Realty Income Hits Home Run With American Realty Acquisition

| About: Realty Income (O)

According to Bloomberg data, eight U.S. REIT purchases were announced this year, amounting to average price of $1.36 billion and an average premium of 46%. Last year, 26 REIT acquisitions were accomplished, with a total price of $27.4 billion and an average premium of 23%.

The highest amount paid was $2.92 billion, agreed upon by W.P. Carey & Co. (NYSE:WPC) to buy Corporate Property Associates 15 Inc. in February this year. With this merger, W.P. Carey would most likely turn into a REIT, with a diversified portfolio that includes major brands such as Best Buy (NYSE:BBY), Barnes & Noble (NYSE:BKS), Foster Wheeler (FWLT), Kroger Co. (NYSE:KR), Marriott International (NYSE:MAR) and UTI Holdings.

And this has been in line with the stabilization of the commercial real estate industry in the United States. Stuart Skaug, VP, CBRE Inc., commenting specifically on the Portland/Southwest Washington area, said:

"Although no one will describe the Portland industrial real estate market recovery as "hockey stick" shaped, we are definitely seeing consistent signs of improvement. 10 of the past 11 quarters have posted positive net absorption for the base market of 193,000,000 SF, with a quarterly average of 294,000 SF. As space continues to be taken, and new construction remains limited, the market will see increasing stability."

This is more or less the case with the whole of United States. Yes, not to deny what Rance Gregory, CEO, Morrison Street Capital, said, the recovery might take a few more years ahead, but it's nonetheless showing signs of improvement.

Recent acquisition of American Realty by Realty Income

Perhaps, this is the sole reason why net lease REIT, Realty Income (NYSE:O), is buying American Realty Capital Trust Inc. (NASDAQ:ARCT) for $2.95 billion, including debt. The deal, still subject to shareholder approval, is expected to close by the fourth quarter this year or first quarter of next year, and will result in the world's largest net-lease real estate investment trust and the 18th-largest publicly traded REIT, that is, Realty Income, twice as large as the next largest net lease REIT.

HUGE purchase, when your market cap is around $5.71 billion! The combined company will have a $7.6 billion worth market cap and an enterprise value of $11.4 billion, a size that nominates it to be included in the S&P 500 index.

RBC Capital Markets analyst Rich Moore said after information from Realty Income's management that "the company had been actively chasing the American Realty portfolio for several years." It must be very valuable to Realty Income, so what might be the reason?

The buyout will give Realty Income 501 additional properties. This will give it more than 3,250 properties owned under long-term leases to major commercial and retail tenants. Chief Executive Officer Tom Lewis said in the statement:

"This acquisition comprehensively advances Realty Income's strategic objectives of increasing its revenue generated by investment-grade tenants and further diversifying its portfolio outside of the retail industry."

Since three-quarters of American Realty portfolio consists of investment grade tenants, the revenue from investment grade tenants in Realty Income's income statement will increase to 34%, up from 19%. With the addition of these properties to the Realty Income portfolio, the expected rental revenue generated by 10 largest industries declines from 73% to 64%, the largest 15 tenants' declines from 49% to 42%, and its revenue from retail properties declines from 86% to 77%.

The biggest tenants of the combined portfolio will be FedEx (NYSE:FDX), Walgreens (WAG), CVS (NYSE:CVS), the GSA, Dollar General (NYSE:DG), Express Scripts (NASDAQ:ESRX), PNC Bank and Whirlpool (NYSE:WHR), with FedEx amounting for 6% of the rental revenue income.

The transaction is supposed to be immediately accretive to Realty Income's FFO, and it is expected that annualized FFO per share will increase by approximately $0.20-$0.22, with annualized AFFO per share to increase by approximately $0.14-$0.16 per share. The expected annualized AFFO per share is supposed to be in the range of $2.06-2.11 per share in 2012 and $2.31-2.37 per share in 2013. With the positive impact on the operating income, it will increase its dividend by approximately $0.13 per share, or 7.1% to approximately $1.94 per share, while maintaining a conservative payout ratio. Analysts polled by FactSet expect 2012 FFO of $2 per share and 2013 FFO of $2.16 per share.

"This is almost a perfect synergistic relationship being created," Mr. Schorsch said. "Putting the portfolios together gives more duration and better credit quality to the entire portfolio."

But a few analysts seem to differ. Joshua Barber, an analyst at Stifel Nicolaus & Co. in Baltimore, wrote in a note to clients today:

Realty Income "is focused today on improving its tenant credit quality, but in doing so, the company is venturing into newer property types with a very mixed long-term operating history..."

"Whether this transaction will truly be accretive to O's historically strong operating profile through cycles is a bigger question; frankly, we have doubts."

Effect on the company financials

The deal is being financed by both stock and debt. Around $1.9 billion will be paid in stock, amounting to 45.6 million shares. American Realty shareholders will get 0.2874 Realty Income shares worth about $12.21, or about 2.1% premium, for every American Realty share based on the stocks' Wednesday closings. The remaining amount will be paid with the assumption of around $526 million in debt to repay around $574 million in outstanding debt and transaction expenses.

How does it affect the balance sheet?

Well, as the press release says:

"The transaction is essentially balance sheet neutral. Realty Income will issue approximately 45.6 million shares with a market value of approximately $1.9 billion and assume approximately $526 million of American Realty Capital Trust company debt, and Realty Income will immediately repay approximately $574 million of outstanding debt and transaction expenses. Through the issuance of $1.9 billion of common equity without any issuance costs, Realty Income will be able to maintain its strong balance sheet."

Now, let's look at the historical free cash flow (FCF) of Realty Income (blue), Tanger Factory Outlets (SKT, green), Regency Centers Corp (REG, red) and Kimco Realty (KIM, orange) below.

Needless to say, Realty Income fares far better than the above popular players in the REIT industry in terms of free cash flow generation in the last one year.

Here's another table for you:


Dividend Yield

Total Debt-to-Equity

Operating margin

Return on investment (ROI)

Realty Income





General Growth Properties (NYSE:GGP)





Glimcher Realty Trust (GRT)





Inland Real Estate (NYSE:IRC)





It seems to me that while Realty Income is already in a stronger position in the REIT industry, this acquisition will only entrench its position in the industry even further. And this is in tune with what Moore said:

"Realty Income has the lowest cost of capital in the net lease space and few other buyers could swallow an acquisition of this size."

In short, seems fine to me.

Disclosure: I 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: Please contact your personal financial adviser before investing in any market securities.

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