Thesis: Falling Interest Rates Are Preferable To High Inflation For WPC
W. P. Carey Inc. (NYSE:WPC) is a multi-continental, diversified triple-net lease REIT that has gained popularity in the last year or so because of its unique use of CPI-linked rent escalators in its leases.
But WPC is still a net lease REIT, and the primary driver of growth for all net lease REITs is accretive portfolio expansion – i.e., property acquisitions wherein the cap rate, or net operating income (“NOI”) yield, is higher than the REIT’s cost of capital.
As I will show below, WPC’s rent escalators, as truly unique as they are in the triple-net lease space, only generate same-store rent growth around half the rate of inflation, and only with a lag. This is a far cry from the kind of inflation protection offered by other commercial real estate property types like apartments, industrial, and self-storage, which have put up same-store rent and NOI growth numbers in the double-digits in the last year or so.
At the same time, cap rates are always slower to follow interest rates higher during rising interest rate environments, because property prices become “anchored” and sellers become reluctant to drop their prices to allow cap rates to rise at the same speed as interest rates. This has the effect of making net lease REITs’ external growth (property acquisitions) less accretive, because their cost of capital is rising faster than acquisition cap rates.
Thus, because rent escalators do not fully offset elevated inflation and the rising interest rates associated with elevated inflation reduce the profitability of external growth, falling interest rates would actually be better for WPC than high inflation.
Fortunately, I believe 2023 will deliver falling interest rates, at some point. That, I believe, will be better for WPC than an economic scenario wherein both inflation and interest rates remain elevated.
Let’s dive into both parts of this argument, starting with the CPI-based rent escalations.
Inflation-Based Rent Escalators
WPC’s inflation-linked rent escalations truly are a unique aspect of the REIT, and I do not mean to diminish their attractiveness as part of WPC’s overall investment case. Because the vast majority of WPC’s properties were acquired through sale-leasebacks in which WPC was able to negotiate its preferred lease terms, the REIT has steadily built up an expansive portfolio of leases with CPI-based escalators, most of which are uncapped.
Notice, however, that 45% of WPC’s leases do not feature CPI-based escalators, and another 18% feature ceilings on their CPI-based rent resets, meaning that rent growth will be capped at, say, 3-5% per year. And the 40% of leases that feature fixed escalations usually have average annual bumps of 1-1.5%. Only 37% of leases feature uncapped CPI-based rent escalations.
Therefore, when inflation is running hotter than around 4-5%, WPC’s portfolio will only be able to generate same-store rent growth about half that of the CPI.
Now, don’t get me wrong. WPC’s particular mix of contractual rent escalations provides far better inflation protection than those of the average net lease REIT! I am not complaining. WPC provides about as much inflation protection as a landlord of traditional net lease property types can offer.
What I am saying instead is that inflation protection is not and should not be the primary draw of any net lease REIT. If your primary concern is inflation protection, invest in multifamily, industrial, or self-storage REITs who have put up double-digit same-store NOI growth rates in recent quarters.
In the US, the CPI peaked in June at 9.1% and spent the summer and fall months around 8%. This high inflation is currently dragging WPC’s quarterly same-store rent growth rates up with it, albeit with a lag.
Since rent rates reset based on backwards-looking CPI measurements, this metric will continue to go higher. But will it go all the way up to 8-9%? No, it will not. CEO Jason Fox stated on the Q3 earnings call:
As current inflation flows through to rents, we expect our contractual same-store rent growth to move even higher in 2023 to between 4% and 4.5% and to continue seeing the benefits into 2024.
That 4-4.5% portfolio-wide rent growth metric is based on the peak CPI rates of 8-9%.
Again, this is very impressive organic growth for a net lease REIT! I am not complaining. But it’s still only half the CPI. If 100% of this flowed through to AFFO per share growth, then the REIT’s AFFO per share growth would trail the rate of inflation by 50%.
So, if WPC wanted its AFFO per share growth to beat the rate of inflation, it would have to rely on accretive external growth.
The paradox is that the very inflation pushing WPC’s organic growth rates up is also pushing up its cost of capital at a faster rate than cap rates can keep up. That’s the subject of the next section.
Narrowing Gap Between Cost of Capital & Cap Rates
Between cash on hand and untapped forward equity wherein the price is already locked in, WPC ended the third quarter with about $830 million in existing buying power.
As CEO Jason Fox stated on the Q3 conference call:
We currently have approximately $650 million of untapped equity forwards raised at a stock price averaging in the 80s, and we raised debt capital priced in the mid-3s through our recent private placement Eurobond issuance. Furthermore, our recent upgrade by Moody’s to BAA 1 should enhance pricing on our bonds. And with over $2 billion of total liquidity, we’re confident in our ability to continue investing in appropriately priced opportunities.
Between the forward equity agreements, recent bank loans, and some amount of free cash flow available for investment, Fox estimated on the conference call that WPC’s weighted average cost of capital of already raised capital sits around the mid-5% range.
Compare this to the investments WPC made in the third quarter at cap rates averaging 6.3%, inclusive of capital expansion projects.
At WPC’s current pace of acquisitions, this available buying power will last about two quarters, which means WPC will need to raise more capital in order to continue acquisitions into 2023. Fox says the REIT has over $2 billion in total liquidity, but that includes the ~$1.2 billion of availability on WPC’s credit facility. Most REITs don’t use the credit facility except as a temporary bridge until long-term financing is obtained.
So, when WPC needs to raise more capital around mid-Spring or early Summer of next year, what will their cost of capital be?
Well, if BBB-rated corporate bond yields remain around where they are, then WPC is looking at raising debt at an interest rate of about 6%.
What about equity?
Well, WPC’s current AFFO yield is 6.6%, so we can use that as a simplified cost of equity, assuming the stock price doesn’t rise meaningfully in the next few quarters (which, admittedly, may or may not prove accurate).
Assuming a mix of 55% equity, 40% debt, and 5% free cash flow, WPC’s WACC rises to the low 6% territory.
This is not good when cap rates are rising only at a creeping pace. In the first half of 2022, WPC completed investments at an average cap rate of 6.1%. That rose to 6.3% in Q3.
Due to the large amount of capital still available to chase deals, cap rates are responding to spiking interest rates only very slowly. As Fox said on the conference call, “some sellers have been stubbornly slow to react to current market conditions.”
This situation has led to a big squeeze on the crucial spread between cap rates and cost of capital. In fact, the spread between net lease cap rates and the 10-year Treasury yield is close to its narrowest on record.
While this situation looks bad for WPC if the scenario remains the same, or if WPC’s cost of capital continues to rise faster than cap rates, I do not think it will last very much longer.
In fact, I think that by the time WPC needs to raise more capital, either the REIT’s cost of capital situation will have improved, or cap rates will be significantly higher, or both.
On Cap Rates
Fox told shareholders on the Q3 conference call that they are “actively exerting our pricing power [for] new deals, demanding higher yields, which we’re beginning to achieve.”
How much higher exactly?
So right now, we’re targeting cap rates. I would say the range has moved up from 5% to 7% in the past to 6% to 8% now. And I would expect us to be probably more likely in the midpoint of that range in the high 6s and into 7s.
If WPC can actually move its investment cap rates to around 7%, that will go a long way toward maintaining the crucial spread over its cost of capital. That is especially true if you factor future rent escalations into the calculation.
On Interest Rates
One of the most reliable predictors of an oncoming recession is an inverted Treasury yield curve wherein the 10-year Treasury rate trades at a lower level than short-term rates such as the 2-year or the 3-month.
This is a strong signal from the bond market that economic weakness will soon force the Federal Reserve to cut short-term interest rates back to the point where a normal yield curve is restored.
And when the Fed cuts short-term interest rates, they typically do it rapidly, spurring long-term rates to follow them down to some degree.
Thus, even if a 2023 recession causes inflation to drop, it should also cause interest rates to drop, and the beneficial effect of falling interest rates should more than offset the detrimental effect of falling inflation for WPC.
WPC is a big, diversified, complex net lease REIT with lots of moving parts that I didn’t address in this article. For instance,…