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Co-produced with Trapping Value

Real estate traditionally has been a defensive asset as tenants shell out the rent in almost all cases. That was the theory. In practice however, things got far more out of control than what anyone envisioned. Today, we look at one of our favorite segments in real estate, the triple-nets.

Triple-Nets

The triple-net REIT space is one that attracts a fair deal of investment capital. Transferring all the capital expenditures onto the tenant reduces risk in the business, which in turn lowers the cost of capital. Landlords sit back and collect rent from mainly single-tenant properties with extremely long leases. Rents go up annually with inflation or via some other fixed escalators. This is about as close to getting an equity with “bond-like” features as there is. In addition, since real estate appreciates over time, it also has built-in inflation protection.

There are a fair number of triple-net REITs out there, many of which we have covered at some point or another. We recently highlighted Spirit Capital (SRC) which came back into our buy zone after we had booked nice profits a few months earlier. Today, we do a head-to-head comparison of two picks and tell you why each one can have a role in your portfolio. We also pick a winner for this unusual environment.

Realty Income Corporation & W.P. Carey Inc.

Realty Income (O) is one of the newest “Dividend Aristocrats,” being introduced into the S&P Dividend Aristocrats Index in early February 2020. It got this title after raising its dividend for each of the past 25 consecutive years. O prides itself on being a monthly dividend entity and is one of the few REITs listed in the US (unlike all those listed in Canada) that pays dividends monthly.

WP Carey (WPC) was founded more than 46 years ago by William Polk Carey. His mission statement was “investing for the long term” and he understandably chose the real estate sector to do it in. After nearly half a century of steady growth, WPC has evolved into one of the largest triple-net lease REITs. They are internally managed and own a portfolio of operationally-critical commercial real estate around the globe.

Portfolios

O has a predominantly US portfolio with a heavy concentration in retail.

Source: Realty Income Website

O recently took a small step of establishing a presence in the UK via its first set of acquisitions in 2019. UK currently forms under 3% of O’s rental revenues.

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WPC on the other hand has much smaller exposure to retail with industrial, warehouse and self storage forming about half the properties.

Source: WPC 1Q2020 Presentation

WPC also has significant non-US holdings with Europe making up about a third of its real estate revenue.

Source: Q1 Fact Sheet 2020

Neither O nor WPC have any exposure to malls. While we do not see the end of retail space, this segment is currently facing a lot more turbulence than other sectors of the triple-net space. Overall, O’s portfolio is extremely retail-centric and that gives the edge to WPC in our opinion.

Top Tenants, Occupancy and Lease Renewals

O’s top tenants are well known and recognized household names including Walgreens Boots Alliance (WBA) and FedEx (FDX).

Source: O 1Q2020 Presentation

WPC on account of its large international exposure has plenty of tenants that investors may have to look up. What’s critically different also is that WPC has about half as much exposure to its top 10 tenants as O does. WPC’s top 10 exposure is actually the lowest in the triple-net REIT space.

Source: WPC 1Q2020 Presentation

A critical part of the triple-net promise is that leases are very long term and the REITs focus on maintaining a very high occupancy at all times. O certainly has succeeded in this area and occupancy levels have consistently been extremely strong.

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Source: O 1Q2020 Presentation

WPC has done just as well and we would give neither REIT an edge in this area.

Source: WPC 1Q2020 Presentation

O has about 10.6% of its leases coming up for renewal by end of 2022.

Source: O 10-Q

WPC has 8.4% of its leases coming up for renewal by end of 2022.

Source: WPC 1Q2020 Presentation

WPC has the better lease renewal profile but O will likely get better traction on its AFFO if inflation rears its head down the line.

Valuation and Debt

The big difference in this metric between the two businesses is key in our opinion. WPC trades at about 12.25 times 2020 AFFO (or adjusted funds from operations), while O trades at close to 16 times. The 3.75 times higher multiple is a critical reason why WPC gets the stronger edge in almost any downside scenarios as it already holds a cheaper valuation.

Valuation also can be looked at from the perspective of a consensus value in liquidation or a net asset value. While current NAV values aren’t readily available, we can deduce from the April consensus NAV that Realty Income currently trades at about a 20% premium, while WPC trades at just about the liquidation value. Both valuations are far lower than historical averages for the two companies. Both also are far cheaper than the market as a whole. FFO multiples for REITs are comparable to P/E ratios for the broad market. So O’s and WPC’s multiples are lower than the 23-25 shown below.

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Source: Bloomberg

AFFO multiple does not adjust for debt, so we looked at the debt metrics for both. O has a current fixed charge coverage ratio of 5.5 times while WPC comes in at 5.2 times on the same metric. Realty Income currently has one of the lowest cost of debt in the S&P 500 with a weighted average cost of just 3.6%. Due to its large European exposure, WPC actually manages to beat this number and comes in at 3.2%.

While both companies have well laddered maturities with neither taking on excess interest rate risks, one area where they differ is in the amount of non-recourse secured debt. O uses a minimal amount of this and most of its debt is at the corporate level.

https://static.seekingalpha.com/uploads/2020/6/1/47392447-1591019756970368.png

Source: O 1Q2020 Presentation

WPC has actually done far better here and has used the very low property level mortgage rates to its advantage. WPC has almost 27% of its total debt at as non-recourse secured debt.

Source: WPC 1Q2020 Presentation

This allows it to walk away should there be issues with a specific property or tenant and the value of the asset drops substantially. Secured mortgages create a “put” on the property value for the borrower and is a far superior option, specially in today’s distressed environment.

April Rent Collections

While the baseline metrics are great to examine, we got to see the portfolio resiliency in real time as the pandemic stuck. Rent collections suffered across the globe for obvious reasons. O reported 82.9% of April rent was collected as of May 4. A large part of that deferred rent was from theaters. WPC solidly beat this and reported close to a 96% collection. This was the lower retail exposure showing up in spades. In the longer run, O will have to work with a lot more tenants to get arrears settled and WPC’s greater diversified model will work slightly better in our opinion. On the flip side, many (not us) believe that office space will take a permanent wound post the pandemic. O has virtually no exposure here and WPC might have to concede on some planned rent increases should the office space bears turn out correct.

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Dividends: Monthly or quarterly?

Both companies pay generous dividends covered easily by their cash flow. The current yields are high compared to their individual histories but WPC offers almost 2% more.

ChartData by YCharts

This is a very big advantage for yield seekers. O does pay monthly vs. the traditional quarterly payment for WPC. But at this differential it would be just plain silly to make a decision based on this factor. On a $10,000 investment O would pay about $39 per month while WPC would deliver $156 quarterly (based on June 4 share prices).

Both dividends are very safe even in today’s turbulent environment and based on all the information, O and WPC enjoy the highest dividend safety rating on our proprietary Kenny Loggins Scale.

https://static.seekingalpha.com/uploads/2020/4/5/47392447-15861299433961058.png

Conclusion

Lower valuation metrics, a higher European diversification and a greater yield are all things that make us lean one way in this contest. WPC is a clear winner in our opinion between these two rather high-quality REITs. O, however, is one that deserves a place in your portfolio as well. O is moving into Europe slowly and its low cost of capital should create attractive opportunities there. Over the past 15 years both have delivered excellent returns and have outpaced the broader market indices.

Chart

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Disclosure: I am/we are long O, WPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.