(Published by Bob Ciura on April 20)
Real estate investment trusts, or REITs as they are more commonly known, are great sources of income.
It is not uncommon to find REITs with dividend yields that are several percentage points above the Standard & Poor's 500 average, which hovers around 2% right now.
Realty Income (O, Financial) and Omega Healthcare Investors (OHI, Financial) are no different.
Both stocks have dividend yields well above the index average.
Each stock has a long history of raising its dividend regularly. Realty Income and Omega are both Dividend Achievers, a group of 265 stocks with 10-plus years of consecutive dividend increases.
You can see the full Dividend Achievers List here.
Realty Income and Omega are high-quality dividend stocks because they have strong real estate portfolios and generate steady cash flow.
If an investor chose between them, which one would be the better investment today?
Business overview
The REIT business model typically involves purchasing properties through a mix of debt and equity financing. The cash flow generated by those properties helps purchase new properties, which then throw off additional income.
This helps create a “snowball” effect that helps REITs generate growth over time. In addition, they can periodically raise rents to build revenue growth.
Realty Income’s portfolio is comprised mostly of retail properties, such as retail outlets, drugstores, movie theaters and fitness gyms.
In all, it has a portfolio of more than 4,700 properties.
Source: 4Q Investor Presentation, page 14
Approximately 79% of Realty Income’s rental revenue comes from retail properties.
Omega has a different property portfolio than Realty Income. It invests in health care properties. It is the largest REIT focused on skilled nursing.
Approximately 86% of Omega’s 981 operating facilities are skilled nursing. The other 14% is comprised of senior housing.
Its portfolio is spread out across 42 U.S. states and the U.K.
Moreover, 83% of Omega’s portfolio is made up of rental properties with a mix of mortgages and direct financing leases making up the remainder.
Source: March 2017 Investor Presentation, page 19
Realty Income and Omega both utilize the triple-net lease structure. They both purchase properties to lease under long-term agreements.
The triple-net structure means that, in addition to paying rent each month, the tenant is responsible for the property’s operating expenses, such as taxes, maintenance and insurance.
This leasing method reduces exposure to rising property expenses and helps maintain a fairly predictable cash flow stream over the long term. These are positive factors that provide consistent growth, which helps support dividend payouts.
Growth prospects
Both REITs are generating growth.
Realty Income’s adjusted funds from operation (FFO) rose 5.1% in 2016, thanks to rising rents and occupancy.
Omega’s adjusted FFO per share increased 9.3% last year to $3.42.
Omega likely has stronger growth prospects than Realty Income moving forward for two reasons.
First, Omega’s focus on health care properties puts it in a great position to capitalize on the aging population.
The U.S. and U.K. are aging populations with large numbers of people in or nearing retirement. This is expected to create rising demand or health care properties such as skilled nursing and senior housing, which will be a long-lasting tailwind for Omega.
The fundamentals of health care real estate are attractive.
Source: March 2017 Investor Presentation, page 11
Second, Realty Income is heavily exposed to the retail industry. It could suffer from the deterioration of brick-and-mortar retailers.
Internet retailers, led by Amazon.com (AMZN, Financial) and others, are waging war against physical retail. If the trend continues, it could eventually put downward pressure on Realty Income’s rents and occupancy rates in the years ahead.
Dividend analysis
Realty Income has an advantage when it comes to dividends, as it makes monthly dividend payments to shareholders.
Most companies, including Omega, pay quarterly dividends. Realty Income’s monthly payout helps investors compound their dividends at a faster rate.
Realty Income has a dividend history that is very hard to beat. Its April dividend payment is its 561st consecutive monthly dividend. That makes nearly 47 years of uninterrupted dividends.
Realty Income has increased its dividend 91 times since its listing on the New York Stock Exchange in 1994.
Source: 4Q Investor Presentation, page 38
One downside for Realty Income is that its dividend yield is relatively low, compared with its average yield over the past several years.
The company has a current annualized dividend of $2.532 per share, which works out to a roughly 4.1% yield.
This is still double the average yield in the S&P 500, but it wasn’t too long ago that Realty Income was a 5% yielder. Its share price has increased 65% in the past five years, which has brought down its dividend yield.
Meanwhile, Omega is a much higher-yielding stock. Its current dividend yield is 7.2%.
The reason for the disparity is that Realty Income stock has a much higher valuation. The rally in its share price has elevated its valuation.
The two stocks have price-to-FFO ratios as follows, based on 2016 results:
- Realty Income: 22.
- Omega: 10.
Investors have kept a tight lid on Omega’s valuation multiple, which has kept its dividend yield high.
One reason for this could be Omega’s more aggressive balance sheet. It is more highly levered than Realty Income.
Source: 4Q Investor Presentation, page 34
Realty Income maintains a fairly conservative capital structure.
As a result, it has superior credit metrics. It holds a credit rating of BBB+ from Standard & Poor’s, which is solidly investment grade.
Meanwhile, Omega has a credit rating of BBB-, which is just one notch above junk status.
Realty Income’s low cost of capital is a competitive advantage because it allows the company to lock in more competitive financing to use for property acquisitions.
Final thoughts
Both Realty Income and Omega are high-quality companies with dividends that are sufficiently supported by their cash flows.
In the end, which of the two REITs is a better buy largely rests on the investors’ risk tolerances.
Realty Income is the slow and steady pick of the two. It has a much lower dividend yield and higher valuation multiple.
Its future returns likely have a lower ceiling than Omega’s but a higher floor as well.
Omega has a much higher dividend yield and could generate stronger growth moving forward, thanks to its stronger industry fundamentals.
But it also has a lower credit rating. If interest rates are about to rise, this could be a challenge.
As a result, Omega’s dividend yield and valuation are more attractive while Realty Income is the better pick for risk-averse investors.
- To see how Realty Income compares with one of its closest competitors, W.P. Carey (WPC, Financial), click here.
- To discover a high-quality REIT with a 9% dividend yield, click here.
Disclosure: I am not long any of the stocks mentioned in this article.
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