It’s something of a misnomer to view dividend growth investors as only concerned with income. Those that follow a dividend growth investment philosophy also value share price appreciation as this, coupled with dividend yield, can provide market beating returns.
Personally, when looking for income, I am also concerned with the underlying company’s ability to grow its business. A growing business tends to lead to earnings and free cash flow, which in turns leads to dividend growth.
One of my favorite income producing names that appears headed for future growth is Realty Income Corporation (O, Financial). The real estate investment trust recently reported a solid quarter and announced a merger that is likely to benefit shareholders and lead to future dividend increases. Let’s look at why I continue to view Realty Income as a core holding.
A rundown of earnings results
Realty Income announced first quarter financial results on May 3. Revenue grew 6.9% to $442.8 million, which was $26.7 million above what Wall Street analysts had expected. Adjusted funds from operation per share, or AFFO, of 86 cents was a 2.2% decrease from the prior year, but 12 cents better than expected. The year-over-year decline in AFFO was due to a higher share count. Adjusted funds from operation grew more than 7% without the share dilution.
The trust’s 6,662-property portfolio was 98% leased in the quarter, down from 98.5% in the same period a year ago but up from 97.9% in the fourth quarter of 2020, so Realty Income did see a slight sequential improvement in this area.
Recent collection stayed the same or improved amongst nearly every client category. Total rent collected across the portfolio was 94.1% for the quarter, which is a 50 basis point improvement on a sequential basis. The trust’s top 20 clients had rent collection of 89.8%, which was stable during the quarter. Those clients with an investment grade credit rating, which includes names such as Walgreens Boots Alliance (WBA, Financial), Dollar General (DG, Financial) and FedEx Corporation (FDX, Financial), had 100% of rent collected each month of the quarter.
Realty Income’s weakest client categories were those that have been most severely impacted by the Covid-19 pandemic. Theater clients remains the most challenged as total rent collection was just 14% in the first-quarter. A loosening of restrictions did have a small impact on this group as the quarter progressed as rent collection went from 13.3% in January to 15.5% in March. The category has a long way to go before it is out of the woods, but a small improvement is a positive sign.
Rents collected from health and fitness clients improved 500 basis points from the first month of the quarter to the last, with nearly 92% of rents collected overall. Health and fitness and theaters represent 7% and 6% of Realty Income’s total real estate portfolio, respectively, and 6.4% and 5.6% of total revenues, respectively.
Realty Income is often in the business of acquiring additional properties. The trust purchased 77 properties in the U.S. with an average lease term of 13.5 years and an initial average cash lease of 5.6%. Realty Income has also started to expand its international presence, adding 12 properties in the U.K. with an average lease term of more than 10 years and an initial cash lease yield of 4.9%. In total, the trust invested more than $1 billion in properties and properties under development in the most recent quarter to go along with an additional $1 billion in investments in the fourth quarter of last year.
Adjusting for a 13-cent headwind from early redemption of debt, Realty Income expects FFO of $3.44 to $3.49 for 2021. This would be a 2.4% increase from the prior year and a new record for the trust, an impressive feat considering that the share count has nearly tripled since 2011.
Merger details
The trust’s most recent quarter showed improvements in most areas, but its another announcement around the same time is what has me very bullish on Realty Income’s future.
On April 29, Realty Income announced that it had agreed to purchase VEREIT, Inc. (VER) in an all-stock transaction. Following the completion of the merger, VEREIT shareholders will receive 0.705 shares of Realty Income shares for every share of VEREIT that they own.
Immediately after the closing of the merger, the combined trust will spin-off nearly all of the office properties in the portfolio into a new, self-managed and publicly traded REIT. The new trust will have 97 properties initially, with high concentrations in healthcare, telecommunications, insurance and financial services. Realty Income investors will own ~70% of the spin-off with VEREIT shareholders owning the remainder. Both transactions are expected to take place in the fourth quarter of this year.
The merger will have several significant impacts on shareholders of the new Realty Income. First, Realty Income expects that AFFO will be 10% accretive from the midpoint of the trust’s guidance for the year. The trust had AFFO growth of 5.4% from 2011 through 2020, so this expected increase in the first year is very meaningful.
The merger will also make Realty Income one of the six largest REITs in the U.S. REIT Index, giving the combined entity a sizeable advantage over most of its peers.
The trust also expects the dividend, one of the primary reasons many investors have a position in the name, will continue uninterrupted. VEREIT shareholders will, once the merger is closed, begin to see a monthly dividend payment from Realty Income just as shareholders of the latter already enjoy.
Realty Income will also see cost synergies of $45 million to $55 million, three-quarters of which are expected to be achieved within a year of the merger. In terms of general and administrative expenses as a percentage of gross real estate value, Realty Income and VEREIT already possessed the two lowest figures in the triple net lease industry, but now this percentage will be even lower as a result of cost synergies.
An additional benefit to the merger is that VEREIT will benefit from Realty Income’s credit rating when it comes to refinancing debt. VEREIT had nearly $6 billion of outstanding debt at the end of last year with a weighted average interest rate of around 4% and an average term to maturity of nearly six years. Realty Income has a credit rating of A3 from Moody’s and A- from Standard & Poor’s, both of which are considered medium investment grade. Realty Income is one of just eight other REITs in the U.S. to have two credit ratings at least this high.
These credit ratings are both higher than VEREIT’s credit rating, though Moody’s did announce that it had placed the trust’s credit rating on review for upgrade after the announcement of the merger. Benefiting from Realty Income’s solid credit rating, VEREIT’s debt will likely be able to be refinanced at much lower rates. With access to capital, and cheap capital at that, REITs are able to make investments in properties to help grow the business. The lower costs to do so will be a tailwind to the trust.
The merger and the subsequent spinoff will result in a diversified global portfolio of more than 10,000 mostly single-tenant and triple net lease real estate properties. Realty Income will have properties in every state in the U.S. as well as Puerto Rico and the U.K.
Source: Investor presentation
Total portfolio annualized rent should reach $2.5 billion, with 45% of rent generated from clients with investment grades. The makeup of the top 10 industries will largely remain the same, except that theaters and health and fitness clients as a percentage of the total portfolio will drop. No industry will make up more than 9% of the total portfolio. Top tenants will largely remain the same as well, though the percentage of the total portfolio declines slightly for most names.
The merger with VEREIT will make Realty Income into a more diversified business with less reliance on any one industry or tenant. The merger will also make Realty Income the largest triple net lease operator in terms of enterprise value by a wide margin. The combined entity has an estimated enterprise value of nearly $50 billion, with its next closest competitor at less than $20 billion.
Final thoughts
Realty Income trades at $70 per share. With an expected AFFO midpoint of $3.47, the stock has a forward price-AFFO ratio of 20.2. Shares have had an average price-AFFO ratio of 18.9 since 2011. The current valuation premium isn’t terrible and perhaps even warranted given the positive from the pending merger with VEREIT. Using the trust’s guidance of the merger adding 10% to this year’s AFFO would give Realty Income a forward price-AFFO ratio of 18.3, a slight discount to the long-term average multiple.
Realty Income produced a solid quarter, which, if not for a higher share count, would have demonstrated growth both for revenue and AFFO per share. The trust maintains a very high occupancy rate that most peers cannot top.
The pending merger with VEREIT is very attractive in that it will transform Realty Income into one of the largest publicly traded REITs as well as offer further diversification of its business. Not overly relying on one industry group or tenant provides Realty Income with protection in case of a weak environment.
Realty Income has increased its dividend for 26 consecutive years and pays a yield of 4% at the moment. Though this is below the stock’s 10-year average yield of 4.5%, it is superior to the 1.4% average yield of the S&P 500 index.
Given the positive outlook of the business, expected growth due to the merger with VEREIT, the reasonable valuation, yield and dividend growth history, Realty Income remains one of my favorite investment options in the entire market place. The name is also one of the five largest holdings in my portfolio. Investors looking for exposure to the REIT sector could do well buying shares of Realty Income.
Author disclosure: the author maintains a long position in Realty Income, Dollar General
