Realty income ( O) is one of the best triple-net lease companies in US, with strong dividend track record for almost 26 years (titled as "monthly dividend company"). One of three REITs in the S&P 500, which is also a Dividend Aristocrats, with a rating of A3 by Moody’s and A- by S&P. They own a diversified portfolio of 6,592 properties located in 49 U.S. states, Puerto Rico and the United Kingdom (U.K.), with approximately 110.8 million square feet of leasable space. Their properties are leased to approximately 600 different clients doing business in 51 separate industries.
Last year was very difficult for all REITs, Realty income was not an exception. For couple of months I followed company very closely and paid attention to every step they made, especially at the beginning of Covid pandemic. Despite this gloomy situation they were able to hold superior rating, raise dividend and keep investing. It is extraordinary job and I´m not able to say the same about many REITs.
Over the last few weeks, market starts to worry about raising yields and also old issues related to theatres and health and fitness came to my mind. So I decided to take a look at company´s recent situation. Just to re-assure myself that investment thesis about "temporary/unique situation" in REITs is still valid and Realty income is still worthy to own.
What about health & fitness and theater situation
As mentioned above Realty Income owns very well diversified portfolio, with focus on retail (mostly on convenience stores - 11.9% of total annualized contractual rent, grocery stores - 9.8%, drug stores - 8.2% and dollar stores - 7.6%), which represented almost 84% of all rent revenue during the 2020. This type of diversification proved to be very resilient during pandemic.
Despite the shutdowns, Realty Income maintained very high 97.9% occupancy rate, down slightly from 98.6% a year ago (still extraordinary result in current environment). It also collected 93.6% of contractual rent in the fourth quarter, significant improvement form 82 % in June.
Source: Q4 and Q3 20 Realty income investor presentation
While many of Realty’s tenants were able to pay rent without any issue, there were two industries, health and fitness and theaters, that were failing to pay rent constantly during Covid 19 pandemic (not completely, but rent collection was not great). What worries me is that they represent 12,3% of all revenue rent.
In Q4 20 company collected 82% of health and fitness rents (in comparison to 42% in Q2 20) and only 14% of theatres rents (in comparison to none in Q2 20).
In case of health and fitness we already see some progress and situation probably will improve over time with better and faster vaccination (only 21% of US population received one dose of vaccine yet). Current statistic states that people are planning to continue exercising at home (mostly due to equipment they bought), but with all restrictions lifting and social aspect, health and fitness will do just fine.
Timescale for being comfortable going back the gym or an exercise class due to the coronavirus (COVID-19) pandemic in the United States as of October 2020
Despite the fact, that theaters on the other hand represent only 5.6% of Realty Income's rent, they are accounted for 80% of the uncollected rent in the fourth quarter 2020. Situation here is more difficult. They faced headwinds before Covid and pandemic only accelerated these changes. New competition represented by streaming companies such as Netflix, Disney and HBO Max, missing production and changes in distribution lines (AT&T has a plan to bring all new movies to HBO Max and Disney tried similar concept with Mulan) caused some serious damages (and keep doing in future).
During the earnings conference call multiple times was emphasized, that 80% of December´s un-collected rents were related to theatres, but company is optimistic to see some improvement in near future. Despite that, they´re planning to trim share of theatres to 3% (from current 6% of overall portfolio). Currently in high demand, last mile distribution and multifamily project, represent one of opportunities how to deal with non-profitable theatres with interesting location as well.
“While we do expect the industry to downsize in the future, we continue to believe it will remain a viable industry in a post pandemic environment, especially for high budget blockbuster movies."
"That said, we do acknowledge that the industry is changing and that there likely will be a rationalization of theaters in a post pandemic reality. Under this scenario, underperforming theaters may not survive.“ said by CEO Sumit Roy.
Honestly, I do not share company´s enthusiasm about theatres comeback, but I´m more than satisfied with move to cut share to 3%, which will be more beneficial from long-term perspective and save management and investor some sleepless nights.
What about rising yields
In last couple of weeks we were witness of tech meltdown caused by raising yields. Many dividend investors now wonder how higher interest rates will impact REITs.
I have to admit REIT business benefits greatly from declining yields for more than couple of decades, but claiming that rising yield cause the opposite, is little bit simplistic approach.
According simplysafedividend.com, Standard & Poor's reviewed six periods since the early 1970s during which the 10-year Treasury yield increased substantially. REITs recorded a positive total return in four of those periods and beat the market during half of them.
To simplify situation, we can claim, that there are only two main reasons for raising yields: economic recovery and inflation. In both cases we can expect some additional costs related to business, but if they´re followed by increase in revenue, there is no need to be not worried.
I don´t have to spend time with economic recovery analysis, as relationship between better financial conditions of tenants could be translated to better financial result of Realty income.
In case of higher inflation expectations company already has some level of protection in place, in form of CPI adjustments (with proper ceilings), but this is not applied to all leases. With lease renewals in upcoming years (2021 1.7% lease renewal, 2022 4.7% and 2023 7.3%), these costs can be easily incorporated into new contracts. This is what I like about Realty income, ability to reflect very reasonably additional costs/expenses in new rents.
Hand in hand with raising yields higher interest expenses are expected. In such case you have to keep an eye on level of debt. Current levels raised from 6,698m in 2019 to 8,568m in 2020, but company was already able to complete early redemption of 950m debt at the beginning of 2021. This leaves company only with 44m debt for rest of the year. This is great news if you´re investor.
Company benefits greatly from current situation and FED promise to keep interest rates unchanged for longer time period (at least till 2023 based on last FOMC statement). Not only by keeping debt level within manageable levels, but mostly by lowering average interest rates. Which significantly dropped from 3.89% in 2019 to 3.48% in 2020. Lower cost of capital then allows company to acquire highest quality assets.
Very good summary of an issue was provided during the call by CEO Sumit Roy:
“One of the questions that often comes up, okay, if the interest rate environment continues to go up, it's going to impact your cost of capital, and that is absolutely true. But what we have found in prior cycles is that cap rates tend to follow suit as well. And there is definitely a lag, but it does sort of follow and then it allows us to continue to maintain the spreads that we have. And in certain situations, even enhance our spreads if the cap rate moves faster than our cost of capital. So, we feel like we are very well positioned as a company. And based on some of the investments we've made and some of the areas that we have focused on, we feel like we are very well situated to handle an interest rate environment that increases an inflationary expectation environment that increases.“
Despite good debt financials (5.1 debt coverage, debt levels and decreasing average interest rates ) what worries me is 2.1% AFFO growth this year with current outlook for 2021 only between 1,5 – 2,9%. As mentioned above, raising yields bring additional costs, which should be followed by revenue growth in case we want to avoid some issues going forward.
From short-term period, it´s little bit premature to expect some serious materialization of higher yields in financial results, but from long-term period it´s only matter of time when yields raise permanently (cause either by economy recovery or inflation).
Based on response from earnings call above, company already handled such situation successfully in past, so hopefully we will see more significant AFFO growth after 2021. I would like to avoid some generalization based on past performance (past performance is never guarantee of future gains). I will rather pay attention to management steps in this area continuously/ going forward.
What about pre-Covid levels
Realty Income's stock price is down about 25% from pre-Covid level, but still remains one of the best dividend stocks in market and continue to deliver increasing annual dividend for investors (109 th increase this year since company's listing in 1994, growing the dividend at a compound average annual rate of approximately 4.4%).
Currently Realty income trades for $63.92 per share, with the 12-month average price target $68.50; almost in line with my own expectations (Goldman Sachs sets price to $79, but this is in my view too optimistic).
Based on technical analysis price is locked within trading channel between $66 - $57 for couple of months. If you take a look at valuation, price is moving around historical 17x PE/AFFO, which means, that company is currently fair-valued (only couple of times company dropped below this line – this only highlights it´s superiority).
But please pay attention to multiples, you could easily end up paying premium, which can harm your long-term results (depends on your investment strategy).
Currently we´re missing some catalyst, which could deliver some significant capital appreciation (maybe if optimistic theatre scenario will be fulfilled or in case of significant economic recovery). Till then, I´m expecting that price will oscillate within the range of $66 - $57.
I bought Realty income mostly due to dividend income and I wanted to bring some stability into my portfolio, so I´m fine with current situation. My plan is to hold current position and slowly adding new shares within bottom line of trading range.
Realty income is one the best REIT companies with extraordinary portfolio, which were able to deliver great numbers during these difficult times. I think increased AFFO, 4,4% dividend yield and smaller average interest rates speak for themselves. It is one of the best management teams within REIT industry and they deserve every penny.
Situation with health and fitness is improving gradually, but in case of theatres there is still long way ahead of us. Hopefully we will see improvement there as well. I do not share management optimism here, but I praise recent steps. They were doing great job so far and I think they will continue doing the same going forward.
Company was able to handle raising yields in past, so assuming they deliver the same outcome today as well or going forward. And yes, more significant AFFO growth in 2021 would make me happier, but still outstanding job in current situation.
This only re-confirms my investment thesis, that situation is probably “temporary” and Realty income is a good choice for my extra money at current levels.