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Below is part 1 of the PRO+ team's interview series that provides a contrarian take on popular dividend growth stock Realty Income (NYSE:O). Arturo Neto, CFA runs a wealth advisory firm and has almost 30 years of experience in the financial services industry.
Seeking Alpha: Before we discuss the bearish thesis, what do you think the "consensus" bullish thesis is? Why is it such a popular stock among the dividend growth investing crowd?
Arturo Neto, CFA: The company is a well-oiled machine and has raised its monthly dividend over 100 times since it went public. There isn't much not to like about it. Its business model of triple-net leasing means that the risk of any increases in operational expenses is passed on to tenants. But it's not just the triple-net lease factor either - many of the company's tenants are in internet resilient segments, like drug stores, convenience stores, discount retailers, and other service and entertainment venues.
It's also popular among the dividend crowd because it pays a monthly dividend instead of a quarterly dividend. For investors relying on income for monthly expenses, it's such a convenience not to have to figure out which month your dividends will be paid. It's called the Monthly Dividend Company, after all, which from a marketing perspective is genius.
SA: The impressive dividend history is one of its most attractive qualities - what is your outlook for dividend growth? Is the current/projected dividend covered, and if so, by how much? Will the historical dividend growth slow?
AN: Dividend growth will persist but the growth rate on dividend payments will slow, in my opinion. It already seems the company raises its dividend by $0.0005 at a time. It might raise the dividend several times a year but as growth in AFFO becomes more difficult, dividend growth will be challenging as well - although there is still plenty of room for dividends to grow based on the current payout ratio.
The dividend is so well-covered, I think the company sandbags a little bit so it gives itself a margin of safety to be able to continue to raise the dividend without fail. It would be disastrous for the company if it misses a quarterly boost - more so than if any other company were to keep their dividends flat. The payout ratio relative to AFFO is around 80%.
SA: How is O valued on an absolute basis and/or compared to its historical trading range or peers? Are there other NNN peers trading at more attractive valuations?
AN: I think O is slightly overvalued. Historically it has traded at a P/AFFO multiple of around 17.4 and is currently trading at a price/AFFO multiple of 22.6. That's a 30% premium over its historical average. There has to be considerable growth in AFFO for that multiple to 'normalize' or the price of the stock will have to come down. It's not the only triple net lease REIT that is overvalued. There has been considerable interest from investors and the entire sub-sector looks expensive now. W.P. Carey (NYSE:WPC) trades at a 47% premium to its historical P/AFFO multiple.
Compared to peers, however, O looks expensive as well. It's not enough to look at its P/AFFO multiple compared to the other REITs in the sub-sector on an absolute basis - it always trades at a higher multiple than its peers. The key is the relative premium and how it currently trades relative to the long-term average premium. It currently trades at an 11% premium to NNN compared to the long-term average of just 9%. It also trades at a 15% premium to STOR while the average premium it has traded at historically is 13%.
I think the entire sub-sector is trading at rich multiples but if I had to pick one - hesitantly - I would pick Store Capital (NYSE:STOR). I think it has higher dividend growth potential than some of the others.
SA: How will the prospect of lower interest rates impact the valuation/cap rates?
AN: If rates continue to decline, it will continue to benefit REITs in general, especially as investors have to reinitiate their search for yield alternatives outside of fixed income. Where I worry about lower rates is the impact it will have on the underlying performance of the portfolio. While Realty Income's tenant base is less sensitive to competition from internet retailers, it isn't immune to a drastic decline in economic activity. Consumers drove all of the growth in GDP in Q2 and so long as consumers are employed, happy, and spending, retailers will be OK, but an overall pullback in spending will hurt. I can't see consumers spending $40 for two people to watch a movie at an AMC theatre or Regal if the economic outlook deteriorates. We're not there yet, but if the Fed continues to cut rates, it's likely because of imminent economic challenges or a negative outlook. That will hurt O as well even if not as much as it might affect other REITs.
SA: What is your outlook for O and the NNN space in general in terms of operating performance?
AN: I like the business model and I think it will be the best performing REIT sub-sector in a pullback, but the only way these companies are growing are through acquisitions and it's becoming more difficult with property values so rich.
Realty Income has 1% escalators in their leases and while the rent recapture rate on new leases has improved, the average remaining lease term is around 10 years - meaning they can only increase rents on 10% of their portfolio annually.
The international expansion with the acquisition of the Sainsbury portfolio could provide a boost to growth but it does add some complexity to the business model. Real estate is all about location and if you have an expertise in one location it doesn't always translate to another location - especially when you're talking about another country altogether.
Generally speaking, my outlook is for steady cash flows with moderate growth, which is OK in a volatile environment laced with uncertainty. But I don't expect much price appreciation other than the initial cash inflows from investors - and we may already have seen it.
SA: What "needs" to happen for the stock to actually sell off? Is a high valuation alone enough or does it need a catalyst? What were the drivers of past sell offs?
AN: The company currently has almost 6,000 properties and last quarter alone it acquired 105 new properties at a price of $520 million. It also just bought a 454-property portfolio for $1.25 billion!! The expected boost to FFO from that huge acquisition is just $0.01 per share. The previous quarter's acquisitions increased property count by 1.8% at an acquisition price that was 1.8% of its total enterprise value. While the recent acquisition added another 7%+ properties to the portfolio at an acquisition cost of around 4% of total enterprise value. The latter was a much better 'deal' but the boost to FFO growth is just 0.3%! Finding 400+ properties per quarter that will meet the company's underwriting standards is becoming increasingly difficult and the number of properties it needs to acquire to maintain growth is increasing not decreasing. If the acquisition pipeline fails to meet expectations in any given quarter, I think some investors will start getting worried - and that might put some pressure on the stock.
SA: Is O more or less exposed to the well-known retail headwinds?
AN: O is less exposed to retail headwinds, but is nowhere near being immune to them. As mentioned earlier, retailers that make up its top tenants are in internet resilient sectors but they are also focused on needs-based goods and services. Even if consumers start spending less or if certain goods are made conveniently available through Amazon or a similar service, consumers will still visit the corner drug store and convenience store.
SA: Can you provide a summary of your bearish thesis on O?
AN: The company is one of the best-run REITs and has a robust business model with little operational risk, however, all of the reasons why the company makes for a solid investment are embedded in the price. In fact, the price may have gotten a bit ahead of valuation as investors have reallocated funds to more defensive names with dividend growth potential and stable cash flows. So long as uncertainty reigns, the stock will hold up, but the slightest tilt towards a risk-on environment could cause a slight pullback. A much larger pullback may occur if the company can't keep up with its acquisition rate to maintain growth in AFFO and dividends. At a 30% premium to its historical trading range, the price is just too pricey and will be overly sensitive to any news that fails to meet investor's optimistic expectations.
Thanks to Arturo for the interview. If you'd like to check out or follow his work, you can find the profile here.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: Arturo Neto, CFA is long STOR