Net Lease Office Properties quarterly report, Q3 FY2023

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Business context and reporting period

Net Lease Office Properties (NLOP) filed this unaudited Form 10-Q for the quarter ended September 30, 2023. The filing’s operating results are for NLOP Predecessor, a carve-out of W. P. Carey Inc. (WPC); NLOP itself had no operating activity in the quarter. WPC completed NLOP’s spin-off on November 1, 2023, transferring 59 office properties. Accordingly, the historical results and allocated costs are not necessarily indicative of NLOP’s results as an independent company.

Following the spin-off, NLOP became a publicly traded company and intends to elect REIT taxation beginning with its 2023 tax year. Its portfolio comprises approximately 9.3 million leasable square feet, 62 corporate tenants, and properties primarily leased on a single-tenant net-lease basis.

Financial and operating metrics

Predecessor results below are in millions of dollars unless noted otherwise.

  • Revenue: Third-quarter revenue was $43.1 million, up 7.0% from $40.3 million. Nine-month revenue was $128.6 million, up 13.2% from $113.6 million. Growth primarily reflected nine properties acquired in WPC’s 2022 CPA:18 merger.
  • Profit: Third-quarter net income attributable to NLOP Predecessor was $2.8 million versus $1.1 million. Nine-month net income was $10.3 million versus $13.7 million, down primarily because of higher interest expense.
  • Funds from operations: Third-quarter FFO was $20.5 million versus $17.6 million; AFFO was $24.2 million versus $22.9 million. Nine-month FFO was $63.4 million versus $59.2 million; AFFO was $72.3 million versus $65.6 million. Both are non-GAAP measures and are not substitutes for GAAP earnings or cash flow.
  • Cash flow: Nine-month operating cash flow was $63.9 million, compared with $67.3 million. Investing cash outflow was $4.6 million versus $21.1 million; financing cash outflow was $59.0 million versus $47.6 million. At September 30, predecessor cash and cash equivalents were $5.1 million, with $1.1 million of restricted cash.
  • Debt and liquidity: At September 30, predecessor non-recourse mortgage debt was $166.7 million and WPC-affiliate parent debt was $94.3 million. On November 1, NLOP drew $455 million under new financing and reported estimated consolidated debt principal of approximately $622 million. At the spin-off, estimated cash and cash equivalents were $53.8 million.
  • Portfolio and occupancy: September 30 annualized base rent was $145.0 million; occupancy was 97.1%, unchanged from year-end 2022; weighted-average lease term was 5.7 years versus 6.2 years. One tenant generated 18.7% of nine-month revenue and represented 13.3% of long-lived assets.

Material changes versus the prior comparable period

  • Nine-month revenue increased $15.0 million, while nine-month attributable net income declined $3.4 million. Interest expense rose $6.2 million to $24.4 million, reflecting merger-related debt and higher allocated corporate interest costs.
  • Nine-month depreciation and amortization increased $7.8 million, reimbursable tenant costs increased $3.5 million, and general and administrative expense increased $1.3 million. Separation-related costs declined $1.2 million.
  • Nine-month operating cash flow declined $3.4 million. Financing cash outflow increased $11.5 million, including financing costs associated with the spin-off financing.
  • The remaining direct-financing-lease investment was reclassified to operating lease accounting following a lease extension; direct-financing-lease income consequently declined.

Outlook, risks and unusual items

  • No quantified earnings or revenue guidance is provided. Management expected operating cash flow and property disposition proceeds to fund liquidity needs, but noted that refinancing at higher rates, unanticipated costs, and elevated operating expenses could adversely affect liquidity.
  • New financing funded at the spin-off: a $335 million mortgage loan due November 2025, bearing one-month Term SOFR (subject to a 3.85% floor) plus 5.0%, with an interest-rate cap at 5.35%; and a $120 million mezzanine loan due November 2028 at 14.5%, including 10.0% current-pay interest and 4.5% payment-in-kind accrual. Approximately $350 million of net proceeds was transferred to WPC. The filing estimated $47.7 million of interest on the new arrangements due over the next 12 months.
  • Under WPC advisory agreements, NLOP is to pay approximately $7.5 million annually in asset-management fees and reimburse approximately $4.0 million annually for administrative services; the asset-management fee decreases after property dispositions.
  • After quarter-end, a BCBSM lease extension extended two properties’ lease expiration to January 2037. Separate agreements shortened leases on four other properties to no later than June 30, 2024 or their sale, in exchange for aggregate termination fees of approximately $12 million to $13 million.
  • Tenant and geographic concentration, interest-rate and refinancing exposure, and foreign-currency fluctuations are key risks. Texas and Minnesota represented 31% and 16%, respectively, of nine-month portfolio revenue. Management warned that higher rates and debt balances could materially affect results. No material litigation or real estate impairment was reported.
  • Historical predecessor statements include WPC cost and interest allocations that may not reflect standalone costs. NLOP’s balance sheet at September 30 precedes the property transfer and new financing. The filing states that NLOP had not filed all required Exchange Act reports during the preceding 12 months.

Important facts for investors to verify

  1. Post-spin-off debt, cash, debt maturities and interest burden, including the effect of the high-cost mezzanine loan and interest-rate cap.
  2. Actual standalone operating costs and advisory-fee expenses compared with the predecessor’s allocated expenses.
  3. BCBSM termination timing, receipt of the stated fees, property-sale plans, and the effect on rent and occupancy.
  4. Tenant concentration and lease rollover exposure, particularly the largest tenant and the shortened leases.
  5. REIT qualification and distribution requirements, and NLOP’s progress in meeting ongoing reporting and control obligations.