The company is in the business of acquiring triple-net lease properties from owners, and then leasing them back using long-term lease contracts.
As a Real Estate Investment trust, the company has to distribute almost all of its net income to shareholders. An important metric for evaluating REITs is Funds from operations (FFO), which stood at $1.98/share in 2011. Realty Income distributed $1.746 /share in 2011.
FFO is defined as net income available to common stockholders, plus depreciation and amortization of real estate assets, reduced by gains on sales of investment properties and extraordinary items. Once the company’s FFO payout ratio decreases, it should be able to generate higher dividend growth to shareholders.
Over the past decade, dividends have increased by 4.30%/year. Dividend growth has been limited over the past five years, due to the high payout ratio.
The company’s strategy involves:
- Tenants with reliable and sustainable cash flows
- Tenants with revenue and cash flow from multiple sources
- Real estate that is critical to the tenants ability to generate revenue
- Tenants willing to sign long term leases
- Real estate where profits will exceed cost of capital
This strategy has enabled to company to pay a stable and increasing distributions since it went public in 1994. The company has been successful in adapting its business model to changes in the economy. In its property acquisition strategy, Realty Income has exclusively focused on tenant quality. Examples of that include the acquisition of vineyard and winery assets in Napa Valley, which are leased to Diageo (DEO). This shows the company’s willingness to invest in retail industries where there is little competition and that are likely to do well in the future.
Realty income has also managed to continuously re-evaluate its existing group of tenants, using its methodology, and group them into different clusters. It’s team of research staff has evaluated tenants based on a wide variety of factors such as revenue and gross margin trends, profitability, credit rating, including stress tests and what if scenarios if interest rates increased or if tenant revenues declined. This evaluation helps the company identify industries in which it needs to focus its acquisition efforts, while also identifying areas where it needs to scale back or even dispose of existing properties.
Some of the biggest risks that the company faces include decrease in occupancy rates, competition of its tenants and rising interest rates.
The company has managed to proactively acquire properties in promising industries over the years. However, if its team fails to renew leases as they expire, Realty Income might end up with properties which are not generating income and might have to be sold. Between 3% and 4% of leases expire each year, which is why being able to renew or find new tenants is imperative for long-term success. Inability to do so could decrease cash flow available to shareholders, and might even lead to reduced dividend payouts. In addition, deterioration in the financial conditions of its tenants might lead to them breaking leases, depending on the severity of their financial situation. The company’s tenant base does appear to be somewhat diversified, although about ten tenants account for 50% of revenues in 2011. The company does look at its properties, and is not afraid to sell real estate in order to reduce credit risk.
Over the past year, two of its tenants which generated 7% of annual revenues, Friendly’s and Buffets Holding filed for bankruptcy under Chapter 11. Friendly’s accepted 102 out of 121 leases, and received rent concessions and term reductions on some of their leases. The company estimates that it will be able to recover 80% of annualized rent that Friendly’s was paying prior to its bankruptcy. Buffets accepted 79 out of 86 properties, and obtained term reductions and rent concessions from Realty Income. The REIT is expecting to recover 65% of annualized rent that Buffets was paying before its bankruptcy. The rejected properties have been made available for re-lease.
Realty income does face a great deal of competition from other public and private REITS, as well as an array of investors, who are actively looking to increase exposure into the lucrative triple-lease property market. Luckily, the company has been able to proactively pursue opportunities in new markets. In addition, its expertise and experience in the sale-leaseback market has allowed it to uncover opportunities. The decrease in interest rates has led to a decrease in cost of capital, which has been sufficient to compensate for lower yields on new properties.
Another major factor behind Realty Income is rising interest rates. Although expectations are for interest rates to remain low until 2014, a continued increase would diminish investor appetite for high yield REIT’s and their fixed income securities. This will essentially increase cost of capital, and might even cause liquidity issues. Realty income has been able to grow through issuance of equity and bonds, which is why future growth could be in jeopardy if it has to pay higher interest rates to investors.
Currently, I find Realty Income shares to be priced above my buy range. I would consider adding to my position in the company on dips below $35, which is equivalent to a 5% yield. A 6% yield would correspond to a drop in the price all the way to $29.20 /share.
Full Disclosure: Long O and DEO