Experts have expressed concern about commercial real estate properties and the impact higher interest rates could have on their refinance costs. CBRE Group, one the world's largest commercial real estate companies, recently told investors that "transaction activity has slowed significantly." Office properties, in particular, have come under the microscope, and the company notes that it could take years for these properties to recover their value.
W.P. Carey (WPC -1.70%) is a high-yield dividend payer that has significantly reduced its exposure to office properties. This week, the real estate investment trust (REIT) announced plans to accelerate its exit from these properties by spinning some holdings into another publicly traded company while selling off the remainder. Here are the details of its strategic move and the impact it will have on investors.
Headwinds in the commercial real estate market
Commercial real estate has dealt with headwinds that drastically slowed the industry this year. According to CBRE Group, the industry faces headwinds from high interest rates, which the Federal Reserve uses to stave off inflationary pressures in the economy. Other factors, like stress in the banking system and declining demand for office space, have contributed to the industry's challenges.
Since early 2022, the Federal Reserve has increased interest rates by over 525 basis points (5.25%). It has been one of the fastest rate-hiking campaigns ever by the Fed.
Rising interest rates have raised borrowing costs for everything from mortgages to credit card loans. Since early last year, the bank prime loan rate, or the benchmark interest rate banks use to lend to clients, has risen from 3.25% to 8.5%.
Bank Prime Loan Rate data by YCharts.
Rising interest rates hurt commercial real estate because many loan terms are five to 10 years long and refinanced as they come due. This makes the industry particularly sensitive to the recent interest-rate increases, and leaves property owners with a difficult decision: refinance loans at today's multidecade high borrowing costs, wait to see if interest rates come down, or walk away from the property.
Office properties face more pressure because of work-from-home or hybrid work arrangements. Couple this with a reduction in employee headcount by many major companies, and the result is tepid demand for these properties.
W.P. Carey's accelerated exit from office real estate
W.P. Carey has gradually reduced its office real estate exposure for several years. Eight years ago, office properties accounted for 30% of its annualized base rent (ABR). These properties account for 16% of its total ABR through the second quarter of this year. It's been a steady process exiting its office assets, but the company decided it was done with these properties and created a plan that "vastly accelerates our exit from office," according to CEO Jason Fox.
The company is taking a two-pronged approach to exiting this market. First, it will spin off 59 of its highest-quality properties into a publicly traded company called Net Lease Office Properties (NLOP). It expects the spinoff to close on Nov. 1.
Once the spinoff is completed, shareholders will receive shares of NLOP through a pro rata special distribution. Next, it will sell its remaining 87 office assets, aiming to complete these sales by January 2024.
Image source: W.P. Carey.
By eliminating the company's office assets, Fox says it can "achieve a lower cost of capital and be better positioned for long-term value creation for our shareholders." It wants to maintain only high-quality assets by increasing its holdings in warehouse and industrial assets, which are expected to hold up better in today's challenging environment.
The move will help it reset its dividend policy
W.P. Carey's strategic exit from its office portfolio will also affect its dividend. According to CFO Toni Sanzone, the company's goal is to "reset the payout ratio at a level that we feel comfortable with and one where we can retain a higher amount of cash flow." It will target a pro forma adjusted funds from operations (AFFO) payout ratio of 70% to 75%. Last year, its payout ratio was around 80%.
The move likely will result in a dividend cut for W.P. Carey, ending its 26-year streak of raising its payout. While investors don't like to see a longtime dividend grower cutting its payout, management at W.P. Carey decided this move was in its best interest to position it for long-term growth.
The stock took a hit following the news and is down 27% year to date. It will likely continue to face pressure in the coming months as the company spins off NLOP and sells the remainder of its office properties.
