Realty Income Puts Cheap Capital To Good Work

| About: Realty Income (O)

This morning, Realty Income (NYSE:O) announced that it is purchasing American Realty Capital Trust (NASDAQ:ARCT) in an all-stock deal worth $2.95B. Under the terms of the agreement, American Realty Capital Trust shareholders will receive a fixed exchange ratio of 0.2874 Realty Income shares for each share of American Realty Capital Trust that they own. The transaction has the following benefits for Realty Income and ARCT investors:

  • The credit quality of the REITs tenants improves, which improves the stability and consistency of their rental stream (Revenues generated by investment-grade tenants increases from approximately 19% to 34% of pro forma total revenue).
  • The purchase allows Realty Income to further diversify their tenant exposure and exposure to the retail sector (largest 15 tenants declines from 49% to 42%, and its revenue from retail properties declines from 86% to 77%).
  • The transaction modestly increases occupancy (97.7% from 97.3%) and lease duration (11.4yrs as compared to 11.1yrs).
  • The transaction is immediately accretive and does not rely on "synergies" to create the accretion.

I wrote an article last week entitled "Why I Am Selling Realty Income's Stock" in which I opined:

While I admire Realty Income and the REITs management, love is for people and pets, not positions. I have done well with my investment in the company and hope to be involved in the equity again, but current valuations make me nervous and as a result, it is time to sell the position.

My primary concern with the company was (is) that their stock is currently overvalued at 21x FFO multiple and a significant premium to net asset value. While this is not great for investors, it makes an all-stock deal very compelling to Realty Income as they are using cheap currency! An overvalued stock creates cheap acquisition currency and Realty Income is using that currency to reinforce their already bulletproof model.

As a result of the transaction, Realty Income has stated that it will increase its dividend by over 7% to $1.94. From an ARCT perspective, their dividend yield has gone from a 6% yield to a sub 5% yield, but they are being paid a premium (12% based on closing value) to do so. They are also getting the best management in the business (no ARCT employees will be moving to Realty Income).

Bottom Line: Realty Income just pulled a rabbit out of its hat by buying high-quality assets and investment grade tenants with cheap currency. The deal is accretive and will lead to a dividend bump for shareholders. Realty Income investors give up 25% of their company in return for high-quality assets and greater growth potential. American Realty Capital Trust investors give up dividend yield for a share price premium (they have done well since the IPO in March 2012), a rock solid, investment grade balance sheet and the best management in the business. From both perspectives, this deal is a win-win.

There will be a webcast on the transaction at 11:00 EST (8:00 PST), which will be here.

Deal Slide presentation here.

Disclosure: I am long O. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My long position in Realty Income is in their Series F preferred stock.