2024-01-03 23:29:41 ET
Summary
- The recent spin-off of troubled office properties spurred a lot of discussion of management's credibility, but I see it as a long-term positive.
- WPC will soon have $2 billion in liquidity, which will enable them to pay off all 2024 debt maturities and get through the year with no need to raise capital.
- I present my positive outlook for the REIT and suggest a potential re-rating higher now that the portfolio has improved.
Dear readers,
W. P. Carey ( WPC ) has generated a lot of discussion in the investment community lately, because of management's sudden decision to spin-off the majority of their office portfolio into a new entity, Net Lease Office Properties ( NLOP ).
The spin-off, which has been covered extensively, allowed WPC to (1) clear their portfolio of troubled office assets and focus on true net lease properties with much lower OPEX and better occupancy prospects, (2) generate liquidity which will be very helpful in repaying near-term debt maturities, and (3) avoid a gradual drag on earnings over the following years as vacancies increase due to large lease expirations and a poor office market leasing demand.
At the same time, it caught many investors off guard, because it was completely unexpected and resulted in a 20% dividend cut . This led many investors to question the quality of management, especially because they had just raised the dividend in the previous quarter and were about to reach a dividend Aristocrat level with 25 years of consecutive dividend increases. To make matters worse, a large portion of investors were likely invested in the stock for the dividend, as the REIT hasn't materially grown their FFO per share for years.
The stock took a major hit on the spin-off announcement, going as low as $50 per share, but has recovered nicely since to around $65 per share today.
Now that the dust has settled, I think it's fair to assess long-term prospects of WPC's portfolio, which will have zero office exposure as soon as they finalize their Office Sale Program .
The program consists of a planned disposal of the Spanish government office portfolio of 70 properties and 17 single-tenant office properties in Europe that were excluded from the spin-off. The disposal process is expected to be finalized in early 2024 (with 90% already under contract by Q3) and should result in $800 Million of disposition proceeds for WPC.
WPC's Portfolio
Post spin-off and after the Office Sale Program is finalized, WPC will have a strong net lease portfolio with 62% of industrial/warehouse properties, followed by retail at 20% and self-storage at 5%. The remaining 14% will be accounted for by properties such as an education facility, a hotel (net lease), a laboratory, a gym or a movie theatre.
The portfolio has a long weighted average lease term of over 11 years and, over the past 14 years, has never seen occupancy below 96.6%. As of today, occupancy stands at 98.9% and with low near-term lease expirations (6% in 2024 and 4.4% in 2025) it's likely to remain high.
I've previously argued that net lease REITs with long lease terms aren't very well positioned for an inflationary environment, because low tenant turnover hinders their ability to increase rents. This is, however, not true of WPC, which has one of the highest portions of CPI-linked leases with no caps in the sector. In this regard, WPC's portfolio with 36% of uncapped CPI-linked leases is second to only VICI Properties ( VICI ).
As a result, the REIT's YoY ABR growth reached 4.2% in Q3, despite a low recapture rate of only 81% on Q3 re-leases. Such low rent recapture rate is obviously bad, but it's important to mention that it was primarily a result of poor leasing terms on office properties and restructuring on three out of four movie theatres, both of which are unlikely to cause drag on performance going forward. Moreover, it only related to 0.9% of leases that expired in Q3. Going forward, as inflation declines, I expect same store revenue growth to trend down towards 2-3% per year.
For 2024 management has issued AFFO guidance of $4.60-$4.80 per share, down about 10% YoY as a result of the office spin-off and the exercise of a purchase option by U-Haul, which has decided to buy all 78 self-storage facilities leased from WPC at an 8.2% cap rate for total proceeds of $470 Million.
Financials and liquidity
WPC's balance sheet was upgraded to a BBB+ rating in January and has a reasonable net debt / EBITDA of 5.7x, but there is a mountain of debt maturities in the coming years. In 2024 alone, the REIT will have to deal with $1.3 Billion in maturities.
I expect that refinancing of mortgage debt could prove difficult and refinancing the entire $1.3 Billion by unsecured bonds at a rate of 6% (vs 3.5% today), would cause a significant increase to net interest expense of more than $30 Million per year.
Luckily, WPC currently has (or will soon have) about $2 Billion in liquidity, consisting of:
- $350 Million received from the NLOP spin-off
- $385 Million received in the settlement of forward equity agreements
- $800 Million expected from the Office Sale Program in Q1 2024
- $470 Million expected from U-Haul purchase in Q1 2024
This liquidity puts WPC in a position to repay all of their 2024 debt maturities in cash. Moreover, given the company's investment targets, management doesn't expect a need to issue to capital until the end of 2024, which could be quite valuable if capital markets remain unfavorable.
Is WPC a BUY?
I agree that the spin-off should have been communicated in advance and discussed with shareholders, but I don't think it was as big a deal as some made it sound. Remember, shareholders were holding the troubled office properties either way and this way management simply gave everyone the option to decide whether they want to continue to hold them or not.
While raising the dividend one quarter, only to cut it three months later is a chip on the shoulder of the management, I don't think it has made the stock uninvestable. Quite the opposite. Following the spin-off and successful execution of the Office Sale Program, WPC's portfolio will be much stronger than historically and will likely deserve a higher multiple that the 13x AFFO it has averaged historically.
Management targets a dividend payout ratio of 70-75% of AFFO which implies a dividend of somewhere around $3.40 per share in 2024. At today's price that's a yield of 5.2% and one that's likely safe and may even grow slowly from the reset level going forward.
The stock trades at a forward price to 2024e AFFO of 13.8x which is below 14.6x of Realty Income ( O ). From this perspective, and given O's better rating, I see WPC as fairly valued relative to peers. But I do expect that once all office exposure is eliminated from WPC's balance sheet, the stock could re-rate higher. O has historically traded at 17x AFFO and I see no reason why WPC couldn't close at least half of the gap between its historical multiple of 13x and that of O.
At 15x AFFO, WPC's price target for 2025 is around $73 per share, up 12% from today. Combined with dividends, I expect a total annual return of around 10% for the next two years. Though obviously not as appealing as one or two month ago, I think the outlook for WPC is positive and rate it a HOLD here at $65 per share.
For further details see:
W. P. Carey: Positive Outlook Once Office Sales Are Finalized