The Financial Health of Realty Income's Tenants is On Watch, but the Dividend Continues to Look Safe

What is a landlord to do when many tenants, all at once and to no fault of their own, can't operate their businesses and are strapped for cash?

This is the question facing Realty Income (O), whose dividend, having never experienced a cut since the firm's founding in 1969, is under its greatest test ever.

Realty Income is set to report earnings on May 4, and management will provide insight into the impacts of the coronavirus pandemic on tenants then.

For now, based on our analysis below, we are maintaining Realty Income's Very Safe Dividend Safety Score. However, a downgrade could be in order if evidence arrives that many tenants will suffer mightily for longer than a few months.

Our initial estimates indicate that between 20% and 40% of the company's rental revenue is sourced from businesses considered non-essential and likely closed.

These non-essential businesses include gyms (7.3% of rental revenue in 2019), movie theaters (6.7%), and a wide variety of retailers and other shops.

Even businesses that are considered essential and remain open may be suffering as people stay home and reduce discretionary spending.

The bottom line is that many tenants are reeling and likely requesting reductions or deferrals on rent until operating conditions stabilize.

Spirit Realty (SRC), another retail REIT, revealed yesterday that the firm had received rent deferral requests equating to about 40% of total revenue. Deferrals range from 30-90 days and are to be paid back within 12 months.

While the two firm's portfolios are somewhat different, our analysis suggests that a similar percentage of Realty Income's revenue may be at risk of deferral.

When a tenant is in distress, landlords often have the upper hand in negotiations since the tenant can be evicted and replaced with a new one.

But since few brick-and-mortar businesses will be seeking to expand or move during the pandemic, Realty Income's leverage in negotiations is greatly reduced.

The good news is that the stimulus act passed by Congress includes a program to cover two months of payroll and rent for small businesses and certain chains, making it somewhat easier for REITs to push back on rent deferral requests.

In fact, Spirt said that the firm had so far approved only a quarter of deferral requests, which probably constitutes less than 5% of total annual rent revenue.

However, rent deferral itself is not the major issue since landlords will, in theory, still receive what they're owed in due time.

The larger questions are how much rent will actually end up being collected and what lasting effects the pandemic will have on the financial health of tenants.

After all, even if the economy were to fully reopen tomorrow, many people may continue to avoid gyms, movie theaters, restaurants, etc. until the virus is gone.

Some businesses are even considering enforcing reduced capacity to ensure the safety and comfort of customers, according to the Wall Street Journal.

The longer it takes for life to return to pre-pandemic normalcy, the more likely it is that some tenants won't survive or will require rent relief to stay in business.

And if the economic downturn is severe and prolonged, finding replacement tenants will be difficult, impairing Realty Income's leverage in rent negotiations.

The bottom line is that while Realty Income, as a mere collector of rent, is one step removed from the financial health of tenants, the firm still depends on a strong economy for its own business to thrive.

As a result, it's likely that the firm's revenue will take a hit this year, and perhaps even next year. But the extent and duration of the decline is highly uncertain.

Despite poor visibility into short-term prospects, we expect Realty Income's strong balance sheet, investment grade A- credit rating from Standard & Poor's, and relatively low payout ratio coming into this crisis to support the dividend.

For one, we estimate that Realty Income's rental revenue could fall by as much as 14%, and the dividend would still be covered by cash flow. (For context, Realty Income's revenue declined by less than 1% during the last recession.)

But let's say Realty Income's ability to collect rent is even more severely impacted by the pandemic, and revenue declines by 50% this year.

In this extreme scenario, the firm's cash flow would come up about $600 million short on covering the dividend, so management would be required to use cash reserves or borrow money in order to maintain the dividend.

As of April 9, Realty Income had $1.25 billion of cash on hand and could borrow up to $2.2 billion under its revolving credit facility, which doesn't expire until March 2023. Less than $350 million of debt is due for repayment in 2020 or 2021, too.

With substantial liquidity and manageable near-term debt repayments, Realty Income should be able to keep the dividend a priority.

Realty Income's net debt to capital ratio currently sits at a conservative level of 45%. By taking leverage up to 49% (still a moderate level), the firm could borrow $1.2 billion, enough to cover a $600 million annual shortfall for two years.

Of course, a 50% decline in revenue would imply a catastrophic situation unfolding for tenants and the economy in general.

Under such extraordinary conditions, credit markets may become inaccessible and management might question whether it's prudent to take on more debt.

The point, however, is that Realty Income has a high degree of flexibility to maintain the dividend in a wide range of scenarios if management so chooses.

Given the importance of Realty Income's dividend track record to the firm's reputation with investors, it seems likely that management will remain committed to the dividend so long as conditions don't spiral out of control.

Indeed, Realty Income just announced its regular monthly dividend today.

For now, we feel comfortable maintaining Realty Income's Very Safe Dividend Safety Score. However, we will be keeping a close eye on the health of the firm's tenants and will provide updates as new information arrives.