Business

On November 1st, 2023, W.P. Carey spun off a portfolio of 59 office assets into a publicly traded REIT, Net Lease Office Properties. Whereas a typical REIT manages properties and distributes rent from these properties to shareholders in the form of a dividend, Net Lease Office Properties is different in that is it liquidating its portfolio of Real Estate and using the proceeds to pay down the punishing debt it was loaded with during the spin-off and distribute the residual cash to shareholders in the form of special dividends.

Industry

There are concerns surronding the strength of the US Real Estate Market.

Properties were purchased with financing at a near zero percent interest rates. In a similair dynamic to what has occoured with the implosion of SVB and First Republic, interest rates went up, and property values went down.

You may have seen headlines about properties selling at a fraction of their pre-COVID sales price. Some examples include:

• The Mongomery Park Office Building (Link)

2019 sale price - $255 million

2024 sale price - $37.7 million

• The DLTA Office Tower (Link)

2024 Sale Price - $145 million, 50% below the debt on the building

• Park Avenue South Building (Link)

29% stake sold for $1

Many of these buildings were having issues with vancany prior to their sale, which is not the case with Net Lease Office Properites. Many of these properties were in ‘Prime’ locations (Los Angeles, New York), while Net Lease’s portfolio of buildings is located in ‘secondary’ markets (Texas, Florida, International).

The sale price on Net Lease’s buildings so far has been more than satisfactory.

Competitive Advantages

Net Lease Office Properties does not benefit from any identifiable competitive advantages. Since Net Lease Office Properties is in the process of liquidating its Real Estate Holdings, it does not need to benefit from above-market returns on capital from operations.

Valuation

A Liquidation value model can be found by clicking this link

Given the fact that Net Lease Office Properties is in the process of selling their real estate portfolio, I will be attempting to establish the liquidation value of NLOP properties.

NLOP carries the value of ‘Land, Buildings, and Improvements’ at cost, so it is necessary to independently assess the potential value of their Real Estate Portfolio at sale. At the time of writing, NLOP has 49 properties in their portfolio with the total Annualized Base Rent (‘ABR’) of these properties is $117.4 million.

In my attempted valuation, I have broken to properties down into three groups: (1) Properties with a Weighted Average Lease Term (‘WALT’) of greater than 10 years, (2) Properties with a WALT between 5 and 10 years, and (3) Properties with a WALT of less than 5 years. Operating expenses associated with the properties (Property expenses, excluding reimbursable tenant costs on the Statement of operations) has consistently been around 5% of revenue, so I deduct these from the ABR of the properties to arrive at Net Operating Income, the numerator in arriving at a Cap Rate on sale.

I assign Cap Rates to the properties based on their WALT, assuming that properties with longer tenant terms will have a lower Cap rate.

On the May 2nd, NLOP announced the Sale of three properties, and the transfer of two others to their lender. Details of the sales are as follows:

The sale of the property in Stavanger, Norway appears to be an outlier, and the sale of the properties in Collierville and Hoffman Estate imply a cap rate between 8.4% and 8.0%. These properties had a WALT of 15.9 and 15 years respectively.

I assumed Net Lease Office Properties can sell their existing Group (1) Properties at a Cap Rate of 8.5%, their Group (2) Properties at a Cap Rate of 9.5% and their Group (3) Properties at a Cap Rate of 11.5%.

There is a great deal of uncertainty surrounding what cap rate Net Lease Office Properties will exit their Real Estate Portfolio at and over what timeframe, so I do not feel confident assigning a specific IRR to the security as I have done in the past. A sensitivity analysis was conducted that attempted to illustrate possible IRR based on various Cap rates and timeframes for liquidation.

Furthermore, I attempted to estimate the Cap Rates necessary to pay off Net Lease Office Properties Debt, and break even on equity, given where it is trading at current prices, given as estimated annual NOI of $111.58 million

Given its current real estate portfolio and Capital Structure, I believe that Net Lease Office Property’s current valuation makes it an attractive investment, and one where investors have a high likelihood of generating an attractive IRR.

Risks

There are two primary risks facing NLOP. First, it is a highly leveraged security, and it is dependent on the value of US CRE.

Net Lease Office Properties is highly leveraged REIT and reports three forms of debt on their balance sheet. Mortgage Loans, Mezzanine Loans, and non-recourse mortgage debt.

Mortgage Loan

NLOP’s Mortgage loan stands at a value of $199 million. This loan bears interest at an annual rate equivalent to the SOFR rate plus 5%. This debt is also subject to an interest rate floor of 3.85% and an interest rate cap on the SOFR rate of 5.35%. The SOFR currently stands at 5.31%.

Mezzanine Loan

NLOP’s mezzanine loan bears interest at an annual rate of 14.5%, 10% of which is paid on a monthly basis, and 4.5% is subject to a PIK accrual. The balance of the mezzanine loan is approximately $100 million.

Non-Recourse Mortgage Loan

NLOP has approximately $147.4 million in non-recourse mortgage debt, with a weighted average interest rate of 4.8%

Given the fixed nature or interest rate caps in place, I believe there is limited risk of higher interest rates having an adverse effect on NLOPs debt. The risk higher interest rates pose to NLOP is in the form of higher Cap Rates on the sale of their properties. Real Estate has some similarities to Bonds, with rent being akin to coupon payments, and the property value being akin to principal component of a Bond. There is an inverse relationship between bond prices and interest rates, and an increase in interest rates will adversely affect the sale value of NLOPs real estate.

This equals approximately $42 million per year of annual interest expense. With an estimated annual NOI of $111.6 million, NLOP should be able to comfortably cover its interest expenses associated with its debt.

Catalysts

Because NLOP is already in the process of liquidating its Real Estate, it has a built-in catalyst. Net Lease Office Property’s 10-K explicitly states that its strategic objective is to liquidate its Real Estate Holdings.

“Our business plan is to focus on realizing value for our shareholders primarily through strategic asset management and disposition of our property portfolio over time. Our Advisor is generally responsible for all aspects of our operations including but not limited to formulating and evaluating the terms of each proposed disposition, arranging and executing the disposition of each asset, negotiating and monitoring the terms of our borrowings, preparing and filing our financial statements and required filings with the SEC, and other management services, under the supervision of our Board of Trustees. We anticipate using the proceeds of dispositions to pay down debt, pay distributions to our shareholders, and reinvest in our properties through capital expenditures, as needed.” - 10-K (2023)

These are not just words from a management team telling shareholders what they want to hear. NLOP was initially spun off with 59 properties and is already down to 49. NLOP has $383.9 million of debt coming due in 2025, so it will be highly incentivized to sell their properties and deleverage their balance sheet before this, as NLOP already has expensive debt, and a refinancing would likely be punitive.