THESIS SUMMARY
As of Nov 1, 2023, Net Lease Office Properties (NLOP) is a tiny, ugly, spinoff of W. P. Carey Inc (WPC). No one likes this thing. Due to poor sentiment, poor spinoff execution, a bad spin ratio, a large difference between the asset type of the Parent and SpinCo, uncertainty about the value of its assets, and even just the size of the company (sub-200m market cap), it's currently undergoing a heavy sell-off. Management from the Parent are going to also be running NLOP. They're going to be issued 750k shares and 1.5m options which haven't been struck yet, so they're incentivized to see a low initial trading price for the shares. NLOP's assets are high quality (even more so considering the craziness surrounding the office property industry at the moment), with large stable tenants, a reasonable WALT, and a low vacancy rate. Adjusted book value is 3.7x their current price. This book value will be realized over the next few years because the purpose of spinning off NLOP was to liquidate the assets without a fire sale. Oh, and the cherry on top is a likely 16%+ annual dividend while you wait for the properties to be sold.
INTRODUCTION
W. P. Carey Inc (WPC) is a multi-billion dollar REIT that owns a variety of properties spanning Industrial, Retail, Warehouse, Office, and Self-Storage. They're seeing carnage in the Office segment; there are parts of Houston and San Fran with 30% vacancy rates. Since WPC has low vacancy rates with a reasonable WALT and great tenants, they figure now is the best time to sell their office properties.
In addition, WPC is trading for a low AFFO multiple of 11x. This is close to Office REITs in general, which trade on average at 10.2x AFFO. They're trading at an Office multiple, even though Office Properties are only a tiny portion of their overall portfolio. As a REIT, this makes it hard for them to raise equity in a way that accretive – their cost of equity is too high.
So, they started to sell their properties and they've made progress in a short period of time (you can look up their Office Sale Program that's set to complete by the end of 2023). But they have 59 office properties remaining which they do not want to sell in a fire sale because it doesn't make sense to do so. These are long-term tenants like Google, CVS Health Corp , and McKesson. The best way to get their cake and eat it too is to spin these properties off into Net Lease Office Properties (NLOP). NLOP will seek to sell off these assets over time, so no fire sale. And WPC immediately justifies a higher multiple to lower their cost of equity by getting rid of their toxic waste.
“Obviously, I was excited about… the toxic waste.” – Joel Greenblatt
THE SPINOFF
On Nov 1, 2023, WPC issued one NLOP common share for every 15 shares of W. P. Carey common stock outstanding. This resulted in 14,261,721 NLOP shares outstanding. NLOP accounts for 58 (14.6%) of WPC's tenants, 59 (4%) of their properties, 141.5m (9.6%) of their ABR, and 1.7B in gross RE value. Overall, they're not getting rid of many properties, but the properties are actually more valuable than WPC's properties on average (i.e. only 4% of properties, but 8.3% of gross value and 9.6% of rent). Additionally, NLOP has more investment grade tenants than WPC as a whole.
In executing the spin, NLOP is taking on debt (see below), and is paying WPC a 350m dividend which WPC will use to pay off their own debt. After all this shuffling around, NLOP has about 590m in consolidated debt, which will be paid off incrementally as properties are sold off.
SENTIMENT
Part of this whole spin-off process will involve cutting WPC's dividend to about 70-75% of AFFO (previously it was ~80%). To say that their current shareholders are upset is putting it mildly. The sentiment is vitriolic.
The anger
Over the history of WPC, they've attracted a specific shareholder base that wants dividend income with a safe yield that “never goes down”. They've attracted this investor base over decades. These investors wanted utility-like cash-flow predictability. Here's what those investors get instead: WPC is ending a 24-year dividend streak. In the minds of REIT investors, this makes them “feel betrayed”. A lot of their investors believe there was no other reason to hold the REIT – the dividend was the only reason.
Uncertainty over the safety of their assets
WPC didn't even cut their dividend during the GFC – one of the few REITs that didn't. That means investors believe management's confidence in the business is at 24-year lows. The weighted average lease at WPC is 9 years, and newest acquisitions have 20-year leases. Nothing wrong with that, so it must be something else… Investors think the only reason for a dividend cut is that the non-office portfolio is somehow not as high quality as management led investors to believe. Further to this, rating agencies say the “safe payout ratio” for a triple net REIT is 90%. What does that say about the safety if management dropped it to 70-75%? Management didn't even announce that they were considering this, so investors believe this was some sort of “emergency action”.
S&P bulletin says they like the deal and that it's credit neutral, but the investors' response is that S&P only cares that WPC can keep paying interest on its bonds and doesn't go bankrupt. Investors aren't saying WPC is a dying company, but they don't like the idea of owning a 5.9% yielding REIT where they believe management has just said there's something very wrong with the rest of its property portfolio.
“This thing is a value trap. The long term chart goes nowhere. The stock is 10 points higher than where it was 10 years ago. I'm looking elsewhere.” – Disgruntled shareholder
Poor spinoff ratio and execution
I love this spin ratio. 15:1, and only 4% of WPC's properties. Additionally, it's intended to be a taxable distribution, so some people are going to have to sell the shares to pay the tax on them – or even if they don't sell the shares, they will owe tax based on the initial trading value of those shares
“I'll probably just sell off the new shares as I don't have that many WPC shares where I'd end up with a decent position on 15:1 basis.” – Another disgruntled shareholder
Institutional selling
Right now, the market cap of NLOP is ~185m. It's spinning out of WPC which has a market cap of $12 Billion. It contains only office properties, which is substantially different from the remaining portfolio. 20% of shareholdings of WPC belong to Vanguard and Blackrock. Other institutional holders are probably selling this too given the differences in size and asset type.
The counterpoint (aka. the reality)
The whole point of this exercise is to realize more value in their shares. And yet, in the short term, their shares are undervalued – but they still need to grow. From a capital allocation perspective, it makes much more sense to retain earnings that can be funneled into new growth than issue new shares – at least until the shares start trading at the higher multiple the RemainCo properties deserve. This is why I believe they cut the dividend. Doing what's right in the face of criticism is actually a strong demonstration of capital allocation skills. Analysts now predict they will grow at 4%.
This sentiment and sell-off of WPC also applies to NLOP. In fact, I believe NLOP is getting rage-sold even harder. Here we have the bastard child of a hated REIT, full of office properties that “everyone knows” are imploding. In this situation, it's important to keep an eye on management. So, what is management doing?
MANAGEMENT
The CEO, CFO, and Chief Controller are going to be running NLOP. In return, they're compensated with Advisory Fees that amount to 7.5m/year. This amount decreases over time as they continue to sell the properties (in proportion to the properties remaining). In addition, they've created a stock incentive award plan that could be very lucrative for themselves. They've reserved 750k common shares and 1.5m shares issued in connection with stock options under their Incentive Award Plan. Since there's no other staff, these shares and options will be split among management and the board.
These shares and options have not been granted as yet. As such, management benefits from a massive initial sell-off of the shares to ensure their options get struck at as low a price as possible. Let's just say they're not saying anything that would make their shareholders feel better. In addition, board members (i.e. non-employee trustees) have a dollar cap limit on any awards granted. That means the lower the price, the more options and shares they can be given.
To summarize what we have so far, we have a hated, tiny REIT of office properties with an “ick” factor. Institutions don't want it. Other shareholders don't want it. The management – the executors of the plan – are coming over to manage the spin. They're being incentivized appropriately, and they even benefit from a low initial share price. Sounds good to me. Let's take a look at the REIT itself.
NLOP ASSETS
– 59 properties
– 1.7B gross property value
– 62 tenants
– 8.7m sqft
– Annualized Based Rent (ABR) of ~141.5m, almost all located in the US
– 89% North America, 11% Europe
– WALT (weighted average lease term) 5.7 years
– Occupancy 97.1%
– Investment grade tenants 66.9%
– Rent 16.21/sqft
In terms of rent escalations, 21% of their properties are CPI linked. 73% fixed. 6% other (e.g. leases with a percentage rent, like participation in gross revenues, as well as those with no escalations)
Since these are “Net Office Leases”, tenants are responsible for upkeep on the properties. This greatly limits their maintenance capex. In addition, because they're looking to liquidate over time, they won't be spending anything on growth capex. Depreciation is large in comparison to capex.
I went through each one of the 59 properties to assess whether management's gross value claim is in the ballpark. I found the address of most properties, looked up that area, and found a sample of office properties for sale in that area. I sorted that sample by cap rate, found the highest cap rate (i.e. lowest resale value), rounded up, and used that cap rate to estimate the value of each of their properties.
For example, KBR, Inc is located at 601 Jefferson St, Houston, TX 77002, United States. In Houston, at the 77002 zip code, I found a number of office properties for sale. The highest cap rate I found was ~7.5%. This likely included much smaller properties with higher cap rates, but regardless, I included them to be conservative. I rounded that up to 8% and used an 8% cap rate to value the property based on the rent amount the company disclosed.
I did this for all 59 properties, and the value I came up with was 1.76B in value, which roughly matches the disclosed gross value of 1.7B. As such, I'm confident that management might be being conservative in their stated gross value.
CORPORATE STRUCTURE AND DEBT
There are three types of debt in NLOP: Non-recourse mortgages, a secured term loan, and a mezzanine loan. The non-mortgage debt has a total gross value of 455m. After paying out the dividend to WPC, accounting for the mortgage debt, and shuffling a bunch of stuff around, total consolidated debt is 590m.
The non-mortgage debt is structured in a complicated fashion. NLOP owns a subsidiary (“NLOP Mezzanine Borrower”), which owns a certain number of properties and has a loan (the Mezzanine Loan of $120m) with those properties as collateral. NLOP Mezzanine Borrower also owns another subsidiary (“NLOP Mortgage Loan Borrowers”), which also owns a certain number of properties, and also has a loan (the Term Loan of $335m) with its properties as collateral.
I initially tried to go about this by trying to identify which properties belong to each subsidiary, but that isn't disclosed in the loan agreements. Instead, each property falls under its own LLC, and it's those LLCs that are mentioned in the loan agreements – not the properties themselves. But perhaps we can figure this out with just the information given.
Out of the total 59 properties, 40 of them reside in the subs and are deemed the “Mortgaged Properties”. The company stated that there was a “loan-to-value ratio of approximately 43% with respect to the Mortgaged Properties, implying a value of approximately $163 per square foot for the Mortgaged Properties.” There are 8.68m square feet in all 59 properties. If that $/sqft metric was applied to all 59 properties, it means the lender is assigning a value of 1.4B to all the properties, and we've already been told they have a gross value of 1.7B, so this is a 17% margin of safety for the bank.
Since we know the value of the loan (455m), and we have the LTV ratio of 43%, we know that the 40 properties in the subs have a value assigned by the bank of 1,058m (out of their of total 1.4B). This means the bank has a loan against 74.8% of the total gross value of all 59 properties.
This means the remaining 25.2% of gross value is ~428m (1.7B x 25.2%), which applies to the remaining 19 properties. There is $168.5m in non-recourse mortgages against 14 of these properties. Since this debt is non-recourse, we'll assume this mortgage debt is against all 19 properties.
Netting out the mortgages leaves you with 260m, and the current market cap is 185m. This is a great deal except in one scenario…
RISK
These are office properties. Vacancy rates are at all-time highs, perhaps due to WFH trend that might be a sea change. The longer interest rates stay high, the more we're going to see businesses go under, which isn't a rosy picture for their respective office buildings. Plus, as soon as the leases expire, they can be very costly and difficult to re-lease. Tenants know this and so they're in a strong position to negotiate lower rents and expensive improvements. It's likely we may find that these properties sell for significantly below value. How much below? It's hard to say, and therein lies the uncertainty. I think if commercial office real estate falls through the floor, and we have a situation of a 57% drop in value of these properties (i.e. GFC 2: Electric Boogaloo), here's what happens:
The LTV on the Mortgaged Properties hits 100%, giving the company incentive to default. The bank takes 74.8% of your gross value. You're left with 19 properties with a gross value of 428m, which has in all likelihood dropped 57% too, so you're left with 184m in gross value. Subtract the mortgages, and your remaining equity is 15.5m.
I believe this is very unlikely for a few reasons.
1. The tenants are very high quality and are diversified across multiple industries. We're talking the likes of FedEx, Total E&P, JPMorgan, McKesson, Siemens, etc. Even if we go through a painful time, and even if these companies all look to renegotiate their leases, I find it doubtful that every one of these companies will be able to request 50%+ long term decreases in rent.
2. The WALT on these properties is 5.7 years. The GFC lasted 1.5 years, so the lease term itself would outlast a very long recession
3. The company is aware of this risk and is taking steps to sell all their properties to pay off debt and distribute the proceeds. Every single sale mitigates risk.
4.You're collecting a hefty dividend (see below) that also mitigates your risk substantially
With that bit of highly improbable ugliness out of the way, what might this be worth?
VALUATION
NLOP is looking to liquidate their assets in a controlled manner while they pay off debt and distribute the proceeds to shareholders. As a result, I believe the best way to look at this is to value to the assets on the balance sheet. However, I also included other metrics below for completeness. In terms of the balance sheet, as a result of the spin, many of these assets are already marked to fair value. I updated the balance sheet from Dec 2022 to the numbers provided in the pro forma statements in Jun 2023. I also adjusted a couple of line items to be conservative.
After making the adjustments detailed below, book value is 689m or $48.13/sh. This is 3.7x higher than the current market price of $13/sh.
Adjustments to the Balance Sheet
In-place lease intangible assets: I've kept this value as-is. There are certain costs involved in getting a property leased by a tenant. This includes rent lost during downtime, rent concessions, leasing commissions, etc. As long as a tenant is occupying the property, these costs do not have to be borne by the property owner. This has value, in the sense that if the properties are acquired without a tenant, the acquiring company would have to pay this cost to get someone in. Since there’s already someone in there, the acquiring company should reimburse the selling company for this cost.
Above-market rent intangible assets: This represents the portion of some leases that are being paid above market. It gets amortized over the life of the lease. I set this to zero to make the assumption that every single tenant may try to renegotiate back down to a market rent.
Goodwill: Set to zero.
Below-market rent intangible liabilities: This is the value of the amount of below-market rents currently being paid. I kept this liability on the balance sheet for conservatism.
Other Valuation Metrics
Total Debt (millions) … 590
Cash ………………………. 55.63
Noncontrolling interest 4.63
Market Cap………………. 185
Adjusted book …………. 689
EV …………………………… 725
EBITDA-Capex………….. 114
Price/Book 26.9%
Earnings Yield (EBITDA-Capex/EV) 15.7%
EV Multiple 6.3X
DIVIDENDS
The dividend policy should roughly match WPC, given that the same management is running it. WPC used to dividend out ~80% of AFFO. This was dropped to 70-75% to finance growth. Since NLOP will not be growing, it's likely that the dividend will be higher than the new dividend at WPC. My best guess would be 80% of AFFO, but I'm going to assume 60%. This is less than the 70% payout ratio of WPC, in case NLOP wishes to pay off their debt faster.
In the six months ended on Jun 30, 2023, AFFO was 48.1m. Over the year, you're looking at 96m of AFFO. I'm getting 47m in interest expense, leaving 49m in AFFO.
Based on a 60% payout ratio (and it's likely to be higher), this works out to 30m, or $2.06/sh. You're collecting a 16%+ annual dividend while you wait for these properties to be sold.
TOTAL RETURN
Let's assume it takes 4 years to sell off all the properties. We'll assume the dividend decreases by 25% each year as properties get sold. Here's what the return looks like:
Distributions from sale of properties (aka adjusted Book Value): 689m, or $48.31/sh
Dividends (per sh): 2.06 (yr 1) + 1.55 (yr 2) + 1.03 (yr 3) + 0.52 (yr 4) = 5.16/sh
Total return over 4 years: $53.47/sh, or 42% CAGR
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