W. P. Carey: Bull Thesis Confirmed By Two Independent Assessments

Investment thesis

W. P. Carey (WPC) is a global real estate investment trust (“REIT”) that invests in commercial properties. The business has a long and successful history (45+ years) of working with different companies to monetize the value in their real estate. And our bullish thesis is based on the following considerations:

1. WPC holds a large and diversified portfolio of high-quality real estate totaling 146 M square feet. The company boasts an occupation rate of more than 90% and an annualized base rent of $1.2 billion. More than 99% of the leases have an escalation built-in. With the current inflationary prospects, this will serve as a good hedge should inflation persist longer and higher.
2. It remains active in its real estate investments in 2021 and finds plenty of opportunities to invest. Its year-to-date total reached about $1.193 billion as of 2021 Q3, versus the full-year guided range of $1.5 billion to $2.0 billion. Its recent acquisitions further strengthen its high-quality real estate with warehouses, office buildings, retail properties of the Casino Guichard-Perrachon, et al.
3. In terms of valuation, the recent price correction created an entry opportunity. It generates stable cash flows thanks to its long-term leases that contain strong contractual rent bumps. And you will see that it is attractively valued in terms of FFO multiples. From a completely independent perspective, its current valuation is also attractive in terms of its real estate assets, as to be detailed immediately below.

Assessment 1: FFO valuation

Thanks to its high-quality and diversified real estate portfolios, WPC enjoys strong and stable organic income. In its most recent earnings report, it affirms the 2021 AFFO guidance range of between $4.94 and $5.02 per diluted share. This includes Real Estate AFFO of between $4.82 and $4.90 per diluted, based on a full-year investment volume of between $1.5 billion and $2.0 billion.

Notably, WPC is also well poised to benefit from inflation. More than 99% of the leases have an escalation built-in, and the vast majority of the leases have CPI-linked rents, which are scheduled for rent increases over the next few quarters.

Through property investments and long-term tenant partnerships, WPC has been delivering stable income to investors. WPC investors have been handsomely rewarded in the past decade through a combination of earnings growth, valuation expansion. In terms of FFO multiples, as seen from the following chart, WPC has been on average valued at 13.4x historically. And shareholders have been often rewarded by valuation expansion over the past.

Thanks to its robust and stable earnings, the chart also shows whenever the price falls near or below 13.4x FFO, it has been a good time to buy. And as you can see, how is such a time. The stock is valued at about 14.5x FW FFO, quite close to its historical average of 13.4x.

Assessment 2: the Asset + Income Valuation approach

For REIT stocks like WPC, another very intuitive and effective valuation approach that we use ourselves is based on its asset and income. The details are provided in our recent article on STORE Capital, and a brief summary is provided here to facilitate this discussion:

• If you think like a long-term business owner (instead of a stock trader), then investing in REIT is nothing more than buying a piece of real estate property to collect rent. So the investment value consists of two parts: the value of the property itself and the future rent.
• Our valuation method approximates the first part by its book value (“BV”) and the second part by 10x of its dividends. In other words, the investment value (“IV”) of a REIT stock should be: IV = BV + 10 x dividend.
• This method offers the advantage of valuation anchored in the most easily obtainable data with the least amount of uncertainty: BV and dividend. In investing, we always prefer the use of a few data points that are reliable than many data points that are less reliable.

Hope the above should be very intuitive to you – when we invest in REITs, we are willing to pay up to the face value of the business (the BV) and 10 years of rent. Just to provide a data point for reference, the weighted average lease term for WPC is 10.6 years.

With the above understanding, the following chart shows the results of this method applied to WPC. As can be seen, it captured the market price very nicely since 2012. Note that the business was not a REIT business until it converted in 2012. Therefore, the stock behavior before 2012 was more a transition and it made sense that it did not follow the IV closely. As seen from this chart, after the transition ended, when the market price fluctuates below the IV, it presents good entry opportunities followed by handsome total returns – though you do have to be able to stomach the short-term volatility.

Note that I’ve applied a multiplier, M, to the book value in this calculation. The idea is that if a given REIT (like WPC) can earn more than average on its property, then each dollar of its property should be worth more than the average. The details are again in our recent article on STORE Capital. The M applied for WPC here was 1.36. WPC has been earning about $0.14 of FFO on every dollar of its BV (i.e., its FFO return on equity is 14%). Average REITs earn about 12%, so M = (14%/12%)^2 = 1.36.

As seen, the current IV, based on the forward BV and dividend, is about $72.5. And at a price of $75, the stock represents a quality business for sale at an attractive price under today’s overall expensive market, very consistent with the FFO assessment above.

Potential returns

The first table below shows its valuation and projected return based on FFO (and dividends). As can be seen from the following numbers in the table, at its current price level, it’s very close to fairly valued. It’s about 9% overvalued based on historical FFO multiples, and almost exactly fairly valued based on historical dividends yield.

Looking forward, for the next 3~5 years, a low mid-digit annual growth rate is expected (near 6.5%) due to A) its strong portfolio and stable cash generation, B) its active ongoing investments, and C) the ongoing inflation adjustment built into the majority of its leases. And the total return in the next 3~5 years is projected to be in a range of 18% (the low-end projection) to about 27% (the high-end projection), translating into a healthy 4.3% to 6.2% annual total return.

In terms of the asset valuation method, it is relatively straightforward to project a “normal” return scenario in the next 3~5 years too, as summarized in the chart below. This projection is made under the following very conservative assumptions:

• BV grows at ~1% per year to $40 per share in 3~5 years.
• FFO return on equity remains at the historical average of ~14%, and consequently, FFO grows to $5.2 per share.
• The dividend would grow to $5.3 per share.

Based on these assumptions, the projected IV in 3~5 years would be about $100, again very close to those projections obtained from FFO analysis. And at the current price level, the total return is projected to be about 33%, or 7.4% annualized.

There is no need to overlook the mid- to upper-single digit annual return. It is a solid return when adjusted for risks – consider A) most of the return will come from dividends, which are funded by stable rent income locked in for many years out, and B) a large part of the stock price is backed by real estate properties.

Risks

A major risk is the interest rates risk. The company carries a fairly high debt load (as all REIT businesses do). Its current long-term debt is about $6.7B. Hence, a 1% increase in its interest rate would translate into $67M of additional interest expenses. Its FFO is about $930M in 2021. Therefore, the additional interest expenses are about 7% of its FFO, a sizable risk.

Although the reality is more complicated and could be better or even worse than this simple estimate here. On the positive side, most of WPC debt is fixed-rate and well-laddered as shown below. So the effects of higher interest costs will be gradual and not abrupt to give management time to respond and adapt.

But on the negative side, there’s always the possibility that the interest rates rise more dramatically than the Fed’s current dot-plot. And WPC also needs to keep issuing new debt to fund its new investments. For example, as of 2021 Q3, WPC raised $457.2 million through forward share sales and also raised a net $123.2 million in debt.

Conclusion and final thoughts

Recent price correction created an entry opportunity for WPC. It is attractively valued both in terms of FFO and real estate assets. And our bullish thesis is supported by the following considerations:

1. WPC holds a large and diversified portfolio of high-quality real estate. The company boasts an occupation rate of more than 90% and more than 99% of the leases have an escalation built-in.
2. It remains active in its real estate investments in 2021 and finds plenty of opportunities to invest. Its recent acquisitions further strengthen its high-quality real estate with warehouses, office buildings, retail properties of the Casino Guichard-Perrachon, et al.
3. In terms of valuation, the recent price correction created an entry opportunity. It is attractively valuation is confirmed by two independent assessments. Both approaches show a target price near $100 in 3~5 years, translating into an upper-single digit annual return (around 7.4%). There is no need to overlook the mid- to upper-single digit annual return. It is a solid return when adjusted for risks – consider A) most of the return will come from dividends, which are funded by stable rent income locked in for many years out, and B) a large part of the stock price is backed by real estate properties.