W. P. Carey: Slight Overvaluation But Manageable Risks

Jul. 25, 2021 9:02 PM ETW. P. Carey Inc. (WPC)15 Comments

Summary

  • At its current price levels, W. P. Carey Inc. (WPC) represents a quality REIT business that is slightly overvalued.
  • Although a healthy return on investment can still be expected from this quality stock.
  • Finally, a yield spread analysis also suggests manageable short-term risk at the current price level.

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CHUNYIP WONG/iStock via Getty Images

Thesis and Background

As a conservative investor who focuses on capital preservation in the long term, the REIT sector is a great place to look for investment opportunities. Also due to my past work experiences in the housing sector, I have a soft spot for REIT stocks. At its current price levels, W. P. Carey Inc. (NYSE:WPC) represents a quality REIT business that is slightly overvalued at this moment. Although a health return on invest can still be expected from this quality stock. For investors interest in market timing, a yield spread analysis suggests manageable short term risk at the current price level.

Overview of the businesses

WPC is a global real estate investment trust ("REIT") that invests in commercial properties. The business has a long history (45+ years) of working with different companies to monetize the value in their real estate. As seen from the next chart, WPC holds a large and diversified portfolio of high-quality real estate totaling 146 M square feet. The company boasts an occupation rate of more than 90% and an annualized base rent of $1.2 billion. Also note that more than 99% of the leases have an escalation built in. With the current inflationary prospects, this will serve as a good hedge should inflation persist longer and higher.

Through property investments and long-term tenant partnerships, WPC has been delivering stable income to our investors. As seen from the chart below, WPC investors have been handsomely rewarded in the past decade through a combination of earning growth, valuation expansion. The stock delivered 240% of total return over the past decade, compares very favorably to that delivered from the SP500 index as seen below.

Source: WPC Investor Presentation

Source: Seeking Alpha

Also thanks to its diversified property investments and long-term tenant partnerships, WPC enjoys stable profitability and stable financial strength. As seen from the following chart, its interest coverage (defined as EBIT divided by interest expenses) has been very stable over the past decade with an average around a very safe 2.6x. And currently, with an interest coverage of 2.9x, it is at a better position to service its debt than the historical average.

Source: Author based on Seeking Alpha

The valuation and potential return

As can be seen from the following numbers in the table, at its current price levels, WPC is slightly overvalued depending based on various valuation metrics. In terms of relative valuation, WPC is overvalued from a few percent to about 24% against its own track record. In terms of absolute valuation, its current valuation (P/AFFO ratio around 16x) is around the average.

Source: Author and Seeking Alpha

Based on the above analysis of the business fundamental, growth potential, and valuation metrics, it is relatively straightforward to project the return in the next few years. Here let’s consider the following “normal” scenario. This scenario considers the following return drivers:

1. 6.5% growth in the earning based on consensus forecast.

2. Share dilution at 1% per year based on its historical track record.

3. Dividend on the 5.6% level (assuming dividend increase would keep the dividend yield approximately at the current level).

4. A valuation revision to the mean due to market mood swing. If this occurs, it will cause a -4% CAGR in the next 3~5 years.

Based on the above return drivers, the annual return should be around 7.1% a year as shown below, with a total return of about 20% in 3~5 years.

Source: author and Seeking Alpha

Market timing based on spread yield

For bond like equities like WPC who enjoys stable income and pay a regular dividend, a major indicator I rely on (and fortunately with good success so far) has been the yield spread, as illustrated in the following chart. This chart shows the yield spread between WPC and the 10-year Treasury since its inception. The yield spread is defined as the TTM dividend yield of WPC minus the 10-year Treasury bond rate. As can be seen, the spread is bounded and tractable. The spread has been in the range between about 2% and 4.5% the majority of the time. Suggesting that when the spread is near or above 4.5%, WPC is significantly undervalued relative to 10-year Treasury bond (i.e., I would sell Treasury bond and buy WPC). In another word, sellers of WPC are willing to sell it (essentially an equity bond) to me at a yield that is 4.5% above the treasury bond. So it is a good bargain for me.

And when the yield spread is near or below 2%, it means the opposite. Now sellers are demanding such a high price that drives yield to be only 2% above the risk-free yield – which makes less sense to me as a buyer. Such a dynamic allocation opens up opportunities for dynamic allocation to benefit from the price movement in the short- to mid-term with good reliability, as seen in the next chart below.

Source: Author based on Seeking Alpha data

The next chart shows the next 2-year total return on WPC (including price appreciation and dividend) when the purchase was made under different yield spread. As can be clearly seen, first that is a positive trend, indicating that the odds and amount of the total return increases as the yield spread increases. More specifically, the correlation coefficient is 0.59. For readers what are not familiar with the correlation coefficient, it is a number between -1 and 1. When it is 0, it indicates that there is correlation between two variables (in this case, yield spread and return, respectively). And 1 indicates a perfectly positive linear correlation between two variables. A number around or above 0.7 suggests a strong correlation. And in this case, the correlation is 0.59, suggesting a positive but moderate level of correlation.

Particularly as shown in the orange box, when the spread is about 4% or higher, an investment in WPC has not lost money in 2 years historically. For these opportunities, the total returns in the next 2 years are all positive and quite large (all from 10~35% except one data point).

As of this writing, the yield spread is 3.9%, close to the historical high end of the yield spread, suggesting a manageable risk profile relative to owning Treasury bonds even when the current valuation is slightly overvalued.

Source: Author based on Seeking Alpha data

Conclusion and final thoughts

At its current price levels, W. P. Carey Inc. represents a quality REIT business that is slightly overvalued. Although thanks to its quality and diversified property holdings, a healthy return in the upper single-digit range can still be expected from this quality stock. Also more than 99% of its leases have an escalation built in, serving as a good hedge should inflation persist longer and higher.

An analysis based on yield spread relative to the risk-free rate is also performed to gauge the short to near term risks. As of this writing, the yield spread is 3.9%, close to the historical high end of the yield spread, suggesting a manageable risk profile relative to owning treasury bonds even when the current valuation is slightly overvalued.

Thx for reading! And look forward to hearing your thoughts and comments.

This article was written by

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** Disclosure** I am associated with Envision Research

I am an economist by training, with a focus on financial economics. After I completed my PhD, I have been professionally working as a quantitative modeler, with a focus on the mortgage market, commercial market, and the banking industry for more than a decade. And at the same time, I have been managing several investment accounts for my family for the past 15 years, going through two market crashes and an incredible long bull market in between. 

My writing interests are mostly asset allocation and ETFs, particularly those related to the overall market, bonds, banking and financial sectors, and housing markets. I have been a long time SA reader, and am excited to become a more active participator in this wonderful community! 


Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

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