Prices rise over time, so inflation isn't a new phenomenon. However, when inflation spikes, as it is today, it's a problem for you and, just as important, for the companies in which you invest. The solution for companies is to raise prices, but that's not as easy as it sounds, especially for real estate investment trusts. Here's how W.P. Carey (NYSE: WPC) has long prepared for this high-inflation moment.
A host of problems
First came the pandemic in 2020 that hit some real estate investment trusts (REITs) so hard they were forced to trim or, wose, suspend their dividends. W.P. Carey sailed through that, basically collecting all the rents it was owed and raising its dividend (admittedly by token amounts) each quarter of that dreadful year. The REIT is ready to shine again, but there's some background to cover that helps explain why.
Setting things up, governments took drastic action during the pandemic, asking people to socially distance, forcing nonessential businesses to close, and handing out massive amounts of financial stimulus/aid. The result of these events, to simplify a complex issue, was a lot of cash floating around and little way to spend it. As the world started to reopen, people quickly began burning through the cash lining their pockets. Only the supply chain and employment have yet to fully recover, so there are fewer goods than desired. The result? A big spike in inflation as companies pay more for shipping, workers, and the limited supply of available parts and products.
Companies are raising prices to adjust, and they can pass their rising costs on to consumers. The process takes time, so near-term earnings are likely to be weak. However, eventually, there will be an equilibrium. But some REITs have a big problem: They signed long-term leases and have to abide by whatever they've contractually agreed to, including how annual rent increases are handled. Net lease focused W.P. Carey was forward looking on this front.
Net lease REITs like W.P. Carey own single-tenant properties for which their tenants are responsible for most of the property-level operating costs. It's generally considered a low-risk way to invest in real estate and tends to come backed by long lease structures. Wall Street often looks at net lease REITs as bond alternatives. But there are three broad rent structures investors should know about.
The first is a flat lease with no contractual rent increases in the agreement. Super high-quality tenants, like investment-grade retailers in high-demand sectors (think drug stores), can get such a lease. The rent from these leases gets eaten by inflation even during the good times and ravaged when inflation spikes.
The second type of lease contains flat rent escalations, usually in the low single digits. This model is a bit of a balancing act. When inflation is low, rent hikes will provide real growth. When inflation is high, the buying power of rent collections will shrink. Over time the hope is that things will even out, but flat increases still sting when inflation spikes.
The final approach is to tie rent increases to an inflation gauge. This means rent growth will go up and down over time, along with inflation. But when inflation heads notably higher, these leases offer material protection to the landlord's rent roll. It's probably the best option of the three given the long-term nature of the leases in the net lease niche.
Most net lease REITs have a combination of these lease structures in their portfolios. However, W.P. Carey happens to have 60% of its rent roll tied to inflation. That's a sizable number and positions the REIT well for the current environment, noting that its average lease term is roughly 10 years. About 35% of its rents come from leases with flat increases, and the rest, a very modest sum, contain no hikes or are unique in some way.
With regard to the leases that are tied to inflation, roughly 60% have no cap, so the entire inflation increase passes through at the next annual rent bump. All in, W.P. Carey is likely to weather this inflation spike just as well as it weathered the pandemic hit.
Prepared for almost anything
To be fair, W.P. Carey will be impacted by inflation, just like most REITs. However, it has a solid lease portfolio that was, essentially, designed for the day when inflation reared its ugly head again. This is just one more example of management's diversified and opportunistic approach to its portfolio. And one more reason to love this REIT and its generous 5.3% dividend yield today. While many REITs are likely to feel the harsh sting of inflation, W.P. Carey should, once again, sail easily through the storm because it prepared for this eventuality well in advance.