September 21 ended up being a really interesting day for shareholders of W.P. Carey (NYSE:WPC), a REIT that owns a diversified portfolio of real estate assets. The company’s shares closed down about 8% after management announced that the The company will get rid of its entire office portfolio. Some of the assets will be spun off and the rest will be sold. This took investors by surprise and, the most interesting thing, is that the time frame for all this to happen is incredibly short. Obviously, the market reaction to this event was negative. I can understand why it is like that. After all, in one very important respect, the transactions are very likely to make the company more expensive than it was previously. But in another aspect, there is some benefit.
A look at the transactions
According to the Press release issued by WP Carey, the company has decided to implement a Strategic plan intended to allow it to exit office real estate space. This will actually be done in two different ways. A portion of the assets will be spun off into a separate, publicly traded company, and management expects the deal to close on November 1 of this year. And the rest of the assets will be sold, with an expected completion date of January next year.
If this surprises me, I understand. But there is a very real reason behind this maneuver. as I have written about previously, the office real estate space is facing real problems right now. At the beginning of this year, occupancy rates across the country were estimated to be around 50%. Although many companies have decided to change course following their decisions during the pandemic to allow more people to work remotely, there is still a real threat for office owners that occupancy rates will remain low and, as a result, that Property values plummet. Management clearly views this threat as very real and, despite having high occupancy rates on its office assets, has made the decision to reduce risk to shareholders while also using some of the proceeds to reduce overall leverage. of the company.
Although this announcement is abrupt, the company has been working for years to reduce the exposure of its offices. In 2015, for example, 30% of its annualized base rent, or ABR, came from office assets. Today, that figure is 16.1%. Once these transactions are completed, it will drop to 0%. It may be easier to start by describing the sale of certain assets and then move on to the more complicated spin-off. The sales side of the equation actually includes the largest amount in terms of property count. The company is selling 87 properties, of which 70 are currently leased to the Spanish government. The other 17 are occupied by a total of 20 tenants. Together, these assets have six million square feet of space and generate $77 million ABR. As far as office assets go, they look quite attractive. Those leased to the Spanish Government have a 100% occupancy rate and a remaining weighted average lease term of 11.5 years. The other 17 properties included in this portfolio have an occupancy rate of 86.7% and a more modest 8.2 years remaining on the lease.
Obviously, since the company is going through the sale process, there is nothing defined in terms of the price investors should receive. But management revealed that they expect revenues of around $800 million. In addition to this, around $140 million of outstanding mortgage debt would need to be transferred from WP Carey to the buyers of those assets. So this should give us total revenue, without transaction costs or taxes, of $940 million if managed correctly.
The other operation involves the division of certain assets of the office. Management calls the company Net Lease Office Properties, or NLOP for short. This will consist of just 59 properties which are occupied by a total of 62 tenants. Although the number of properties is smaller, the square footage is larger: 8.7 million square feet. On top of this, the ABR is substantially higher at $141 million. Investors should consider these to be higher quality assets, as evidenced by the current occupancy rate of 97.1%. However, the weighted average lease term is considerably lower at 5.7 years. 89% of the ABR associated with these properties comes from North America and the rest of Europe. To put this into perspective, the assets sold derive around 31% of their ABR from North America and the rest of Europe.
Unfortunately, we have no idea what kind of value should be extracted from these assets. This is something the market will decide when the spin-off occurs. But we have some things to work with. For starters, we know that management will unload $169 million of mortgage debt on this new publicly traded company. In addition, the new company will receive a line of credit of 455 million dollars, from which it will withdraw 350 million dollars in order to transfer them to WP Carey.
In an attempt to discover what kind of value might exist for this independent company, I decided to consider both a conservative scenario and a liberal scenario. But first we have to be a little creative. While we know the ABR of these assets, we do not know the EBITDA. And the easiest way to value what’s happening is to start with the EV/EBITDA multiple. What I do know is that WP Carey generated annualized EBITDA of $1.51 billion during the second quarter of the company’s fiscal 2023 year. If we say that the ratio between EBITDA and ABR is the same across WP Carey today, then we would get an EBITDA for the assets for sale of $79 million. And for the spin-off company, we would get $144 million. This is not the clearest way to look at the company, mainly because it has other, smaller sources of income in addition to leasing its properties. The most notable is the income it generates from certain operating assets. But based on my review of the company, we can’t really split up all these other revenue streams. Therefore, we create some risk that the EBITDA of these office assets is being slightly overstated. For conservative purposes, I have reduced the EBITDA of each of these office property portfolios to match their ABRs.
Following this approach, the assets being sold are realized at an EV/EBITDA multiple of 12.2. That will mark the conservative end of the spectrum. Meanwhile, before this announcement was made, WP Carey was trading at an EV/EBITDA multiple of 14.8. That will mark the liberal end of the spectrum. This would imply an enterprise value for the assets being spun off of between $1.72 billion and $2.09 billion. When we eliminate the debt, we end up with equity of between $1.2 billion and $1.57 billion.
Upon completion of this transaction, WP Carey will generate around $1.25 billion in ABR per year. This move increases the weighted average lease term of its remaining properties from 11.2 years to 11.9 years, while also causing its occupancy rate to increase from 99% to 99.3%. This alone is certainly positive. What’s more, 66% of its ABR will come from North America, with 33% attributable to Europe. At the end of the day, this will also result in around 62% of its ABR coming from industrial properties and warehouses. This compares to the 53% it generates today from those types of assets. Retail will be the second largest category, with 20% compared to the company’s current 17%.
It’s unclear what exactly management will use the cash proceeds it receives for. But if they use everything to reduce debt, the company will go from having net debt of $8.56 billion to $7.1 billion. If the company prioritizes paying down term loan debt and line of credit debt, and we take into account the mortgage debt it is getting rid of, then I estimate it will save about $52 million in interest expense over time. anus. This should result in operating cash flow of around $1.05 billion and EBITDA of approximately $1.28 billion. Despite the reduction in net debt, the company’s EV/EBITDA multiple will increase from the 14.8 we saw immediately before this transaction was announced to between 15 and 15.3. However, due to the reduction in interest expenses and capital associated with the spin-off that will be deducted from WP Carey, the company should see its price/operating cash flow multiple decline from 13 to between 11.6 and 12.
Based on the data currently available, I can understand why some investors might be concerned about this transaction. In terms of EV to EBITDA, we expect the company to become more expensive than it currently is. But relative to operating cash flow, the opposite is happening. It is likely the bottom line cash flow and the aforementioned concerns about the office’s asset class that encouraged management to pursue this set of transactions. Frankly, I consider this to be a marginal positive for the company. But it’s not enough to encourage me to increase my rating from “hold” to “buy.”