W. P. Carey (NYSE:WPC) proved itself to be one of the most resilient REITs during COVID-19 as its rent collections, occupancy, and cash flows barely felt any impact. As a result, the company continued to raise its dividend through that challenging period at the same time as many other REITs were freezing, slashing, or even suspending theirs.
However, despite outperforming during the crash, the stock price has since been dogged by slow dividend growth and AFFO/share headwinds from exiting the asset management business. As a result, it has materially underperformed the broader REIT market (VNQ) thus far this year:
While we are not complaining about the juicy and safe yield over 5%, at the end of the day we want our investments to at least keep pace with their broader sector. Investors have spoken loud and clear: While they like safety and security of a nice fat yield - which WPC provides and proved in spades during the COVID-19 crisis - at the end of the day they want investments that can grow and generate significant capital appreciation alongside fat yield. If they want stable and secure yield, they would buy a preferred equity or bond. Equity investments must also offer growth to be worthwhile.
The good news is that the Q3 results showed that the narrative - and we believe the total return performance relative to the broader index - is about to change for WPC. Here are three reasons why:
#1. Inflation Is Here
WPC is arguably the best positioned in the net lease REIT space and probably also one of the best positioned in the entire equity REIT space to benefit from inflation, as 60% of its ABR is tied to CPI. As management wasted little time pointing out on the earnings call:
Higher inflation had a positive impact on our same-store growth during the third quarter, especially for leases tied to uncapped CPI. However, it is really just the start, with the bulk of the impact occurring over the next few quarters.
After acknowledging that their strategy of tying so much of their rent increases to CPI has reduced growth in recent years, management fully expects this narrative to change in the near future:
With inflation picking up in recent months, we expect leases tied to inflation to drive rent growth, and strongly outpace the 2.3% average fixed rent bump we saw for the third quarter. Inflation began to flow through to rents during the third quarter, although on a relatively small portion of our portfolio. Leases with CPI-linked rent increases, they went through scheduled rent adjustments during the quarter, experienced rent increases averaging 3.3%. The vast majority of CPI-linked leases, that did not bump during the third quarter, are scheduled to do so over the next 9 months, adding about 100 basis points to our same-store rent growth based on current inflation forecasts.
The bottom line here is that WPC is in the process of receiving a major boost to growth from inflation which is something that most of its fellow REITs will not see. As a result, as the market goes from focusing on fixed rent bump-driven organic growth to inflation-linked rent bump-driven organic growth, WPC will surge to the front of the line for investors looking at options that combine that cash flow stability of the net lease REIT model with inflation protection. This, in turn, will generate valuation multiple expansion on top of accelerating bottom line growth.
#2. The Growth Pipeline Remains Robust
Thus far this year WPC has been investing aggressively in growing via acquisitions of new properties. Management expects that total deal volume will come in between $1.5 billion and $2 billion for the year, but signaled on the earnings call that it could very well come in at the high end of that number and if not, it will by early 2022. Given that WPC has a total enterprise value of $21.7 billion and much of this deal flow has already been completed, this means that the company is expected to grow by about 10% this year.
Even better, management is achieving pretty attractive terms on these acquisitions, especially when you take into account the cheap debt it's raising and the quality of the assets it's purchasing. For example, in Q3 WPC completed about $200 million of investments primarily into Class A warehouse properties in the U.S. at a weighted average initial cap rate of 6.2%. The weighted average lease term on its acquisitions this year is a whopping 19 years as well which is among the longest for new investments across the net lease sector.
Management also highlighted a strength in these acquisitions that further sets it apart from the competition:
Our ability to structure these deals with long lease terms and strong rent increases averaging over 2% for those with either fixed rent increases or floors, translates to an average annual yield of over 7%. The metric that we believe better captures the prolonged accretion we're achieving.
The cheap cost of capital was further enhanced during the quarter when management tapped the ESG markets to issue a 10-year green bond at a paltry 2.45% interest rate. The spread between this rate and the assets they are investing in is enormous and shows just how strong the growth potential for the company is, especially when they are investing in such a high volume of deals.
#3. Increasingly A Pure-Play Industrial REIT
Exiting the asset management business has put the company in a “worst of both worlds” scenario where the company is facing headwinds to its bottom line due to reduced asset management fees while also not enjoying the multiple that comes with being a pure-play equity REIT. As a result, it should not be surprising that WPC has underperformed in recent years.
However, that's about to change as 98% of the company’s cash flow now comes from its real estate portfolio and its final asset management fund is supposed to liquidate next year. As a result, it should finally command a greater multiple as a pure play equity REIT and also will no longer have headwinds from declining asset management cash flows.
Furthermore, WPC is increasingly become concentrated in industrial/warehouse properties alongside a strategic portfolio of specialty retail and mostly investment grade tenant office properties. Management highlighted once again repeatedly on the Q3 earnings call that the vast majority of its year to date acquisitions and its pipeline are warehouse and industrial assets.
On top of that, management also has made clear that it intends to continue moving away from its office assets and that over time its allocation to industrial and warehouse assets will steadily increase. Given how in favor industrial real estate is, this should enable WPC to enjoy further multiple expansion as it compares very favorably to its retail heavy net lease peers.
While WPC has underperformed in recent years due to the burden of not being a pure play equity REIT and facing growth headwinds from losing asset management fees, it has all but completed its transition to being a pure play equity REIT. On top of that, it has positioned its portfolio to thrive in the current inflationary macroeconomic environment, is flush with near limitless growth opportunities, and is becoming increasingly focused as an industrial and warehouse equity REIT.
Meanwhile, the stock continues to trade at a discount to pre-COVID levels and most of its peers, thereby keeping its very safe dividend yield well north of 5%. As management stated on the earnings call.
We believe WP Carey currently offers one of the best combinations of external and internal growth across the net lease sector supported by the strength of our near-term pipeline, ample liquidity, and continued access to well-priced capital, in addition to providing an attractive dividend yield.
WPC remains our top pick in the net lease space and we fully expect it to outperform moving forward.
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