In the first quarter of 2019 diversified net lease real estate investment trust (REIT) W.P. Carey (NYSE: WPC) saw a massive revenue increase -- and an adjusted funds from operations (AFFO) decline. Since AFFO is a key performance metric for REITs, there's a dichotomy here that needs to be looked at closely. Indeed, it's usually not a good thing for AFFO to fall, since it means there is less cash around to cover dividends, but there's more going on here.
Here's what's going on at W.P. Carey, and why dividend investors should actually be OK with the AFFO decline.
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A big makeover
W.P. Carey has been executing some important changes. The company was once a combination of a net-lease, property-owning REIT and an asset management company that created, sold, and managed non-traded REITs. The property-owning side of the business accounted for roughly 80% of AFFO, with the asset management operations chipping in the remaining 20% or so.
On the top line, meanwhile, the asset management business contributed about 15% of revenue. (For reference, the asset management arm was contributing a huge 40% of revenue at the start of the decade.) Although clearly not as important as the property-owning side, asset management was still an important business for W.P. Carey.
That said, asset management was a somewhat lumpy operation. There was stable revenue from managing the portfolios of non-traded REITs, but there was also episodic revenue from things like fees for buying and selling properties on behalf of the non-traded REITs and fees related to the creation and sale of new non-traded REITs. Moreover, the non-traded REITs W.P. Carey managed generally had finite lifespans, which meant that any revenue it generated on that side of the business could eventually end.
In practice, W.P. Carey had historically acquired the non-traded REITs it operated and added their portfolios to its owned portfolio. With intimate knowledge of the assets, it was often the best option for the end-of-life sales of the non-traded REITs. However, the non-traded REITs were overseen by an independent board that could, if it wanted, sell the entities to anyone. To put it simply, there were a lot of uncertainties around the asset management business that often left W.P. Carey with a discounted valuation relative to peers.
That's why the company decided to get out of the business.
Not quite there yet, but almost
After a contentious review of its operations that led to the departure of its CEO, W.P. Carey decided that it wanted to simplify its business. In mid-2017 the decision was made to essentially close down the asset management operation. The first step was pretty easy -- it simply meant no longer creating any new non-traded REITs. However, W.P. Carey was still responsible for managing those that had previously been created, and doing so still generated a notable amount of revenue for the company.
That's why the second step has proven to be a bit more difficult, and the first quarter's AFFO drop is the end result. In late 2018 the company acquired the largest non-traded REIT it managed on the asset management side of things.
The deal was a game changer for the company operationally, resulting in a notable increase in rental revenue that could be relied on for years to come. By bringing those assets onto its own balance sheet, W.P. Carey no longer had to worry about a sunset date on the revenue they generated. And after the close of that acquisition, the asset management business is down to a low-to-mid single digit contribution to AFFO and responsible for about 5% of revenue. W.P. Carey is now largely just a boring triple net lease REIT.
The problem is that buying the non-traded REIT meant issuing new shares of W.P. Carey. Despite an increase in the company's overall AFFO, the dilutive impact of the new shares actually led to a drop in AFFO per share. That helps explain why year over year AFFO in the first quarter of 2019, the first full quarter after the acquisition, was down 5.5% on a per share basis despite a nearly 50% jump in revenue. AFFO per share is expected to decline about 10% in 2019 based on the midpoint of guidance. Moreover, using the midpoint, the REIT will have a roughly 85% AFFO payout ratio this year, down from a more comfortable 75% or so in 2018. Neither of these key metrics is going in a good direction, and if you only looked at these numbers you would likely, and perhaps justifiably, be a little worried about W.P. Carey.
But -- and this is a big but -- the overhaul of the company's business drastically improves the quality of AFFO. Quarterly ups and downs based on volatile fee income will be reduced materially, and so too will the fear that the income stream from managing a non-traded REIT will disappear some day. At this point, with the acquisition now complete, management can get back to doing what it really does best: building a net lease business. Only now it will basically be putting all of its time and effort into its own portfolio instead of splitting time among various managed entities.
W.P. Carey will likely need to take a few quarters, or even a year or so, to fully integrate the non-traded REIT's portfolio with its own. It may even sell off some assets that don't fit well within W.P. Carey. But when all is finally said and done, W.P. Carey is easier to understand today, and has a more reliable income stream than it had just a year ago. That's a net win for long-term investors.
Executing the plan
Transitions can be hard to watch, and W.P. Carey's current makeover has led to some worrying operating results. But when you understand the backstory a little, those results aren't quite as concerning. Yes, you need to watch what's going on today as W.P. Carey continues its transition to a pure play net lease REIT. But so far, there's nothing to be worried about. Everything is still going according to plan.
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