WPC: Slam Dunk? Rejected.
W.P. Carey (WPC) came out with a plan that could've been great. It could've been. Or in other words, it wasn't.
Let's be clear. I'm not pulling any punches. WPC is a big net lease REIT with a strong record prior to today. They successfully navigated difficult environments.
What Happened?
WPC announced they would eliminate office from their portfolio. That's good. They decided they could do it faster by using a spin-off. That will make it a "pro rata special distribution" which is expected to be taxable.
That's not great since many shareholders may hold WPC in taxable accounts. It was a long-term dividend growth stock. It was suitable for many taxable accounts owned by income investors. The new REIT will be Net Lease Office Properties and the ticker will be (NLOP). Perhaps FLOP was unavailable.
I'm not thrilled with this choice. It wasn't optimal, but it's not enough to botch the plan.
Unfortunately, this transaction was structured to not require shareholder approval. If it did, shareholders may have rejected this terrible plan.
Dumb Decision
This is where things get stupid.
WPC indicated that this plan was expected to result in the company being more appealing to many investors. It won't.
In WPC's press release, they didn't mention the impact on dividends.
However, WPC's presentation references resetting the dividend.
They wanted to target a 70% to 75% payout ratio on AFFO. For reference, the current payout ratio is about 78% of AFFO. However, the transaction will be dilutive to AFFO.
That's how WPC botched this.
WPC had a 25-year history of dividend increases. During the GFC (Great Financial Crisis), they raised dividends. During the pandemic, they raised dividends. That 25-year history was actively contributing to a lower cost of capital. It enabled them to show up in screening tools and indexes that don't include dividend cutters.
To be clear, the equity cost of capital is not the dividend rate. If that were the cost of capital, the solution for every company would be to just cut dividends. Instead, the cost of capital is generally thought of as the earnings yield, cash flow yield, or AFFO yield (depending on the sector).
What WPC wants to achieve is a higher share price. That would allow them to issue new equity for acquisitions at accretive rates. Well, in most cases, they could do that. It's actually getting much harder to get accretive acquisitions due to the high cost of debt.
Net lease REITs are known for two things:
- They carry higher dividend yields than other equity REIT types.
- Three of them had dividend growth history of around 25 years or longer.
WPC's decision is about to make them less attractive to most investors.
Lower Cost of Capital is a Pipe Dream
On the call, management repeatedly referenced lowering their cost of capital. That won't happen. How can you tell it won't happen?
The market rebuked WPC's plan with a slap across the share price. See the chart below for the change in triple net lease REITs, along with Treasuries (TLT) and the Vanguard index ETF (VNQ):
Source: Seeking Alpha
It was a down day for equity REITs, but WPC clearly took the biggest hit. Global Net Lease (GNL) is one of the junkers in the sector with weak management and too much debt. If we toss GNL out, WPC fell more than twice as much as the next biggest decline.
Weak Presentation
The presentation left a great deal to be desired.
WPC will be externally managing NLOP. In other words, after taking several years to finally get out of asset management, WPC is right back in it. Well, so much for that.
But there are also questions about how analysts should try to update their models.
For instance, how should analysts model for AFFO next year? Guidance was updated for 2023, but it only includes a brief period after the spinoff.
How should we model the cash flows when sales are planned for 5% of total rent and a spin-off is planned for 10% of total rent?
Rather than providing analysts with more hard numbers in the presentation where they could be quickly copied over to a spreadsheet, management saved the commentary for the call. They did not provide a transcript of the call. Outstanding.
Terrible Call
The first question starts at 20:41, for anyone who really wants to hear it.
The first question from an analyst is about the:
...AFFO per share impact of the first bucket? Losing the asset level revenues? Then the third, which was the income from NLOP?
Pretty clear, right? It sounds like he has his existing model and wants to figure out what adjustments he should apply. That's pretty normal.
Here's the answer:
Yeah, I think, you know [stutters], as you highlighted [stutters], we gave kind of the building blocks in total dollars. And I think, you know, we we [sic] did not give the per share impact predominantly because it does depend on how we redeploy the capital. Um, so you know, again [stutters] whether we're doing debt or equity in this [sic]. We did mention that this does de-risk our equity requirements for next year. So those are actually assumptions, that you know, we're not getting into at this point. It's something we'll give a little more color on when we get into 2024 guidance, but I think what you have should be sufficient on the dollar basis to really get there, and you know, this is just to recap the spin. Umm, we provided the ABR, the expenses, which we expect to take effect November 1st, and the balance sheet sales, umm, largely through year-end and into the January [sic].
I'll wait for a transcript to get the rest of the call. This was just painful. This data should've been provided explicitly in the presentation. Hiding it doesn't make it look any better.
Target Adjustment
I will adjust the targets over the weekend. I want the call transcript. It makes it vastly easier to find the numbers. The only thing worse than using audio to convey this much information would be putting in another language or adding static.
WPC will see an increase to the risk rating and a reduction to the price target. All net lease REITs were expected to see some reduction to the increased yield on TIPS (Treasury Inflation-Protected Securities). Income alternatives are a big risk to net lease REITs and the higher Treasury yields are raising the cost of borrowing.
However, WPC will see a bigger reduction than peers. That reduction is because management appears far less competent today.
Management stated:
We expect our actions to broaden our appeal to both debt and equity investors, resulting in a lower cost of capital, wider investment spreads, and an enhanced earnings growth profile.
Clearly, the market ripped up their plan and threw it back at them.
What is a lower cost of capital for equity?
If it means a higher AFFO multiple, they will probably get that. The price may fall by less than real estate AFFO per share. That's a term I didn't want to bring back out.
However, it's unlikely to be a higher share price than they would've had. Can they really call it wider investment spreads if the cost of capital is lower because AFFO is lower? Usually, we think of improving investment spreads by getting a higher share price or a higher cap rate on new assets. Getting lower AFFO isn't really the goal.
They did certainly emphasize that this plan doesn't require shareholder approval though. Almost as if they knew investors would vote against it if given the choice.
What They Should Have Done
They already have several office sales under contract. If they just announced that, it would've been great. They could've also announced that they are planning to exit the rest of their office assets over time. That would've been great also.
If they were committed to creating a taxable distribution that creates a liquidating REIT, they still COULD have maintained the dividend. Coverage would've been dreadful, but they could've done it. They could've gone to a dividend increase of $.01 per share per year. With their rent escalators, they would've worked their way out from under it. Earnings growth would've been slow with the debt, but they could've worked through it.
They could've committed to shareholders that they could still cover the dividend and we're just going to grow slower for a few years. They could've backed it up by buying shares to create more credibility for the statements. This isn't hard.
NLOP
NLOP will be saddled with some very expensive debt. A large chunk of the cash from that debt will be used to send cash to WPC. This is pretty stupid. The debt NLOP is taking out will be at SOFR + 5% with a 3.85% floor and requiring them to buy a SOFR cap of 5.35%. In other words, after pricing in the cap, the rate will be quite a bit higher than SOFR + 5%.
Since NLOP shareholders will initially be WPC shareholders who are still footing a tax bill, this isn't the greatest move. The weighted-average cost of debt between the two companies will be higher than the cost was for WPC alone.
NLOP will also have a mezzanine loan with a 10% rate for 5 years and a 4.5% payment-in-kind accrual feature. Yeah, NLOP is terrible. It would've been more efficient to just sell these assets gradually off WPC's balance sheet.
Conclusion
Thoroughly disappointed in WPC's management. Someone should've rejected this plan way before it reached the market. Yes, it will give WPC a better growth profile. However, they are losing the credibility they spent 25 years building. They won't be better off for the slightly better growth profile. It will still take years just to recover real estate AFFO to the current level, so "faster growth from a lower baseline" isn't super impressive.
In the years they spend recovering AFFO per share, they could’ve just been selling off the office assets directly from their portfolio.
Disclosure: Long all shares in CWMF’s Portfolio. No position in WPC or the other net lease REITs presently.
Member discussion