Net Lease Office Properties (NLOP)
I’ve been hesitant to invest in anything office related since Covid. I don’t like predicting longer-term trends as much as valuing cash flows in steadier situations. That said, along came W.P. Carey (WPC), who spun off their remaining office exposure in November, dumping a small, unwanted, taxable spin onto their shareholders. I’ve been drawn to Net Lease Office Properties (NLOP) due to its relative simplicity: a bet on the near-term liquidation value of a 59-asset portfolio. Per the W.P. Carey call to discuss the spin:
“In terms of the complexities, by separating into an externally managed REIT, I think that's the -- we're really using that structure to expedite the office exit in the most efficient way we can. And maybe your question implies, did we consider or should we have considered an internally managed vehicle. That would have been costly. I think it would have been very difficult to put a new management team together to run that. And really, the external management agreement is appropriate given NLOP's business plan. It's not a growing business, we'll not need to raise new capital. And we think that we've structured a pretty simple and efficient management structure for NLOP and it's finite in nature.
And I think lastly, everything that we'll do for NLOP is going to be done within mainly our asset management team, who has always overseen our strategic asset management and disposition strategy for any of our assets for that matter. So nothing will change there, and we think it will be pretty seamless.
Eric Borden
Okay, that's helpful. And then one last one for me. Just on the initial SpinCo and the NLOP, just curious on your thoughts, just given the lower wallet in that portfolio, what is your thoughts for that piece? Will you look to renew those leases or will you potentially sell down those assets and try to recoup distribution?
Jason Fox
I think it will be a combination. Brooks, do you want to provide any color there?
Brooks Gordon
Sure. I mean the vast majority of the assets in NLOP don't require incremental asset-level activity. There's certainly some great opportunities to create some value and extend leases and then exit, but the large majority, we're going to exit those in an orderly manner, and we're really hitting the ground running there. So we're making good progress on that, sort of already.”
So rather than take a long-term view, NLOP investors are primarily calculating a liquidation value for the portfolio. The company is already making good on this claim, beginning January with an announcement that they had exited four properties at attractive valuations. Of the properties sold in December, two were set to become vacant and two were leased past 2030. They sold in aggregate for about an 8% cap rate:
Raytheon building in Tucson, AZ - $24.6m for $2.0m of Annual Base Rent (“ABR”) (26th highest rent for US locations out of 54, Investment Grade (“IG”))
Carhartt building in Dearborn, MI - $9.8m for $0.7m of ABR (43rd highest of 54, Non-IG)
AVL building in Plymouth, MI – vacant, $6.2m for $0.6m of prior ABR (47th of 54)
BCBS building #5 in Eagan, MN – vacant, $2.5m for $0.3m of prior ABR (51st of 54)
NLOP structure (as of 9/30/2023):
59 buildings totaling 8.7m square feet of office space
$145m of annual base rent and $7m of annual property expenses/tax (per WPC spin call)
5.7 Weighted-Average Lease Term (“WALT”)
97% Occupied
67% Investment-grade tenants
40 of the 59 properties were pooled to secure the $455m of new debt financing (2-year term with two 1-year extension options), along with 14 that have individual mortgages ($167m total) and 5 that are unencumbered. About $16m of NLOP’s base rent was set to expire during 2024. The sales to date represented about 2.5% of base rent but were used to pay down 10% of the spin-co debt.
Valuation Approaches
Cap Rate - NLOP disclosed on their spin call there will be $7m of expenses/taxes associated with these triple-net properties, versus $142m remaining in-place rent after the sales. At $135m of NOI, with a $300m market cap, $409m of pooled debt and $167m of mortgages, NLOP is trading at a 135/876 = 15.4% implied cap rate. Given they have liquidated 4 properties to date around 8%, this certainly seems punitive. If we assume an undemanding 12% aggregate cap rate, the equity value would be approximately $550m/14.6m = $37.60/share (63% upside). Interestingly, fellow spin-off ONL, with half the WALT of NLOP, less investment-grade tenants, a mandate to recycle capital into new office properties, but a similar NOI and debt profile, trades at the same $300m market capitalization. I think investors are lazily comparing the two without digging further.
Appraisal Value - NLOP got their $455m of financing for the spin after JP Morgan appraised the 40-property pool at $1.08B (43% LTV). While some may quickly dismiss this value given the loans were issued at a blended 12% interest rate, the first four sales out of this pool seem to validate this number and would imply ~100% upside to the equity before evaluating the individually mortgaged and unencumbered locations.
Cash Flow - For 2024 (high-level before more asset sales and after 2024 lease expirations), I estimate $145m rents plus a BCBS lease termination payment, less $11.5m management/G&A fees paid to WPC, less $50m interest expense and $7m property expenses & taxes (per WPC spin-off call) = $76.5m free cash flow, which will be focused on debt paydown. Even more importantly, I expect NLOP to focus near-term sales to reduce their interest expense even further. More than $20m of >10-year leases remain in the portfolio. If these can continue to be sold around 7-8% cap rates, NLOP could reduce another $250-300m of debt from selling 15% of in-place ABR. Because the pooled debt carries a 12% blended interest rate, these sales would be very accretive to future cash flow.
This third valuation approach is the most compelling and requires the least imagination. If you sell all the 10+ year leases during 2024 and generate $80m of cash flow (thanks to less interest expense), NLOP can pay off basically all the remaining pooled debt. After that, you are left with a basket of properties with about a ~3-year average lease term and $120m of ABR = $360m of contractual cash flow. From the remaining rent, you can justify the current market cap. If some properties sell at attractive multiples, and I think they will, your downside is near the current share price and your upside could be $50-60/share.
Other Considerations
Because the 14 individual mortgaged properties have non-recourse leases, NLOP can selectively default on locations where the value doesn’t exceed the mortgage. In the cap-rate scenario above, I assumed pay down of all mortgage debt, but this may prove conservative, especially as the company can continue to collect rents on the locations until forced to default.
NLOP can redevelop some locations for non-office use. Two in progress include a Philadelphia listing being pitched for Multi-Family (https://invest.jll.com/us/en/listings/land/720-vandenburg-road-kingofprussia-pa-unitedstates) and their largest BCBS site being converted to a warehouse for Johnson Brothers (https://www.bizjournals.com/twincities/news/2023/12/13/johnson-bros-eagan-approval.html). Given the process is being overseen by a $15B market cap REIT, I’m expecting positive ROI on any further capital investments or spending to extend in-place leases.
Property Analysis
Given real estate is location-specific, I want to provide a deeper dive on their largest locations, representing almost half their ABR.
Houston Tower (12.9% ABR) - Company is currently sub-leasing vacant space for $17.50/sq. ft. Property is >90% rented but may become challenged if KBR exits after 2030 (90% of space). If we value this location at a 12% cap rate it should be worth at least $150m on its own – a third of the entire new debt package. The present value of rents justify over $100m for this building. While the building itself is a 1970s era tower, my understanding is it is in the “right” part of Houston to remain viable.
FedEx (3.9% ABR) - This space has a 16-year term remaining on the $5.5m lease. I don’t see how such a lease sells for worse than an 8% cap rate after their recent sales. One broker I spoke with suggested triple net leases with this kind of term should trade about 100 points wide of the company’s debt, suggesting closer to a 6% cap rate. This feels aggressive to me, but if we split the difference and assume 7%, we get $75m of value.
BCBSM (3.5% ABR) - While this was the third-largest lease, BCBSM represents almost 10% of ABR across 6 locations (one now sold). At the time of the spin, a deal was struck to terminate the two largest and smallest leases while extending the middle two for 10 years, in exchange for a $12-13m termination payment. NLOP loses about 2/3rds of their annual payments from BCBS but added $50m of future rent. It certainly appears they did this deal with some visibility on selling soon-vacant locations with one already sold in December and the conversion having been approved by city council. If the conversion is successful, >400k of warehouse space that rents around $7/sq ft could be worth $25m after conversion expenses.
Total Norge (3.5% ABR) - This property is unencumbered and has over 7 years remaining on the $5m annual lease. WPC bought the location for about $70m in 2014, and I’m fine assuming $50m remains a safe value for the location.
JP Morgan (3.3% ABR) - Another property with over 6 years remaining on the lease at a $4.7m annual rate. Rents in the immediate vicinity are $10.75, so ~10% less than what JP Morgan is currently paying. A 10% cap rate on $4m of annual NOI would still get you a $40m valuation here, not much more than the remaining contractual lease amount.
McKesson (3.1% ABR) - This is the first vacant location in NLOP’s register, with the lease expiring in Jan-24. Fortunately, this and a location across the street are currently on the market for a significant premium to the current lease, suggesting strong local leasing fundamentals remain. Using some re-lease assumptions, you can credibly underwrite a $100/sq ft valuation to sell the location. $20m isn’t bad for a location set to contribute nothing to 2024 earnings as it currently stands, and there could be a lot of upside if they can secure a new tenant for the building.
CVS (3.0% ABR) - Another lease with 15 years remaining, which seems safe to use a 7% cap rate and move on. $60m of value. This is a great example of a property where the investments required to extend the lease were made by WP Carey this past year, and now NLOP will benefit from selling the upgraded property.
Siemens (3.0% ABR) - The first property on the list with an individual mortgage - almost $40m. This Norwegian property only has two years of lease left and could conservatively be considered worthless after the debt. In the event the lease can be extended, or a sale is reached below a 10% cap rate, NLOP may recover a small amount from the location.
Omnicom (2.8% ABR) - Five years remain on this $4m lease, and a small office property nearby is being offered at a 4.35% cap rate, or a new lease nearby for $50/sq ft. I think NLOP’s $33/sq. ft. lease is therefore reasonable, and you can safely value this at a 10% cap rate for about $35m.
PPD (2.8%) - Another 10 year, $3.9m lease with a quality tenant. Probably good for an 8% cap rate, or $50m.
In summary, I believe one can safely underwrite over $500m of value from their 10 largest locations, requiring only another $200m from the remaining 45 locations to justify the current valuation. And there’s plenty more quality leases on the register, like the $3m, 15-year lease with DMG MORI SEIKI that carried 3% annual escalations; or the seven year, $3.3m Iowa Board of Regents building with no attached debt and uncapped CPI-linked rent increases; or the iconic “Binoculars Building” leased by Google in Venice, CA (https://www.atlasobscura.com/places/binoculars-building); or the two BCBS buildings that just got their $2.5m leases extended another 10 years each.
Risks
Rate cuts are expected in 2024 and would likely improve the cap rates for NLOP properties; however, if inflation reaccelerates NLOP may suffer reduced liquidation values.
If the assets are not truly worth more than $1B and end up being liquidated for around the value of the debt, shareholders of NLOP could face significant losses. However, remember that $167m of their debt is non-recourse mortgages, giving NLOP a “put option” where they can walk away from select properties with no equity recovery above the mortgage value. The J.P. Morgan $1B appraisal was only on the 40 properties collateralized by the new financing deal.
Perhaps asset sales drag out after properties become vacant, forcing NLOP to invest capital to maintain them or improve them for a sale. Such a delay could compound the impact of their high interest debt if significant repayments cannot be made. I could also be wrong about the pro-forma cash flow profile of the company if undisclosed expenses are uncovered. Seeing four properties sold in the first full month after the spin certainly supports the premise that sales will occur quickly.
Tenant defaults? This is possible with iHeart Radio among the tenants, but I believe their recent renegotiation with BCBS is a better starting point for understanding what could happen to lease arrangements for tenants that want out early. Most of the NLOP tenants are investment-grade.
There are a lot of office loans maturing in 2024, which may lead to fire sales from lenders and depress sales prices. The local markets for NLOP’s properties seem to be holding up well, but this will be an area to watch in 2024.
Qualitatively, there are two ways to think about the NLOP portfolio. One is that it represents the left-over pieces WPC couldn’t sell earlier. The second, which I am inclined to believe, is it represents mostly healthy situations where WPC wasn’t in a rush to sell the locations because little work was needed and plenty of term remained. My impression going through the locations has been that most of the “problem” leases have been dealt with proactively.
Conclusion
NLOP represents an asymmetric way to gain exposure to the liquidation of an office portfolio with limited downside and substantial upside. Early sales results suggest substantial value remains in the NLOP portfolio. I expect most of the debt to be eliminated during 2024 via asset sales and asset cash flow, resulting in substantial appreciation to the share price. Even if sales lag my expectations, I believe NLOP’s value is well-supported at $23/share. I can get 60-100% upside to the equity using multiple approaches and expect shareholders will be well rewarded in the coming years.
