The Tale Of 2 Net Lease REITs: Realty Income Vs. Store Capital

Summary

• Triple net lease REITs offer investors exposure to what's likely the highest operating profit margin business in the world.
• It's important to realize that there's no such thing as a true "apples to apples" comparison in the equity space.
• In this piece, we'll look at the differences between two of the most followed stocks in our coverage area.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

This article was co-produced with Nicholas Ward.

In this day and age, computers account for most of the trading volumes via algorithmic trading and electronically-traded funds. As such, it's easy to view the market as one giant, solid entity.

On most days, the short-term, sentiment-driven tide seems to either lower or lift all boats. Because of this, it's no wonder investors tend to forget the stock market is indeed just that: A market of individual stocks.

Even within the REIT space, people too quickly group competitors as if they're all apples-to-apples comparisons. Yet that doesn't change the fact that they're not.

That's why we'll be looking at the differences between two of the most followed stocks in our coverage area: Realty Income (NYSE:O) and Store Capital (NYSE:STOR).

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They're both triple-net lease REITs. Which means they both offer exposure to what's likely the highest operating profit margin business in the world. These companies regularly post margins in the mid-90% range.

This is due to their structure, which passes along the expenses associated with owning/operating a physical structure - including taxes, insurance, and maintenance - to the tenant. These high margins combined with high occupancy rates result in strong cash flows that lead to reliable dividends.

Simply put, the triple net REIT structure is an income-oriented investor's dream. However, even though they follow the same general plans and practices, they're certainly not all created equally.

Old Vs. New

If you've been following us even just as of late, you need no introduction to Realty Income. It's considered a "cult stock" by some because of its large and royal following among the dividend-growth community.

Realty Income went public in 1994 and has provided investors with outstanding market-beating returns since then.

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Furthermore, it's become known as "The Monthly Dividend Company," with 598 consecutive months paid out… and counting. In fact, O already has declared its 599th, to be paid to shareholders on June 15.

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Our iREIT team has covered it extensively in recent months. The company has remained one of our top Buy-rated stocks, and several of our analysts are shareholders themselves.

For a more in-depth dive into Realty Income and its operations, consider the following:

• On May 18, Nicholas Ward published this piece highlighting the rationale behind his most recent purchase into the company.
• On May 5, Williams Equity Research received an Editor's Pick for breaking down O's Portfolio and likely rent collection data during the REIT selloff.
• On April 12, we produced this piece highlighting iREIT's recent exclusive interview with Realty Income CEO Sumit Roy - where he highlighted the company's dedication to its dividend.

All summed up, we have a very good opinion of this company for some very good reasons.

Up Next: Store Capital

We've also paid close attention to Realty Income's rival, Store Capital. So when our subscribers recently asked about the differences between the two, we decided it was a great time to compare them.

While STOR hasn't been public for nearly as long, it has generated very strong results for its shareholders. Debuting in November 2014, it has since provided annualized total returns of 16.6% - as CEO Christopher Volk highlighted in the company's 2020 Annual Letter to Shareholders, published in late February.

That beats both the broader market and its peer-group index. And STOR's dividend growth also has been more impressive in recent years, even up against Realty Income.

Furthermore, throughout this outperformance, the stock continued to trade with lower multiples than its peers. This implied that the associated risk/reward ratio remained superior than those available elsewhere in the REIT space.

Again though, that was prior to the shutdowns. Since then, both STOR and O have experienced significant weakness.

Source: Yahoo Finance

For instance, prior to the COVID-19 selloff, Realty Income was trading near 52-week highs in the $85 area. Once it did though, that price fell precipitously, down more than 55% to $38.

As for STOR, it was trading for nearly $41 in late February, only to drop to $13, or roughly 68%.

As you can see, even though these stocks were both looking great at the beginning of the year, O fared much better once negative volatility occurred.

Source: Yahoo Finance

As our subscribers asked, what gives?

It's true that O's long history of success and dividend security would give defensive investors more confidence than most. However, this is still a legitimate question to ask.

Prior to the selloff, many of Store's fundamental metrics and multiples were much more attractive in terms of both relative valuation and growth prospects.

With all that in mind, we delved into dissecting the dichotomy. And two things really stood out: Management's messaging and the quality of the real estate portfolio.

Tale #1

It may be easy to say that management messaging is unimportant relative to actual fundamentals. But we believe most long-term investors stay with a company so long - even throughout periods of uncertainty - because of trust in management.

For income-oriented and/or dividend-growth investors especially, this means believing that management teams are committed to their payouts.

Realty Income's Sumit Roy called his company's dividend "sacrosanct." Since that's quite the SAT word, here's the Merriam-Webster definition:

Source: Merriam-Webster

In other words, in Roy's view, there's no Realty Income without the dividend. And he doubled down on that sentiment on the Q1 conference call on May 6.

Here's what he said after analyst Barry Raskin asked if the company could continue paying it:

"Yes… And it goes back to our payout ratio. We have 20% off of room within our business model to help support the dividends that we have in place."

He went on to say that this is more than just a status quo. "It is very much part and parcel of how we operate our business. It is our mission." And so Realty works hard to "manage liquidity."

It's enough to:

"… withstand disruptions - even medium-term disruptions - and still be able to maintain a profile of the business that continues to be very strong and continues to support the dividends. As you know, we were added to the dividend aristocrat (list) earlier this year. It took us 25 years to get there."

Frankly put, he didn't have to say any of that. He could have easily been cryptic, pointing toward uncertainty and thereby kicking the can down the road. Yet he didn't.

It's that kind of honesty that led us to reassure shareholders that Realty's monthly payments would continue. And this is exactly what's happened so far.

Tale #2

Then there's STOR. When CEO Christopher Volk was asked about the dividend - both by iREIT in an exclusive CEO interview and during a recent conference call - he was fairly elusive.

While he remained bullish on STOR's operations and prospects, he wasn't as adamant about the dividend as Roy was.

During the Q&A session of STOR's conference call, he also got an analyst question or two. One was from Jeremy Metz, who asked about his "latest thinking around the dividend," to which Volk said:

"Yes, I think we expect to be able to answer that in June for you. I think our board of directors is going to evaluate the dividend closely, and they're going to do what they should do."

In other words, they don't want to promise anything until they have to promise something. Until they "have some predictability of where… the world is heading."

"Then I think boards are going to be in a very good position to make cogent and clear policy. And of course, the stuff changes every day as you know. So, one day things are closed; the next things are open and so on so forth…

So that means that you'll have an update. Now, you should expect one in June. And so, when we do the one in June, we'll be able to talk about it - dividend policy as well. And then we'll have another update in July."

We certainly don't blame Volk for being conservative during what's an unprecedented environment for REIT managers. We even respect it.

Yet we also respect investors' reactions to it. Volk's roundabout statements without a doubt implied weakness with regard to STOR's dividend safety and growth prospects.

Investment Grade Wins The Day

Look at the two maps below that highlight Realty Income and Store's geographic diversification. There are a lot of similarities.

Realty Income

Source: Q1 ER CC Presentation

Store Capital

Source: Q1 CC Presentation

Frankly, it's pretty amazing to see the overlap. Though, when you compare their recent occupancy ratios, STOR actually performs better, with 99.5% occupancy in Q1 vs. 98.5%.

The major difference, however, appears to be the quality of its tenants.

Store Capital focuses heavily on unit-level profitability and individual contract credit ratings when making acquisitions, whereas today's market appears to prefer deals with partners that have increased liquidity.

As you can see below, more than 70% of STOR's contracts are investment grade. And it says the deals it makes with its partners often have less investment risk than the credit risk of its tenants.

Source: Q1 CC Presentation

Historically, STOR has focused on middle-market companies, and management continues to be bullish on this strategy. During the Q1 call, Volk said:

"The results from its sensitivities to this black swan event that mandated a broad albeit temporary cessation of commerce. Surveying the wider landscape beyond a net lease arena, this notion becomes even more clear given the limited payments of rents from retailers of all sizes and credit ratings."

Even so, "everything is relative" right now, from rent collection to tenant type to occupancy rate.

"… our approach to investing begins with an integrated business model that we pioneered in 1980 and refined over the past four decades across three separate and successful public investment platforms. Viewed in this light, I believe STORE's non-rated tenant April rent collections led in that leased sector."

He also highlighted the company's sector-specific diversity, including areas of the economy that were less impacted by the shutdowns.

"And given the general spread between lease rates attainable from investment-grade to non-rated tenant(s) I would also posit that STORE's April cash yield on investment impacted as it was by lease deferrals lay near the very top of our net lease peer group."

Volk reiterated the company's commitment to its tenants. And, together, he sees them succeeding, even coming out on the other side of the shutdowns stronger than ever.

"Companies like STORE," he said, "are essential for real estate capital formation among middle-market and larger nominated companies and will help this country as we emerge from this pandemic."

Optimism, Facts, and Analysis

It may be true that STOR's non-investment-grade tenant portfolio outperformed its peers. But investment-grade tenants are proven to be more likely to pay their bills during this crisis.

The middle-market strategy is well and good during most market environments. But in today's world, where doors are shut, cash flows are turned off, and rents are hard to pay.

It certainly pays to have partners with deep pockets.

While Realty Income has changed its tune with regard to value vs. quality over the last decade or so, Store remains seemingly convinced in its ability to seek out gems, regardless of their credit quality.

That shows in how it only managed to collect 68% of April rent.

Management did reach deferral agreements for the vast majority of its partners that didn't pay. Rent collected plus deferral agreements equaled out to roughly 97% of STOR's tenant base.

But that 68% figure is still much lower than Realty Income's 84.2% collection rate the same month.

STOR did highlight the fact that about 75% of its deferred rent came from just six industries.

Source: Q1 CC Presentation

But he also doubled down on his middle-market focus, saying, "If you're in a COVID-19 sensitive business, you're going to be really, really hurt by this" no matter what.

His solution is to simply keep doing "what we do best. And we're going to stick to our strategy, and we're going to evaluate these sectors closely."

Facts and Analysis on the Other End Too

Realty Income recently updated investors on its May rent collections as well, which came in at around 82%. Add that to how management previously noted its around-80% payout ratio headed into the crisis.

Together, those figures provide a lot of solace to income-oriented investors.

What really stood out though was that, during April, the company collected:

• 99.5% of its rent from its top four industries
• 99.9% of rent from its investment-grade tenants.

And during May, it collected 98.4% from investment-grade tenants.

Since the Great Recession, O has focused on increasing its exposure to those higher-quality businesses. When looking at its top 15 tenants in 2009, only 3.2% of them fit that category.

Today, that figure lies at 28.5%. And roughly half of its rent comes from such.

In short, STOR's focus on investment-grade deals at the micro level has proven successful in the past. But Realty Income's decision to increase its own exposure has proven to be even more prescient and highly productive.

As shown below, O's portfolio isn't perfect in terms of social-distancing viability. It has significant exposure to movie theaters, gyms, casual dining, and childcare - none of which have performed particularly well in recent months.

Source: Q1 ER CC Presentation

However, prior to the shutdowns, many of the industries struggling today are exactly the types investors wanted to see REITs focus on to help diversify away from physical retail.

With that in mind, we certainly don't mind seeing the diversification across O's portfolio, especially when there's a focus on investment-grade tenants.

We believe its long-term track record speaks for itself. In fact, we haven't lost an ounce of faith in Realty Income's ability to navigate this and future volatility.

Source: Q1 ER CC Presentation

Conclusion

People often say that "a picture is worth 1,000 words." Well, that's certainly true in terms of the company overview Realty Income provided during its most recent earnings report.

Source: Q1 ER CC Presentation

At the end of the day, it just doesn't get any safer than O's illustrious history, culture of success, strong management team, impressive balance sheet, and best-in-class property portfolio.

For the record, we continue to like STOR as a long-term play, though its low rent collection numbers do appear to put the dividend at risk for now.

We're not necessarily predicting a cut. But we certainly wouldn't be surprised to see one.

That's why it continues to be rated a Speculative Buy compared to O, which carries a firm Buy rating.

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking

Analyst’s Disclosure: I am/we are long O, STOR. 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.