-Seven Year Revenue Growth Rate: 13.6%
-Seven Year FFO/Share Growth Rate: 3.2%
-Seven Year Dividend Growth Rate: 3.9%
-Current Dividend Yield: 4.14%
-Balance Sheet Strength: Stable, Conservative
Realty Income continues to deliver, but the comparatively high valuation has pushed the dividend yield to rather low levels, which reduces the expected long-term rate of return.
OverviewRealty Income Corp. (NYSE: O) is a Real Estate Investment Trust (REIT) that maintains a portfolio of over 3,500 properties in 49 states that are leased to over 200 tenants. The business is rather lean, with a nearly $10 billion market capitalization and under 100 employees.
They focus on acquiring and maintaining properties that already have long-term leases contracted for tenants that they believe operate in healthy industries that absolutely require property for their day-to-day operations. (In comparison, that is, to tenants that may be able to shift some of their business towards the internet, or businesses where their property is a smaller focus of their operations.) Most of their contracts are structured so that the tenant, rather than Realty Income, is responsible for paying property taxes, maintaining the interior, exterior, and land of the property, and for insurance. Realty Income also occasionally trims its portfolio by selling properties that no longer align with their goals.
The ten largest tenants for Realty Income are:
Northern Tier Energy
Over three-quarters of the rental income comes from tenants in Retail, while the remaining quarter is split among Distribution, Office, Agriculture, Manufacturing, and Industrial properties. Currently, over 97% of the properties are occupied.
(Chart Source: DividendMonk.com)
Revenue growth over this period has been a significant 13.6% per year on average, and Funds from Operations have grown at 10.9% per year on average over the same period.
As will be shown by the next chart, much of this growth is fueled by issuing new shares, which dilutes the numbers on a per-share basis. Over the course of this charting period from 2005 to 2012, the REIT went from 83.7 million shares outstanding to 133.4 million shares outstanding. Because the REIT pays out most of its incoming funds as dividends, there is only a modest amount that can be reinvested to grow the property portfolio. Therefore, most of the property acquisitions are paid for by issuing new shares.
Funds From Operations and Dividends
(Chart Source: DividendMonk.com)
This chart depicts growth on a per-share basis. FFO per share grew by an average of 3.2% per year over this period, while the dividend grew by an average of 3.9%.
The current dividend yield is 4.14%, and Realty Income pays out 85-95% of its FFO as dividends. Realty Income pays out its dividend on a monthly basis.
Approximate historical dividend yield at beginning of each year:
As can be seen, Realty Income’s yield is at a low point compared to the recent historical average. The valuation has been pushed higher, resulting in a lower yield.
Balance SheetRealty Income maintains an investment grade BBB+ credit rating.
As of the most recent quarter, the REIT has $8.76 billion in assets, $3.62 billion in liabilities, and therefore $5.14 billion in shareholder equity.
Investment ThesisThe thing that stands out about Realty Income is its dedication to shareholders. They brand themselves as “The Monthly Dividend Company”, and the bulk of their website is an atypically user-friendly dedication to educating potential shareholders about their business.
The first thing you may notice if you read their annual report is that the depictions are mostly of shareholders, whereas most annual reports by companies focus on their customers. When you look through the colorful annual reports of most businesses, you’ll generally see depictions of their customers, products, and operations. Indeed, Realty Income does depict some of their properties in their report. But at the forefront of their report are pictures depicting shareholders. There are five pages worth of various pictures of the demographic that they view as their shareholders: typically upper middle class, middle-aged or retired, and generally enjoying life. How a company chooses to market itself, including to its own shareholders, is an expression of that organization’s culture.
Realty Income’s role in a portfolio, over the 4+ decades of operation, has generally been to provide solid current income that keeps up with inflation. Payments come monthly rather than quarterly, and as a REIT the payout ratio is rather high, resulting in a decent current yield of 4+% (though historically higher than that). From a diverse and stable set of properties with long-term contracts, Realty Income seeks to provide good retirement income.
American Realty Capital Trust Acquisition
In the first quarter of 2013, Realty Income completed their acquisition of ARCT for $3.2 billion. This adds 515 properties, leased by 69 tenants in 44 states, to Realty Income’s portfolio, and has resulted in an unusually large dividend increase for the REIT of nearly 25%.
The acquisition also increased the overall occupancy rate of Realty Income, and increased the percentage of investment grade tenants. Currently, about two-thirds of Realty Income’s tenants are investment-grade businesses.
Real Estate Investment Trusts Vs. Directly-Owned Real Estate
Owning property is one of the oldest forms of wealth and investment. Of course, real estate can be owned actively with direct property, or passively through publicly traded REITs.
Owning direct real estate can result in a rate of return that exceeds the historical average of the stock market. Individual real estate markets are generally less efficient than stock markets, less liquid, and require more direct time and attention. When operated skillfully with the proper application of leverage, consistent double-digit returns are possible in many markets. The downside is that, as a hands-on approach, it requires a degree of real estate skill and of course time.
In comparison, owning shares in a REIT is a passive activity, but the returns will generally be lower. The reason for the lower returns is that as an investor, you’re paying a premium for the complete convenience. The book value of Realty Income is less than half of the current market capitalization. If, as a direct real estate investor, you owned shares of Realty Income at direct book value, your dividend yield would be doubled to nearly 10%, with dividend growth that generally keeps up with inflation. You’d be looking at low double-digit returns, which historically is better than the S&P 500.
As a publicly traded entity, the liquidity and passivity of the investment results in a fair price that is higher than book value, and therefore lower returns. Historically this REIT has still outperformed the market, but during most of that period, the valuation was lower and the yield was higher than it currently is.
RisksRealty Income’s performance comes from the team’s ability to acquire and maintain a highly occupied property portfolio. General economic weakness can decrease their occupancy rates as their tenants struggle.
None of Realty Income’s tenants account for more than 10% of overall rental income, but the top six tenants each account for over 3% of rental income each. Of this, their largest tenant Fed-Ex accounts for 5.5% of rental income.
Conclusion and ValuationOverall, Realty Income is clearly a well-run operation that has historically served investors well. The nature of property inherently gives them somewhat of an economic moat, and the conservative balance sheet and diversified property portfolio give shareholders some protection against loss. The REIT’s strong focus on shareholders and monthly high-yield dividend can be very attractive to those that seek current income.
The question, though, is whether Realty Income is trading at an attractive valuation. Assuming a constant valuation and dividend payout ratio, long-term returns are approximately equal to sum of dividend yield and dividend growth. For Realty Income, that sum is about 8%.
So, based on the Dividend Discount Model, investors looking for an 8% long-term rate of return, can pay up to $49 for shares of Realty Income, assuming that a 4% dividend growth rate occurs. If only a 3.5% long-term dividend growth rate is expected, this fair value drops to $43 instead.
If investors are looking for 9% annual returns over the long-term, and are expecting 4% dividend growth per year, then the fair value drops to $39.
Therefore, at $52/share, Realty Income is set to deliver shareholders a rate of return in the high 7% range, which is lower than the historical market rate of return, but comparatively solid for those seeking current income. Because the REIT is trading at a historically high valuation with a correspondingly low dividend yield, caution is advised.
Full Disclosure: As of this writing, I have no position in O.
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