When a company that's increased its dividend annually since its initial public offering announces that it's planning to cut the payment, you know something big is going on. That's exactly what's happened with W.P. Carey (WPC -1.70%).
Investors have reacted negatively, selling the stock, as you might expect. Before you follow suit, here's a look at what's really going on with the real estate investment trust (REIT).
W.P. Carey is ripping off the bandage
The office property sector is facing very difficult times today, thanks to the lingering work-from-home trend that got started during the early days of the coronavirus pandemic. However, office assets have never exactly been easy to run. They're large and often require material investment to release or even when just renewing an existing tenant. This is why Realty Income (O -0.17%) spun off its office properties into Orion Office (ONL 0.31%) not too long ago following its acquisition of peer VEREIT.
W.P. Carey is riding Realty Income's coattails to some degree on this one. But the path toward zero office exposure isn't a new one for W.P. Carey. In 2015, roughly 30% of the REIT's rents came from office properties. By mid-2023 that figure was down to 16.1%. After the spinoff, which is expected by the end of the year, the figure will be 5.8%. And the number is projected to hit zero early in 2024 as the remaining office properties are sold. So the current development is really just W.P. Carey speeding up the pace of its office exit.
The problem is that a REIT can't just get rid of 16.1% of its rent roll without having an impact on its dividend. That's just too much revenue going out the door in too quick a period. As such, W.P. Carey has chosen to reset its dividend, with a projected adjusted funds from operations (FFO) payout ratio in the range of 70% to 75%. At this point, it isn't clear what the actual dividend will be, other than lower.
Shareholders will also be left with shares in the new office REIT, which is to be known as Net Lease Office Properties. That said, the new company is going to be loaded up with debt and largely designed to liquidate itself over time. It's a solution to a problem for W.P. Carey, but probably not the best investment opportunity for shareholders. There's a potential for dividend payments, but probably only after debt is reduced materially.
W.P. Carey's logic is sound
So why go through all of this effort? Most shareholders probably would have preferred a slow and orderly exit without the spinoff and dividend reset. That answer comes down to management's attempt to find a way to deal with the rising rate environment. In some ways, the office spinoff is a solid business move, even though investors may not be happy.
For example, the company's office exposure is one of the reasons W.P. Carey has traded at a discounted price relative to some of its most prominent peers. That's probably not going to change overnight, but management is hoping investors will give it a higher valuation in the future after the spinoff. That's notable because selling stock is a key way REITs raise capital for new investments. So right now, W.P. Carey is at a relative disadvantage. It's hoping to rectify that with the office exit.
That's particularly important right now, because interest rates have been rising. That means it's more expensive to raise debt capital. When interest rates were hovering close to zero, it was easier to ignore the stock side of the capital story. But that's just not the case anymore. As such, management is making a big, aggressive change to the portfolio as it looks to keep its cost of capital as low as possible. That, in turn, should help the REIT grow more quickly in the future.
Will all of this work for W.P. Carey?
W.P. Carey is likely to be seen as a company in transition for some time. After the dividend cut, investors are probably going to shun it, which will keep the cost of equity capital high. But if you own W.P. Carey, you might not want to sell it. Getting out from under the office portfolio is actually a good long-term goal that should make the portfolio stronger, with a heavier emphasis on industrial and warehouse assets (roughly 62% of rents post-spinoff). These property types have been doing quite well of late and have strong prospects over the long term.
The key to the stock's performance from here will probably be a return to dividend growth. The sooner the company does that, essentially rebuilding shareholder trust, the better it will be for investors. If you own W.P. Carey and are willing to ride through this material portfolio change given its long and mostly successful history in the REIT sector, watch the company's dividend closely. When it starts growing again, the story here will probably change directions again. Unfortunately, it still might take a full year before investors are willing to forgive W.P. Carey for cutting its dividend in the first place.
