- The triple net lease space has proven to be one of the top income investments in recent years.
- However, with inflation soaring and interest rates potentially headed higher, this sector - widely viewed as a bond proxy - is at risk.
- WPC has the strongest inflation protection in the triple net lease space, making it an exception to the rule and an opportunistic time to invest.
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The triple net lease space (NETL) has proven to be one of the top income investments in recent years, with triple net lease REITs like Realty Income (O) and STORE Capital (STOR) beating the broader real estate sector (VNQ) in recent years by a healthy margin:
The reason for this is simple: the triple net lease is a bond-like business model with high security and seniority for the rental contract along with lengthy terms spread across thousands of properties that all combines to create a very safe and stable source of cash flow for the REIT that it can then distribute to shareholders via dividends while retaining some of it to reinvest.
On top of that, there are annual rent bumps worked into the lease contracts, which combine with the retained cash flow to generate very consistent and attractive growth. This means that, not only do these triple net lease REITs serve as bond proxies as a lucrative and stable source of income, but they also incorporate growth into their model, essentially making them a best-of-both worlds investment by combining the safety and yield of bonds with the growth potential of equities.
As the cherry on top, publicly traded triple net lease REITs like STOR and O also almost always trade at a premium to NAV thanks to their many inherent strengths which add value to the underlying real estate. As a result, management can issue new shares on an accretive basis which it can then pool together with its retained cash flows and cheap long-term fixed-rate debt to generate even faster growth.
STOR illustrates the power of this business model by showing that - in addition to its attractive mid-single digit dividend yield - it expects to grow cash flows organically by over 5% annually before considering the impact of issuing new shares.
source: Investor Presentation
However, with inflation accelerating and interest rates potentially headed higher, this sector - widely viewed as a bond proxy - is at risk. Income investors need returns to not only exceed the rate of inflation to protect their principal, but also need income yields to grow at a rate that is near to the inflation rate in order to preserve their purchasing power.
Unfortunately, the typical triple net lease REIT only has fixed annual rent bumps in the vast majority of its leases, meaning that income growth relative to inflation is likely going to decrease. Furthermore, the existing yield on the investment relative to the inflation rate is also going to decrease as inflation rises. Meanwhile, if interest rates head higher, the risk-free rate will rise, making the valuation of triple net lease REITs less attractive on a relative basis. Cap rates will likely expand and the cost of new debt will also rise. This in turn will reduce the net asset value of triple net lease real estate and likely cause shares of triple net lease REITs to decline. All of this adds up to a higher cost of capital as well, making it harder for REITs to grow via issuing shares and new debt.
While all this is true, there is one triple net lease REIT that is uniquely well-positioned to weather inflationary pressures: W. P. Carey (NYSE:WPC). We share three reasons why in this article why it is your best bet in the triple net lease space for weathering the current inflationary environment.
#1. 60% Of WPC's ABR Is Linked To CPI
60% of WPC's ABR is linked to CPI, leading management to point out on the Q3 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... 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.
While STOR and O (which only has ~30% of its ABR linked to CPI) will be seeing 1.8%-2.5% annual rent bumps from their leases, WPC will likely see much higher thanks to its positive exposure to inflation. CPI is soaring at the moment, and if this continues in the coming year, WPC will see significant daylight between its rent bump growth rate and its peers:
#2. WPC Is Buying Properties Hand-Over-Fist
On top of this strong fundamental protection from inflation, WPC is also growing via acquisitions at a rapid pace. In 2021, management took advantage of the low-interest rate, high equity pricing environment to issue a bunch of equity and debt on very favorable terms and then has proceeded to pour it into an aggressive pipeline of industrial and warehouse properties.
The company expects that total 2021 deal volume will come in near $2 billion with average cap rates of 6%+ on lengthy weighted average lease term of ~19 years. This aggressive acquisition growth rate should an additional layer of protection from inflation by giving shareholders an even higher overall growth rate.
#3. WPC Has A Margin Of Safety
Last, but not least, WPC's share price has a margin of safety that should also help protect shareholder principal from the eroding influence of inflation. The dividend yield is currently 5.2% and the Price to FFO ratio is 17.3x, both of which imply a distinct discount to O, which offers a 4.15% dividend yield and a Price to FFO ratio of 20.6x despite being at greater risk of negative impacts from inflation. Even STOR - which has a weaker credit rating than O and a weaker portfolio than WPC given that it lacks the significant exposure to industrial and storage that WPC has - trades at a premium to WPC with an 18.47x Price to FFO ratio and a 4.45% dividend yield.
As a result of these built in discounts and the fact that WPC should command a greater multiple anyway as it finally transitions to a pure-play equity REIT this year (it only has one final asset management fund to wrap up this year), is increasingly recognized as an industrial/warehouse REIT, and is seen as the most inflation-resistant triple net lease in the market right now, WPC looks like it is the least likely triple net lease REIT to get punished by the markets from rising inflation.
While the triple net lease REIT space has an impressive history of generate very attractive dividend growth and total returns over the long-term, the current inflationary environment poses a new threat to the business model that has not been seen in a long time.
As a result, we believe that WPC continues to offer the best risk-adjusted return outlook in the sector thanks to its best-in-sector resistance to inflation.
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This article was written by
Samuel Smith is Vice President of Leonberg Capital, he has a diverse background that includes being lead analyst at several highly regarded dividend stock research firms. He is a Professional Engineer and Project Management Professional and holds a B.S. in Civil Engineering & Mathematics from the United States Military Academy at West Point and has a Masters in Engineering.Samuel leads the investing group High Yield Investor investing group. Samuel teams up with Jussi Askola and Paul R. Drake where they focus on finding the right balance between safety, growth, yield, and value. High Yield Investor offers real-money core, retirement, and international portfolios. The services also features regular trade alert, educational content, and an active chat room of like minded investors. Learn more.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of WPC either through stock ownership, options, or other derivatives. 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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