2023-11-14 07:20:22 ET
Summary
- Net Lease Office Properties is a spinoff of office assets from W.P. Carey and now trades under its own ticker symbol.
- NLOP has $141 million of annual base rent from mostly investment-grade tenants.
- NLOP has a strong balance sheet with $1.45 billion in properties and $624 million in debt, and its properties are fully occupied with a weighted average remaining lease term of 5.7 years.
Quick background
Net Lease Office Properties (NLOP) is the spinoff of roughly $1.5B in office assets from W.P. Carey (WPC). As of 11/2/23, it now trades as its own separate entity under the ticker symbol NLOP.
The Buy Thesis
While office is a troubled real estate sector, the value here is so extreme that shareholders can potentially come out ahead in even some of the most bearish office scenarios. NLOP has $141 million of annual base rent ((ABR)) from mostly investment-grade tenants versus a market cap of $142 million. With a 5.7-year weighted average remaining lease term, NLOP will collect more than 5X its market cap in rent during existing contracts alone.
Netting management fees, interest expenses, taxes, and operating expenses out of the ABR implies an annual AFFO of $62.75 million. That implies an AFFO multiple of 2.7X. That is far too cheap for the quality of these assets.
In this thesis we will discuss:
- Balance sheet
- AFFO/share
- Properties and tenants
- Earnings trajectory
- Valuation
- Reasons why NLOP is trading so cheaply
Balance sheet
NLOP's real estate consists of 59 office properties with 8.7 million leasable square feet that are currently under lease agreements for $141 million annual base rent. The most recent appraised value was $1.45B and they were previously on WPC's books with a cost basis of $1.5B
NLOP additionally has $55.6 million in cash.
On the liabilities side, NLOP has the following debt per the 8-K.
"As of June 30, 2023, 14 properties were encumbered by 11 outstanding mortgages totaling approximately $168.5 million. In addition, in connection with the Separation, on September 20, 2023, the NLOP Borrowers have entered into (i) the $335.0 million NLOP Mortgage Loan with the Lenders, and (ii) the $120.0 million NLOP Mezzanine Loan with the Lenders, both of which are expected to be funded, subject to the satisfaction of certain conditions, substantially concurrently with the Separation."
We have tabulated them below.
The interest expense will come into play as we calculate AFFO, but for now it is the $624 million debt figure at which we will be looking.
$47 million of accounts payable largely nets out the cash so the balance sheet really comes down to $1.45B of properties against $624 million of debt.
Nominally, this is a 43% loan-to-value ratio.
Book value of equity is just over $800 million.
NLOP AFFO calculations
NLOP has $141 million of ABR and the following expenses:
- $59.752 million interest expense
- $11.5 million G&A (most of which goes to WPC)
- $7 million Property OpEx and taxes
This sums to an annual AFFO of $62.75 million.
Divided over 14.26 million shares outstanding, NLOP is looking at $4.40 AFFO/share. Note that this is significantly south of the $88.7 million of AFFO back-calculated for 2022 shown in the 8-K.
The revenues are essentially unchanged, the difference is that the loans are new as part of the spinoff so interest expense is much higher now.
Properties and Tenant roster
The average size of offices in NLOP's portfolio is 147K square feet and the average rent per foot is $16.20.
This passes the sniff test as it is a normal rent per foot. Any time there are long-term net leases one should be cautious when rent is unusually high. In such cases, ensure that it is indeed a trophy asset that warrants such high rent otherwise, it might be dramatically above market and lose rent later on.
In this case, however, $16.20 is entirely normal rent for offices of the types of properties that NLOP owns which are corporate offices for major companies. These properties are fully occupied at 97.1% weighted average occupancy with a weighted average remaining lease term of 5.7 years.
It is worth noting that 66.9% of tenants are investment grade which is extremely high compared to just about any other triple net REIT. The tenants themselves are mostly large companies that are household names.
NLOP
Historically, rent collection has been 100%, and given the tenant roster, I suspect it will remain at essentially 100%.
Therefore, it looks like smooth sailing for the next few years with the primary risk being what happens when the leases expire.
Earnings trajectory
There is clearly some opacity here with regard to the office macro environment a few years down the road.
- To what extent will companies enforce a return to the office?
- What percentage of existing office supply will have been converted to other uses?
Without knowing the answer to these questions it is difficult to know what the leasing environment will be like a few years down the road which is the relevant time period given NLOP's 5.7-year weighted average remaining lease term.
My base case is that it will be somewhere in between today's environment and mediocre. Given the lack of clarity, I will be discussing the main drivers of earnings as opposed to hard numbers. There are 4 main drivers:
- Escalators
- Dispositions
- Debt paydown
- Re-leasing
Nearly all of NLOP's leases have escalators ranging from a fixed rate of a couple of percent to CPI-linked. This will naturally increase AFFO/share slightly over the next couple of years.
Dispositions seem to be a big part of the plan as per the spinoff presentation.
Offices were divided between NLOP and WPC proper based on the expected timing of disposition. Those which were under some sort of deal or LOI stayed at WPC while those which are intended to be sold down the road went to NLOP.
The sale of leased office space would come with lost ABR offset by what is done with the proceeds.
WPC's office sales are to be executed at an 8.3% cap rate.
2MC using data from company filings
This cap rate is pulled down by the massive property leased to the Spanish government.
Sales of more normal office assets such as those in NLOP are probably at a slightly higher cap rate. I would estimate NLOP's offices sell at a 10% cap rate.
In most cases, real estate dispositions at a 10% cap rate would be dilutive to AFFO/share, but NLOP has very expensive debt.
Proceeds should and likely will be prioritized to pay down the $120 million mezzanine loan with a 14% interest rate. Thus, any disposition at a cap rate below 14% is actually accretive to AFFO/share.
Finally, we get to the re-leasing which kicks in a few years down the road. I anticipate re-leasing to be a largely negative event. Leases are at roughly market rates so I don't think rents will be cut, but some portion of properties will go vacant and those that do get re-leased will be done so with a wave of tenant improvement costs and leasing commissions (TI and LC).
Thus, the overall earnings trajectory for NLOP is flat to slightly up in the next couple of years followed by a slight to moderate decline in the out years as leases expire.
Valuation
Office is not a strong asset class so it should and does trade at discounted AFFO multiples.
The average office REIT trades at 9.9X forward AFFO. Most people believe the value of office assets will decline so the sector also trades at a steep discount to NAV.
Most office REITs are trading at just over half of NAV.
At today's price of $11.91, NLOP is trading materially cheaper than its peers. (Note that since writing NLOP has moved up to $15.77. The stock is moving 10%+ each day)
- 2.7X AFFO of $4.40 per share.
- 21.2% Price to asset value
NLOP has not been trading long enough to have a consensus NAV among Street analysts. I calculated asset value to common below as a sort of book value measure.
2MC
NLOP is extremely cheap relative to office peers and I don't think it is warranted.
I think the extremity of the discount represents material mispricing.
Why is NLOP trading so low?
Office in general is a feared sector in the market so the baseline sentiment for an office spinoff is already low.
On top of that, NLOP is following a series of REIT spinoffs in which the spun-off portion was a disaster.
A common pattern for spinoffs is for the parent company to dispose of as much junk as possible by spinning the bad stuff into the new company. This was seen with Spirit Realty ( SRC ) which put its troubled properties along with a large portion of its debt into its spinoff. The spinoff performed terribly as bad properties with an overburdened balance sheet is a tough combo.
The market seems to have assumed NLOP is a similar "get rid of the junk" type of spinoff as NLOP collapsed in its first days of trading.
However, as we showed above, NLOP's assets, tenants, and balance sheet are all in reasonably good shape.
This was a different sort of spin-off which I like to call a categorical spinoff. Office assets in 1 bucket - non-office in the other bucket.
It is probably most comparable to Realty Income's ( O ) spin-off of its office assets in the form of Orion (ONL).
This comparison also put fear into investors as ONL has been awful.
So what is the difference here?
The difference is that ONL spun out at a price that was far too high for an office portfolio. It was initially attributed a multiple similar to that of Realty Income, its parent.
Of course, it fell. Office has no business trading at a high multiple.
WPC was apparently more aware of the market perception of office and they assigned an already low multiple to NLOP.
The market took the multiple even lower to where it is today at 2.7X forward AFFO.
Summary of the thesis
NLOP is simply too cheap. While I am bearish on office and materially underweight office relative to the REIT index, this is an instance in which I think the reward is worth the risk.
NLOP is trading at such a low multiple and such a big discount to asset value that even in scenarios where office continues to struggle, it could provide a nice return.
Perhaps this is made most clear by the fact that rental revenues under existing contracts are $803 million which is more than the entire enterprise value of NLOP. They will use retained cashflow and asset dispositions to pay down the debt and what remains, in my opinion, is worth much more than $11.91 per share.
For further details see:
W.P. Carey's Spinoff Net Lease Office Properties: The Deepest Of Deep Value