W.P. Carey (WPC -1.70%) is one of the largest net lease real estate investment trusts (REITs). The business is usually driven by fairly long leases, with W.P. Carey's average remaining lease term coming in at 11.2 years. That's good because tenants are locked in for the long term, but it's also bad because inflation can take a big bite out of the income a property generates if it isn't adjusted higher over time. On that front, W.P. Carey has a very good record, as evidenced by its 4.3% same-store rental growth in the second quarter.
Net leases are largely financing transactions
Perhaps the most important thing to understand about net lease REITs like W.P. Carey is that they are a mixture of a landlord and a financial partner. The simplest transaction here is that a company with vital property sells it to a net lease REIT and then instantly leases it back under a net lease. A net lease requires the tenant to pay for most property-level operating costs. The cash it generates can be used to fund growth investments or to solidify the balance sheet, among other things.
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The net lease structure is good for the tenant because of the cash it generates, of course. But with generally long lease terms (often 10 years or more) and the requirement that the tenant pay for operating costs, the tenant still has functional control of the property. That allows it to ensure access to a vital asset while also making sure the asset is maintained to the company's standards. REITs like W.P. Carey, meanwhile, get a reliable tenant, a long lease, and a property that requires little effort to maintain. It's pretty close to a win-win.
The fly in the ointment here is that tenants want to minimize their rental costs. Thus the highest-quality tenants often sign leases that have no rent rate escalators in them at all. That means that inflation eats away at the value of the rental income in such leases, which can stay the same for a decade or more. That's a win for the tenant, but not a great outcome for the REIT (or its investors). But for years, inflation was so low that nobody really paid much attention to this risk.
Inflation rockets higher and W.P. Carey is ready
W.P. Carey, which has been doing net lease deals for roughly half a century, didn't ignore the risk of inflation. About 55% of its leases included inflation-linked rental hikes. Another 40% or so had fixed increases built into the contracts (that's not nearly as desirable, but it is far better than no rent increases). The company was basically preparing for the day that inflation returned well in advance of that event.
Well, inflation is back -- and in a big way -- at least partly thanks to the economic dislocations caused by the coronavirus pandemic. And W.P. Carey's portfolio is prepared. In Q2, its same-store rent growth was 4.3%. That was the second consecutive quarter at that rate. By comparison, net lease bellwether Realty Income only achieved same-store rental growth of 2% in the quarter. So W.P. Carey is doing more than twice as well on this key industry metric.
The change over time in same-store rental growth is also important to highlight. In the second quarter of 2022, that number was 3%. In Q2 of 2021, it was 1.5%. So not only is W.P. Carey's same-store rental growth higher than its largest peer, it is also much higher than it was before the rapid spike in inflation. While that's exactly what you would expect, it illustrates that the company's prescient decision to include inflation-linked rent escalators has worked out just as intended.
W.P. Carey is taking a long-term approach
W.P. Carey was a pioneer of the sale/leaseback net lease business model. So it has been doing this for a very long time and clearly knows a thing or two about the sector. It takes a long-term approach when it makes decisions, which is clearly evidenced by the inflation-linked rent escalators it put into the majority of its leases even when inflation was historically low. While it is nice to see the big rent boosts, what's even more attractive is the vindication of the REIT's commitment to a long-term approach.
