Is Realty Income Really A 'Buy And Hold Forever' Stock?

Summary

• Do rising interest rates hurt O?
• Does the REIT benefit from its equity selling at a premium?
• Is O a “buy and hold” forever stock?
• I answer all the above questions and give my verdict on shares.

Realty Income (NYSE:O) is a triple net lease ("NNN") real estate investment trust (REIT) known as the “Monthly Dividend Company.” This company has gained a large following due to its status as a “Dividend Aristocrat,” which is achieved only after increasing dividends for at least 25 consecutive years. In this article, I do a deep dive to determine if it really is true that O can somehow be a better buy when its equity is more expensive, to a surprising conclusion. Despite the appearance of its steadily growing dividend, its future may be anything but. I am bullish on O, but I caution investors from blindly buying and holding forever. Do you know what you are holding?

(Source: Realty Income)

Business Overview

As an NNN REIT, O is essentially a real estate bank. A typical transaction goes as follows: give a large sum of capital to the customer in exchange for their property, and the customer agrees to pay rent equal to about 6.5% of the capital given for about 15 years. When things go well, O just collects rent checks, as the customer still takes care of property taxes, maintenance, and insurance (the triple nets). One should not be blamed for thinking O is just like any other lender in this case. I should point out that unlike the typical bank, O does not have customer deposits as a source of capital for lending, making it more dependent on debt and equity than the typical bank. When things go wrong, however, that is where the real distinction materializes. O would then likely need to dispose of the property so that it can replace it with another income-producing property.

O has gained a reputation as a best-of-breed NNN REIT because it usually sees the best case, as evident from the fact that occupancy levels have never dipped below 96%:

(Source: Realty Income 2018 Q2 Presentation)

Its tenant base is known to have a larger concentration of investment grade quality:

(Source: Realty Income 2018 Q2 Presentation)

O is perhaps most well known for its history of steady dividend increases, which have been on average 4.7% annually:

(Source: Realty Income 2018 Q2 Presentation)

One may get the impression from looking at these slides that O has a very simple business model which just plays itself - but is this really true?

The Flip Side of Investment Grade Tenants

While on the surface it all looks very simple - find a tenant, raise rents 1% annually, raise dividends, be happy - in actuality, it’s much more complex than that. As we can see below, O has seen strong “recapture” rates in recent years:

(Source: Realty Income 2018 Q2 Presentation)

These refer to what happens at lease expiration. However, as we can see above, O did see a roughly 4% decrease in rents for the 15 years or so prior to 2013. So here’s the catch: O and other NNN REITs in general do not own prime real estate. If you wanted to own the kind of land which sees 10-15% leasing spreads upon expiration, then you probably should be looking at companies like Federal Realty Trust (FRT) or Simon Property Group (SPG). NNN REITs are able to acquire properties at 6.5% cap rates because the real estate is not prime. They are lucky if they are even able to average 2% leasing spreads on renewals.

This presents a very important reality: while not necessarily often, a significant number of their properties will underperform either before or at lease expiration. While O tries to reduce the credit risk by purchasing higher-quality properties at lower cap rates, it however then also faces the issue of tenants which enter these sale and leaseback transactions just to repurchase stock and potentially with the aim of eventually changing locations upon lease expiration.

STORE Capital (STOR) CEO Chris Volk has said, “It turns out that it is common for real estate occupied by investment grade tenants to sell for considerably more than it costs to create. It also turns out that it is typical for real estate that is leased to investment grade tenants to have rents that are well above those in the local marketplace.” This means that a property left vacant from an investment grade tenant tends to especially bothersome to deal with. In order to create the image of smooth financials, NNN REITs need to acquire new properties with “fresh” leases to effectively hide the negative results from the lemons in their portfolio. This is where the importance of cost of capital comes in.

The Self-Fulfilling Prophecy

Because NNN REITs essentially need to grow their asset base in order to improve and maintain their credit quality, this means that a REIT’s cost of capital has a very high influence on its ability to achieve high credit ratings and low cost of capital. Sounds like circular logic? Keep reading. Consider a REIT, like O, which historically has seen high credit ratings and low cost of capital. This has helped O continue to grow its asset base because it is able to do so easily and accretively, as we have just seen. Then, the continued additions to assets help to improve the credit quality, completing the cycle. Funds from operations ("FFO") and dividends keep increasing, and shareholders profit.

Consider another REIT which historically sees high cost of capital. Unable to grow its asset base, the portfolio continues to see diminishing credit quality, which further decreases its investment grade ratings and increases its costs of capital. This then makes it even harder to grow its asset base, leading to deteriorating credit quality, creating a negative cycle. FFO/share is pressured, dividends are frozen and eventually cut, and shareholders start running for the hills.

This is why it is absolutely crucial for NNN REITs to either have their equity trading at attractive costs of capital or maintain low levels of leverage to ensure they can rely primarily on debt when their equity is not so attractively priced. Without the ability to grow its asset base, an NNN REIT may see a slow but sure deterioration in overall portfolio and credit quality. Otherwise, it would need to grow for the sake of growing, at the expense of AFFO.

The takeaway is that, contrary to intuition, O is sometimes a better buy at higher equity valuations than lower equity valuations due to the REIT's ability to grow its asset base (I explain the math in the next two sections).

Cost Of Capital Examples

In general, O could acquire companies using three methods: debt only, equity only, or a combination of both. There are two main leverage ratios that O needs to manage: debt-to-EBITDA and fixed charge coverage. Allowing any of these multiples to get out of hand risks credit downgrades and increasing costs of debt.

1. If O acquires properties solely by issuing debt, which is the most accretive to AFFO, then it would see incremental benefits to cash flow based on the spread between the cost of debt and the yield on investments. However, this type of issuance would hurt the company's debt to EBITDA and fixed charge coverage. It should only do this if its leverage ratios are significantly low enough that it can afford leverage expansion.

2. If O acquires properties solely by issuing stock, then it would see a primary benefit of an improving balance sheet, as debt-to-EBITDA and fixed charge coverage would both improve. However, this option is usually the least accretive to AFFO. The company might only resort to this kind of issuance when shares trade above 25 times AFFO, as the cost of equity would be so low. If things are going bad, then a company might do this even if it is dilutive to AFFO in order to improve its leverage ratios, but that is not an ideal scenario.

3. Typically, O will acquire companies with a combination of debt and equity, so that it can manage to boost earnings while limiting the impact to leverage. Finding the right combination is critical for the long term.

To see visually how important equity valuations are in determining cost of capital, let’s work through an example. Let’s say the company wishes to acquire a property for $1 billion at a cap rate of 6.5%.

In order to maintain a debt-to-EBITDA multiple of 5.5 times, it would be able to issue a maximum of $357.5 million, assuming there are no operating expenses. Let's however just focus on fixed charge coverage and AFFO/share impact.

Let’s look at two examples, for both of which we assume the REIT wishes to acquire properties at a fixed charge coverage ratio of 4.8 times. For simplicity, we are assuming all operating expenses are included in the 6.5% cap rate on acquisitions.

Below we see an example of a company with a high cost of capital:

(Chart by Author)

As we can see above, this company is unable to acquire properties without sacrificing either fixed charge coverage or dilutiveness to AFFO. There isn’t any combination of debt and equity which would allow O to grow without decreasing its credit quality. This illustrates clearly the important role that equity plays in the acquisition process. This company is in the unfortunate position of likely needing to acquire some properties at slight dilution to AFFO. Otherwise, it may need to reach for yield and find properties at higher cap rates.

Let’s see the difference in the case of O due to its lower cost of capital. The company was able to issue $2 billion in unsecured debt at 3.7% interest rates and average term of 14 years in 2017.

(Chart by Author, data from 2017 10-K)

Because O has low average interest rates and attractively priced equity, it does have a combination of debt and equity which would allow an acquisition to be both accretive to AFFO and credit neutral at the same time. I should stress again that this acquisition would even arguably be credit positive because the company would be adding “fresh” properties to its portfolio.

Quick take - The metrics below are all very important in understanding the fundamentals of acquisitive potential for O:

• Cost of debt
• Cost of equity
• Debt-to-EBITDA multiple
• Fixed charge coverage
• Spread between cap rates and cost of capital
• Cap rates on acquisitions

O has done an excellent job of managing the first four, but the last two are not really under control and may impact the company's ability to continue excelling in the first four.

Valuation

Trailing AFFO/share for O was $3.06. At recent prices of $57.67, O trades for 18.8 times AFFO and a 4.58% dividend yield. Its dividend growth rate has averaged 4.7% since inception, and I anticipate that this should continue to slow down due to the increasing difficult task of acquisitions. The growth rate may increase if the company somehow manages to see an expansion in cap rates, but this seems unlikely due to increased competition in the space. I, however, believe that the 4.7% yield is still attractive, as real dividends are hard to find in this market.

Now, an interesting question: does O become a better buy as the price keeps going up because it is able to grow AFFO faster through acquisitions? I have the view that the equity price point is only so important up until that magic number (discussed above) which allows O to execute acquisitions as it needs to. As shares trade higher than this magic number, the benefit from a more rapidly rising AFFO would be offset by the reduced return potential from loftier valuations.

Risks, and When to Sell O

• Because O has a real estate portfolio worth upwards of $15 billion and growing, the company needs a large and increasing amount of acquisition activity to maintain the smoothness of its financials. At some point, the law of large numbers may come to play, as O may find it simply impossible to execute so many acquisitions year after year. We, however, have not yet seen NNN REITs get so big as to experience this issue, so it isn’t clear at what number exactly we should start being worried. I have a hunch that at some point O will have to spin off some of its lower-quality assets so that it would be able to execute two different acquisition programs under two different sets of criteria: one for a higher-yielding but less credit-restricting entity, and another for the current lower-yielding and high-credit O. This would remove the problem of the law of large numbers and potentially allow O to repeat its growth story of the past two decades all over again.

• Rising interest rates may increase the cost of capital for the REIT. Even though O is likely to continue to experience lower interest rates than peers, should interest rates move up in aggregate, the company will be affected all the same. I do not see it as likely that O will be able to pass on the rising costs to its tenants in the form of rent bumps, as evidenced by the low renewal spreads it has seen historically. The company would instead count on expanding cap rates on new acquisitions to help compensate for the rising costs, but this once again highlights how important acquisitive activity is for O. As such, investors may find it useful to monitor the spread between cap rates and debt of NNN REITs in determining their acquisitive abilities.

• I would be concerned if debt-to-EBITDA multiples begin expanding towards the 6.5-7.0 range. From the current multiple of 5.5 times, there is still plenty of room before this occurs. However, should the multiple expand, it would add significant risk to their business in the form of increased interest rate risk (that’s a lot of debt that needs to be refinanced) and the inability to rely on debt for acquisitions when the equity is undervalued.

• If O sees its equity trade at depressed valuations for a long period of time, this may force the company to rely on debt for acquisitions and lower its credit quality. I, however, find such a possibility to be very unlikely.

In short, if O is unable to acquire properties for whatever reason, be it due to an overleveraged balance sheet or the inability to do so accretively, then it becomes a Sell for me. I do not believe the company will see the steady financials it has produced in the past without continuing its significant acquisitive activity.

Conclusion

Currently, O has access to low costs of debt and has equity selling at a distinct premium to peers. For now, this gives it a significant advantage over peers in acquiring properties and keeping the dividend train going. If these change, however, and O is met with the perfect storm described in this article, then even the “monthly dividend company” becomes a Sell. O needs to continue to be able to acquire new properties. Investors are advised to closely monitor the fundamentals to make sure that the REIT keep doing so. O is a good buy for the long term - but be careful.

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