2023-12-19 04:17:53 ET
Summary
- W. P. Carey has recovered its losses since announcing its office spinoff and dividend reduction.
- The company has higher exposure to industrial and warehouse properties than peers, leading to stronger same store sales growth.
- I expect the stock to re-rate higher as management completes the sale of the remaining office properties next year.
W. P. Carey ( WPC ) has rebounded strongly from the lows as it moved past its drastic exit from office real estate assets and also benefited from increased hopes for declines in interest rates. While many income investors seem unhappy with the dividend reduction association with the office spinoff, I am instead eyeing the multiple expansion potential from the higher quality portfolio. WPC continues to post best-in-class same store sales growth and I expect that to be only more pronounced moving forward given the increased exposure to industrial and warehouse properties. WPC still trades like a typical net lease peer, but arguably deserves a premium. I expect the stock to re-rate as management executes against their full exit from the office sector. I am downgrading the stock from “strong buy” to “buy” due to valuation, but remain bullish for the name long term.
WPC Stock Price
After a recent rally in the REIT sector, WPC has made up almost all of its losses since accelerating its exit from the office sector with a spin-off of Net Lease Office Properties ( NLOP ).
I last covered WPC in October where I rated the stock a strong buy due to the attractive valuation. This rally has tempered the value proposition though I continue to see upside ahead from a quality re-rating.
WPC Stock Key Metrics
WPC is a net lease REIT which has seen among the strongest results relative to peers due to high exposure to CPI-linked leases. In other words, the high inflationary environment has enabled WPC to charge higher annual lease escalators.
In its most recent quarter, WPC delivered 4.2% same store rent growth. In contrast, the typical NNN REIT typically has average escalators in the 1% to 1.5% range with same store growth falling short of that due to leakage.
WPC has a solid balance sheet with debt to EBITDA standing at around 5.7x which is typical in the sector.
That said, WPC does face a large amount of debt maturing in the near term, with 55.8% maturing in the years of 2024 through 2026. Refinancing these maturities at higher interest rates may pose significant headwinds to growth rates. Realty Income ( O ) has recently priced 16 year notes at a 6% interest rate and Crown Castle ( CCI ) has priced 11 year notes at a 5.8% interest rate . Assuming that WPC refinances the maturing debt at a 6.5% interest rate (conservatively high), that would imply roughly $120 million in additional interest expenses. That may imply an average of a 3.9% headwind to AFFO annual growth from debt refinancings alone.
On the lease expiration front, WPC has a more balanced near term outlook with a weighted average lease term of 11 years.
Expiring leases are typically a potentially negative event for NNN REITs due to the potential for poor renewal rates (though it should be noted that Realty Income has somehow been able to show solidly positive leasing spreads as of late). In this past quarter, WPC saw the rent recapture rate stand at just 81%, impacted heavily by poor leasing rates on some theater and office properties. I note that these expiring leases represented 0.9% of overall rent.
Looking ahead, management is guiding for 2024 to see AFFO between $4.60 and $4.80 per share. This assumes a completion of the sale of the remaining office properties as well as the exercise of the U-Haul purchase option which I have previously discussed as being dilutive .
This is a good moment to note that I made a mistake in my past bullish report on WPC, as there I had expected 2024 AFFO to come at around $5.22 per share, implying a dividend of around $3.80 per share. My mistake was in not extending the dilutive effects from the NLOP spin-off for the whole year. Based on management’s 2024 guidance, the dividend moving forward is likely to hover around $3.44 per share.
On the conference call , management noted that their investment volume was depressed in the third quarter mainly due to them being more “disciplined” and seeking higher cap rates. They had repriced their deals to “cap rates in the mid-to-high 7s and even into the 8s” which caused greater hesitancy on the behalf of sellers. While this may mean some near term pain, it is the right decision in my view as the higher interest rate environment has elevated risk and warrants demanding higher cap rates. I prefer WPC’s decision to slow down deal volumes over peer Realty Income’s seemingly insatiable appetite to grow at any cost .
Management gave expectations for 2024 to see around 3% same-store rent growth for the full year, which in conjunction with the retained cash flow should help to more than offset any headwinds from debt refinancings.
Is WPC Stock A Buy, Sell, or Hold?
Based on a $3.44 annualized dividend payout, WPC is trading at around a 5.4% dividend yield. Much earlier in the year, I had advised avoiding WPC when it was yielding in excess of 6% . Based on valuation alone, one might think that I would now have a similar view of the stock, but the thesis has changed. For starters, the lower dividend yield is less relevant than the fact that WPC is still trading at around 13.3x 2024e AFFO, representing some discount to the 13.5x multiple for Realty Income. More importantly, WPC has made great progress on exiting its office exposure. WPC has already completed its spinoff of NLOP, which has brought its office exposure down to around 5%.
The remaining 5% office exposure is declining rapidly as well. As noted on the conference call, management has already signed contracts to dispose of another $500 million of office assets, including their office asset leased to the Spanish Government. Management estimates that they have “transactions in place on over 90% of assets in the program.”
Once WPC fully disposes of its remaining office assets, the company would have approximately 62% exposure to industrial and warehouse properties.
I view office real estate as facing headwinds similar or worse as those seen by mall REITs, which has seen three publicly traded names file for bankruptcy over the last 5 years (CBL Properties, Washington Prime Group, and Pennsylvania REIT). While the spinoff has undoubtedly come at significant cost, I expect the market to look back at the transactions as being disciplined and timely. The remaining portfolio is likely to feature stronger growth due to the higher overall quality of the tenants. I expect WPC to trade closer to the 24x AFFO multiple seen at Prologis ( PLD ) than the 13.8x multiple for Realty Income. Assuming a 17x AFFO multiple, I could see WPC trading at around $80 per share.
What are the key risks? Given how rapidly WPC is exiting the office sector, I am doubtful that the company has material office-related risks. Instead, highly visible risks include aforementioned headwinds from debt refinancings, which (as discussed above) may heavily impact growth over the next 3 years. An underappreciated risk may be that of competition. It is possible that the growing number of net lease REITs may be a crucial reason for why cap rates have not expanded in-line with the rise of broader interest rates. If acquisition cap rates do not expand to the 7.5%-8% range or higher, then WPC might not be able to deploy retained cash flow at attractive rates of return. That would also imply that acquisition volumes must come down moving forward given that issuing debt to fund acquisitions would not make so much sense. In this scenario, investors may need to wait patiently for WPC to work through its large debt maturities over the next 3 years before stronger growth rates can return. In the meantime, the 5.4% dividend yield might not provide enough to help the stock keep up with the broader market. I note that WPC is now trading near the higher end of my fair valuation range.
I am downgrading WPC from “strong buy” to “buy” due to the reduced multiple expansion potential, but continue to see upside ahead as WPC should eventually trade more in-line with industrial REIT peers.
For further details see:
W. P. Carey: The Bulls Have Been Validated, But There's More Upside Ahead