W. P. Carey Inc. (WPC) Earnings Call Transcript & Summary

Good afternoon. My name is John Kim with BMO Capital Markets. It is my pleasure to be hosting or moderating this presentation with W. P. Carey, celebrating its 50th year pretty soon as a real estate company. With us today, Jason Fox, CEO; Jeremiah Gregory, with the company as well. I think we're going to go though like a presentation and an overview to begin with. And then we'll go into Q&A.

Yes. And I'll just take a minute to give a quick overview. Jason Fox, CEO of W. P. Carey; Jeremiah Gregory is with me, who heads up capital markets for us. Yes, we are celebrating several anniversaries actually in 2023. The company was founded 50 years ago. We became a public company actually 25 years ago in 1998. And we also began investing in Europe for the first time 25 years ago when we pioneered sale-leasebacks in the European markets. Today, we're one of the largest owners of net lease real estate and among the top 20 REITs in the index with a market cap of around $15 billion. Actually, I just checked, it's exactly $15.00 billion as of today. We are a diversified net lease REIT. We own a highly diversified portfolio across geographies, tenant industries and property types with the primary focus in North America and Northern and Western Europe. And the largest concentration of our real estate assets are industrial with retail the next largest asset class after that. The portfolio as of the end of the first quarter of this year was comprised of 1,400 net lease properties that generate about $1.4 billion of ABR. We have a weighted average lease term of approximately 11 years. 62%, so just a little bit under 2/3 of our portfolio, is from properties in the U.S. with a little bit over 2/3 from those in Europe. And again, that's primarily Northern and Western Europe. As I mentioned, we're primarily focused on acquiring industrial real estate in the U.S. with industrial and retail in the European markets as well. Currently, industrial represents a little over 50% of our portfolio at this point in time. We run our investments teams out of New York and London. We have a proactive asset management approach with a team here in the U.S., and a team based out of Amsterdam in Europe, that runs our European operations. We have an investment-grade balance sheet, recently got upgraded by both S&P and Moody's to BBB+ and Baa1. And we really have a successful track record of investing in net lease across many cycles over our 50-year history with a focus on downside protection and growth going forward. So with that, let me turn it back to you, John, and you can fire away some questions.

You talked about diversification that you have by asset type and geography. Can you just talk a little bit about the benefits of that model? And where are you seeing the best opportunities as far as investments on a risk-reward basis?

Yes. Look, diversification is beneficial on the downside protection. We have no kind of overallocation to any one industry or geography. And that's great in an environment like we're heading into or have been in with a slowing economic environment. On the growth side, we have a wider funnel. We have more opportunities to choose from in how we allocate our capital. This is both across property types as well as geographies. We currently have one of the lowest top 10 tenant concentrations amongst the net lease peer group at about 18% of our ABR. And no single tenant is more than, I think, 2.7% of our portfolio. So the benefits are really on finding the best opportunities. And when Europe is slow, like it is right now, we are overallocating in the U.S. And when we see opportunities pick up and maybe we can be opportunistic in the European markets, we'll find some there as well.

Can you talk a little bit about the cap rate differential and your spread to your cost of capital?

Yes. Sure. Between the geographies or just generally, yes. Right now, we're seeing better opportunities in the U.S. Cap rates have expanded more here than they have in Europe. Just to give you some examples and some historical context, run rate for us on cap rates going back kind of 2 to 3 years, was in and around 6% for going-in cap rates. The fourth quarter of 2022, that expanded to about 6.8%. Year-to-date, we've done about $750 million of new transactions at a weighted cap rate of around 7.2%. And that in our judgment is kind of indicative of where the markets have gone. We're still able to generate spreads that make sense for us. We have a cost of capital that works in this environment, and our balance sheet is really well-positioned to take advantage of these rising cap rates. In terms of spreads, we think of things in 2 different ways. Number one, accretion is important. We're very mindful of whether or not a new transaction is going to generate some day one earnings accretion for us, and that's something we focus on. Perhaps more important, though, is a focus on the spreads to our cost of capital with regards to an unlevered IRR. And that's mainly because a going-in cap rate doesn't always tell the full picture for us, especially given the types of lease structures that we're able to negotiate in our sale-leasebacks. They primarily all have built-in annual rent increases. Our current portfolio has -- over 50% are indexed to inflation. Those that aren't indexed to inflation have healthy fixed rent increases. And so for us, it's more important to look at either an unlevered IRR or an average yield and compare that to our cost of capital. In the current environment, despite the rising cost of debt and where equities have traded, we're still within a zone that we've been historically in terms of generating spreads, and a lot of that has to do with cap rate expansion but also the type of bumps we really negotiate.

Okay. On the sale-leasebacks, just can you talk about why this is increasing recently as far as that pipeline of transactions? And also, what are sellers looking for? Are they looking for maximizing price on the sale or having affordable rents that help some of their business going forward?

Yes. I mean -- let me start on the second question first. I mean sellers are focused on the economics primarily so it's optimizing their occupancy cost. But one of the big drivers of why companies do sale-leasebacks is because they have a use of proceeds. And really, this is for us, I would say, 90-plus percent of the deals that we source over the last number of years have been either sale-leasebacks or build-to-suits, which have a similar structure in which our counterparty on a transaction is ultimately our tenant. And there's a lot of benefits to that. But what drives sale-leasebacks are use of proceeds. And during growth environments like we saw, say, in 2021 and even into 2022, there's a lot of correlation with M&A activity, where sale-leasebacks are part of the capital stack in a buyout or other corporate transactions. I think as we find ourselves in a slowing economic environment or even a recession, I think sale-leasebacks are equally beneficial to corporates but maybe for different reasons. I think it's more going to be a source of proceeds to be used for getting ahead of debt maturities maybe as an alternative to other sources of capital like debt or equity. But the use of proceeds is key. And the -- where we see ourselves and sale-leasebacks right now is perhaps maybe the most constructive environment that I've seen in the 20-plus years I've been doing this. You have really 2 factors playing into that. Number one, when companies are looking at generating a use of proceeds, they look at their alternative ways to raise capital. And currently, where we focus, which is just below investment-grade, call it, the BB-type credits. The high-yield markets, leverage loan market, have gotten very expensive, call it, high single digits or even into double digits of where the borrowing cost could be. So a sale-leaseback, call it, in and around 7% or 7-plus percent is quite competitive, even when you factor in the meaningful bumps we will negotiate. This is about as competitive as sale leasebacks have been in a long time relative to other corporate capital opportunities. I think secondly, the competitive environment for sale-leasebacks are competitors that we've historically faced when looking at sale-leasebacks have primarily been the private equity real estate, the net lease arms of some of the big asset managers like KKR or Carlyle or Angelo Gordon or others. And they typically target returns based on higher-leverage transactions, and they're mainly using mortgage debt to achieve their leverage. So debt's gotten a lot more expensive. Mortgage financing, especially in the 60-plus percent range, has moved a lot more than investment-grade bonds at, which is how we're funding our deals at this point in time. So our competition are either outbid because they're not competitive or they can't actually even find mortgage financing that works for them. So it's a good spot for us, both a supply standpoint but also from a competitive environment.

Okay. One of your big transactions this year is the Apotex acquisition, sale-leaseback primarily based in Canada. Can you just give some color behind the transaction? Was it sourced from their sponsors or I think SK Capital and whether or not this could lead to other transactions with either the sponsor or with the company?

Yes. This is a good example of -- I would say it's a pretty typical sale-leaseback for us. I mentioned earlier that during growth environment, sale-leasebacks can support M&A activity. And this is a deal that we've been working on or have been working on for several months at this point in time. It was in support of a buyout, a company called SK Capital, which is a New York-based private equity firm, was buying Apotex, a family-owned business in a leverage buyout, and the sale-leaseback was a meaningful component of the capitalization of the company. I think the transaction itself checks a lot of boxes for us. When we think about credit, Apotex, for those that know it, is the largest generic drug manufacturer in Canada. They have roughly a 30% market share. We view them as critical Canadian pharmaceutical infrastructure in many ways, moderately leveraged balance sheet as part of the buyout. I think importantly, the real estate, another piece of the transaction that we focus on is how does it fit into the operations of the company. The portfolio that we acquired comprised about 90% of the operating assets really generate about 90% of the revenue for the company, so highly critical. We structured it on a master lease. These were 11 properties we structured on a master lease, which provides meaningful downside protection. Cherrypicking is something that you're at risk for with individual leases on a master lease. In a restructuring, you're not permitted to do that. And while we don't think a restructuring is likely for this company anytime soon or at all, we do structure our transactions with that in mind. The real estate itself is quite strong. These were -- or our advanced manufacturing and R&D facilities for this company. They are infill Toronto, one of the tightest industrial markets in North America with low single-digit vacancies, so very well located. And the basis at which we acquire these were probably somewhere less than half of replacement cost. So I would say we pretty much checked every box in this. And then on top of that, it was a deal where the private equity firm was depending on us to provide a meaningful portion of their financing. So I think that it was a fair pricing that we put on the table but something where we had some pricing power, and they depended on us as part of the capital stack. So SK Capital is a great firm. We're looking at more deals with them. We expect to do more deals with them in the future. It's a relationship business as a lot of things are. And I think that's one of the things that we provide probably more than anyone else is certainty of execution in this environment. That's pretty important.

And would you say the cap rate you acquired of that is reflective of the market? Or did you get a slightly higher yield?

Yes. Look, I mean when we source sale-leasebacks, one of the benefits is that there are fewer competitors that have the track record to complete buyouts, especially one this large, which was close to $500 million on a sale-leaseback basis. We don't think there are other bidders on this. We think it was market pricing from how we price sale-leasebacks where we get, I would say, anywhere from 50 to 100 basis points of incremental yield relative to where net lease typically trades from a third-party landlord in the secondary market. The cap rate, while we don't disclose specific cap rates, it's within our target range right now of cap rate into the 7s. As I mentioned earlier, our weighted average cap rate for the year was 7.2%. This was a big part of our year-to-date volume at this point. So you can get a sense for where that cap rate would have settled out. I think importantly, and I mentioned this earlier, it had meaningful bumps. These were 3% fixed increases, which probably lagged the market, but that certainly impacts our total economics in how we price a deal. And it's -- the economics are primarily driven by your going-in cap rate in the lease bumps. And the lease term, in this case, it was 20-plus years.

I think I see this on the earnings call, but -- so Apotex is paying U.S. rent?

Yes.

How important was that for you? Are you willing to take currency risk?

We do have currencies other than the U.S. in this deal. And really, I think probably almost all the Canadian deals that we've done have been U.S. dollar. There's ways to hedge currencies. There's ways to borrow in Canadian dollars, if we wanted to. But for this one, the company has a lot of U.S. dollar revenue, and we don't think it's a mismatch from a corporate standpoint. And ideally, we pay our dividends in dollars. We trade on U.S. stock exchange. So ideally, when there's a situation where we can do a U.S. dollar-denominated deal, we will, and that's the case here.

Okay. One of the differentiated factors of W. P. Carey is the amount of CPI-linked rent increases that you have. Can you just provide an update as to what percentage of your portfolio is CPI-linked? And how you're viewing inflation in Europe versus U.S.?

Yes. Sure. It's about 50% -- 57% of our portfolio is indexed inflation. Importantly, about 2/3 of that amount is uncapped CPI. So we're really seeing the tailwinds flow through to our earnings as well. And even within the fixed component, which is the other 43%, it's sizable. I think on average, historically, we've seen about 2% fixed increases apart -- across our portfolio, which tends to be perhaps double what's typical in the net lease world, which is why we emphasize that going-in cap rates don't tell the whole story in terms of spreads and accretion. It's important to bake in the built-in rent growth. And especially when you get to our size, having really strong internal growth is a great supplement and maybe a big driver in addition to externally driven growth. In terms of the current opportunity set, obviously, inflation has become more of a conversation for our sale-leaseback counterparties. It's more of a discussion. I think in Europe, it's been more customary. More of our inflation-based increases are in Europe. You mentioned earlier about 1/3 of our ABRs in Europe, but about half of our CPI-based increases are there as well. So it's a little overweighted. I think in terms of new transactions right now, as I said, it's more of the conversation. And while we may not be getting uncapped CPI as much in this current environment, when we do get CPI that is capped, these caps have gotten higher. We've also added floors, and the floors are at higher levels. Where we might have been floors in the 1% to 2% range with caps in the 3% to 3.5% range, our floors are probably more around 2% and our caps are going to be more in the 3% to 5% range at this point in time. So even though we're not essentially getting uncapped CPI all the time like we have in the past, it's still flowing through. And importantly, it's flowing through to our fixed increases. I mentioned earlier that historically, we've been closer to 2%. Our year-to-date -- for our year-to-date deal volume, the weighted average fixed increase is 3.0%. So again, something that's meaningfully higher than we've had historically and probably multiple of our competitors. And what does that mean in terms of growth? And we provided this disclosure on our earnings. Our Q1 contractual same-store growth was at 4.3%. We expect 2023 to be at 4%, again, multiples above the net lease peers. We've also provided a forecast for 2024 as well, which we expect our contractual same-store increase to be around 3%. And that assumes that inflation is at 2% by the end of 2024. So to the extent that it takes longer to get there or we're at something higher than 2% by the end of next year, then we would expect our same-store growth to be higher. And a lot of this is the lag effect. I mean not all of our leases bump on an annual basis, some every 2, 3 or 5 years. So we're going to see this effect for years to come. It's also the formulas that we use tend to lag inflation by 3 or 4 months. So the bumps that are happening right now is going to be based on inflation from, call it, February, January and December.

Another unique characteristic of W. P. Carey is post your CPA:18 merger. You do have some operating asset exposure in hotels and self-storage. I think you provided guidance that's about $100 million of NOI. Do you feel comfortable with that amount of operating income? And if you could just provide an update on lots of these portfolios?

Yes. So there's really 2 groups of operating assets. The largest of them is operating self-storage assets as part of the CPA:18 merger. We acquired, I would say, the bulk of those 84 operating self-storage properties. This was last year. The other component of the operating portfolio are some operating hotels. And it's primarily the 12 Marriott hotels that had been under lease with Marriott for the past roughly 30 years that just expired, and those are now franchised operating hotels as opposed to net lease investment. So instead of receiving rent directly from Marriott, we're receiving the NOI that these operating hotels generate. And actually, there's a pickup in earnings from that because there was coverage at these hotels. To your question, are these something that are long term? The operating assets are of an asset class that we've been investing in for quite some time, in fact, we first invested in self-storage where we did a large sale-leaseback with U-Haul back in 2004 and helped them fund their exit from bankruptcy by buying some of their best storage assets. And so we learned about the business and through some fund vehicles that we had, namely CPA:17 and 18, we did acquire a number of operating assets. I think the way we look at this is, long term, we'd like to be a pure player -- as close to possible as a pure-play net lease company. I think that we have a lot of options with the self-storage assets. We did do a conversion of a number of properties from operating assets to net lease with Extra Space, 4, 3.5 years ago now. I think that's certainly an option. Whether it's Extra Space or another counterparty, there is a way to put a lease in place with these properties and generate some maybe more visible, stable cash flows. But by and large, we like the asset class. It has a lot of the same characteristics that we like about net lease: stable cash flows through various economic environments, low CapEx. You have the ability to raise rents on a monthly basis. So in effect, you have an inflation hedge much like we have with our net lease portfolio. So the reasons of why we're comfortable owning operating assets in some part as well. And I think, look, lastly, the option is always to sell some of these assets. I think over the past 2 years, when storage was producing 20-plus percent same-store growth, we wanted to continue to watch these stabilize at maybe a more moderate or historic growth level that we're seeing now. So to the extent that selling storage is the best way to fund new net lease deals, that's certainly an option that we would consider. I think right now, we have well-priced capital, and I think Jeremiah can touch on some of our balance sheet, if that's of interest. But it's something that we can always do if we think that selling storage is the best way to fund net lease, we'll certainly do it. My guess is that we'll do all the above. We'll probably convert some, we'll probably sell some, and we may hold some that ultimately could be solar-converted as well.

It's probably worth noting that the Marriott Hotel portfolio, that is targeted for sale in 2023. So don't necessarily have visibility on exactly what the pricing or the exact timing is. On our guidance, we've assumed that those hotels -- we get the NOI from those hotels throughout the end of the year. But we are targeting those for sale this year. We expect those to be disposed of, and we won't be owning operating hotels as part of the portfolio.

Yes. It's a good point to make, and we've talked in some detail there. There are 12 Marriott assets. 9 of them we expect to sell by the end of the year. 3 of them we expect to continue to operate as we entitle them for a higher and better use. We have 1 right on Newark Airport. It's likely going to be industrial, A+ location right on the airport. We have a Courtyard Marriott in Torrey Pines in San Diego. That's got new lab development all around it. So we think we can add density there, and we would likely either do a build-to-suit for a tenant or sell to a lab developer, but that's the highest and best use. And the third one is prime, prime location in Irvine, California, which could be multifamily, it could be creative office, it could be industrial, it could be R&D. If it's industrial or R&D, we could do a build-to-suit there. But in all likelihood, we would sell to a developer once we have entitled.

Across all of your geographies and asset types and including some of your operating assets, what are your views on a recession? When do you -- are you seeing any signs of stress today in your portfolio? And what are you forecasting as far as how you operate your business going forward? When do you think it's going to happen?

I mean, look, we're built for a recessionary environment. I think that the portfolio is diversified. I talked about that earlier. We have a long weighted average lease term of over 11 years. Occupancy is in the high 90s. We have a track record, frankly, of operating through multiple cycles. I think COVID is a great stress test to look at. Despite having just 30% of our ABR and investment grade, we were the market leader in collections throughout COVID. Quickly in May and June, we were collecting 98% and 99% of our rents. And maybe that's the most important part is what's the performance. We think we're great at credit picking and structuring. And ultimately, we do have some tenants to get upgraded over time into investment grade, which is why we have a portion of that, but I think that's a good litmus test for us. It's also a good environment to be opportunistic. I think when there's weakness and we have some operating or some pricing leverage, especially when world capitalized like we are right now, it's something that we think that we fared quite well. When we look at our credit watch list, it's quite benign. The peak in COVID, we call it our heightened watch list, which are defined as companies that have a reasonable likelihood of a payment default. Within COVID, it peaked at 4%. The trough between them and now is around 1%. Right now, we're sitting at around 2.5%. And it's important to note, even during COVID when we had a 4% heightened watch list, we were still collecting 98%, 99% of our rents. When you have critical operating assets on master leases even in restructurings, we tend to get paid in whole. So just because it's on a heightened watch list doesn't mean that it ultimately results in a payment default, but that's how we kind of monitor our portfolio. No big themes within the portfolio. When you think about the typical areas that net lease have run into trouble, theaters, 20 basis points of our ABR is in theaters. It's on our watch list. Restaurants, we have 1 restaurant on our watch list that's under 10 basis points. We have a department store, but it's a logistics asset. And frankly, if our tenant defaults, we can terminate that lease. We're under market, and there's going to be upside there. So it's a pretty benign list and even a lot of the details when you kind of dig into it, there's no themes and there's -- there could be some good outcomes at the same time.

Any questions from the audience?

How the higher interest rates and your financing going forward, what's kind of plan there? You could add it up rental increases in the existing pieces to cover the higher interest costs [indiscernible]?

Yes. And so the question was about higher interest rate environment. Yes?

That you're going to be either refinancing or financing at a higher cost?

Right. Yes. I'm just repeating the question for the audience that's not here in person. So the question is about higher interest rates and how that flows through to our business and impacts it. Jeremiah, do you want to touch on balance sheet and how we manage that?

Yes. I mean I'll just talk broadly about the balance sheet and how it's set up. I mean we certainly assume that we're going to continue financing new investments on a leverage-neutral basis, that means more equity than debt. That's how we financed historically. That's how we'll continue to finance going forward. On the debt side, I think we have bonds coming due. Like many large REITs, in any given year, we have some bonds coming due. Our first bond that comes due is April 2024. That's a U.S. bond. It's at a 4.6% interest rate. So we would assume there would be some leakage, some headwinds from rising interest expenses, but perhaps not as meaningful, at least, on these near-term financings as people might think. So I think for the most part, we're looking wherever we can to lock in long-term cost of debt and not be in a position where we have meaningful headwinds in any given year from interest rates. But I think where interest rates are today, I think probably for all REITs, there's a little bit of a headwind there as you work through your refinancings. For us, we have a very well-laddered maturity schedule as well. So it's going to have to play out really over the next 10-plus years. That -- where rates go and where we do refinancings kind of every year from here on is going to really drive it over time. Any one bond is probably not going to have a huge impact on overall weighted average cost of capital. But we're certainly -- we're setting up and we're expecting and when we do planning, we assume rates are going to be at this higher level. And I think importantly, when we make new investments, we're looking at investments that could be funded with debt at these levels or equity where it's trading. The last thing I'll just mention on our equity, I mentioned that that's going to be a majority of our capital structure. We are very well positioned right now on the equity side where we're sitting on close to $400 million of equity forward that was raised in the mid- to low 80s, so about average price of $83 a share. That's obviously well above where we're trading today, and that gives us a really good ramp when we think about deploying capital and using capital over the rest of 2023. That helps give us a lot of confidence that, I guess, in addition to our $1.8 billion revolver, which allows us to be opportunistic in terms of how we fund things. We would never look at the revolver as permanent capital, but it does help us manage the capital markets and going into the bond markets at the right time.

Stock has been [ right ] from about [ 90 to about 70 ] the last [indiscernible]. As lot of that [indiscernible].

Sorry, can you repeat the question? Yes, go ahead.

Sorry. So your stock price has come down from 90 to around 70. Where do you think the disconnect is between your performance and the market reaction?

Yes. Look, we do think there's a disconnect. And I think I'll read so I may say the same thing, but this is a buying opportunity, in our mind. I mean there's a disconnect because when you think about what drives net lease performance, it's about growth, and we're very well positioned from an internal growth standpoint. We don't need to do as much external growth deal volume as many of our peers because we have the internal growth driving a big portion of that. Yes, as Jeremiah mentioned, we're very well set up from a balance sheet perspective to take advantage of the rising cap rate environment. And frankly, where we position ourselves for a recession, I think that's something that we've proven that we performed quite well during down cycles. And when you layer on top of that a 6% dividend yield, we think that it's an opportunity to acquire quality at an interesting opportunity right now.

We're running over time, so I'm just going to ask you one last question. You can answer it in less than a minute. Do you think there will be M&A in the sector -- in the net lease sector? And where does W. P. Carey stand in that?

Yes. Look, there are 20 to 25 net lease REITs, many of which are below $7 billion or even $5 billion at that point. So I think there'll be fewer net lease companies. Maybe a year from now, we probably should see some M&A activity. A lot of it's going to be dictated by the divergent in cost of capital, mainly equity multiples. We are diversified. I think that puts us in a good position to look at a lot of different companies. We certainly have an appetite for growth. Portfolio quality really matters. The spreads matter. Clearly, you have to pay a premium for M&A. So it's not just kind of headline numbers right now. But we want to grow and we want to do it in a smart way. So I think it's an opportunity and an option for us, but we'll have to see how things play out.

Okay. And with that, I want to thank everyone for attending the session.

Great. Thanks, everyone.