Ackman Explains Why He's Short REIT Realty Income

Pershing Square hedge fund manager Bill Ackman presented his latest short idea at the Great Investors Best Ideas conference in Dallas, TX where he spoke with other prominent hedge fund players such as David Einhorn of Greenlight Capital. At the conference, Ackman laid out a short thesis for Realty Income (NYSE: O).

The rationale behind his play is as such: He thinks Realty Income will suffer because it has tenants with poor credit quality, many with junk ratings. Additionally, he cites the fact that many of its tenants are in the dreaded consumer discretionary segment. This sector has been notably hit due to the recession and many stores have closed down over the past 12+ months. He also mentioned that Realty Income trades at a 7.5% cap rate or so, whereas the private market value is a 10-11% cap rate, a 40% premium.

Ackman's presentation also touched on the $26 share price level, as the stock never seems to be able to go all that much higher in the recent past given the fact that the company keep issuing shares around that level. Realty Income is essentially a 'serial equity raiser'. Furthermore, its stock vesting program is a bit odd in that the older you are, the quicker your stock vests.

We've certainly seen a massive wave of REIT equity dilutions over the past year, and Realty Income seems to be no different. If anything, Realty Income is even more aggressive in this regard.

Ackman also noted that the REIT is very levered to occupancy as it essentially doubled its asset base at the peak of the market during the years of 2005, 2006, and 2007. So, Realty Income certainly has its share of fundamental problems, as many other REITs in the space do.

In the end, Ackman basically said that this company is appealing to your everyday retail investor due to the monthly dividend stream that it touts. He thinks this dividend will have to be cut and this would play out similarly to what we saw earlier in the year with many other major REIT players cutting dividends or paying dividends in the form of stock. And, he feels that once the dividend starts fading, so will all the retail investors. This is all the more interesting to note given that Realty Income just raised its monthly dividend to $0.1426875 per share, up from $0.142375 per share (hey Realty Income, can you guys squeeze anymore decimal places into that amount? Geez). The REIT has now boosted its quarterly dividend each year for the past 15 years as the name currently yields 6.2%.

Pershing Square was already short in the REIT space to some degree in an effort to hedge its long position in General Growth Properties (GGWPQ). Its largest short position is a valuation hedge on this investment. Pershing had also previously mentioned in its letter to investors that it was short a REIT that has weak assets, trades at a higher valuation, and has poor business prospects. So the question now becomes, was Realty Income the company Ackman was referring to in his letter? It definitely appears as though it was. Once word of his presentation got out, shares were down over 7% at one point on Wednesday. We found this interesting given that Ackman typically doesn't short equities on the short side of his portfolio, preferring instead to use derivatives as a means to maximize the reward of Pershing's play, as we noted in our profile & biography on Ackman.

In the WSJ the other day, Analyst Andrew DiZio from firm Janney Montgomery Scott cited both the long and short cases for Realty Income, noting that shorts are centering in on a potential bankruptcy by some of its tenants. He says,

shorts believe large-scale vacancy from bankruptcies will reduce cash flow, necessitating a dividend cut and resulting in the exodus of [Realty Income's] large retail shareholder base.

On the long side, DiZio notes that

In the event of a Chapter 11 filing, a tenant will likely affirm the leases of profitable stores, closing those that are cash flow negative. Realty Income's due diligence process results in the REIT purchasing only those units that are cash flow positive, increasing the likelihood of lease affirmation in the event of a bankruptcy.

He currently has a 'neutral' rating on the company, but interestingly enough, has said that dips provide an opportunity.

Ackman has been pretty actively involved in real estate plays with his portfolio, most notably with his position in General Growth Properties debt and equity (GGWPQ). So far that position has done extremely well for him as he's up more than 12-fold on the equity since its buy at $0.34 per share and the unsecured debt Pershing owns has tripled in value over the same timeframe as noted in its latest investor letter. Additionally, he also has a large stake in Target (TGT), whom he proposed a REIT spin-off for earlier on that never panned out. Not to mention, his experience stems back to his former hedge fund Gotham Partners which closed two of its funds back in 2003 after a merger was blocked between one of Ackman's top holdings and a real estate player. Ackman certainly has ties to the sector though, as his father, Lawrence D. Ackman, is chairman of the Ackman-Ziff real estate advisory firm.

Overall, an interesting set of thoughts from Ackman and we'll be sure to cover more developments regarding his thoughts as we obtain them. Don't forget that you can hear more investment ideas from both Ackman and David Einhorn at the upcoming Value Investing Congress on October 19th and 20th and we highly recommend attending. We also wanted to mention that at the same Dallas conference, Einhorn mentioned that he was buying interest-rate options that he will make money on if yields head higher. This is likely a very similar to Julian Robertson's curve caps play, as we now see yet another prominent hedge fund player enter this trade. These plays are definitely inflationary in nature and Einhorn has set his sights on this outcome, as he also holds a lot of physical gold. We'll also watch developments in this regard and will post up further information as we obtain it.

You can view our coverage of Bill Ackman's Pershing Square portfolio here and David Einhorn's Greenlight Capital portfolio here. Lastly, make sure you check out our profile/biography on Ackman & Pershing Square.

Taken from Google Finance:

Realty Income Corporation, The Monthly Dividend Company, is organized to operate as an equity real estate investment trust (REIT). The primary business objective of the REIT is to generate dependable monthly cash distributions from a consistent and predictable level of funds from operations (FFO) per share. The Company’s monthly distributions are supported by the cash flow from the portfolio of retail properties leased to regional and national retail chains.

Comments

[davidbdc:]

O might be overvalued here, but I don't think its wildly overvalued. They aren't crazily overleveraged so its kind of interesting that this REIT would be chosen. Will be interesting to see this play out. Personally, while it might be a profitable trade I don't see shorting O as being any kind of "home run" play.

Oct 11 07:08 AM

[Brad Castro:]

I agree with davidbdc.

And then there's the monthly dividend. Why would you short stock that pays a monthly dividend? When you short the stock, YOU pay the dividend.

Oct 11 09:00 AM

[Old Trader:]

"In the event of a Chapter 11 filing, a tenant will likely affirm the leases of profitable stores, closing those that are cash flow negative. Realty Income's due diligence process results in the REIT purchasing only those units that are cash flow positive, increasing the likelihood of lease affirmation in the event of a bankruptcy."

In their analyst's report, M* mentions the same thing. I've owned O in my core portfolio for a number of years, but have started to trade around the position this year, taking advantage of the volativity.

Regarding their last round of share issuance, they used the proceeds to pay down some credit lines; something I feel was a prudent move, and now, have no debt due until 2012, I believe. Btw, O is the only REIT I own.

Oct 11 11:11 AM

[InvestingSa...:]

I'm not sure I understand the basis for shorting O. There are other REITS out there that are in a more precarious position and highly leveraged.

Oct 12 01:05 AM

[sh@rky:]

I believe ackman knows his game, Well let's see how it pans out.
As for GGP that will be a home run, Bet you !!!

Oct 12 01:44 AM

[H.J. Huneycutt:]

This is a somewhat goofy short if you ask me. I'm not bullish on O and it's unlikely that I ever will be (since it seems to trade sidewards all the time), but I don't believe the short is likely to pay off all that much, nor would it accomplish its primary objective of "hedging" Ackman's long REIT positions.

O and General Growth are two completely different beasts. Ackman will come out ahead on his pair trade, but mostly because O will trade sidewards, while General Growth has traded upwards.

Also, as someone mentioned above, why short something paying a substantial monthly dividend? I get the fact that he believes the dividend will be undermined, but I question the rationale --- O is one of the most diversified REITs on the market. Take a look at their depreciation schedule some time --- it's like trying to read the tax code!!! At best, you can make broad generalizations about their properties at that's about it. In fact, that's yet another reason why I'll probably never buy into O --- it's too big and sprawling.

Maybe I'm wrong, but this pair trade doesn't make much sense to me. It seems like there are much better real estate service stocks out there to use as a short hedge.

Oct 13 07:42 AM

[Kinabalu:]

"Realty Income just raised its monthly dividend to $0.1426875 per share, up from $0.142375 per share (hey Realty Income, can you guys squeeze anymore decimal places into that amount? Geez). The REIT has now boosted its quarterly dividend each year for the past 15 years "

I know it doesn't make sense but just reading that sentence makes me want to short them. Wow, a dividend increase of $0.0003125 per share. For a thousand shares the dividend will go up 31 cents.

Oct 13 08:45 PM

[Kinabalu:]

As noted in the article Ackerman uses derivatives rather than equities to accomplish his shorts. Avoiding dividend payments is probably part of his reasoning.

On Oct 11 09:00 AM Brad Castro wrote:

> I agree with davidbdc.
>
> And then there's the monthly dividend. Why would you short stock
> that pays a monthly dividend? When you short the stock, YOU pay the
> dividend.

Oct 13 08:52 PM

[Patrick Harden:]

I've questioned O's dividend policy in the past of overdistributing its taxable income, but really, the short thesis here is lacking some meat. It's as if Ackman has shorted the best of breed on the theory that the REIT model itself is unsustainable.

All REITs have to continually raise equity if they are successful - it's a circular path. To successfully generate cash flow over the long term, REITs must earn some taxable income. If the REITs earns taxable income, it must pay it out to shareholders. There is little to no remaining operating cash flow to grow the business, so it's time for either debt or equity.

Like most of the commenters, I'm totally puzzled why Ackman going after Realty Income? There are plenty of other junky REITs out there that have gotten ahead of themselves in the dash for trash.

Oct 13 09:30 PM

[REITBull:]

Ackman may be trying to play the decline in the lower end of CRE. According to their 10K, Realty Income has "average leasable retail space per property of approximately 8,130 square feet". There seems to be an abundance of small box CRE property on the market. This should put pricing pressure on their rents for the foreseeable future. Also the smaller box tenants tend to have less credit availability.

Oct 18 09:49 AM

[30yr RE Vet:]

In a down market I'd take Realty Income's portfolio over GGP's portfolio any day of the week. GGP's properties are pretty. O's properties make money.

Oct 20 12:13 PM