Realty Income: Monthly Pay Dividend Aristocrat With A Fat Yield
- Realty Income has seen its share price drop almost 40% on the back of the COVID-19 crash. A worst-case scenario already is priced in and the upside isn't.
- The company made some well-timed moves, issuing both debt and equity at recent market peaks to improve its financial position.
- At the same time, the company's low WACC combined with its long-term history of rewarding shareholders implies significant upside for those who invest now.
- Today, it's selling at a highly opportunistic price. Buy O for its high yield and long-term gains.
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Realty Income Corporation (NYSE:O) has built a quality reputation as the "Monthly Dividend Company," and has recently reached dividend levels over 5%. The company is one of the largest publicly-traded REITs, with a market capitalization of more than $15 billion. O is one of the newest "Dividend Aristocrats," being introduced into the S&P Dividend Aristocrats Index in February of 2020 after raising their dividend every year (often multiple times a year) for 25 years.
O is a "triple-net" REIT, meaning that they primarily own standalone buildings that are leased to single tenants under long-term "triple-net" leases. These leases are characterized by being extremely hands off for the landlord, with the bulk of property level expenses being the responsibility of the tenant. Historically, this has been one of the most durable types of REITs, maintaining high occupancy levels and consistent revenue in even the worst recessions.
In the REITworld, O is universally recognized as one of the best operators and companies in a very defensive sub-sector of REITs. Call it a "blue chip," "SWAN," "top tier," "high-quality," "premium" or whatever your favored designation is. We call it a high-dividend opportunity that will produce reliable and growing income.
The company's near 40% drop in share price, as a result of COVID-19 concerns, means that now is the opportune time to add this quality dividend payer to your portfolio.
Realty Income headquarters - San Diego, CA
Realty Income Liquidity Improvements
Realty Income has managed to dramatically improve its liquidity in recent months, positioning the company well for the upcoming downturn.
Specifically, Realty Income has made two major decisions to improve its liquidity since the start of the current situation. In early April 2020, the company withdrew $1.2 billion under its revolving credit facility, where $1.2 billion now remains (not counting a $1.0 billion accordion feature). The company now has a cash balance of $1.25 billion equivalent to ~7.5% of its market capitalization and over 75% of their gross annual revenues.
Additionally, the company's interest rate on this borrowing is a mere LIBOR + 77.5 basis points. Given the current USD LIBOR rate of less than 1%, the company's interest on this borrowing is ~$20 million / year. That's some cheap borrowing to position the company to handle a possible downturn.
Another impressive liquidity move that Realty Income made, and a particularly well-timed one, is the company's decision to issue 9 million shares of common stock in early March. The company managed to issue this stock at an incredibly impressive $75 / share, with a yield on cost for the issuance of roughly 3.7%. Given the company's stock price has dropped more than 30% since then, the company picked a good time to issue shares to improve its financial position.
Realty Income 2008 Performance
It's important to evaluate Realty Income's 2008 performance to analyze what can happen during a recession.
Source: Realty Income Investor Presentation
In 2008, Realty Income performed incredibly well. Despite the magnitude of the recession, the company only saw one year of negative earnings growth, 2009, with a 2.1% decline in earnings. Throughout this time, the company's occupancy levels remained strong, dropping from a 2006 level of 98.7% to a 2010 bottom of 96.6%. That 2.1% decline in occupancy lines up with the company's earnings decline.
More importantly, throughout this time, the company managed to maintain its returns to shareholders. From 2006 to 2010, the dividend increased from $1.4475 to $1.7229. O did much better than surviving. They increased dividends to shareholders by 19% during a real estate-based recession.
One reason that O has been able to maintain such high occupancy and produce extraordinary results is that they have very high quality tenants.
Source: Realty Income Investor Presentation
At the same time, even in an unprecedented worldwide shutdown, Realty Income's tenant roster is strong. Many of the company's largest tenants are incredibly well positioned to handle the crash, in fact, some like FedEx (FDX) and Walmart (WMT) could even see demand for the company's products grow. Looking through the company's top customers, out of the top 20 customers (53.3% of revenue), we would estimate that 13.2% of the company's revenue is "at risk." Considering the portfolio mix, approximately 25%-30% of revenue is tied to tenants who might require rent deferral.
Specifically, the revenue from AMC theatres, Regal, Lifetime Fitness, BJ's, and LA Fitness. However, it's also worth noting that these are five of the biggest entertainment and dining companies, and even with some potential bankruptcies, leases and locations won't be completely closed. With all indications pointing toward the lockdown being lifted soon, we would expect most of their tenants will resume regular rent this summer and be able to start catching up on back rent.
It's important to recognize REITs are deferring rent, not forgiving it. In some cases, O might decide to renegotiate terms for tenants facing dire situations. That will be a somewhat smaller portion, and O will certainly get something in return for any long-term concessions.
For O, a tenant bankruptcy is not particularly scary. For a landlord with such a vast scope, it's not an infrequent occurrence. In most cases, rent is paid during bankruptcy, and the lease is assumed by the new entity. The property is integral to the tenant's business and the long-term lease is a benefit for the new owner. If liquidation occurs, O will sell the property and redeploy the proceeds.
Realty Income Growth Potential
Looking into the long term, the thesis to invest in Realty Income comes from the fact that the potential 12.4% 2020 revenue drop (and what we believe to be immaterial 2021 revenue drop) is more than contained in the company's share price given its near 40% share price drop. That doesn't count the premium the company traditionally would have received in a normal recession due to its yield in an environment where interest rates have dropped, along with the relative safety of real estate.
However, past that, another major catalyst for Realty Income is its operation in one of the largest markets in the world (commercial real estate) and the significant growth potential afforded as a result of that.
Source: Realty Income Investor Presentation
Since 2010, Realty Income has invested dramatically into the business, spending $16 billion in property-level acquisition volume. The company has been forced to accept a lower cap rate in recent years, as a result of increased demand for real estate. However, it has still managed to do admirably well, getting a 6.4% cap rate across > one-decade leases and a strong percent of investment-grade customers.
More specifically, the company's focus on relationship-driven investments and selectivity has allowed it to build a best-in-breed real estate portfolio. The beautiful thing about commercial real estate is the company could continue doing this for >100 years before getting anywhere close to a significant portion of the market. Its runway for growth is nearly unprecedented among various industries.
The company's low cost of capital means its ability to invest can result in significant returns, especially when it makes moves like issuing equity at a low yield. Specifically, the company's recurring capital expenditures for its buildings are 0.6% and its long-term weighted average cost of capital (or "WACC") is ~5.4% (although its WACC from debt is a mere 2.5%). That means the company's actual costs are 3.1%-6% depending on whether it wants to go with full debt or introduce equity.
Compared to the company's historic cap rate, in the range of 6.4 - 7.9%, that's a spread the company can capture through investing billions of dollars annually. More so, it's important to account for the fact that this WACC includes dividend growth on newly-issued shares, so any spread above the long-term WACC that the company captures rewards only existing shareholders.
As is clear, not only does Realty Income have significant room for growth, but they have the financials to use growth to generate significant cash for current shareholders. The company is spending billions to take advantage of this.
Realty Income Shareholder Return History
Realty Income has been sticking to its "bread and butter" as the monthly dividend company for years and using that to drive significant dividends to shareholders.
Source: Realty Income Investor Presentation
Realty Income has managed not only consecutive annual increases in the dividend but a staggering 89 consecutive quarterly increases. While the majority of these are token increases, four token increases a year still adds up to a dividend that has grown by the mid-single digits annually since the company went public. That track record has made the company one of only three REITs in the S&P 500 dividend aristocrats index, with a 79% AFFO payout.
There are some significant things to pick apart here. First, the company's 2013 acquisition of ARCT started a trend of significant shareholder returns. Given the fire-sale prices some of the smaller and more debt burdened REITs are trading at right now, there's no reason to believe the company won't try something similar in the future. Such a move could catalyze another significant round of dividend increases, something that's worth paying close attention to.
Additionally, the company's 79% AFFO ratio places the company in a strong position to handle a potential 2020 revenue drop without being forced to borrow in order to pay its dividends. While the company has withdrawn its 2020 guidance due to uncertainty in the markets, its 1Q 2020 earnings, due to be released on May 4, should help provide significant additional color to the company's operations and their risk.
We believe the company, which maintained its dividend aristocrat status during the atrocious real estate centered market collapse of 2008, will be able to maintain that status going forward. With a 40% share price drop already pricing in much of the worst-case scenario, there's little reason not to invest now.
Realty Income Risks
Realty Income is a publicly-traded corporation, and like all publicly-traded corporations, its business model can face risks. More specifically, the company's single biggest risk (and only risk worth discussing) is COVID-19.
Despite declining infection rates, antibody tests, increased overall testing, and potential treatments all being touted as reasons to be optimistic, along with increasing signs of an economic re-opening, COVID-19 has shown that it's unpredictable. As a disease that has torn apart lives and caused more than 55,000 deaths in the United States alone, it has led to unprecedented lockdowns.
These lockdowns have contributed to the U.S. unemployment rate increasing to more than 50% higher than its 2008 peak, as businesses struggle with an unprecedented threat to their model. It also created significant cash flow pressure on many consumer-facing businesses, as revenue has dropped to near zero for many businesses.
The largest current threat is that some of Realty Income's largest customers, like AMC, have stopped paying rent. Other triple-net REITs have reported that 25%-35% of their tenants did not pay rent in April. It's reasonable to expect that O will report something in a similar range.
We believe that most of these tenants will catch up, but that cannot be guaranteed. To the extent that any tenants cannot recover, O will be forced to seek back rent in court and would have to find a new tenant or sell the building, possibly at a loss.
2020-2021 will be difficult years for Realty Income, however we believe that a very bad scenario already is priced in and therefore a unique buying opportunity presents itself.
Realty Income, as a real estate company for some of the largest service industry businesses, has some exposure to businesses with lock-downs. The market has reacted to this, driving down the company's share price by almost 40%, in an almost unprecedented destruction of shareholder value given the company's low historic volatility beta vs. the S&P 500. Despite this, the company has taken impressive steps to raise $1.25 billion of liquidity in difficult times, at incredibly low rates, with more than $2 billion in spare borrowing capacity.
Additionally, the company's conservative investment strategy, low WACC, and size all provide it with a significant growth runway. Not only can the company continue to invest, capturing a WACC to cap rate spread to reward investors, but the company can use this time for opportunistic acquisitions like it did in 2013. The company has a strong history of rewarding shareholders and the risk-reward ratio favors a continuation of that history. It's not every day that this solid "Dividend Aristocrat" offers a fat monthly pay yield +5%. This opportunity will not last long.
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