Inside Realty Income's Capital Structure

Jan.10.12 | About: Realty Income (O)

As the markets continue to vacillate and add volatility to investors' portfolios, I expect that many investors will continue to look to income-generating investments to enhance returns. One of the names that often comes up is Realty Income. Instead of merely focusing on the equity, I thought it might make more sense to analyze the capital structure, as investors have access to the majority of the company’s capital structure. What follows is my analysis and opinions on the various levels of the capital structure. (Unless otherwise noted, all data is derived from company reports and presentations, and was compiled by me.)

Company Description

Realty Income Corporation (NYSE:O) is a Maryland corporation organized as an equity REIT focusing on freestanding, single-tenant locations which are leased to regional and national companies under long-term net lease agreements. Essentially, Realty Income provides sale/leaseback financing to less than investment grade tenants (although not necessarily less than investment grade, as the majority of 2011 investment was with investment grade tenants). As of September 30, 2011, O owned a diversified portfolio of 2,600 properties located in 49 states. Their properties are leased to 134 companies doing business in thirty eight industries and have an occupancy rate of 97.7%.

Summary

Realty Income Corp owns a diversified portfolio of real-estate assets under long-term leases and employs a conservative financial profile. Their business profile provides income investors with a stable income stream although capital appreciation upside is somewhat limited in the common and preferred segments of the capital structure (which I view as fully valued). The debt portion of the capital structure is more compelling as the sector trades cheap from a ratings perspective and provides security via financial covenants. Further, the triple net segment of the REIT sector is typically underfollowed and can provide a stable, higher yield core holding in a fixed income portfolio. With that said, let's look under the hood.

Properties

As earlier stated, O has has a diversified property profile both geographically and by industry/tenant. This is a credit positive as a downturn in one industry or region will not inordinately affect the company’s cash flow stability. The company’s top five industries account for 54% of the net assets. The top five industries are:

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Of these, casual dining and theaters tend to concern me the most, as they are the most sensitive to economic downturns and disruptive technologies (think streaming content and 3-D televisions). Looking just at theaters (2 of the top ten tenants), the Motion Picture Association data showed admissions down 5% during 2010, and it would have been greater if not for the increased release of 3-D movies. The trend is disconcerting, and the properties are difficult to re-lease, due to the size and the configuration of the buildings. This does not bode well for future rent increases or re-leases, should they become necessary.

While I am normally concerned about the sensitivity of restaurants, recent statistics from the National Restaurant Association point toward decent growth within the sector. The Restaurant Performance Index stood at 100.6 in November, up 0.6 percent from October. November represented the second time in the last three months that the RPI stood above 100, which signifies expansion in the index of key industry indicators. I am still cautious about restaurant growth rates, due to their need to pass along higher food costs to consumers.

Realty Income’s top ten tenants are as follows:

Recently, Friendly Ice Cream filed Chapter 11 bankruptcy, and their 121 leases represented 3.6% of O’s revenue. As it currently stands, Friendly rejected only 15 of the 121 leases. More leases could get rejected and/or renegotiated, causing a drop in revenues, and therefore AFFO. While this is certainly possible, I believe that the AFFO impact will not be significant, as the remaining leases are on better locations and the rejected locations can be re-leased (albeit after some TI and probable rent reductions).

Leases

One of the attractive features of Realty Income’s portfolio is the longer-term leases. As of September 30, 2011, the weighted average remaining lease term was 11.1 years. The percent of total rental revenue renewing over the next ten years averages less than five percent per year. This is a positive, as there are no “chunky” years where a large amount of leases come up for renewal and have the possibility of going dark for an extended period of time, thus affecting cash flow.

In the most recent 10Q, the company pointed out that during the first nine months of 2011, 69 properties with expiring leases were leased to either existing or new tenants. The rent on these leases was $7.3 million, as compared to the previous rent charged on these same properties of $8.0 million. At the same time, the company stated in their release that same store rents increased 1.8% compared to the same quarter in 2010. This infers that some of the company’s leases are above market (not a huge surprise given the longer term nature of their leases and the change in the economic environment since the signing of the leases) and when re-leasing to new tenants, rent levels are lower.

The question this leads us to is how big of an impact will this have on the company in the near to intermediate future. Looking out the next five years, approximately 20% of the company's leases come up for renewal (biggest year being 3013 with 5.1% of rental revenue coming up for renewal). Of this number, it is almost an even split between first time renewals and subsequent renewals. These numbers are pretty balanced and reasonable and should not significantly affect AFFO.

Cash Flow

Cash flows for the company have been growing at a moderate rate. Both FFO and AFFO have been growing at a CAGR of approximately 4.5% over the last five years. Top line growth has grown at a CAGR of 7.5%. The difference being taken up by increased interest and G&A expenses. A snapshot of the company’s top line and cash flow (I include trailing twelve month numbers, but did not use them in the CAGR calculation):

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Capital Structure

First, an overview of the capital structure, then details and my thoughts of each level.

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Equity: The company currently (as of 9/11) has 133.2 million shares outstanding with a market capitalization of 4.65B. Key equity stats (and those of peers) are as follows:

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Source: Bloomberg.

Realty Income is generally in line with peers, with the exception of P/B.

Realty Income focuses on income investors (they do call themselves the “monthly dividend company”) and continues to raise its dividend as FFO permits. I would expect that the company will continue to raise the dividend in line with same store growth which should average 1.5-2% (which fits well with the 1.2% CAGR of dividends).

If we assume a 5% yield hurdle for investors (which I believe is prudent) that limits the upside for the stock from current levels. Further, from a risk premium perspective, should rates in the US start to rise, the stock price will have to fall accordingly. Bottom line -- capital appreciation from these levels is very limited. For Income, you might want to consider the NNN-Cs if you like the triple net lease sector.

Preferred (Baa2)

Realty Income has two series of preferred stock outstanding, the series D (7.375%) and the series E (6.75%). Both are $25 par, cumulative and currently callable.

The following is detail on the current status of Realty Income’s preferred stock and that of its peers:

Price source: Bloomberg.

As you can see from the above table, Realty Income’s preferred stock does not present value at this time. While the monthly dividend on the O preferreds is nice, bigger dividends are better. I would be more focused on the NNN-C preferred issue as it is in the same space as O, has low volatility and yields more. By way of further comparison, PS Business Parks is doing a $25 par with thoughts around the 6.5% area, and PSA just did a 5.9%.

Debt (Baa1/BBB)

Realty income has $1.75B in debt outstanding. As with most REIT debt (with the notable exception of one Kimco issue), the indenture contains financial covenants. The covenants and company compliance is as follows:

The company is well within its covenanted limits, and has significant headroom under its covenants. So how does the company stack up in terms of value? Here is a snapshot of the company’s yield/spread versus peers:

In my opinion, O is cheap to NNN, and the triple net lease sector is cheap to other similarly rated REIT sectors, and typically has lower volatility.

Disclosure: I am long the NNN-c preferreds, O-E preferreds as well as O equity. As a result of the analysis, I plan to swap between O and NNN equity and possibly preferreds within the next 72 hours.