W.P. Carey (NYSE:WPC) is a blue-chip triple net lease REIT that owns a combination of industrial, logistics, essential retail, office, and self storage real estate. It has a phenomenal track record of weathering recessions and consistently growing cash flow and dividends per share, leading to long-term market-beating returns for shareholders:
With its solid investment grade balance sheet, well-diversified and conservatively-positioned real estate portfolio, and proven track record, WPC is in great shape to weather the current economic downturn that we find ourselves in. In this article, we will share two important takeaways – one positive and one negative – from the company’s recently released Q2 earnings report and provide our update investment thesis on the company.
Between WPC’s robust acquisition momentum, strong equity price, and the inflation tailwind to its rental income, its risk-adjusted growth profile has not been this strong in years.
WPC invested $477.8 million during Q2 and has followed that with $307.6 million so far in Q3, bringing the total year-to-date investment volume to $1.1 billion. With total dispositions in the first half of 2022 summing to $119.4 million, WPC has grown its portfolio by $1 billion already. This prompted management to raise its full-year investment volume guidance to between $1.75 billion and $2.25 billion. With an enterprise value of $22.9 billion, this means that the company will likely be growing in size by ~9% this year, which is quite impressive for a conservatively run triple net lease REIT that pays out a high percentage of its cash flow as a dividend.
This strong acquisition growth rate is being bolstered by the company’s favorable share price at the moment, which trades at a clear premium to NAV. As a result, WPC is able to issue shares and lock in forward share sale agreements at accretive pricing. This means that WPC can sell equity at a premium to its private market value and then reinvest the proceeds in real estate in a manner that grows NAV per share. This is especially valuable during a period in which interest rates have soared, thereby increasing that half of the company’s cost of capital equation. As the CEO stated in the earnings release:
the outperformance of our stock has enabled us to enter into additional equity forwards at prices that partly offset the impact of higher interest rates on our investment spreads.
On top of that, the company’s same-store ABR growth rate soared to 3.0% in Q2, doubling from just 1.5% in the year-ago period. Given that these properties are leveraged, the equity impact of a doubling in the organic growth rate is even more amplified. The reason behind this is primarily due to inflation-linked rent escalators which – given the fact that they take time to flow through to the bottom line – should only serve to drive the same-store ABR growth rate higher in the coming quarters. After the CPA:18 merger closes, WPC will have 57% of its ABR linked to CPI, with 37% of it uncapped, giving it significant same-store ABR upside from here.
Between the robust acquisition volume and the accelerating same-store ABR, management was able to raise its AFFO per share guidance to $5.26 at the midpoint. Analysts had previously expected WPC to generate $5.23 per share in AFFO this year and the company generated $5.03 in AFFO in 2021, so the new guidance midpoint level implies solid 4.6% growth on top of the mid-single digit dividend yield.
The main negative from the quarter is that – despite the accelerating AFFO growth rate – it appears the company still remains several quarters – if not years – away from meaningfully accelerating dividend growth. This is because (1) the company’s AFFO per share growth rate has been diluted by substantial equity issuance this year, (2) rising interest rates are substantially increasing the cost of capital, (3) WPC still has some upcoming headwinds from leaving the asset management business, (4) WPC has some major lease expirations coming up, and (5) the stronger US Dollar is weighing on results given that 36% of its portfolio is outside of the United States.
While revenue was up a whopping 7.7% year-over-year, AFFO per share was up by a less impressive 3.1% year-over-year. Furthermore, AFFO per share actually declined sequentially by 3%. A big part of the disconnect between the two is simply that WPC has issued hundreds of millions of dollars worth of equity so far this year. While this should pay off over the long term – assuming management prudently reinvests the proceeds (which we expect them to) – it does result in dilution short term to cash flows per share. As a result, AFFO per share growth is lagging overall AFFO and revenue growth, keeping the payout ratio elevated and postponing dividend per share growth.
Another headwind for WPC is the rise in interest rates. With inflation in both the Eurozone and the United States raging in the high single digits and interest rates remaining well below those levels, there’s every reason to believe that interest rates will continue to rise in the near term. Meanwhile, demand for high quality real estate – especially in the industrial and logistics space – remains strong, especially for triple net lease assets given the safety they provide during a period of economic uncertainty. As a result, WPC’s investment spreads will likely continue to face pressure. Yes, the strong WPC share price is helping to alleviate some of that cost of capital pressure, but it also dilutes shareholders in the near term and cannot fully offset the rising cost of debt.
WPC also is still completing its exit from asset management, which will continue weighing on AFFO per share growth. While it’s closing and merging with its final major fund (CPA:18) this year. That still means that it will face some headwinds to AFFO per share growth on a year-over-year basis in 2023. Its current 2022 AFFO per share guidance is $5.26 while its real estate AFFO per share guidance is $5.17 at the midpoint. That implies a $0.09 per share drag on AFFO in 2023 as WPC transitions to being a pure-play triple net lease REIT. Yes, some of that will be offset by merging with CPA:18, it still will not be fully offset as WPC is having to issue shares and take on debt to acquire those assets.
Fourth, WPC will also face headwinds from the lease maturities to U-Haul and Marriott (MAR) in 2024. Management had this to say about these maturities in our recent interview with them:
Regarding U-Haul, we fully expect them to exercise their inflation-linked option to repurchase those assets at the expiration of the lease. We obviously can see this coming, though, so we will have new assets lined up by then in order to eliminate the drag between the sale of those assets and redeploying the capital. However, we will likely still suffer some reduction in AFFO per share from that transaction as the option contract will likely work out such that U-Haul will be able to repurchase those properties at an 8%-12% cap rate. Obviously, under current market conditions with the caliber of assets and markets that we are looking to purchase real estate in, our cap rates are in the 5%-7% range, so there will be a hit to AFFO per share from that transaction.
The Marriott lease expiration is one which we expect to be immaterial. First of all, only one-third of our rent from Marriott expires in 2024 and we feel like we have a decent chance to resign the lease. Even if the hotel market is weak in 2024 and we are unable to resign the lease on attractive terms, we have prior experience operating hotels ourselves, so in a worst-case scenario we will just operate those assets until we can opportunistically sell them. Overall, we do not expect much of a hit to AFFO per share – if any – from the Marriott situation.
Finally, WPC’s 36% exposure to geographies outside of the United States means that when the US dollar is strong (as it is now), there’s a meaningful headwind to US dollar-denominated cash flows.
There are a number of very positive developments at WPC and we continue to like it as an attractive combination of current income, recession resistance, and inflation protection. However, investors who are expecting strong growth in same-store ABR and its impressive acquisition pipeline to immediately translate to a large acceleration in dividend growth will likely be disappointed. Between the dilutive impact of share issuances and the rising cost of capital due to higher interest rates this year, the drag on AFFO per share from the loss of CPA:18 in 2023, and the material headwind from the large lease expirations in 2024, it’s entirely possible that we will not see a large increase in the dividend growth rate until 2025.