W.P. Carey (WPC +0.27%) embodies the image of a diversified real estate investment trust, or REIT. Which is why it was surprising to hear the company's CEO, Trevor Bond, discuss splitting the business into three parts -- a U.S. REIT, European REIT, and an asset manager -- during the company's third-quarter call.
For some, the breakup removes what differentiates W.P. Carey from peers like Realty Income (O +0.24%) and National Retail Properties (NNN 0.34%), but the benefits of a simpler business and lower cost of capital could tip the scales and make the company -- or companies -- an even better buy.
Simplicity
When you boil it down, W.P. Carey has consistently traded at a discount to Realty Income and National Retail. The hope is that a simpler approach will help improve the company's valuation.
The chart below shows each company's enterprise value to EBITDA. The metric is similar to price to earnings, but it swaps net income with EBITDA -- a key cash flow measure -- and market cap with enterprise value, which gives a more comprehensive view of a company's total value.
W.P. Carey believes it can close the gap in valuation by aligning the right shareholders with the right aspects of their business.
For instance, W.P. Carey's asset management arm creates nontraded REITs and then sells shares to private investors. The concern is that this creates awkward incentives, as you have two companies under one roof targeting similar assets. Also, there are strict rules for how REITs can generate income -- a split could allow the asset manager to more aggressively pursue non-real-estate ventures.
Moreover, I can understand that others might not want exposure to European real estate or appreciate the company taking foreign currency exchange losses. Ultimately, W.P. Carey works as a unified business, but to engage more investors it might make sense to break the business into pieces.
Better cost of equity
If the breakup improves W.P. Carey's valuation, the benefit is a lower cost of equity. This is particularly important because REITs tend to issue a ton of new shares of stocks. In fact, W.P. Carey has increased shares outstanding by 18% since 2014.
As of today, W.P. Carey has a dividend yield of 6% -- that is an annual dividend of $3.82, divided by its stock price of $61 per share. At a minimum, that means each new share of stock the company issues is expecting to receive $3.82 per year, or a 6% return.
The 6% return becomes W.P. Carey's hurdle rate. Meaning, it only makes sense to issue new shares of stock if the company can use the $61 to create returns in excess of 6%. If it can't, then W.P. Carey is diluting the value of its stock.
On the other hand, both Realty Income and National Retail have a yield of 4.6%. For W.P. Carey's valuation to match up, its stock price would have to increase to $83 -- an annual dividend of $3.82, divided by $83 per share, equals 4.6%.
The higher valuation lowers the hurdle rate. And for each new share of stock W.P. Carey issues it would receive $83, but is expected to create the same $3.82. In short, there is no guarantee a split would suddenly skyrocket W.P. Carey's valuation, but if it did improve, a lower cost of equity would be a substantial advantage.
It is still unique
The final piece to the puzzle is whether W.P. Carey will still be unique. I believe the answer is yes.
For starters, the asset management business is at the core of W.P. Carey's history. The business is 42 years old and, according to Bond, "No full-term investor has lost money with those funds." I believe that track record helps to separate it from the pack.
Second, W.P. Carey owns about $3 billion in European real estate. If that business were spun off, says Bond, it would be the largest publicly traded net-lease REIT in Europe -- and that's pretty unique.
As for the U.S. REIT, I think W.P. Carey's investment approach differentiates it. The company focuses on the quality of the tenant and the importance of the property to the tenant's business. This philosophy has led to investments in a much wider variety of properties, including office, industrial, self-storage, retail, and hotels. And I believe this creates greater opportunity compared to Realty Income and National Retail, which focus almost exclusively on retail properties like convenience stores and gas stations.
Bond concluded the company's third quarter conference call by saying the company is going to be methodical with this process. He also added that there are a number of different outcomes for the breakup. However, as a W.P. Carey shareholder myself, I think investors should be happy with the current direction. A simpler, more focused W.P. Carey will be an even better buy.
