Realty Income: Prudent Management, Justified Premium?

Business Summary:

Realty Income Corporation (O) is an REIT that focuses on sale-leaseback deals. This is where a business, such as a restaurant or convenience store chain, raises capital by selling the land and buildings used to conduct the firm’s business, but retains the use of the property through a long-term lease.

Sometimes Realty Income will acquire a portfolio of properties, with the bulk of the properties meeting the company’s purchase criterion, but with a few that do no not. The properties that do not are passed to the company’s taxable subsidiary, which will sell the properties. The company has a weighted average lease term of over twelve years; this had historically resulted in very dependable cashflow.

Although the sale-leaseback market is competitive, with many REITs and private investors pursuing sale-leaseback opportunities, Realty Income is focused on acquiring the properties (usually freestanding) of smaller businesses that tend to not have a credit rating, where competition is typically less intense.

However, this makes the acquisitions riskier, in that if a tenant goes out of business, the REIT’s rental revenue drops. Still, by focusing on this particular market segment for many decades, Realty Income has become very skilled in evaluating the financial strength of these small businesses, and tenant bankruptcies have had a negligible impact on the company’s performance. This market focus allows the company to obtain a higher than average acquisition yield, which is the ratio of the property’s net operating income divided by the purchase price.

Since the company has a high credit rating for an REIT (BAA1), its cost of capital is usually low; combined with the above average acquisition yields this provides an above average return on invested capital.

Operating History:

Because the company purchases properties that are already occupied and have a long lease term, and typically disposes of properties quickly when a lease is not renewed, the company has a very high occupancy rate, usually over 98%. This, combined with the fact that these leases are triple net leases, where the tenant pays the property tax and handles all improvements and maintenance, has resulted in a 67% ten-year average profit margin (measured as adjusted funds from operations dividend by revenue), well above the industry average.

Despite the lease provisions for periodic rent increases tied to changes in the consumer price index, same property revenue has lagged inflation by approximately –1.5% over the last ten years.

Still, by steadily increasing the number of properties owned, the company has grown adjusted funds from operations (AFFO, which is funds from operations less recurring capital expenditures) at a real annual rate of 2.5%, with very little volatility. The reason for the negative real same store growth rate is because the inflation adjustments and rent increases incorporated into new lease agreements typically kick in after the first five years of the lease.

So if the rental portfolio increased 50% over the last four years, the rent increases for these new properties still have not kicked in, and the long-term same store rental growth rate is considerably understated.

With this in mind, the actual likely real long-term same store rent growth rate on existing properties will likely be closer to zero.

Liquidity:

Realty Income has the best debt maturity schedule of any REIT I have analyzed, both from the standpoint of total debt to adjusted funds from operations and the weighted average maturity, which is over ten years.

Currently, all debt consists of unsecured notes. Because REITs are required to pay out 90% of earnings as dividends, not all of Realty Income’s adjusted funds from operations are available for paying down maturing debt.

If the future conditions of credit markets make it undesirable to refinance, Realty Income does have several options, including taking out secured mortgages on its properties, selling properties, and raising equity. Part of maturing debt can also be paid down using retained AFFO.

Currently the company has almost $20M of annual retained AFFO, and could boost this up to $97M by cutting its dividend to equal 90% of earnings (the minimum payout allowed by the REIT act).

Tenant Risk:

Substantially all tenants are below investment grade. However, Realty Income only purchases properties where the tenant has demonstrated that their business is viable over at least one business cycle.

Furthermore, a tenant’s bankruptcy is not a complete disaster, as the tenant will typically continue to make rent payments on at least some of the properties during restructuring.

And since Realty Income usually purchases the best properties in a tenant’s retail chain, there is a reduced probability that any of Realty Income’s properties will be selected for closure.

Realty Income has been through several tenant bankruptcies, and each time most of the properties continued to provide rental income.

Moreover, even if the tenant completely liquidates, the company still owns the property, and can attempt to either re-lease or sell it. Since most tenants are engaged in non-cyclic industries (convenience stores, auto service, child care, and restaurants being some examples), it would probably take a severe recession to significantly impact the tenant’s earnings, in which case a small percentage might be pushed into bankruptcy.

Recent events have increased tenant risk in two respects. First of all, the bankruptcy rate of non-investment grade companies is expected to reach over 10% by the end of 2010. Second, the contraction of credit markets makes it less likely that a tenant could receive debtor in possession financing.

Valuation:

The company expects 2009 per share funds from operations to range form $1.83 to $1.87; let’s use $1.85 as the midpoint. Since the properties are triple net leases, the tenant pays for recurring capital expenditures, and adjusted funds from operations has historically been close to funds from operations.

As of yesterday, Realty Income’s stock price is $21.20, giving a price to AFFO ratio of 11.46. Although this is a higher multiple than most other investment grade REITs at this time, considering how well Realty Income has held up during the recession, the premium may be justified.

We can also compare a REIT’s valuation to its net asset value (NAV), which is equal to operating income divided by the historical cap rate for the property type, less any debt. During 2008, Realty Income’s net operating income (which I am estimating as funds from operations plus $94M in interest expense plus $24M in interest on preferred stock plus $23M in G&A and tax) was $303.7M.

Prior to the credit bubble, strip mall cap rates averaged around 10%, so we could estimate Realty Income’s total asset value as $3267M. From this, we can subtract total debt and preferred equity, giving us a net asset value of $1559M.

This is the value that would accrue to common shareholders if the company were liquidated today at a 10% cap rate. We can compare this to the company’s market cap of $2200M, and conclude that from a liquidation perspective, the company is overvalued.

Management:

In my opinion, Realty Income has excellent management. Management kept focused on their core competency, and did not try to boost returns by taking on excessive risk through property development or highly leveraged joint ventures. Also, unlike many of their competitors, they did not assume that cheap credit would be available forever, and kept a conservative balance sheet.

Disclosure: I currently do not own shares of Realty Income Corporation

Comments

[bluesmoke:]

Good analysis. What also should be mentioned is the company's commitment to paying the dividend monthly. For those of us who reinvest this dividend, it has the effect of raising the APR roughly 1%, which totals close to 9% right now. Not too shabby.

May 21 10:32 AM

[Big K:]

So, what's the answer to the title question? Is the stock worth the current price of $21 or the liquidation price of $15? It should be worth more than liquidation price, because even liquidated property has to be managed and a business run of it. Without management and a business, the property will have much less value. So, the actual price has to be higher than liquidation value. I've owned the stock for several years now, and the price has not appreciated, but I've reinvesting dividends for the last year, thus has resulted in 10% more stock and 10% higher dividends. Doing this allows me to get a little raise every month. A couple of decades of this, and we'll be talking about real money. O has to be one of the best REITS out there.

In the REIT world, so many have cut or eliminated dividends that it is scary to hold them anymore. The benefit to shareholders is the dividend, and without it, there is little reason to hold a REIT. So far, O has continued to pay theirs, and has managed their considerable debt well. How long will this continue is anyone's guess. The debacle with REITS in the last 24 months has chased me back to the dividend aristocrats such as SYY, KO, JNJ, PG, PAYX and ABT. The dividend pay rates are lower, but they are much less likely to be eliminated or cut. In fact, these companies are raising their dividends every year. So, if you hold these stocks a few years, they will pay a dividend yield comparable to a REIT, based on your original investment, with much less risk.

The rag is off the bush with REITS. Many of us thought they were safe, boring investments which paid a decent income and would be appropriate for conservative investors. I've been trying them for 6 or 7 years now, and I've discovered that nothing could be further from the truth. They are anything but safe and solid, as it's been one heck of a rocky road. I have had some spectacular rises, only to be followed by armaggedon style crashes. Some have gone belly up (i.e. Mills Corp, GGP), some have plummeted to nothing (i.e. HPT, DDR), and many are just plain old disappointing (i.e. WRI, AHT, SPG). REITS actually represent high risk, leveraged-to-the-hilt, life-on-the-edge, white knuckle type investing. The right way for a conservative growth & income investor is to look at the better managed companies with solid business models that have much lower debt, pay 2-4% dividends, with increasing revenue and earnings annually. With the regular dividend increases, dividend aristrocrats will beat REITS, and the companies will unlikely suddenly stop the dividends or get into serious financial trouble like REITS do (seemingly routinely, nowadays).

May 25 01:25 PM

[Capital Pre...:]

An interesting analysis. I will say that you would be hard pressed to find a "going concern" that from a "liquidation perspective" isn't overvalued. Even so, this sort of reasoned thought is refreshing compared to the sort of off-the-cuff nonsense such as Cramer's " I have got to tell you, that one is too risky for me."

"O" is currently the only REIT in any of the portfolios I manage precisely because I believe it to be less risky than other REITs I have analyzed. Management is conservative and has proven itself and the business model over the years. Moreover, the company is properly focused on ensuring, and growing distributions to its investors.

Jun 10 08:00 AM