Carey Means Clarity

Summary

• To put it in simple terms, Net Lease investing should be simple, there’s really no reason to get “too cute” and try to outthink Mr. Market.
• Like Buffett buying into STOR, catalysts can be pleasant surprises, especially when you are correct with the overall assessment of the company.
• If there’s ever a Net Lease REIT that deserves a STRONG BUY recommendation, it’s W.P. Carey.

It was great to see one of my previously referenced catalysts playing out last week in the Net Lease REIT sector, and while I was not expecting such a big spark with Berkshire Hathaway’s (BRK.A) (BRK.B) investment in STORE Capital (STOR), it proved to be a textbook example of an undervalued REIT flying under the radar. Back in February, I explained:

STOR is trading at a margin of safety, and I expect that valuation gap to close in 2017… I believe there's a margin of safety that represents an outsized opportunity in which returns could fetch 20% per year…

STOR closed the week at $22.45, up around 10%, and in an article last week I added:

…it's clear that Berkshire Hathaway is now holding a Net Lease gem that offers investors a reliable source of dividend income with shares priced at a sizable margin of safety. The latest move also validates the importance of owning Net Lease REITs in an investment portfolio and the high fragmentation that will result in further consolidation.

I pointed out to someone last week that BRK’s investment in STOR was like its much larger stake in Wells Fargo (WFC) and Bank of America (BAC). For the same reasons that Buffett has amassed outsized positions in the two largest banks, I view the move (to owns shares in STOR) as more of a bet on Net Lease REIT consolidation and a validation that Berkshire Hathaway sees value in being a stakeholder in the highly fragmented Net Lease financing sector.

I have been preaching this for some time on Seeking Alpha, that is, being a low-cost consolidator means that investors benefit from stable dividends and steady share price appreciation. No other property sector has demonstrated such resiliency through multiple economic conditions, and Net Lease REITs remain the most favored method for generating reliable and predictable dividends.

To put it in simple terms, Net Lease investing should be simple; there’s really no reason to get “too cute” and try to outthink Mr. Market. There’s really just one reason that Net Lease REIT investors should be investing in these companies: steady and growing dividends.

A few days ago, I wrote on Global Net Lease (GNL):

As far as I'm concerned, Mr. Market is pricing GNL squarely. There is plenty of cheese in the trap (9.5% dividend yield), and I don't see any catalysts that suggest shares will move up "materially."

I went on to explain:

Net Lease REITs should be predictable, and based upon my analysis, GNL is riddled with complexity. Simply said, there's a good reason that the company's dividend yield is 9.5%.

One of the reasons that I viewed STOR as an attractive STRONG BUY is because of the simplicity in execution. Unlike GNL, a REIT riddled with complexity risk, STOR is two-club operation.

In other words, (with STOR) I could bring my pitching wedge and putter and easily outperform GNL, a REIT with complicated financial engineering that distracts from the primary objective for Net Lease investing: steady and reliable dividend growth.

Today I am writing on a Net Lease REIT that is becoming much simpler, and like STOR, I believe consolidation is a catalyst that will drive share price performance. Like Buffett buying into STOR, catalysts can be pleasant surprises, especially when you are correct with the overall assessment of the company: W.P. Carey Means Clarity

Source Photo

The Evolution of this Bell-Weather REIT

Before comparing W.P. Carey & Co. (NYSE:WPC) with the other peers, let’s consider the company’s history…

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).

More Clarity Now

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).

Recently, WPC decided to wind down its Investment Management (non-traded REIT) business and concluded that shareholders would be better served by focusing on its core Net Lease business. Existing funds would remain unchanged through its intended life cycle. There was no change to 2017 guidance. As Paul E. Adornato, CFA, formerly with BMO Research explains:

This removed institutional barriers. Although we had become comfortable with WPC's platform as one of the respectable players with a long track record, some peers muddied the waters in a variety of ways. REIT dedicated investors have never warmed to this business, making WPC an easy name to avoid.

Adornato added:

Changing economics, regulatory uncertainty, and next generation funds (Blackstone) are likely to erode incumbents' profitability, dependent upon large commissions and non-recurring fees. As the platform is no longer significant to WPC's bottom line, we think its absence will be a net positive.

Adornato also echoes the belief that the removal of the investment management business “eliminates conflicts”, and he explained that “investors also objected to the perceived conflict of management sourcing Net Lease investments for both WPC's balance sheet and its NTRs.”

Now a Pure Play Net Lease REIT

Carey now becomes a pure-play Net Lease REIT, and 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:

WPC has subscribed to the view that US retail real estate is overbuilt; it has had little such exposure for years, instead, 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.

Fox added:

...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.

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 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 with 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.

Carey Has This Catalyst

As noted, Carey will soon become a simpler REIT, as the company winds down its Investment Management business. One noticeable catalyst is Carey's Investment Management products:

As viewed above, 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, the $5.8 billion portfolio (CPA:17) was established in 2007, and it is nearing its life-cycle as a non-traded REIT.

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.

Carey previously 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 catalyst going forward.

Why is Carey a SWAN?

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):

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 6.1%, almost 150 bps above the stalwarts, O and NNN:

Let’s now compare the payout ratio:

Clearly Carey’s divestiture from the Investment Management business will have little impact to the Payout Ratio. In other words, assuming Carey walks away from 5% in AFFO, CPA:17 and CPA:18 will boost the bottom line and provide the company with plenty of gun powder to grow the dividend.

Based on P/FFO, WPC is trading well below O and 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 (i.e. SRC), the company has not acquired a portfolio of grocery stores that go belly up within weeks of closing (i.e. SRC). The company has not lowered guidance because of weak tenant (Shopko) credit issues (i.e. SRC). The company is not a sucker yield (like GNL).

No, WPC is the exact opposite, and if there’s ever a Net Lease REIT that deserves a STRONG BUY recommendation, it’s W.P. Carey. The company’s decision to exit the Investment Management business is a good one, and I would not be surprised to see more big money (institutional) going into the name. The stock trades at an 11% discount to Net Lease peers' 14.0x and a 35% discount to REITs' 19.1x average.

To learn more about my REIT Beat service, click here. For a limited time, I am providing new subscribers with an autographed copy of The Intelligent REIT Investor. This is a limited offer, so don't miss out!

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).

Disclosure: I am on the Advisory Board of NY Residential REIT, and I am also a shareholder and publisher on the Maven.

Source: F.A.S.T Graphs and WPC Investor Presentation.

Other REITs mentioned: FCPT, SRC, NNN, VER, O, EPR, and ADC.

Analyst’s Disclosure: I am/we are long AHP, APTS, ARI, BRX, BXMT, CCI, CCP, CHCT, CLDT, CONE, CORR, CUBE, DLR, DOC, EXR, FPI, GMRE, GPT, HASI, HTA, IRET, IRM, JCAP, KIM, LADR, LTC, LXP, NXRT, O, OHI, PEB, PEI, PK, QTS, ROIC, SKT, SNR, SPG, STAG, STOR, STWD, TCO, 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.