Realty Income (O) is a real estate fund that invests in commercial real estate. The REIT owned 6,500 properties, most of which were single-tenant properties. Realty Income has a weighted average remaining lease term (excluding extension rights of the tenant’s choice) of around ten years. These are triple net leases where the tenant pays everything from taxes to property maintenance, while the landlord, like Realty Income, collects rent that increases over time. It’s a pretty cute business provided you can get great locations at great prices.
- FFO trends
- Tenant concentration
- Streak consecutive annual dividend increases
Realty Income is a dividend aristocrat who has been raising dividends for 25 consecutive years. The REIT has a strong track record of paying dividends monthly and increasing them several times a year. It is the gold standard for triple net leases. The company usually increases its monthly dividends a little each quarter, which is a respectable increase from year-over-year. The most recent hike came just last week when the monthly payout was raised to 23.55 cents / share (or $ 2.826 / share annualized). This was the 111th dividend increase since Realty Income was listed on the NYSE in 1994. The new dividend is 0.85% higher than the dividend paid in the same period last year.
For the past decade, Realty Income has managed to grow annual dividends by 4.90% per year. Coupled with high ongoing returns, this has resulted in respectable total returns for shareholders over time.
The top tenants for Realty Income are listed below. Most retailers today are generally doomed, and Amazon is set to be the only retailer of choice going forward. The future will be tough for retail. However, people will continue to shop online and in physical locations. When I look at the list of the top 20 renters, I think we have a small risk of the majority of these locations losing to Amazon.
I wanted to point out that about 80% of rental income comes from retailers. There is a risk of retail going down the drain, leading to bankruptcies and vacancies for landlords. Depending on your beliefs, real estate funds today are either bargains or value traps designed for mediocrity. Rather than falling for a generalized generalization, I decided to look at the top tenants’ real estate income to determine how far the business is being destroyed online. I also believe that while many retailers will have a harder time making a profit, the landlords who own the properties have a certain margin of safety because of the long-term leases. In addition, these landlords could sell or repurpose these locations at any time.
Realty Income points out that 90% of retail rents are rented to tenants with low, non-discretionary and / or service-oriented components. These are retailers who may have higher survival rates. There have been historical tenant bankruptcies in industries to which Realty Income is now only minimally exposed (casino, sporting goods and groceries).
Realty Income has also managed to manage customer exposure over time. The current mix is less cyclical and has better credit and diversification.
Another factor I like when analyzing REITs is reviewing trends in portfolio occupancy. As you can see below, Realty Income has seen high occupancy rates in the 97% – 98% range over the past decade. The worst financial crisis since the Great Depression caused portfolio occupancy to drop to a low of 96.60%. That’s not bad at all. Even Covid-19 didn’t derail much, although there have been a few months when Realty Income took a little over 80% of the rent.
Below are the trends in Funds from Operations (FFO), Dividends Per Share (DPS), and FFO Payouts over the past decade for Realty Income (O).
FFO / share
DPS / release
The company issued an AFFO forecast per share for 2021 of $ 3.44 to $ 3.49.
Real estate income managed to grow dividends per share during the Great Recession. This was supported by the growth in FFO / share. As a result, the FFO payout is roughly the same as it was a decade ago.
As a REIT, Realty Income pays most of its free cash flow to shareholders in the form of dividends. As a result, it grows by relying on the capital markets for investment capital. In the past, it relied more on equity than on debt, as shown by the conservative capital structure of 72% equity and 28% debt.
Realty Income can add a few leverage to FFO / Share:
1) Increase in rent to tenants
2) Purchase of new real estate at a capitalization rate that is higher than the cost of capital (debt or equity)
3) Strategic acquisitions where the acquisition costs are below the cost of capital, after taking into account potential synergies
4) cut costs
Since the company has long-term leases, this limits the annual volatility of the rent. Annual rental growth rate in the same business of ~ 1.0% / year over the past decade.
The cap rate Realty Income achieved on newly invested capital has fallen to around 6% over time. The increasing competition for real estate has definitely squeezed profits.
However, this is higher than the 3.50% weighted borrowing cost that Realty Income pays to creditors. Most of these debts have a fixed interest rate, which is good when interest rates are rising. With interest rates falling over the past 25 years that Realty Income has been publicly traded, this has been a strong tailwind for performance. Unfortunately, this debt has to be carried over from time to time, exposing the company to the whims of the credit markets, especially when they freeze or interest rates are higher when Realty Income needs to tap into capital markets for funding.
The other factor to consider is that the dividend yield on property income has traditionally been lower than the yield that could be obtained from renting properties to tenants. If investor sentiment towards REITs worsens, further growth may be limited if dividend yields on property income types exceed rental yields on triple net properties. Rising interest rates could result in lower investor demand for REIT dividends, which would lead to falling stock prices and rising dividend yields. This would be a headwind for future growth. Of course, if the cost of capital rises, there is a very likely high probability that demand for real estate will fall, driving the caps up to make up for the lack of demand (or lower demand). Because Realty Income is high quality and has large business scope, the cost of capital is lower than that of competitors. This is a competitive advantage that could lead to better access to business and potentially better opportunities compared to competitors.
The risk of potentially higher interest rates would make many projects more expensive. Higher interest rates will reduce FFO and the cash available to pay dividends to shareholders. The counter-argument to the thesis of rising interest rates was that rising interest rates are an indication of increased economic activity, which should bode well for landlords. The other counter-argument is that most of the REITs listed below have staggered terms and are primarily activated by equity rather than debt. The third counter-argument is that existing debts are already borrowed at low interest rates. Rising interest rates should have an impact on debt rescheduling and the profitability margin for new properties. Of course, everyone has been expecting interest rates to rise for almost a decade. Nobody can predict the future.
A few months ago Realty Income announced its intention to acquire Verreit (VER). This will be an all-stock transaction that will increase its size and scope. Realty Income plans to outsource its office properties to a new REIT. There will be significant financial synergies and the transaction is expected to increase Realty Income’s FFO / share by 10% in the first year.
Today real estate income is selling at 19.80 times the forward FFO, yielding 4.25%. I believe companies like Realty Income will thrive in the next decade. That’s because they have a solid management team with a solid track record and a fairly conservative record.
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