W. P. Carey Stock: Inflation-Proof Your Income Portfolio

Summary

• 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.
• Looking for a portfolio of ideas like this one? Members of High Yield Investor get exclusive access to our model portfolio. Learn More »

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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:

Data by YCharts

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:

Data by YCharts

#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.

Investor Takeaway

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.

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.

Comments

[Samuel Smith]

Hi,

Thank you for reading! I hope you enjoyed this idea. Let us know if you have any questions.

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[jc4877]

@Samuel Smith - thanks for the thoughtful article. How much do you think the CPI escalators will lift FFO?

[Samuel Smith]

@jc4877 it depends where CPI goes from here, obviously, but I would expect them to lift it by a few percentage points on a per-share basis.

[Strong&Long]

Similarly to WPC, NNN and STOR have most rents CPI linked. From the group, only O has almost all rent-bumps fixed.

[Phillip French]

Samuel, I enjoy reading your articles on SA. You are a very good writer! WPC is a great company IMHO. I bought my current holding at the depth of the Covid plunge around April, 2020, for a great price of about 39.00 with a yield of 12%. As much as I would like to buy more, I have a problem with buying at the current price so I will patiently wait for a drop.

[Samuel Smith]

@Phillip French thanks so much for the kind feedback!

[boog3]

The minutes today said over 2 percent by 2024. Your right if this happens and the money supply is decreased? The pain will start.

[User 138453]

@boog3 The pain, if any, will dissipate fairly quickly because 2% by 2024 is almost back to historic norms for interest rates. 2% is still really low historically. And a gradual increase of 2% over the next two years is easily absorbed by the market.

[jgrever621]

WAY overweight WPC for exactly these reasons. Also DRIPing, at least until the cost rises to 83, which is my current buy below price.

Good article. Enjoyed reading your article as usual.

[Samuel Smith]

@jgrever621 thanks!

[Pablo]

Waiting for a good price. A couple-three months and it will be WPC buy time, March-April most likely.

[Samuel Smith]

@Pablo thanks for sharing

[pelican11]

I’m with you on WPC, one of my largest REIT holdings. Looking forward to watching their 2022 acquisition activity, as they continue to grow, especially their industrial portfolio.

Thanks for the article.

[Samuel Smith]

@pelican11 you're welcome!

[boog3]

The FED is drying up the money supply and raising rates. That to lower inflation. That is the over all threat to the market. Interest rates are at zero. They were about a half percent before the pandemic. Anything can happen. End of year should be interesting. My opinion. Thanks for the article. I own and likeWPC.

[Tressilian]

@boog3 The Fed has only announced that it is slowing its money printing. This after M1 has gone from 4 trillion in Feb 2020 to 20 trillion now. They've screwed us and will not harmlessly get that genie back in the bottle.

[Samuel Smith]

@boog3 you're welcome. The Fed cannot do too much in terms of raising interest rates without crashing the economy and breaking the federal budget.

[User 50124969]

@boog3 WPC can borrow money in Europe at rates next to nothing and spend it on properties globally somewhere rates are much higher. It is a fantastic business model.

[It Is All About The Timing]

Dividend growth sitting at 1.37%. Not so great at keeping up with inflation.

[By_Endurance_We_Conquer]

@It Is All About The Timing

I read and hear that argument very often.

However, I do not understand it. I mean: You invest $1000 and WPC pays you around 5.2% via the dividend yield. Usually, that beats inflation and keeps your original investment intact.

Normally, dividend payers with low yields (below inflation) raise the dividend above inflation. And dividend payers with high yields (above inflation) raise the dividend below inflation.

What you want is the best of both worlds: high yield with high raise (above inflation).

IMHO you are expecting too much!

[cureman55]

@It Is All About The Timing Maybe too slow dividend growth for you but my largest holding allows me to sleep well at night.

[marshbound]

@It Is All About The Timing That's an historical growth rate - inflation has only recently jumped sharply so few contracts have hit their rate reset intervals yet. Sure, rate increases will lag the increase in inflation, but they'll lag the decreases later too, a good thing for investors. In the long run should all wash out.

[Income4ever aka Cyclenut]

WPC is an income investor must have core holding just like O. Period

[PB Investment]

Good yield, but a bit overpriced. I would buy if yield becomes > 5,50%.
However, there is basically no dividend growth.

[User 138453]

@PBInvestment There have been nine consecutive years of dividend growth during the last nine years, including the past two years of quarterly dividend increases during the global pandemic. And a track record over the past 23 years of dividend payments without any decreases even during the Great Recession. Pretty good dividend record and steady growth for the past nine years..

[PB Investment]

@wysockiman DGR of the last 8 years has been ~3,2%.
DGR of the last 10 years has been ~6,7% (thanks to a bump 9 years ago, otherwise it would have been definitely less).
They are both good.
But if you look at the last 3 and 5 years (with COVID) the DGR has been of ~0,9% and ~1,3%, respectively.
If you look at the DGR from 2014 to 2019 (last 5 years before COVID), the DGR has been of ~2,9%.
It's a good stock and a solid dividend. But for these reasons, I would target at least a 5,50% yield. Of course, it depends on your goals. Just stating the facts above :)

[Income4ever aka Cyclenut]

@PBInvestment
Agree that DG is minimal last 5 years but they will achieve the prestigious goal & honor of becoming dividend aristocrat next year.
They are also in the process of unwinding their private fund and once completed as expected later in 2022 that should be a catalyst for more robust dividend growth.

[User 138453]

You make a credible "bull" case for investing in WPC. Thanks for the coverage, Samuel.

[Samuel Smith]

@wysockiman you're welcome!

[Duras]

Samuel, nice clear cut article. You have a habit of writing about companies I've begun circling, thank you, much appreciated.

[Samuel Smith]

@Duras great to hear! Thanks for the kind feedback.