inc. ( WPC ) shocked the market by circulating its strategy to optimize the portfolio by taking relatively painful steps in the immediate future.
As most of you already know, the strategy revolves around a significant recycling of its non-core assets in the office space in conjunction with a ~20% decrease in the dividend to de-risk the balance sheet and maximize the multiple.
The latter component obviously caught the market off-guard causing many dividend-income investors (including passive flows, which track dividend compounders) to exit the stock.
We can clearly see the negative reaction (in September) in the chart above, which compares the performance of WPC to the broader REIT index.
Objective of the article
Prior to WPC's strategic shift, many investors viewed the Company as a strong and solid candidate for the dividend aristocrat status providing consistently growing dividends resembling the overall characteristics of Realty Income Corporation ( O ).
The dividend history of WPC as depicted above indeed sent comforting signals for the investors that the current income streams will be kept stable and protected from any short-term volatility, just as it is currently the case for O.
Considering that both WPC and O carry rather close similarities between each other, the investor base for these two names is presumably quite similar (at least before WPC's strategic repositioning).
Just to mention a couple of similarities:
- One of the largest owners of net lease properties ranking among the Top 20 REITs in the U.S. based on the underlying market cap levels.
- Investment grade balance sheets.
- Track record of consistent dividend growth.
- Diversified property base that is underpinned by long-term leases (including several overlaps in terms of the property type focus).
- Aggressive M&A players taking advantage of their cheap cost of capital.
So in this context, O investors (including myself), who have a strong bias towards current income might wonder whether O is not subject to the same dynamics and forces, which caused WPC to reexamine its strategy and revisit the dividend amount.
Let me contrast and compare O with WPC on the three key elements, which substantiated WPC's decision to cut back on the dividend. Note that the portfolio statistics and data points of WPC reflected the picture through 3Q23, which does not take into account the post-restructured portfolio.
#1- The portfolio structure for WPC is more defensive and supportive of dividend stability
Fundamentally, WPC has directed its real estate assets in segments, which inherently are more defensive and embody greater growth prospects than in O's case.
As we can see in the pie chart below, around half of WPC's ABR stems from industrial/warehouse properties, which currently exhibit secular tailwinds and provide more attractive NOI growth opportunities than conventional retail properties, where O has put a lot of focus.
Besides the industrial/warehouse properties, WPC also has decent exposure to the retail and office segments. O has also deployed capital to both of these areas, albeit predominantly in the retail space.
So, here WPC's holdings in the office segment, which has been struggling significantly and facing increased uncertainty around both the demand and ability to refinance, decrease the overall portfolio quality a bit. Yet, it is important to note that we are talking about ~16% of the total ABR, which is a relatively insignificant amount on a stand-alone basis that destroys WPC's ability to cover the dividend (unless the entire category goes belly up which is highly unlikely of course).
WPC generates approximately 16% of the total ABR from triple net lease retail properties, which is the main focus of O.
The remaining 10% is derived from a mixed bag of different property types such as education facilities, laboratories, hotels (net lease), research and development, specialty, fitness facilities, student housing (net lease), theater, funeral home, restaurant, land, parking and outdoor advertising. Here I do not find hidden risks or positions, which in aggregate could render WPC's portfolio less attractive relative to O's exposure to the retail segment.
O Investor Presentation
For O, however, there is an overwhelming bias toward retail properties, which consume about ~82.5% of the total ABR figure. There is only 13% allocated to industrial properties, whereas in WPC's case, these inherently more defensive assets (which also warrant higher multiples) account for half of the portfolio.
If we look at the underlying performance of these assets, the key metrics are somewhat similar. Both WPC and O have almost fully booked properties with occupancy ratios close to 99% territory. They both have also managed to capture consistent growth in the same store ABR over the years.
Yet, in this situation, we could argue that even the same store ABR growth has been better for WPC than O (i.e., a spread of ~100 basis points in favour of WPC especially based on the past four quarters).
With this being said, from the portfolio perspective, I do not see how O is better positioned than WPC (under a status quo assumption with all of the offices included in WPC's portfolio).
#2 The state of the balance sheet is a game changer for O investors
Although both REITs have investment-grade balance sheets, if we peel back the onion a bit, we can immediately understand why O is in a more solid spot relative to WPC.
The net debt to EBITDA of WPC and O stands at 5.7x and 5.2x, respectively, that offers a slight advantage for O. Yet, the key difference lies in the debt maturity profile, where WPC has more front-end loaded debt maturities, which will inevitably trigger unfavorable repricing of sizeable portions of the outstanding debt, thereby increasing the cost of debt from currently depressed ~3% levels. In the graph below, it is evident how WPC will be subject to unpleasant refinancings already starting this year (and then the picture is getting worse in 2025 and 2026).
While O has ~$1.8 billion to refinance in 2024 and then ~$1.1 billion in 2025, these amounts are not as heavy as for WPC, when the interest rate environment is still uncertain and currently with restrictive SOFR levels.
In a nutshell, without finding fresh capital to pay down the debt maturities this year and for 2025, WPC would inevitably experience a huge downward pressure on its ability to accommodate the dividends. O, in turn, has managed its debt financings in a more laddered and spread-out manner, which comes in extremely handy when the cost of capital is so expensive.
#3 FAD payout is high for both REITs, but WPC's idiosyncrasies have made the difference
The TTM FAD payout of WPC and O stands at almost the same level (78% and 75%, respectively). However, if we measured this in terms of the AFFO, the payout level for O would remain the same, while for WPC it would increase to a rather elevated level - ~87% (on a TTM basis). The AFFO is just a better reflection of the underlying cash flows adjusting some of the non-cash like items, which on paper increase the earnings, but do not actually contribute to cash generation.
Now, distributing almost 90% of the cash is by definition a risky exercise, decreasing the margin of safety when it comes to future dividend payments, which, on top of that, are expected by the market to grow even further.
As a result, if we now combine the aggressive payout with the struggling office sector (~16% of WPC's ABR) and painful refinancings that will shrink the AFFO due to higher interest costs, the communicated dividend cut makes perfect sense.
In O's case we do not see this as, first of all, the prevailing AFFO distribution level is more conservative and, second, the debt maturity profile allows it to avoid (until 2026) major headwinds from the higher cost of debt, which should provide sufficient time for SOFR to normalize. Plus, O has an immaterial allocation in the office segment, which does not move the needle in the underlying cash generation.
The bottom line
The dividend cut of WPC was to a large extent driven by three aspects: the quite exhaustive AFFO payout, which did not provide a sufficient margin of safety; the struggling office segment, which consumes ~16% of the total ABR; and an unfavorable debt maturity wall already in 2024, which if not repaid would trigger higher interest costs, rendering the AFFO payout unsustainable.
Now, after the ~20% dividend cut and expected proceeds from the office portfolio sale, WPC will be able to repay notable chunks of the near-term maturities (e.g., all the 2024 maturities). This in conjunction with a higher concentration in warehouse/industrial properties should establish a solid base from which to return to a dividend growth track in a sustainable manner.
O investors are clearly not exposed to the same headwinds as WPC as the debt maturity profile is more back-end loaded, there is no concentration in office space and the AFFO payout is at a safer level. Having said that, while I still own O (mostly because of the same characteristics that WPC carries as well; e.g., net lease assets, long leases linked to CPI escalators, investment grade balance sheet, and dividend focus), I would not be overly surprised if O was also forced to revise its dividend a bit. For this to happen, the SOFR has to remain elevated until 2026 and beyond, when O's large debt maturities start to kick in and the retail space should exhibit fundamental struggles, which would drive down O's occupancy rate, thereby inflating the AFFO payout from an already relatively high level.
For further details see:
3 Takeaways For Realty Income Investors From W. P. Carey's Case