2023-09-25 17:01:02 ET
Summary
- W. P. Carey's spinoff of its office assets resulted in a 10% drop in stock price over two days due to poor communication with investors.
- The spinoff is expected to have a minimal impact on cashflows and growth trajectory, and the discount in stock price is seen as an opportunity.
- The dividend cut tanked the stock, but is actually a strategic move to retain capital for future growth and maximize total returns.
W. P. Carey ( WPC ) announced a spinoff of its office assets. This move was poorly communicated to investors and resulted in a roughly 10% drop over two days.
This article will analyze the spinoff and the simultaneously announced asset sales. In brief, WPC's fair value is largely unchanged and we see the discount as highly opportunistic. Specifically, we will be looking at the following:
- Spinoff impact on cashflows (AFFO)
- Spinoff impact on growth trajectory
- Asset sale impact on cashflows and growth
- The new AFFO/share runrate (calculated, as it was not provided by WPC)
- Proforma fair value
The selloff exacerbated what was already a large delta between intrinsic value and market price. I suspect the primary motivation for the selloff was a dividend cut concurrent with the spinoff.
Response to dividend cut perhaps more emotional than pragmatic
Dividend policy is one of the most misunderstood concepts in finance. Investors cheer dividend raises and are infuriated by dividend cuts. They are sometimes interpreted as management alignment with shareholders. A raise is viewed as management rewarding shareholders while a cut is viewed as betrayal.
In fact, if you look around the analysis and commentary on WPC since this announcement you will see the word betrayal used dozens of times in reference to the dividend cut.
I think this morality or alignment connotation with the dividend is just incorrect. Many view dividends as a form of wages or salary. Instead of getting paid for their labor, people are being paid for their capital.
When someone gets a pay cut at work it can be quite a financial hit and understandably an emotional event. Dividend cuts evoke that same sense of a pay cut.
However, I think it is worth pointing out that the "wages" we as investors earn on our capital is not just the dividend. It is the total return. Thus, a dividend cut is not akin to a wage cut, it is more like shifting a higher percentage of one's pay into a 401K rather than the cash component of the paycheck.
WPC lowered its AFFO payout ratio to a targeted 70%-75%. The other 25%-30% is still owned by investors. It is just retained for growth rather than paid out. So investors get slightly smaller dividends today, but faster growth going forward which will result in bigger dividends in the future. Different people will have different preferences as to whether they prefer the payment now or later, but from a total return perspective lowering the payout ratio is not a bad thing.
Management has a fiduciary duty to shareholders to maximize total returns. More dividends does not equal more returns. Sometimes less dividends equals more returns.
There is a correct level of payout ratio. It is a judgment call as to what the correct level is and it depends on the sector. For triple net, I would estimate the optimal payout ratio is somewhere between 60% and 90%. The 70%-75% range proposed by WPC sounds quite close to optimal.
Dividend policy is usually value neutral or close to value neutral. The dividend cut did not destroy any value and yet it resulted in the stock down 10%. I think this is an opportunity.
The spinoff
Spinoffs are inherently value neutral with exception to the transaction expenses incurred. Rather than 10, the investors get 5+5 or in this case it is closer to 9+1.
WPC's impetus for the spinoff was that it was being valued well below the sum of its parts. The idea is that by separating the parts it forces the market to value them individually. The mere 16% office exposure was causing WPC's multiple to be drastically lower than peers.
A strong pure-play industrial triple net REIT like STAG ( STAG ) is valued at 18.2X AFFO while a weak industrial triple net REIT like Lexington ( LXP ) is valued at 15.3X. Simultaneously, pureplay retail triple net REITs are valued in the 14X to 15X range.
Yet somehow WPC with its mostly industrial and retail portfolio was at 11.9X AFFO. The market seems to have been fixated on WPC's small office component which resulted in it not getting credit for the industrial or retail. WPC was trading well below the sum of its parts to an extent where the office was functionally being valued at negative dollars.
This isn't even bad office. While it is a weak property type, the property quality and tenant mix is exceptional with 97.1% occupancy and 66.9% investment grade tenancy.
The tenant roster looks excellent.
So the idea is that post spin, the office portfolio will be valued at an office multiple and the industrial/retail portfolio will be valued at an industrial/retail multiple. The sum of those should theoretically be significantly greater than WPC's pre-spin market price.
It makes some sense, but the spin was poorly communicated.
Poorly announced spin
Usually when spinoffs are announced there is a predefined ratio. It will be something along the lines of investors get one share of SpinCo for every 10 shares of stock that they own.
When there is a pre-defined ratio it allows management to come forward with calculations. They could say things like AFFO/share of the spin will be X and AFFO/share of the remaining company will by Y.
Then investors can see the aggregate AFFO and see that if you add it up it is basically the same just coming from two sources instead of one.
For reasons unknown to me, WPC has not yet decided the spin ratio. As such, there is an unknown number of shares of what will be Net Lease Office Properties (NLOP). With an unknown sharecount, they cannot present per share metrics for NLOP.
The communication was made even murkier by the cash infusion to WPC which made it difficult for management to present AFFO/share stats for the WPC leg either. Essentially, the AFFO/share will depend on when that capital gets redeployed and at what cap rate.
None of this is bad in terms of actual value. It is just really bad for perceived value because investors went from a known entity with a known AFFO and known dividend to two new entities with unknown AFFO and unknown dividends. One cannot even calculate the size of the dividend cut because it is unknown how big NLOP's dividend will be.
Investors were left with two choices:
- Figure it out themselves
- Sell it
Many chose the latter and WPC has sold down 10% from an already really cheap level.
I have attempted to build out the new AFFO from the information provided. We will share our calculations below:
AFFO and value calculations
The office properties contributed to NLOP had an initial purchase price of $1.5B. Using the stated loan to value ratio inclusive of 43% the recently appraised value of these properties is $1.451B.
In place annual base rent is $141 million which allows us to calculate a rough AFFO for NLOP given the following expenses.
$141 million less $59.75 million in interest, $11.5 million in G&A and $7 million in property opex/taxes suggests an AFFO runrate of $62.75 million.
That is roughly 29.3 cents per WPC share.
We can use the same figures to calculate the AFFO decrease to WPC. WPC will have $141 million less ABR but will receive the $11.5 million G&A as NLOP's external manager. WPC will also no longer be paying the $7 million in property opex. Property level debt expense of $8.1 million will also be removed from WPC's interest expense.
This suggests a loss of AFFO on the WPC side of $114.4 million or roughly $0.53 per share.
However, WPC will receive $350 million in cash from NLOP. Assuming they put it to work at an 8% cap rate that would be positive contribution of $28 million.
This brings the grand total WPC AFFO impact to a loss of $86.4 million or about $0.40 cents per share.
So the NLOP branch will provide AFFO of about $0.293 per WPC share and WPC will lose about $0.40 per share. That is a net loss to AFFO of about $0.10-$0.11 per share.
This loss comes from the really high interest rate on the mezzanine debt that will be temporarily put on NLOP in its transition. Putting that 11 cents into context, WPC was expected to earn about $5.35 AFFO/share in 2023, so it is a loss of about 2%.
Is the spinoff worth it?
The spinoff is a tradeoff for investors. The 2% loss to overall AFFO is a clear negative, while the removal of office from the portfolio should make it trade at a significantly higher multiple and likely improve the growth rate.
Personally, I would have rather had WPC just stay as it was, but I don't think the overall fair value is changed all that much.
Fair value
Initially WPC's AFFO hit will be bigger as it will take a bit for the cash to be put to work, but I see stabilized AFFO/share at $4.95. Based on where the peer set trades and WPC's relative quality I think a proper multiple would be about 15X-16X. This implies a roughly $76 fair value for the WPC leg.
NLOP, as an office portfolio will likely trade at a significantly lower multiple. Office REITs on average trade at 10.2X forward AFFO.
Due to its smaller size, I suspect NLOP would trade somewhere around 8.5X. $0.293 AFFO/share times 8.5 implies a value of about $2.50. Note that NLOP's actual share price will likely be much higher than this depending on the ratio of NLOP shares to WPC shares, but this is the value per WPC share.
Summing the two pieces, I spot WPC's fair value at $78.50
Other transactions
In addition to the spinoff, WPC is planning to sell its remaining office assets. A large portion of these sales are already under contract. These assets have ABR of $77 million and opex of $10.5 million for NOI of $66.5 million.
The expected proceeds are $800 million which implies an 8.3% cap rate.
An 8.3% cap rate is quite good for office in this market. I think WPC is getting the premium sale price because of the large portfolio of offices leased to the Spanish government included in the sale. Government leased office properties are viewed as reliable sources of income.
WPC can quite easily reinvest these proceeds at an 8.3% cap rate at equal or better quality due to their sale leaseback origination expertise. It will be a dip in AFFO for a quarter or two until the proceeds are reinvested but over the longer term the sale should be neutral to AFFO and accretive to quality.
Also announced with the spinoff was the fulfillment of forward equity purchase agreements. This will result in the issuance of 4.7 million shares for proceeds of $385 million. I generally would not like the idea of WPC issuing equity when it is priced this cheaply, but these agreements were signed at a time when WPC was trading much higher. The shares versus proceeds indicates an average price of $81.91. At that price, WPC can make it accretive on a per share basis.
A growthier outlook
The office properties had substantially lower escalators than the rest of the portfolio. WPC's remaining assets have some of the best organic growth in the triple net space.
Inflation is remaining stubbornly high, but that actually benefits WPC as 55% of its leases are CPI linked. As a result, even if inflation moderates a bit, escalators should drive at least 3% growth annually.
WPC will also have strong mark to market with a mostly industrial portfolio. As leases come due they can be renewed at higher rates. With a weighted average lease term of 11.9 years not a whole lot of leases roll each year, but it should be a steady source of incremental NOI.
Unlocking the equity lever
With an AFFO multiple in the 11s prior to transaction, WPC has been unable to issue equity in a way that is accretive. Management's hope with this spin-off is to trade at a significantly higher multiple which would unlock accretion through equity issuance.
Time will tell if that actually happens, but it would be rational for the market to trade it at a higher multiple. A clear impediment to this will be investors taking a long time to forgive them for the dividend cut.
The bottom line
At the now much lower price WPC is trading at a massive discount to fair value. At today's $57.61, WPC has 37% upside to fair value. Just keep in mind that it could take a while to realize that price.
For further details see:
W. P. Carey's Misunderstood Spinoff