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W. P. Carey: Why I Sold My Position On Valuation (NYSE:WPC)

Oct 11, 2023Oct 11, 2023

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I suspect that W. P. Carey (NYSE:WPC) has many loyal shareholders who hold the stock over the long term but my experience with the stock has been ever so different. After buying into the name just 4 months ago, I am selling the stock as it has somehow quickly achieved a valuation that I had only anticipated over the longer term. While the company is likely to generate same-store rent growth far ahead of peers, its premium valuation relative to peers is still hard to justify. Investors may also be underestimating the risks from pricing pressures as acquisition cap rates remain low in spite of the rising interest rate environment. I am downgrading my rating to "hold" at this time.

As interest rates soared and risks of a recession rise, you’d think that WPC would feel some pressure as a landlord, right? Such a theory has proven incorrect, as WPC has been a rather strong performer over the past year.

I last covered WPC in October where I explained why I was finally moving off the sidelines to buy the stock. At the time, I had viewed the 6% yield as being attractive while I waited for a re-valuation to a 5% yield. The stock has quickly returned around 18% since then - reaching my 5% fair value target - leading me to reassess my position.

WPC is one of the numerous triple net lease real estate investment trusts (‘NNN REITs’) in the market today. WPC is diversified across various industries and has been making a push to increase its exposure to industrial assets.

2022 Q3 Presentation

With so many NNN REITs in the sector, it could be difficult to differentiate between them. The unique point at WPC is its high exposure to inflation, as 55% of its average base rent is linked to CPI.

2022 Q3 Presentation

That has helped the company see accelerating same-store ABR growth over the past several quarters. That 3.4% number in the latest quarter easily paces the pack.

2022 Q3 Presentation

On the conference call, management noted that due to the time lag in when inflation impacts their annual lease escalators, 2023 should see even stronger same-store growth at around 4.5% with continued impact in 2024. That would be an outstanding number in a sector that typically sees around 1% same store rent growth.

WPC ended the quarter with 5.6x debt to EBITDA - management has targeted 5.5x to 5.8x as being their target operating range. It is worth noting that the average debt maturity is only 4.6 years - it is possible that WPC may see rising interest expenses as it refinances maturing debt.

2022 Q3 Presentation

WPC has invested $1.3 billion through the first three quarters of 2022, including $474.8 million in the third quarter. The third quarter investments had a weighted average cap rate of 6.4% (or 6.3% inclusive of capital projects). That represented just 50 basis points expansion over the average cap rate in 2021. Many REIT investors may have been hoping for cap rate expansion in light of the rising interest rate environment, but it seems that net lease real estate remains a seller's market. While management stated on the conference call intentions to remain picky on prices, that stance has not yet shown material impact in the numbers.

Revenues grew 17.7% in the quarter but one should adjust for shares issued for acquisitions. Adjusted funds from operations came in at $1.36 per share, up 9.7% YOY. FFO could sometimes be a suspicious metric to follow for REITs (similar to adjusted EBITDA at other companies) but in the case of WPC it is arguably reliable due to the fact that tenants are responsible for maintenance capital expenditures.

WPC has a decent amount of leases expiring over the coming years with more than half expiring over the coming decade.

2022 Q3 Presentation

It is unclear if the high inflationary environment would prove positive in that regard, as it may either lead to strong re-leasing spreads or perhaps customers may seek to renegotiate leases without CPI-linked adjustments.

The company raised full-year guidance to see up to $5.31 in AFFO per share. That is based on expectations for up to $2 billion in real estate investments and $300 million in dispositions. Regarding that latter point, one negative factor that I have highlighted in prior reports has been the company's high disposition activity relative to acquisitions, which has had a dilutive impact on the bottom line. The projected 15% ratio for 2022 is much more respectable and investors should watch to see if this ratio remains controlled moving forward.

At recent prices, WPC was trading at a 5% dividend yield and 15.8x AFFO. In contrast, Realty Income (O) was trading at a 4.4% yield (and 17x FFO) and Spirit Realty (SRC) at a 6% yield (and 11.7x FFO). I question whether WPC is trading too closely to O and too far from SRC. While WPC is likely to generate superior growth to O due to its CPI-linked escalators, O arguably has a significantly higher quality portfolio as evidenced by the low historic disposition activity. Meanwhile, while SRC has a somewhat lower quality portfolio, it should still generate around 1.8% same store rent growth moving forward. WPC's 4.5% projected same-store growth this year is impressive and if it were sustainable over the long term then I could see justification for the premium multiple. But that's the problem - as inflation eases, those escalators will come back down to earth. The roughly 2% differential in the meantime thus is not enough to justify a 35% premium (based on FFO multiples).

On the flipside, downside may be limited, as sentiment is likely to remain solid here. WPC has a long history of growing its dividend, dating all the way back to 1998.

2022 Q3 Presentation

NNN REITs as a sector are highly respected, especially after their strong financial performance in 2020 amidst pandemic lockdowns. My issue with the stock at these prices is that upside looks rather limited, as it is hard to make arguments for multiple expansion. If one is trying to buy this for the dividend yield, I’d counter that even high quality bond ETFs are trading at comparably high yields. The clear problem is that the high same-store rent growth is not sustainable over the long term, so the stock is unlikely to benefit from further multiple expansion even if inflation persists for longer. I downgrade my rating to a hold.

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This article was written by

Julian Lin is a top ranked financial analyst. Julian Lin runs Best Of Breed Growth Stocks, a research service uncovering high conviction ideas in the winners of tomorrow.

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