W. P. Carey (WPC 1.01%) recently surprised the market by unveiling a two-part plan to swiftly exit the office sector. Shares of the diversified real estate investment trust (REIT) have tumbled over 15% since it revealed that plan, which would see it sell off part of its office portfolio while spinning off the rest of the properties into a new office REIT. The company also said it would reset the dividend following the spinoff.
The diversified REIT decided to make the move in hopes of boosting its valuation. However, it has had the opposite effect. Here's why it might not deliver the anticipated benefit.
Hoping to lift a weight
W. P. Carey owns a diversified commercial real estate portfolio. It has over 1,475 net lease properties in the industrial (29% of its annual base rent), warehouse (24%), retail (17%), office (16%), self-storage (4%), and other (10%) sectors. It also has 85 self-storage properties that it operates.
The company has been steadily reducing its exposure to the office sector over the years. Offices supplied 30% of W. P. Carey's annual base rent in 2015. Over the last several years, the company has cut that level in half by investing in other property types (primarily warehouse and industrial) and selling office properties. Its office exposure will go down to zero as the company completes its two-pronged exit strategy.
The first phase will see the company spin off 59 office properties into a new office REIT, Net Lease Office Properties (NLOP). Those properties currently contribute about 10% of its rent. It expects to complete that transaction in November. Meanwhile, it intends to sell the remaining 87 properties by early next year.
W. P. Carey believes that exiting the sector will help lift a weight off its stock price and drive a re-rating of its trading multiple:
Data source: W.P. Carey.
As that slide shows, its trading multiple is near the bottom of the net lease sector, likely because of its outsized exposure to the office sector compared to its peers. However, by removing its office properties, W. P. Carey will get more than 60% of its rent from warehouse and industrial properties. It believes this change would help nudge its valuation closer to the top of the sector.
A potentially big value hit
While W. P. Carey believes this move will enhance shareholder value, analysts aren't convinced. For example, BMO Capital analyst John P. Kim recently downgraded the REIT from outperform to market perform. The driving factor is that he doesn't believe the market will re-rate W. P. Carey at a higher trading multiple following the office REIT spinoff.
Further, the analyst believes that NLOP will likely trade at a heavily discounted value. Most investors don't want direct exposure to the office sector these days, which will likely lead many to sell the shares they receive in the spinoff, pushing down its value. On top of that, the spinoff will be a taxable event for existing shareholders, even if they don't sell their shares.
In addition to the near-term value hit, W. P. Carey investors will see a payout cut, since the REIT plans to reset its dividend following the spin. It plans to target a 70% to 75% payout ratio on its lower income level following the office exit, down from the current payout level of around 80%.
Rushing to the exit might not pay off
W. P. Carey believes its office portfolio is weighing down its value. However, the REIT's strategy to quickly exit the sector might not unlock shareholder value. Instead, it could have the opposite effect. Its shares have already lost 15% of their value (roughly equal to its entire office exposure).
Meanwhile, shares of NLOP will likely trade lower following the spinoff as shareholders dump its stock. On top of that value loss, investors will see a pay cut from the reduced dividend, which could put more downward pressure on W. P. Carey's stock.
Given these issues with W. P. Carey's accelerated plan, it would have been better if the REIT continued slowly reducing its sector exposure. It could have methodically sold off office properties and recycled that capital into new warehouse and industrial investments. That could have enabled the REIT to keep the dividend at its current level while maintaining its pace of steadily increasing its payout. The accelerated plan makes the stock a much less appealing option for income-seeking investors in the near term.
