naphtalina/iStock via Getty Images W. P. Carey (NYSE:WPC) is scheduled to report Q4 and FY2022 results on February 10th. The company had an eventful couple of months and is riding high due to rising inflation boosting its rents. As we shared back in November after it reported its Q3 results: WPC is still in strong growth mode thanks to inflationary tailwinds and a strong acquisition pipeline that is being fueled by WPC’s strong liquidity and access to equity capital at highly accretive prices…As a result, we are more bullish than we were previously on WPC’s ability to accelerate dividend growth moving forward. However, we think WPC will still wait at least another quarter or two before accelerating dividend per share growth in a meaningful way as it will likely wait to make sure cap rates are moving higher before doing so. We rate WPC a Buy and continue to view it as an attractive risk-adjusted income investment that also benefits from inflation. Since then, our bullishness has paid off with WPC outperforming the market over that time span. In this article, we discuss two important considerations for investors prior to WPC’s upcoming earnings release. Important WPC Consideration #1: Credit Rating Upgrade Impact On Cost Of Capital Cost of capital is an extremely important differentiator in the triple net lease REIT sector. This is because these REITs are generally slow organic growers due to the very conservative nature of their leases. With little to no CapEx and OpEx requirements, lengthy lease terms, and fixed or inflation-indexed rent bumps, these REITs have very stable cash flows and significant visibility into their organic growth profiles moving forward. Furthermore, given the requirement for them to pay out 90% of taxable income to shareholders as dividends in order to retain REIT status, there is often not that much cash flow left over after paying out dividends. As a result, it is practically impossible for these REITs – especially once they reach a large size – to generate anything greater than 5% annualized organic FFO per share growth over a multi-year time frame. Even then 4-5% annualized per share FFO growth is very difficult to accomplish given that most rent bumps are in the 1-2.5% range and with payout ratios typically in the 70-80% range, obtaining the typical 8-10% leveraged cash yield on reinvested capital will bring in at most an incremental 1.5-3% in FFO per share growth the following year. Of course, there is often a lag in deploying this capital and there are the occasional vacancies that also need to be accounted for, which further weigh on this growth number. As a result, triple net lease REITs – while steady compounders – are by design not attractive growth REITs. However, there is one exception to this: issuing new equity and combining it with attractively priced debt to acquire new properties or even entire REITs in order to grow the bottom line in a meaningful way. The largest triple net lease REIT in the market today – Realty Income (O) – did this recently when it acquired VEREIT. Furthermore, O and many other triple net lease REITs (including WPC) make a regular habit of issuing additional shares of common equity and then combining it with attractively priced debt to acquire properties at cap rates that meaningfully exceed their weighted cost of capital, driving FFO per share growth for shareholders. O has long held a distinct competitive advantage in the area of cost of capital (which has helped fuel its rise into the leading triple net lease REIT in terms of size and long-term track record) thanks to its A- credit rating. As a result, it can issue bonds at interest rates that few to no other competitors can match, thereby giving it greater spreads when reinvesting the capital. This leads to a virtuous cycle in which its superior spread leads to a superior risk-adjusted growth rate, which in turn leads to its common stock commanding a superior premium to the net asset value of the underlying real estate, which in turn further reduces its cost of capital. Until now, WPC – while it still had a decently attractive cost of capital – lagged behind O with its BBB credit rating. However, about a week and a half ago, S&P Global Ratings upgraded WPC’s credit rating to BBB+ on: expectations that its contractual rent increases and acquisitions will support further operating outperformance over the next two years despite recession risks. This outperformance will largely be fueled by the fact that ~55% of its leases have embedded rent escalators indexed to CPI. With 2022’s four-decade high CPI readings still flowing through to WPC’s bottom line via indexed rent bumps, WPC should enjoy some very strong cash flow tailwinds in the near term. Meanwhile, its improved credit rating should also result in it having a lower cost of debt on the bond market, which will reduce its cost of capital. As a result, we also would not be surprised to see it command a higher premium to NAV in the equity market, further accelerating its growth potential. It will be very interesting to see if any discussion is made of this on the earnings call and how it may impact WPC’s growth trajectory moving forward. Important WPC Consideration #2: Rising Cap Rate Impact On Dividend Growth Cadence Another important recent development is the fact that WPC has reported that cap rates have finally begun to improve after being so stubbornly low for much of 2022. With interest rates rising rapidly last year, many triple net lease REITs found it increasingly difficult to sustain their growth engines given that cap rates on triple net lease REITs were refusing to move higher in tandem with interest rates. As a result, investment spreads were narrowing significantly. As we wrote in our aforementioned analysis of WPC’s Q3 results: WPC’s returns on invested capital are clearly getting squeezed to a point where there is not much incremental return being earned on invested capital. However, since then, conditions have begun to improve in the acquisition marketplace. In early January, WPC reported that it had completed $1.42 billion in investment volume for 2022 and that during Q4, cap rates finally began to move higher. The company was able to make a meaningful number of acquisitions of high-quality industrial and warehouse properties with cap rates in “the high sixes and into the sevens.” As a result, management is feeling more bullish about its 2023 prospects, stating: We believe this sets up an environment in 2023 conducive to higher investment activity at wider spreads It will be very interesting to see if there is any update on the earnings call about the direction of cap rates that they are getting on acquisitions right now. If cap rates continue to move higher while WPC’s cost of capital improves with its credit rating upgrade, there could be a significant unwinding of the narrowing spreads that the company faced last year. Investor Takeaway WPC has been a stellar long-term compounder and has grown its dividend every year for over two decades in a row. While the stock is not particularly cheap right now and has outperformed many of its peers through the recent inflationary period, WPC’s fundamentals are also receiving a significant boost. Between its CPI-linked rent escalators driving strong organic FFO per share growth, a continued strong acquisition pipeline, a declining cost of capital, and the recent increase in cap rates on new acquisitions, WPC could see a strong increase in its FFO per share and – with it – hopefully a long-awaited acceleration in its dividend growth.
