Realty Income: Follow-Up on Barron's Article

This is a follow-up to Barron’s article Sunday (Sunday, September 13, 2009), as well as to my article, “Realty Income: Excellent Dividend Growth REIT” published on June 29, 2009.

Barron's article made both positive and negative comments about Realty Income (O). Among the positive points (parenthetical comments are mine):

• The company, which pays dividends monthly, has paid 469 consecutive dividends since it began paying dividends (it just declared #470, payable September 15).
• Its current yield is almost 7% (actually about 6.6%).
• The company maintains an image of conservatism and reliability, although it discloses little about its tenants. (Its history of conservatism is more than an image, it is baked into the company’s culture.)
• Realty Income has kept it occupancy rate above 96% despite the recession and the pressures facing its retailer tenants.

Among the negative points:

• Approximately 19% of Realty Income's shares have been sold short.
• An unnamed fund manager (who is a short seller) believes that up to one-third of current tenants are particularly stressed.
• CEO Tom Lewis has said that a decline in occupancy rate beyond Wall Street expectations could tighten the company’s ability to raise, or maintain, its dividend.
• Realty Income shares look overvalued, trading at about 14 times the company's projected 2009 earnings compared to its peer group at about 10.
• The firm's slogan--"the Monthly Dividend Company"—is “gimmicky.”
  

I am still a strong believer in Realty Income (O) as an excellent holding for stock investors focused on a long-term dividend growth strategy. I own the stock in both a publicly published portfolio as well as in my personal account.

Let’s look at some facts. First, there is no question that the current picture for commercial real estate (CRE) is weak. Indeed, many pundits believe that a collapse in CRE is going to be a main factor that stifles the economy back down and leads to a double-dip recession.

That said, Realty Income is not your average investor in CRE. They maintain disciplined practices and a corporate culture that will help insulate them from the worst outcomes of a deteriorating CRE market. Realty Income does not lend money to retailers outright, nor does it build CRE. Instead, it buys existing retail buildings—the “outbuildings” around malls, for example—and leases them back to the original owners under long-term (typically 15 to 20 year) “sale-leaseback” arrangements. Its tenants—leading national and regional retail chains catering to middle and upper-end markets—are responsible for nearly all property maintenance and operating expenses, minimizing Realty Income’s expenses with respect to the properties it owns. The rental contracts have rent escalator clauses.

Thus, Realty Income provides the retailers with immediate access to capital to fuel their own business growth. In essence, Realty Income allows the retailers to outsource the ownership of their real estate. Realty Income collects the rents, paying some overhead and interest charges as its own operating expenses. Most of the remaining cash is distributed to shareholders, monthly. Owned properties have generally been paid for with cash and are unencumbered by mortgage debt.

One important practice of Realty Income that received no attention in the Barron’s article is the company's careful screening procedure for property acquisitions. When considering whether to acquire (or retain) particular properties, Realty Income requires a record of strong cash flow with a margin of safety above and beyond the lease obligation. This is called “rent coverage.” No doubt, some of its retailer/tenants are struggling, and a few will go bankrupt over the next few years. But unless the retailer goes out of business, it is unlikely to close individual stores that are generating good cash flow. When it reorganizes, it will almost always reaffirm leases on those profitable stores—the ones owned by Realty Income.

Another solid practice is that when making an acquisition, Realty Income does not base what it is willing to pay on the tenant’s profitability. Rather, it figures a “fair value” for the property itself and does not overpay. Many of its “peers” lack this discipline. Vacant properties can then be re-leased or disposed of for close to what Realty Income paid for them.

So, Realty Income runs its business with strong discipline and vigorous margins of safety at every step. Might they miscalculate, and might some of those margins of safety fail to hold? Certainly, but the care with which the company is run suggests that severe negative outcomes at Realty Income are less likely than at perhaps any other CRE operation. Its occupancy rate has slid a fraction, but it is still at 96% in its 2,300+ properties.

Barron's remarked that the stock looks overvalued. I agree with that. Since my earlier article, the shares have run up from $23 to almost $26, a 13% increase, and its valuation metrics have increased also. The stock is up almost 17% this year. For a dividend growth investor, that is no reason to sell. The value in the company’s shares lies in their ability to spin out the monthly dividends with regular increases, not in their absolute share price. I might not buy any new shares at the moment, but I certainly intend to hold on to what I own.

As to the insider selling, I do not see that as very meaningful. Restricted stock grants (not options) comprise a large portion of executive pay at Realty Income. It is not surprising that several executives sold stock given the price’s recent run-up. About 1.6 million shares are still owned by insiders.

Finally, there is nothing gimmicky about Realty Income’s devotion to producing dividends for its shareholders. Indeed, that is the company’s publicly stated mission, it is how the company portrays itself, and it has delivered on its promise monthly for almost 40 years. The company states, “Our mission of providing dependable monthly income for our shareholders requires that we maintain a conservative financial structure that supports responsible growth and generates a strong cash flow.” It would be hard to find a company more singularly focused on delivering dividends to shareholders. It has never missed a dividend payment since it began them in 1970. Given that it distributes monthly, this is little short of remarkable. It has raised its dividend twice already in 2009, and viewed quarterly, there have been 47 consecutive quarterly increases—almost 12 years. The company has announced no plans to pay dividends in stock shares rather than cash, which some troubled REITs have done.

Disclosure: Long O.

Comments

[User 80073:]

The summary of the Barron's article that I read did not mention O's successful methods of dealing with bankruptcies-- for example, Buffet Inc. That, in order to continue to operate, in bankruptcy, a tenant still needs to pay the rent, even if, that rent is renegotiated downward as part of the bankruptcy-reorg.

Sep 15 01:43 PM

[Patrick Harden:]

In reference to the dividend growth, it's important to note that 18.8% of the 2008 distributions made to common stockholders were classified as a return of capital for federal income tax purposes. In other words, Realty Income distributed more than the amount necessary to achieve the full taxation benefit available to it as a REIT.

Realty Income's preference for exceeding its REIT distribution requirements has grown over time:

2006: O's cash distributions totaled $139.1 million, or approximately 113.3% of its estimated REIT taxable income of $122.8 million. [source: Realty Income 2006 10-K]

2007: O's cash distributions totaled $182.2 million, or approximately 113.6% of its estimated REIT taxable income of $160.4 million. [source: Realty Income 2007 10-K]

2008: O's cash distributions totaled $193.9 million, or approximately 122.7% of its estimated REIT taxable income of $158.0 million. [source: Realty Income 2008 10-K]

Instead of retaining the excess capital for share repurchases or strategic activities that provide a return ON investment, Realty Income chooses to provide shareholder dividends that are, in part, a return OF shareholder investment.

Sep 15 02:14 PM

[Stocklvr:]

I believe, accurate. They are the reasons that I've owned the stock through all of the current financial mess (going back a couple of years now). I too would like it to come down in price -- so I can buy more.

If "The Monthly Dividend Company" is gimmicky, then please give me more companies with this gimmick! This is exactly what dividend investors look for.

I also like another REIT similar to Realty Income (O) called National Retail Properties (NNN). I think they are also relatively conservative with a good balance sheet. They too have maintained their cash dividend through this nasty market and have, in fact, raised it for 19 straight years. If you look at all the other REITs out there, few (except the healthcare space) have not lowered their dividend. As it stands today, O and NNN stand out among the croud.

Sep 15 02:39 PM

[Stocklvr:]

Part of my comments were cut off. I just wanted to say that the author did an excellent job of rebutting the Baron's article. His comments are spot on!

Sep 15 02:40 PM

[Jimbo:]

I have been investing in O since 1994. I am pleased with the company and its' practices.

Sep 15 02:54 PM

[Mouseym:]

I have owned O since 1990 and I am fully satisfied that it is one of the best of my investments. It went down during the bad months but has never missed its dividend. I own it in all 4 of my accounts.

Sep 16 12:06 PM

[Eagle68:]

I am a satisfied stockholder of O, as well.
You might want to take a look at the company's preferred stock as a dividend source, too. Currently the preferred, O-E, is selling for 9% less than the common (23.42 vs. 25.86) and the dividend is only about 1.5% less (.1406 vs. .1427).

Sep 25 11:20 AM