Net Lease Office Properties: A Crucial Milestone For This REIT (NYSE:NLOP)

Net Lease Office Properties (NYSE:NLOP) is a young REIT that was recently formed following a spin-off from its parent company, W. P. Carey (WPC). Last year, WPC announced that the firm was moving away from office investments after decades in the space. The firm would eliminate its investments in office properties through a combination of direct sales and the spin-off of a separate publicly traded REIT called Net Lease Office Properties. The announcement caused grief among WPC shareholders, primarily because it also entailed a dividend cut.

Many investors, myself included, immediately disposed of NLOP for a variety of reasons. The suburban and single-tenant office markets are some of the weakest commercial real estate subsectors. The office segment still faces headwinds that have few answers or viable solutions to fuel a recovery in the near term. The company and challenges have been covered in depth by a variety of authors on Seeking Alpha. If you’re unfamiliar with the real estate sector or NLOP, I would suggest reading this article from fellow contributor Trapping Value.

NLOP Overview

Before diving into recent encouraging news, let’s take a brief overview of NLOP and look at the firm. The firm is a disposition vehicle for WPC’s office assets. Rather than acquire new properties and grow as a firm, NLOP wants to dispose of its portfolio while maximizing value for shareholders. While waiting to sell assets, the asset management team will continue to renegotiate lease extensions or re-tenant vacant properties to prepare them for sale, all in a difficult office market. WPC provides details of this strategy in their third quarter investor report:

Business plan focused on maximizing value for shareholders through strategic asset management and disposition of properties over time with proceeds from operating cash flow and sales used to repay debt and pay distributions to its shareholders.

This concept is somewhat strange and runs in opposition to traditional REIT strategy. REITs typically want to grow. To do so, they issue debt and equity to buy properties thereby growing market capitalization and enterprise value. So, why would NLOP take the opposite approach? It does not take much reading of the tea leaves to understand that the office market does not have a bright future in the short to medium term. NLOP and WPC do not believe the sector has a bright future and thus selling the properties is the best strategy. This approach leads to an obvious and pressing question given where the commercial real estate market stands. Will the company be able to sell these assets in a time frame and at a price that is advantageous to shareholders? The market has portrayed virtually only pessimism surrounding the office market and the future of the sector.

Recently, the company announced a critical milestone that has instilled confidence in investors and improved the financial outlook, driving up NLOP’s share price considerably. Let’s explore whether the movement is justified and what lies ahead for NLOP.

Disposition of Four Assets

On January 11th, the company announced the disposition of four office assets. The assets are detailed in the table below including location, pricing details, and size. While the dispositions are modest, they represent an important milestone for the company as it begins to prove whether it will be able to successfully execute its business model. Showing shareholders that management can navigate a difficult strategy in a difficult market is critical to the success of the company. The company intends to use the proceeds from these four dispositions to pay down debt. While four properties from a portfolio of nearly 60 is not enough to move the needle significantly, it marks a critical first step for the young firm.

As displayed above, the company transacted in these four properties at capitalization rates ranging from around 7.0% up to 12.0%. Given these assets are not particularly desirable, we cannot expect that they will trade hands with the same capitalization rates as top-tier net lease assets which still trade well below 7.0%. That said, NLOP has displayed its ability to transact on $40 million in assets at a cap rate slightly above 8.0%. The capitalization rates are above the market estimates from the Boulder Group, a net lease broker. The Boulder Group estimates STNL office properties are currently trading at a 7.6% cap rate average, around 80 basis points below the blended cap rate of NLOP’s sale.

Transacting at higher cap rates is likely an indicator of some degree of weakness at the property level. At the end of the day, the transaction cap rate is going to be the main determinant of the cash that ends up in the pockets of shareholders. Management needs to strike the balance between transacting quickly and doing so in a fashion that maximizes value to shareholders. Simply put, the company has its work cut out for it.

The Road Ahead

NLOP has a challenging future. Their strategy is complex and risky because it heavily depends on the execution ability of management. Understanding the difficulties of the suburban office market, NLOP’s team needs to dispose of an entire portfolio of difficult assets spread across a wide geography. Given sentiment around the sector, it’s unlikely that a large investor will be interested in acquiring NLOP or a large portion of the firm’s assets. There is a reason that WPC spun off the assets in the first place. Simply put, WPC’s management believed they had no viable future. This logic fueled the flight by NLOP shareholders when NLOP started trading.

Still, we must give credit where it is due. NLOP’s management has sold four assets and generated $43.1 million dollars to aid the company’s balance sheet. The cash from the transaction is sufficient to support the repayment of upcoming debt maturities in the next year. NLOP’s financials indicate nearly $35 million of mortgage debt maturing in 2024. The company expects to make this principal payment in full, which will mark a meaningful first step for NLOP. The debt on NLOP’s balance sheet was assumed from WPC during the spin-off and is currently split between fixed (75%) and variable (25%) rates with a weighted average interest rate of 4.8% as of September 30, 2023.

NLOP is difficult to value given the strategy. Trying to assign an FFO multiple to compare NLOP against competitors in the space, such as Orion Office REIT (ONL), is unsuitable because of NLOP’s intention to dispose of the portfolio in short order. As of September 30, NLOP’s 59 properties generated $145.0 million of annualized base rent or ABR. With the recent disposition accounting for $3.6 million of NLOP’s ABR, the transaction will result in a 2.5% reduction in annual portfolio rent.

The timeline for NLOP remains unclear and has not been communicated by management. The condition of the office market will likely dictate the future of NLOP. While the organic growth of real estate values continues to serve as the foundation for growth-focused REITs like O, ADC, or WPC, NLOP’s performance relies heavily on asset management execution and disposition economics as the portfolio shrinks. Both factors are difficult to predict without having a look inside the company or talking to management candidly.

Conclusion

Following the sales, NLOP owns a portfolio of 55 office assets, 50 in the United States and five in Europe. By recently announcing its first disposition, NLOP has boosted shareholder confidence that there may be light ahead. While investors cannot predict the future success of any REIT, NLOP’s strategy adds to the murkiness and adds execution risk around individual transactions and activities at the property level. As a shareholder, depending on the competency of a new management team, operating a new company in a difficult market is an enormous risk. At this stage, the optimism is likely overblown. NLOP’s volatility and future risk make the company undesirable for shareholders seeking a REIT investment. Additionally, the strategy in place does not support the future growth of a dividend or the business itself. With a REIT like NLOP, understanding the strategy is critical to understanding the investment. As NLOP continues to mature, we will cover the company from different angles including management, disposition spotlights, and dividend analysis. Given the recent spin-off, the future remains uncertain, but it will certainly be interesting.