There's Nothing Scary About W.P. Carey
Brad Thomas wrote this article and it has appeared previously on Seeking Alpha.
- I would never recommend a REIT as a BUY, especially a STRONG BUY, and then suggest that I would be happy with a dividend cut.
- Recommending a REIT based solely on valuation could result in underperformance.
- Nobody likes unpredictability, and that’s why I decided to focus my article today on a dividend stalwart.
- Quite simply, there’s nothing scary about W.P. Carey.
One of the most important reasons that I own shares in Net Lease REITs is because of their predictable sources of dividend income. In a recent Forbes article, I explained that:
It’s a lot easier to enjoy the benefits of predictable income and growth, without the headaches (of the 3 T’s), and by owning shares in REITs with Single Tenant Net Lease properties (as a bond replacement strategy) you will be able to “Sleep Well At Night”.
As we found out earlier this week, Net Lease REITs can experience volatility, even if the underlying sources of income appear stable. As I explained in a recent article, Spirit Realty (SRC) was hammered last week as the company reported several credit issues that forced it to amend guidance, from the $.89-$.91 per share range to $0.80-$0.84 – a 9% pullback.
I immediately decided to hit the SELL button, and the market responded with a substantial pullback…
Then on Monday, SRC’s CEO was fired, leaving the company with a modest bench, and just a handful of employees who have been with the company for more than a few years. One writer, Jussi Askola, went to an immediate STRONG BUY when the earnings flop was announced, he wrote:
…the underlying value of the properties has not changed nearly that much… the portfolio is of high quality…the setback is only temporary…
This comment was the head-scratcher:
I would actually be happy if the REIT cut its dividend.
He recommends a STRONG BUY, and then suggests that he would “be happy if the REIT cut its dividend.”
The market is reacting to the news as if the REIT was at risk of going under..
Let me be clear, I would never recommend a REIT as a BUY, especially a STRONG BUY, and then suggest that I would be happy with a dividend cut. That is nonsense. More importantly, Jussi is missing one of the most important lessons of investing, and one that is critical to securities analysis, that is, that shareholders are owners and they deserve to be treated with respect and consideration.
SRC’s previous CEO was responsible for a number of mis-fires, and that's what ultimately led to his departure. The market was not necessarily reacting to revised guidance, the market was simply fed up with the complexity created by the management team (multiple forced errors).
Recommending a REIT based solely on valuation could result in underperformance. I have found it critical to evaluate stocks from an owner’s perspective, and while a STRONG BUY may sound good on paper, a shareholder could lose substantial sums with a dividend cut.
Nobody likes unpredictability, and that’s why I decided to focus my article today on a dividend stalwart, and “if you like consistency, you will love this REIT.”
W.P. Carey: Invest for the Long Haul
Now while I disagree with Jussi’s STRONG BUY call with SRC, I agree with his BUY recommendation with W.P. Carey (WPC). Jussi writes:
WPC is an above-average-quality REIT selling at a below-average valuation.
Before comparing WPC with the other peers, let’s examine the differences.
In 1973, Bill Carey started W.P. Carey & Co. with a focus on putting shareholders first and by delivering sound risk management practices. Carey believed that "over the long run" investors would enjoy stable, risk-adjusted returns.
As a pioneer in sale/leaseback financing, Carey was one of the first companies to build a net lease vehicle to assist global companies to monetize free-standing real estate. Over the years, it has evolved into one of the largest net lease landlords in the world, with a successful track record of investing through multiple economic cycles (since 2013).
In 2012, WPC converted from an MLP (W.P. Carey & Co. LLC) to a REIT (W.P. Carey, Inc.) to boost scale and to simplify tax reporting for shareholders (no longer used K1s).
By merging W.P. Carey & Co. and Corporate Property Associates 15, Inc. (a non-traded REIT), the combined company (structured as a REIT) produced enhanced dividend payments and better flexibility to access capital.
Bill Carey, the founder, recognized decades ago that owning high-quality real estate would not produce outsized returns over short cycles; but that instead, the best way to create wealth is to own shares that would generate durable dividends by always "investing for the long run."
See my Forbes article on Bill Carey (January 25, 2012).
A Differentiated Net Lease REIT
When I filter out these higher-quality REITs (investment-grade rated with a long track record of dividend growth), I see even fewer opportunities.
WPC is one such REIT that I consider to be attractive. Based upon my thorough fundamental research, I believe the company is a particularly compelling opportunity based on a number of reasons, all addressed in this article (below).
First, let's begin with the history and composition of the portfolio.
WPC is a leading global net lease REIT that provides long-term, sale-leaseback and build-to-suit financing solutions for companies worldwide. The company is "self-managed" (always a good sign) and operates two business platforms: (1) owned real estate portfolio (95% of AFFO) and (2) investment management platform (5% of AFFO).
I have highlighted CPA:17 (above), and I'll address that later in the article.
As referenced above, prior to converting to a REIT in 2012, Carey was structured as an MLP, and since that time, the company has evolved into a diversified enterprise focused on six key priorities: (1) Organic growth - through acquisitions for the Owned Real Estate portfolio and new and existing Investment Management products; (2) Diversification - of income, capital sources and within real estate portfolios; (3) Operational efficiency and excellence; (4) Balance sheet strength and flexibility; (5) Proactive asset management; (6) Transparency - through disclosure and investor outreach.
At the end of the first quarter, WPC's owned real estate portfolio consisted primarily of 900 properties across 19 countries, comprising 87 million square feet.
As you can see below, the company is diversified with a majority of industrial (30%), office (25%), warehouse (14%), retail (16%) and self-storage (5%).
It’s important to note that WPC does not have substantial retail exposure (compared to ADC, NNN, and O) and retail exposure has never been a core strategy for WPC. Retail is out of favor, and I'll touch upon the portfolio's performance below.
As you can see below, Carey invests in a variety of real estate categories:
With 900 properties in the portfolio, the REIT has a diversified model in which no one tenant accounts for more than 5% in revenue:
Another primary differentiator with Carey is its international exposure - the company has been investing internationally for 19 years, primarily in western and northern Europe.
As you can see, around 33% of its revenue is generated outside of the US (was 37% last year), and the focus internationally has been in Germany (8%), France (2%), United Kingdom (5%), Spain (4%), and Poland (3%).
Carey has a long history of investing in Europe (since 1998), and the platform (built over the last two decades) requires expertise and experience that generates a flow of attractive deals. Jason Fox, WPC’s President explains:
In Europe, activity has picked up modestly from the levels we saw in 2016, accretive investments with adequate spreads do exist especially given the low cost of borrowing. However, absolute yields remain low resulting in high prices per square foot which tend to be meaningfully above replacement cost.
He went on to say:
…our retail portfolio is heavily weighted to Europe, but only about one quarter of retail ABR located in the U.S. equivalent to just 4% of our total portfolio ABR. This is a theme that we had emphasized ever since we began investing in Europe in 1998. We believe that the U.S. has fundamentally too much retail square footage per capita a reality that is exacerbated by the fact that the U.S. ecommerce market is the most developed. As a result, we expect a pace of U.S. store closures and retail bankruptcies to continue.
Other Key Differentiators
One key differentiator for Carey - as I noted above - is the company's exposure internationally, and another unique quality is its growth drivers. Approximately 95% of leases have either fixed or CPI-based contractual rent increases, with virtually no exposure to operating expenses.
By crafting leases directly with its tenants, WPC is able to negotiate leases directly, and this is a competitive advantage that allows the company to generate predictable rent growth. Fox said (previous earnings call):
Focusing on more complex sale leasebacks has several key advantages. First, we face limited competition. There is a much smaller universe of buyers who can legitimately compete outside of the commodity segments of net lease. We have a 43-year track record of executing highly structured sale leaseback transactions, which gives us a high degree of credibility in the marketplace for these type of deals.
Second, access. With a leaseback the counterparty of the purchase becomes our long-term tenant. As a result, we get a high-degree of access to information about the tenant’s business and its long-term prospects as well as access to its senior management all of which ensure we get a thorough understanding of the risks and merits of each transaction. We also get greater access to the real estate itself enabling us to better determine its value and quality and thoroughly evaluate its criticality to the long-term prospects of the tenant.
Third, superior lease structures. Because we are writing the lease, we are able to tailor it to those specific circumstances. As a result, we believe that we are able to achieve stronger more institutional quality leases with longer lease terms, better rent escalations, improved financial covenants when warranted and greater downside protections.
He summarized the sale/leaseback advantage, saying:
Because we source and structure complex sale leasebacks, we believe we are able to generate a significant cap rate premium relative to both the commodity segment of the net lease market and assets that trade on the secondary market. To be clear, however, greater initial deal complexity does not mean greater risk.
As mentioned above, another unique feature of Carey's business model is its Investment Management business.
For many investors and analysts, multiple business models create confusion, and oftentimes, that leads to underperformance in the organization. One of the primary reasons for the confusion relates to conflicts of interest that can distract the goals and objectives creating blurred management responsibilities.
One reason that Carey has been able to successfully operate its two lines of business is because of the company's long track record.
By raising equity through the non-traded REIT channels, the company has been able to build an impressive collection of assets and then merge them with the public business, W.P. Carey. Since 1973, Carey has aggregated hundreds of properties for the purpose of forming entities that would ultimately be sold or merged with W.P. Carey. Here's a snapshot of Carey's Investment Management products:
The non-traded REIT industry is adapting for the better, with lower fees and back-end loads rationalizing the cost consistent with improving governance at the fund level. Also, Blackstone (NYSE:BX) launching its first non-traded REIT validates the continued improvements in the non-traded sector.
*Note: A noted in my disclosure, I am nowon the Advisory Board of NY Residential REIT. See the SEC Filing HERE.
Carey has generated asset management fees, structuring fees and general partnership interests of $120-180 million in recent years. Accordingly, the company has been able to spread costs over a larger asset base.
Two of Carey's entities, CPA 17 and CPA 18, own net lease buildings, and it is likely that CPA 17 will liquidate in the near term (more on that below). The $5.8 billion portfolio (CPA:17) was established in 2007.
CPA 18 is smaller ($2.095 billion AUM), and the property portfolio commenced raising equity just three years ago (in 2013).
As I referenced in the past, *I believe it's highly likely that CPA 17 will eventually merge with Carey's public REIT. As mentioned above, on February 3, 2014, Carey merged with CPA 16 in a deal valued at around $4 billion upon closing; the combined company had an equity market capitalization of about $6.5 billion and a total enterprise value of approximately $10.1 billion.
At the time of the merger, Carey's FFO jumped from $2.78 in 2013 to $4.56 in 2014, and the dividend grew from $2.44 per share to $3.39 per share - over 38%.
Remember, CPA 17 will look to monetize the portfolio, and there will likely be other bidders; however, it is doubtful that a third party will have the inside knowledge of the portfolio and infrastructure to invest internationally that Carey has. Most importantly, I view this unique platform as an asset and catalystgoing forward.
The Balance Sheet
During the 2017 first quarter, WPC completed an underwritten public offering of €500 million denominated senior notes in January and amended and restated its senior unsecured credit facility in February extending the vast majority of debt maturities out to 2021 and beyond.
As a result of this, at quarter end on a pro-rata basis, WPC’s overall weighted average interest rate was 3.7% with a weighted average debt maturity of 5.9 years versus 4.7 years at the end of the Q4-16.
WPC’s unsecured debt had a weighted average interest rate of 3% compared to 5.1% for the company’s outstanding mortgage debt. Over time, as this mortgage debt comes due, WPC will be able to replace it with lower cost upon financing.
At the end of Q1-17, WPC’s net debt to enterprise value was 38%. Total consolidated debt to gross assets was 47.9% and net debt to adjusted EBITDA was 5.7x. As the company continues to grow the balance sheet (through accretive acquisitions), it expects leverage metrics to remain around similar levels, while further enhancing the overall credit profile through the use of unsecured debt under the unencumbered strategy.
WPC is rated BBB (O is BBB+ and NNN is BBB+) and I believe it’s likely that the company could get a credit upgrade (to BBB+) in the next 12-24 months. Furthermore, WPC’s balance sheet improvements also position the company for a potential rollup with CPA:17 in 2017 or 2018.
For the 2017 first quarter, WPC generated AFFO per diluted share of $1.25 and raised the quarterly cash dividend to $0.9950 per share maintaining a conservative payout ratio of 79.6%. The first quarter dividend is equivalent to an annualized dividend rate of $3.98 per share. As you can see below, WPC has maintained a steady and predictable dividend growth strategy.
As noted above, owned real estate generates about 94% of total AFFO for the quarter with the remaining 6% coming from the investment management business.
WPC’s total AFFO per diluted share was $0.06 lower as compared to the Q1-16 due primarily to lower revenue from both the owned real estate and investment management segments, partially offset by lower interest and G&A expenses.
Owned real estate revenue decreased due primarily to lower leased termination income which can fluctuate significantly from period-to-period. The remaining decline was driven by lower leased revenues resulting from plant property dispositions during 2016.
At Q1-17, WPC had seven leases expiring, representing just 1.1% of total ABR, all of which has now been addressed primarily through new leases and lease extensions. The company has 10 leases expiring in 2018 representing just 1.6% of total ABR, two-thirds of which has either been addressed or is in active negotiations.
WPC has affirmed the previous AFFO guidance range of $5.10 to $5.30 per diluted share. Here’s a snapshot of the FFO per share forecaster for WPC and the peer group:
As you can see, WPC is expected to generate modest AFFO per share growth in 2017 and 2018; however, these assumptions don’t include the big catalyst, CPA:17. Here’s my revised forecast based on the CPA:17 deal (assuming to close in 2018):
As you can see, based on AFFO/share growth and dividend safety, I rank these REITs in order of best to worst (to BUY right now): Realty Income, STORE Capital (STOR), W.P. Carey, and Gramercy Property (GPT).
Keep in mind, WPC is the only REIT that has a possible $5 billion portfolio, and while there is no guaranty that CPA:17 rolls up with WPC, it’s highly likely and a key catalyst that makes this REIT a top pick.
Also, WPC’s dividend yield is 6.5%, almost 200 bps above the stalwarts, O and NNN:
Also, WPC is trading well below O & NNN (remember, WPC has modest retail exposure):
The Bottom Line: If there is a case for a STRONG BUY in the Net Lease REIT sector, it would be W.P. Carey. The company has NOT relocated its HQ to Dallas, the company has not acquired a portfolio of grocery stores that go belly up (bankrupt) within weeks of closing. The company has not lowered guidance as a result of weak tenant (Shopko) credit issues. The company is not being run by rookie REIT professionals. The company does not have a toxic retail portfolio with lower-quality assets.
No, WPC is the exact opposite (of SRC), and if there’s ever a Net Lease REIT that deserves a STRONG BUY recommendation, it’s W.P. Carey. Quite simply, there’s nothing scary about W.P. Carey.
DISCLOSURE: I am on the Advisory Board of NY Residential REIT and I am also a shareholder and publisher on The Maven (OTCQB:MVEN).
Source: F.A.S.T. Graphs and WPC Filings (Q1-17).
To get a first look at my upcoming article, "The Evolution of My Durable Income Portfolio," click here. I also include all of my Rhino REIT Ratings in my marketplace product, REIT Beat.
Author Note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors, if they are overlooked.
Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).
Other Mall REITs mentioned: (ADC), (FCPT), (EPR), (STOR), (VER), (GPT), (OLP), and (LXP).
Disclosure: I am/we are long APTS, ARI, BRX, BXMT, CCI, CCP, CHCT, CLDT, CONE, CORR, CUBE, DLR, DOC, EXR, FPI, GMRE, GPT, HASI, HTA, IRM, KIM, LADR, LTC, LXP, O, OHI, PEB, PK, QTS, ROIC, SKT, SNR, SPG, STAG, STOR, STWD, TCO, UBA, VER, VTR, WPC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.