Realty Income (NYSE: O) is a major REIT involved in the acquisition and management of commercial properties that has a history of providing consistent growth. Over the last 20 years, Realty Income has seen steady growth of their funds from operations (FFO) in part driven by the company’s focus on high-quality tenants and diversification of their rental properties. This business strategy has also allowed for Realty Income to continue to grow their key financial metrics and significantly outperform many other competing REITs during the current global healthcare crisis. However, the company faces challenges as a number of their tenants have been adversely affected by the healthcare crisis and store retailers face increasing competition from online sales. Despite these challenges, Realty Income will likely continue to provide a reliable stream of income to investors. Taken together, I believe that Realty Income is a high-quality REIT that has the potential to provide investors a reliable source of dividend income.
Created by author from Source.
Core Business Overview
In order to better understand the company, let’s take a look at Realty Income’s key business tenants. The primary properties that Realty Income rents are divided between four different property types as shown below:
Source: Created by author using O 2019 10-K.
Realty Income has a history of managing their various rental properties to provide solid growth for the company. Expanding from the company’s first acquisition of a Taco Bell restaurant in the 1970s, Realty Income’s funds from operations (FFO) experienced a steady compounded annual growth rate of about 10% during the 2000s. The last decade has seen rapid expansion of Realty Income’s business, with the company’s FFO experiencing a compounded annual growth rate of nearly 20%. As of the end of 2019, we can see that the retail properties made up the majority of Realty Income’s rental revenue, with nearly 84% of the total rent coming from retailers.
Source: Created by author using O Seeking Alpha Financials, O 10-K filings, and O 2020 Q2.
However, FFO alone does not tell the whole story for Realty Income. As REITs are passthrough entities required to pay out at least 90% of their income to unitholders, REITs retain very little earnings and will typically depend on equity capital from investors and raising external debt. Thus, a successful REIT must acquire and manage new property acquisitions to generate cash flow that exceed the interest on new debt and dilution of ownership from new shares. As Realty Income primarily relies on common stock for the majority of their capital structure, the FFO per share growth is a critical metric for measuring financial success of the company. Below, we can see that FFO per share has also seen solid growth, with FFO per share having an average compounded annual growth rate of about 5.2% over the last 17 years. Taken together, Realty Income has shown solid growth of their business over the last two decades.
Source: Created by author using O Seeking Alpha Financials and O 10-K Filings.
Realty Income’s Risk Mitigation Strategy
Part of the company’s growth over the last 20 years is attributed to Realty Income’s risk mitigating management style. Realty Income focuses on targeting tenants that provide a reliable/sustainable cash flow, support cash flows from multiple sources, are investment grade rated companies and are willing to sign long-term leases. For Realty Income’s retail properties, the company looks for tenants that provide essential services, have non-discretionary and/or low-price-point component to their business that can remain competitive to online retailers and are resilient to economic conditions. For the case of the industry segment, Realty Income focuses on tenants who are industry leaders and is much more stringent on investment grade tenants, with over 80% of the current industrial tenants having investment grade ratings.
Furthermore, Realty Income relies on diversification of tenants, geographies, industries and property types to help support a consistent rental income for the company. Over the last 25 years, Realty Income has shifted their business from primarily renting to tenants providing child care services to a much more diverse customer base. Indeed, we can see below that in 1995, Realty Income had over 90% of their rents coming from five industries, while currently the top five industries for the company only make up about 45% of the company’s total rent. Additionally, Realty Income has now expanded to renting properties to 51 different industries throughout 49 states in the United States and Puerto Rico, and recently acquired the supermarket chain Sainsbury’s in the United Kingdom.
Source: Created by author using O 2000 10-K and O 2020 Q2.
Finally, it is also important to note that Realty Income relies on long-term net lease agreements where the tenant is responsible for monthly rent and other property expenses including maintenance, insurance and property taxes. These net lease agreements help the company maintain a predictable income and prevent unforeseen expenses. Additionally, these leases typically allow for rent increases based on the consumer price index, growth of the tenant’s gross sales or predetermined fixed increases. The company is also active in expanding their portfolio of properties in well-located areas to further expand their leases, with Realty Income spending about $3.7 billion for nearly 789 properties in 2019. Taken together, this highlights Realty Income’s strategy to provide reliable and resilient income to investors.
Resilient to Economic Downturns
Now that we have discussed Realty Income’s strategy to provide a reliable income stream to shareholders, let’s explore the company’s performance during the current economic downturn. Above, we saw that FFO per share for the company was flat throughout the Great Recession in 2007/09. During the current global health care crisis, Realty Income was actually able to increase their FFO. Below, we can see that Realty Income has shown a strong increase in rents over the last few years, with the company reporting a 17.8% and 6.7% increase in FFO and FFO per share in Q2 2020 compared to Q2 2019. Furthermore, the company’s diversified strategy ensured that about 86.5% of total rent was collected during Q2 2020, with primarily theaters, health & fitness, child care, casual dining and auto services having significant lapses in contractual rents. The rent collections have also been generally increasing for Realty Income, with Realty Income reporting collecting 91.5% of total rents in July.
Source: Created by author using O 2014 Q2, O 2016 Q2, O 2018 Q2, O 2020 Q2 and adapted from O investor presentation.
The company’s risk mitigating strategy was also further illustrated when comparing Realty Income’s financial metrics to other competitor REITs. Below, we can see Realty Income was the only REIT that reported an increase in adjusted FFO (AFFO) per share in Q2 2020 compared to Q2 2019, with Washington Prime Group (NYSE: WPG) and Tanger Factory Outlet Centers (SKT) reporting huge decreases in AFFO per share. Furthermore, other competitor REITs, including Simon Property Group (NYSE: SPG) and Kimco Realty Corp. (NYSE: KIM), also reported moderate decreases in AFFO per share in Q2 2020. In summary, Realty Income’s strategy has helped to create a resilient source of rental income that is resistant to economic downturns.
Source: Created by author using O Seeking Alpha Financials, SPG Seeking Alpha Financials, WPG Seeking Alpha Financials, SKT Seeking Alpha Financials and KIM Seeking Alpha Financials.
Finally, it should also be noted that Realty Income has a strong financial position. The company’s debt is rated A3 by Moody’s, A- by S&P, and BBB+ by Fitch, 92% of their debt is at a fixed rate and the company also has an additional $4 billion available in liquidity.
Valuation & Dividend Analysis
Taking a closer look at the price per FFO, we can see that Realty Income is currently at a higher valuation. Realty Income is estimated to have a forward price per FFO ratio of approximately 19x as of Friday, August 28th. Comparing this with the historical price per FFO ratio of the company, we see that Realty Income’s forward price per FFO ratio has been higher 40% of the opening market days since 2010 and 59.7% of the opening market days over the last five years. The price per FFO ratio graph below was calculated by dividing the opening price for all market days during the last decade by the FFO per share reported for that particular year.
Source: Created by author using data from O opening price data.
The starting dividend yield for Realty Income is currently below average for the company. Below is an analysis of the percent of market days (vertical axis) that had a particular starting dividend yield (horizontal axis) determined from the opening market price of Realty Income from the start of 2010 to year to date. Over the last decade, we can see that Realty Income typically has an average starting dividend yield just shy of 4.7%. As we can see below, the current starting dividend yield is lower than average, with this yield being higher for about 70.7% of the market days over the last decade.
Source: Created by author from O Seeking Alpha Dividends.
Realty Income has also been increasingly covering the dividend with AFFO. Since 2013, Realty Income’s AFFO has been steadily increasing faster than the dividend payout. As of the end of Q2 2020, Realty Income’s dividend was 80% of the company’s total AFFO. Taken together, Realty Income is at the lower end of the historical starting dividend yield, though the company is at a fair price/FFO and has a secure dividend covered by the company’s AFFO.
Source: Created by author using data from O Seeking Alpha Financials.
Another important metric for dividend growth investing is the future yield on cost (YOC). Below is a model predicting the YOC over time from an investment in Realty Income in 2020. The model assumes the following:
- That all dividends are reinvested in their respective company at an average starting yield equal to the average starting dividend yield for the company over the last decade.
- That dividend growth will be equal to the dividend increase predicted by analysts over the next two years.
- YOC is calculated as:
|Company||Share Price||Current Dividend Yield||10 Year Average Starting Dividend Yield||Modeled Annual Dividend Growth Rate||Modeled YOC in 5 Years||Modeled YOC in 10 Years||Modeled YOC in 20 Years|
Source: Created by author using data from O Seeking Alpha Dividends.
From the model, we can see that purchasing Realty Income at the current share price has the potential to support about a 21.2% yield on cost with dividends reinvested monthly after 20 years.
Other Potential Challenges
One of the major challenges facing Realty Income is the loss of rental revenue from companies affected by the global health crisis. As discussed above, theaters, health & fitness, child care, casual dining and auto services have experienced significant decreases in sales during Q2 2020 and represent over 20% of Realty’s Income’s total rent. In particular, theaters were the worst performing rental industry for Realty Income and were already facing serious competition from streaming services prior to the global health crisis. As of Q2 2020, AMC (NYSE: AMC), a major cinema company that normally provides about half of Realty Income’s theater rent, reported revenue declines of over 99.9% from Q2 2019. Furthermore, even as more companies continue to reopen, governments are enacting guidelines on the number of consumers allowed to use these businesses. Although the global health crisis is creating a strain on many different businesses, Realty Income’s focus on national chains should help better position the company to maintain their rental income.
Another risk for Realty Income is the shift of consumer preference to online retailers. Online sales have rapidly increased over the last few years and represent a serious challenge to retailer stores. The ability of Realty Income to attract tenants with services that can maintain long-term consumer preference will be critical for the company moving forward.
There is a great deal to like about Realty Income. Realty Income’s business strategy revolves around providing a reliable source of rental income for shareholders. Part of this strategy relies on Realty Income’s dedication to diversification, with the company significantly increasing their industry, property and location exposure over the last 25 years. Furthermore, Realty Income also focuses on attracting quality tenants and enacting long-term net leases to further provide the company a consistent income stream. This has resulted in steady increases in the company’s FFO per share over the last 20 years, even during the previous and current economic crises where many other competitor REITs reported significant rent declines. Finally, the company has a fair price per FFO ratio, recently became a dividend aristocrat, has the potential to provide strong yield on cost growth and has a healthy dividend payout ratio covered by the AFFO.
However, there are challenges that Realty Income faces. Realty Income has significant exposure to industries that have been adversely affected by the global healthcare crisis. Furthermore, Realty Income will need to ensure that their tenants provide services that will maintain consumer demand despite increasing expansion of online retailers. Finally, Realty Income’s dividend yield is currently below its average 10-year starting dividend yield.
Below I summarize what aspects of the company I’m personally optimistic and pessimistic about. I believe that Realty Income’s dedication to providing a steady and reliable source of dividend income is the hallmark of a great business and that the current share price is more than fair for the quality of the company.
Please check out my video providing a synopsis of Realty Income:
Source: Created by author.
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Disclosure: I am/we are long O. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a financial advisor and this is not financial advice. Not all relevant risks are covered in this article. Investors should contact a licensed financial advisor and do their own research before investing.