Is Realty Income Stock A Buy After Earnings? A-Rated 4% Yield

Aug. 08, 2022 11:39 AM ETRealty Income Corporation (O)36 Comments

Summary

  • Realty Income has ramped up its acquisition machine.
  • The company has increased its acquisition projections by 20% since the last report.
  • AFFO is expected to rise double-digits this year.
  • Trading at a 4% yield, the stock is highly buyable for those looking for a reliable dividend grower.
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After a recent rally, Realty Income (NYSE:O) is trading near 52-week highs with the wind at its backs. The stock is still very buyable here at a 4% dividend yield. This is a company which has proven the resiliency of its business model and should continue to thrive even in the face of rising interest rates. While the stock might not offer as much upside as tech stocks or even net lease peers, O stock instead offers the benefit of respectable upside with less drama.

O Stock Price

O spent much of the year trading lower before a rally over the past two months has brought the stock back to yearly highs.

Chart
Data by YCharts

I last covered O in May where I rated the stock a buy on account of the strong earnings results. The stock has since delivered double-digit returns, though I still see more upside ahead.

What Were Realty Income's Expected Earnings?

When O released earnings on Wednesday August 3rd, consensus estimates called for $776.2 million in revenue and $0.99 in FFO per share.

Did Realty Income Beat Earnings?

O ended up beating on both these metrics with $1.02 in FFO per share and $810.4 million in revenue. These are modest beats, but respectable considering the high predictability of the net lease business model.

O Stock Key Metrics

In analyzing O’s earnings report, I will focus directly on what I view to be the key metrics. Recall that O is a net lease real estate investment trust (‘NNN REIT’). These are real estate landlords, but are better thought of as providers of real estate financing. This is because they acquire properties through “sale and leaseback” transactions in which future tenants sell properties to O and simultaneously sign long term leases. While O is technically a landlord, the tenant is responsible for real estate taxes, insurance, and maintenance costs. That makes this arrangement very similar to traditional bank financing, with the main difference that O gets ownership of the property.

With this understanding of the business model in mind, O’s primary growth lever is through acquiring new properties. O acquired $1.6 billion worth of assets in the quarter, bringing its year to date acquisitions to $3.2 billion. Approximately 26% of the revenue generated by the acquired properties were from investment grade clients. I note that NNN REIT assets performed strongly during the pandemic even without high investment grade exposure.

acquisitions

2022 Q2 Supplemental

O disposed of $122 million of properties in the quarter, bringing its year to date total to $272.2 million. That represents 8.5% of year to date acquisitions and is high relative to its historical rates. Disposition activity is a useful indicator for underwriting abilities as NNN REITs in general do not wish to undergo aggressive capital recycling. You can see below that most of the dispositions tend to be vacant and nonperforming.

dispositions

2022 Q2 Supplemental

In addition to external acquisitions, another growth lever comes from the annual lease escalators. O was able to generate 2% same store rental revenue growth - far exceeding its 1% annual lease escalators. Investors should not expect that strength to persist indefinitely because it was mainly driven by the fact that theater tenants are on stronger footing now than during the pandemic and are able to better pay their rents.

same store rental revenue

2022 Q2 Supplemental

In the quarter, O was able to generate 5.6% leasing spreads and 5.9% year to date. I do not include this as a growth lever because NNN REITs typically do not realize strong leasing spreads - these strong results are likely to prove more near term.

recapture spreads

2022 Q2 Supplemental

O closed out the quarter with a strong balance sheet rated A3/A- by the credit rating issuers, with debt to EBITDA standing at a conservative 5.2x.

balance sheet

2022 Q2 Supplemental

What To Expect After Earnings

Looking forward, O has increased its full year guidance to up for 2% same store rent growth and $3.97 in AFFO per share.

guidance

2022 Q2 Supplemental

The company expects to acquire $6 billion worth of properties, up from prior guidance of $5 billion.

Is O A Good Investment Long-Term?

O has been a tremendous long term investment for patient investors. O has delivered 27 consecutive years of growing dividends.

dividend track record

2022 Q2 Supplemental

One might wonder how the rising interest rate environment might impact the stock. O notes that acquisition cap rates tend to track interest rates after 12 months.

acquisition cap rate spread

2022 Q2 Supplemental

Couple this with the fact that O’s debt maturities are well staggered, and rising interest rates should not negatively impact the company too much, as it should be able to offset rising debt expenses with rising acquisition cap rates, maintaining the same investment spread.

Is O Stock A Buy, Sell, or Hold?

At recent prices, O is trading at around 18x forward AFFO. O is expected to show 10.6% AFFO growth in 2022, but that is mainly due to its acquisition of Vereit. Beyond 2022, O is likely to see growth decelerate to around 3% annually, especially considering that the rising interest rate environment has likely reduced the synergy potential from refinancing legacy Vereit debt.

Moreover, I retain a dose of skepticism regarding the company’s announced acquisition of casino assets from Wynn Resorts. O had previously announced a $1.7 billion acquisition of the Encore Boston Harbor Resort and Casino at a 5.9% cap rate.

wynn resorts acquisition

2022 Q2 Supplemental

My view is that this cap rate is too low and reflects either management’s desire to juice their acquisition pipeline, rising competition in the net lease space, or a combination of both. It is possible that rising interest rates may not lead to a correlated increase in acquisition cap rates due to that competition. I can see O delivering at least 15% total returns over the next 12 months, reflecting both the 4% yield and double-digit multiple expansion potential. Key risks here, besides those mentioned above, are related to tenant risk. O and other NNN REITs have been able to succeed largely due to investor confidence in the NNN REIT business model. These assets proved resilient even amidst pandemic lockdowns, but if that were to change in the future, then the stock can sell off quite quickly. O in particular, due to trading at a premium to peers, would have greater downside potential. O’s tenants face risks like inflation and e-commerce - it is possible that it is only a matter of time before the cracks start to show. While I rate O a buy, I emphasize my preference for cheaper peers STORE Capital (STOR) and Spirit Realty (SRC), which trade with yields in the 5.5% to 5.9% range.

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This article was written by

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Disclosure: I/we have a beneficial long position in the shares of SRC, STOR either through stock ownership, options, or other derivatives. 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: I am long all positions in the Best of Breed portfolio.

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