Real Estate Investment Trusts, or REITs, can serve as a convenient way for regular investors to profit from rental real estate while also generating income for those seeking to live off dividends in retirement.
Let’s take a closer look at what makes Realty Income such a safe, high-yield income investment, and as importantly, whether or not today could be a reasonable time to add the stock to a diversified high-yield portfolio.
Business Overview
Founded in 1969 in Escondido, California, and going public in 1994, Realty Income is America’s largest single tenant property, triple net lease REIT.
At the end of Q2 2017, the company owned 5,028 properties in 49 states, Washington DC, and Puerto Rico, which are leased out to 250 tenants operating in 47 industries.
Source: Realty Income Investor Presentation
In recent years the REIT has begun diversifying into non-retail properties, including offices, industrial warehouses, and farm land. However, retail properties still generate approximately 80% of total rental revenue.
Business Analysis
Since 1994, Realty Income has grown its real estate assets (at cost) from $451 million to $12.2 billion; expanded the number of industries served by its portfolio from 5 to 47; increased its number of commercial tenants from 23 to 250; and boosted its annual revenue from $49 million to more than $1 billion.
Not surprisingly, Realty Income has several great characteristics that have made it an excellent long-term growth story.
Operating as a triple net lease REIT is the company’s first advantage because its tenants pay all maintenance, taxes, and insurance costs.
This means that Realty Income just sits back and collects rental income, which is under very long-term (15 years) fixed rate contracts, with annual rental increases built in (usually about 1% to 1.5%).
This results in not only very high gross margins and overall profitability, including an adjusted funds from operations (REIT equivalent to free cash flow) margin of 68.5%, but also very predictable cash flow which makes for highly stable and growing dividends.
Another competitive advantage the REIT has is a very experienced management team, led by CEO John Case, who, prior to taking the top spot at Realty Income, was a New York real estate investment banker for 20 years.
The company leverages its relationships with tenants, property developers, brokers, investment banks, and other parties to source acquisition opportunities with strong initial cap rates and built-in rent growth.
Realty Income’s management team has a great track record of growing the REIT through an aggressive but highly disciplined acquisitions of new properties, each one purchased at accretive prices (so that AFFO per share grows over time) and with long-term rental leases locked in with some of America’s largest and most financially sound retailers.
This fast growth in its property portfolio has resulted in one of the industry’s most diversified tenant bases, and more importantly, one that has little exposure to the current struggles in the retail market, which has seen a large number of bankruptcies in 2017.
As you can see, the majority of retail bankruptcies have been in apparel, sportings and electronics chains.
However, not all retailers are equally distressed. In fact, many are thriving.
Source: Hoya Capital Real Estate
Over the years, Realty Income has done a great job of evolving with the retail industry and moving its tenant base away from troubled industries and towards those that are still doing well and largely resistant to the threat posed by e-commerce.
You can see that Realty Income’s largest tenant mix has shifted over the past decade to favor less cyclical industries and tenants with strong investment-grade credit ratings.
And because management is constantly growing the company’s property and tenant base, Realty Income’s rent has become more diversified over time and much safer, focusing even more on e-commerce resistant sectors such as services, convenience stores, and non-discretionary outlets such as grocery stores.
In fact, none of Realty Income’s top 20 tenants are currently distressed, and the portfolio’s weighted average EBITDAR coverage ratio (cash flow/rental payments) is a strong 2.8, among the best in the industry.
This strong focus on higher-quality tenants (those that are more Amazon resistant) has allowed Realty Income to maintain exceptionally high and stable occupancy rates over all manner of economic and industry conditions.
You can see that the company’s occupancy level has never dipped below 96% for more than 20 years.
This kind of strong cash flow security has allowed Realty Income to generate one of the industry’s most impressive dividend growth records, and thus cement its status as “the monthly dividend company.”
This steady dividend growth has, in turn, helped make Realty Income a darling of Wall Street and generate superior total returns compared to the market as a whole and most other REITs as well.
Unlike most other types of companies, it’s important to realize that great stock performance isn’t just about compounding shareholder wealth, but it also serves as a major competitive advantage.
That’s because REITs, by law, don’t pay any taxes at the corporate level as long as they payout at least 90% of taxable net income as dividends.
As a result, the majority of cash flow is paid directly to shareholders, forcing the company to fund the majority of its growth externally, via debt and equity (i.e. selling new shares).
Since each new share is a perpetual claim on future AFFO (and dividends), a strong share price is very important to maintaining a low cost of capital and allowing the REIT to grow AFFO per share over time.
Fortunately, as you can see below, Realty Income’s weighted average cost of capital is far below the AFFO yield it is obtaining on new properties, thus ensuring each acquisition it makes is profitable to shareholders and allows for a more secure and steadily growing dividend.
Realty Income Cost Of Capital
A low cost of capital is also made possible by the REIT’s very strong balance sheet (more on this later), which allows it to borrow cheaply and thus lever the cash returns on any new equity issued.
In 2016, Realty Income bought $1.9 billion in new properties, and the REIT is on track for another $1.5 billion this year. The company currently has about $1.3 billion in available liquidity to fund these purchases.
Or to put it another way, Realty Income has sufficient growth resources to keep buying new properties for another year, even should debt and equity markets slam shut, which can happen to some REITs during a financial crisis, such as the great recession.
Overall, it’s hard not to like Realty Income’s business. The company owns thousands of extremely valuable retail locations; is nicely diversified by tenant, industry, and geography; maintains a conservative capital structure; has plenty of opportunities for future growth; and has a long track record of creating value for shareholders.
Key Risks
While Realty Income represents a fundamentally solid high-yield dividend growth stock and sensible retirement investment, there are nonetheless several risks to keep in mind.
First, even though Realty Income is a best-in-breed industry name, and thus has greater and cheaper access to growth capital compared to most of its rivals, times of economic and market distress can still affect its growth rate.
For example, the rate that Realty Income is able to grow its AFFO per share and thus its dividend rises and falls with the general health of the U.S. economy and the retail sector in particular.
During a recession, a weak stock market lowers O’s share price and thus increases its cost of equity, resulting in slower growth. This is an attribute shared by all REITs, that their ultimate growth rate is often at the mercy of fickle investor sentiment.
Another thing to consider is that REITs can, at times, be highly interest rate sensitive. That’s because higher rates increase borrowing costs and make REIT’s less attractive investment options relative to higher-yielding, risk-free assets such as Treasury bonds (lower demand can mean a lower share price).
For example, Realty Income’s beta to yield, meaning how much its yield changes in relation to the yield on the 10 Year U.S. Treasury, has recently been a high 1.53. This means that should long-term U.S. interest rates rise sharply, Realty Income’s stock price could be in for a correction.
Source: Hoya Capital Real Estate
The good news is that REITs and interest rates aren’t always highly correlated. That’s because, in general, rising rates mean a strong economy, which creates a healthy commercial real estate market that boosts REIT cash flows and growth rates.
In addition, because higher interest rates can result in lower property prices, the net spread on invested capital (AFFO yield – cost of capital), can actually hold up well even in rising interest rate environments.
In fact this is why Realty Income has been able to continue growing strongly in all manner of economic and interest rate environments; even when interest rates were nearly 7%.
The bottom line is that, if you can afford to live entirely off dividends (and are thus less sensitive to fluctuations in share price), then there isn’t much to worry about with interest rates and how they might affect Realty Income’s business over the coming years.
However, for retirees following the 4% withdrawal rule, such short-term price risk is a factor that needs to be considered in your overall retirement plan and asset allocation.
One final detail to consider is that REIT dividends are generally unqualified, meaning that they are taxed at your top marginal income tax rate. That means that it’s best to own them in tax deferred accounts such as IRAs and 401Ks.
Realty Income’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Realty Income has a Dividend Safety Score of 85, indicating a very safe dividend and one of the safest of all REITs.
That’s not a surprise given Realty Income has raised its regular dividend for 23 straight years, meaning it’s just two years away from joining the venerable ranks of the dividend aristocrats.
There are three keys to Realty Income’s high dividend safety.
First, the business model is designed to maximize stable and recurring revenue from rental leases, which are well staggered, meaning in any given year only a small fraction of rental agreements need to be renegotiated.
As you can see below, less than 10% of Realty Income’s overall rental revenue expires any given year through 2031, providing great cash flow visibility so long as its tenants remain financially healthy.
The second factor is Realty Income’s very conservative AFFO payout ratio, which management is highly disciplined in maintaining.
Sources: Earnings Releases
At first, an 83% payout ratio might seem high, and it’s true that Realty Income’s payout ratio is towards the higher end of the industry norm.
However, the reason that the REIT can safely to do this is because of its industry-leading tenant, geographic, and industry diversification.
For example, other smaller triple net lease REITs have more concentrated rental bases, meaning they need to maintain smaller AFFO payout ratios in order to ensure a strong safety buffer against industry downturns.
Triple Net Lease REIT Payout Ratios
Source: Brad Thomas
The third major protective factor for Realty Income is the company’s rock solid balance sheet, which is one of the strongest in the industry.
Now at first glance, Realty Income’s debt levels may appear to be highly dangerous. After all, it has almost $6 billion in debt, almost no cash on the balance sheet, and is generating negative free cash flow.
However, you need to keep in mind that the REIT business model is built around raising external growth capital, meaning that only maintenance capital is funded through rental cash flow, and almost all REITs (even quality names like Realty Income) report negative free cash flow.
In fact, when we compare its balance sheet to its peers, we find that Realty Income has below average leverage (Debt/Adjusted EBITDA) and debt/capital, and a strong interest coverage ratio, all of which gives it one of the industry’s best investment-grade credit ratings.
More importantly, management has been highly conservative about maintaining strong and steady interest coverage and fixed cost ratios over time.
In addition, the company’s conservative approach to debt means it’s nowhere near breaching its debt covenants, which allows it to tap into its large and mostly unused revolving credit facilities, which help fund new property acquisitions.
The bottom line is that Realty Income’s industry-leading, recurring and stable cash flow, very strong balance sheet, access to low cost debt capital, and ability to raise cheap equity growth capital make its dividend not just among the safest of any REIT’s, but also help ensure that management can keep growing the business (and the payout), for the foreseeable future – regardless of where interest rates or the economy turn.
Realty Income’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios.
Realty income has a Dividend Growth Score of 27, indicating a below average future growth rate.
However, for what Realty Income’s dividend growth may lack in size, it more than makes up for in safety and consistency.
Specifically, Realty Income has grown its dividend at an average of 4.7% a year since its 1994 IPO, and given the likely interest rate and industry conditions it’s likely to face in the coming decade, investors can probably expect around 4.5% to 5.5% payout growth to continue.
While that pace of growth is slightly below the S&P 500’s long-term median growth rate, when combined with Realty Income’s high dividend safety, low volatility (over the past five year’s its shares have been 70% less volatile than the S&P 500), and clockwork-like growth, it makes for a strong candidate for a conservative retirement portfolio.
Valuation
Realty Income has underperformed the S&P 500 by about 25% over the past year, but that doesn’t necessarily mean it’s a great value today.
That’s because the stock’s current price / AFFO (the REIT equivalent of a P/E ratio) is 18.5, which is right at its 13-year median value.
What’s more, O’s current dividend yield of 4.5% is below the industry median of 5.3% and somewhat lower than its five-year average yield.
In fact, over the past 22 years, Realty Income’s dividend yield has actually been higher more than 85% of the time.
Now, we do have to consider that interest rates were much lower for most of the last two decades, and even with rates potentially set to rise 1% to 2% in the coming three years (according the Federal Reserve), rates will likely remain at historically low levels, meaning that Realty Income’s yield probably won’t rise much above 5.5%.
Overall, given today’s conditions, Realty Income seems to be somewhat reasonably priced and has potential to generate long-term annual total returns of about 9.5% (4.5% yield + 5% annual AFFO per share growth).
While there are other dividend aristocrats that offer slightly higher total return potential than Realty Income, they generally have a yield about half as large and are more volatile.
Conclusion
Realty Income is the epitome of a safe REIT, one with a proven track record of providing generous, secure, and steadily growing monthly income. That makes it one of the only monthly dividend stocks worth owning and a reasonable choice for almost all dividend investors, whether you are already retired or have 50 years to build your portfolio.
While O’s current share price may not necessarily be a bargain, Realty Income is certainly worth placing on a watch list in order to pick up shares of this impressive dividend grower during the next market or REIT correction.
Brian Bollinger
Simply Safe Dividends
Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).
Source: Simply Safe Dividends