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Realty Income Corporation (O)

Realty Income was founded in 1969 and is one of the largest REITs in America. The company owns more than 5,000 properties located in 49 states and leases its buildings to over 250 commercial tenants operating in 47 diverse industries. 

In recent years the REIT has begun diversifying into non-retail properties, including offices (5% of rental revenue), industrial warehouses (13%), and farm land (2%). However, retail properties still generate approximately 80% of total rental revenue.

All of the company's properties are under long-term triple-net lease agreements, which provide solid cash flow visibility and shift property operating expenses such as maintenance, utilities, insurance and taxes to the tenant.

In other words, the rental revenue received by Realty Income has substantially fewer expenses and more stable net cash flow compared to REITs with a smaller mix of triple-net leases.

Business Analysis

Realty Income has increased its monthly dividend more than 90 times since 1994 and paid uninterrupted dividends for nearly 50 years. Few companies have maintained as strong of a dividend growth track record as Realty Income.

The company’s success is driven by its diversified portfolio, disciplined capital allocation, focused business strategy, and strong financial health. These factors have combined to create an extremely resilient business.

Realty Income’s long-term growth has been nothing short of outstanding. Since 1994, the company has grown its real estate assets (at cost) from $451 million to more than $12 billion; expanded the number of industries served by its portfolio from 5 to 47; increased its number of commercial tenants from 23 to 251; and boosted its annual revenue from $49 million to more than $1 billion.

Management’s growth strategy over this time has been very focused. The company leverages its relationships with tenants, property developers, brokers, investment banks, and other parties to source acquisition opportunities with strong initial cap rates and built-in rent growth.

Realty Income will only purchase freestanding, single-tenant properties located in big markets and/or key locations that it can lease to tenants with superior credit ratings and cash flows. In fact, tenants with investment grade ratings account for 39%, 80%, and 88% of total rental revenue from the firm's retail, industrial, and office segments, respectively. 

The retail business is very much driven by location, and Realty Income’s portfolio clearly plays to this critical success factor. The company’s occupancy rate has never dipped below 96% going all the way back to 1992. Sustained high occupancy rates signal the high quality locations of Realty Income’s properties and the financial strength of its tenants, which have helped the firm recapture more than 99% of prior rent on re-leasing activity since 1996, protecting cash flow.

High occupancy rates are also indicative of the switching costs faced by consumer-focused retailers, who don’t want to risk disrupting their established customer base by moving to a new location to save a bit on rent.

Equally important, Realty Income is not betting on any one client or industry for its future success. After all, a high occupancy rate is of little value if a single tenant accounts for a major portion of rent (e.g. 15%+ of total rent) and goes under or decides to walk away after its leases expire.

Realty Income’s largest tenants by rent are Walgreens (6.6%), FedEx (5.2%), Dollar General (4.0%), LA Fitness (4.1%), and Dollar Tree (3.6%). Its three largest industries by rent are drug stores (10.8%), convenience stores (9.5%), and dollar stores (7.8%), and no state accounts for more than 10% of total rent.

Importantly, Realty Income focuses on leasing to tenants that have a service, non-discretionary, and/or low price point element to their business. Over 95% of the company’s retail tenants possess at least one of these components, which help them survive a variety of economic conditions and better compete with internet retailers. The company's business model is very different from shopping center and mall REITs, which face greater uncertainties and have higher risk.
Source: Realty Income Investor Presentation

As previously mentioned, investment-grade-rated tenants also account for more than 40% of Realty Income’s total annualized rental revenue. All of these characteristics combine to create a durable and stable stream of rental revenue.

Realty Income’s lease renewal schedule is also favorable. Less than 25% of its rental revenue is up for renewal over the next five years, and no more than 9% of its total rent is up for renewal any single year through 2031. The company’s weighted average remaining lease term is also 10 years, and most of its contracts have annual rent increases built in (usually 1% to 1.5% annually).

By staggering lease renewals, Realty Income avoids the risk of needing to renew a substantial amount of its leases at potentially less attractive rates during a down economy.

A final strength of Realty Income’s business is its own financial health. REITs are required to pay out almost all of their taxable income in the form of dividends, leaving very little capital for reinvestment. 

As a result, REITs primarily rely on external financing (i.e. raising debt and issuing shares) to fund their property acquisitions. In fact, Realty Income's share count has more than tripled since 2005 to help fund its property acquisitions.

Realty Income targets a conservative capital structure with more than 70% equity and less than 30% long-term debt. Nearly 100% of the company’s debt has a fixed interest rate, which protects near-term earnings from rising interest rates. Its debt maturity schedule is also well laddered, and its leverage metrics are healthy. 

As a result, each of the major credit agencies has assigned Realty Income’s senior unsecured notes and bonds an investment grade credit rating. Strong credit ratings help the company secure very low-cost funding to finance property acquisitions, providing it with another advantage over its rivals.

As long as Realty Income continues to have access to external financing for growth, there should be no shortage of properties for the company to acquire. The total size of the single tenant retail property market is estimated to be approximately $1 trillion, according to National Retail Properties. Realty Income’s revenue sits near $1 billion, leaving plenty of room for future growth.

Overall, it’s hard not to like Realty Income’s business. The company owns thousands of extremely valuable retail locations; is diversified by tenant, industry, and geography; maintains a conservative capital structure; has plenty of opportunities for future growth; and has a long track record of creating value for shareholders. Realty Income will likely remain a force for many years to come.

Key Risks

It’s challenging to identify many risks that could impair the long-term earnings potential of Realty Income.

The company’s diversification, financial conservatism, and focus on quality tenants and defensive, Amazon-resistant industries eliminate many fundamental risks faced by other REITs.

Realty Income is significantly exposed to the consumer retail sector (80% of total rent), which is constantly evolving due to changing consumer preferences and the continued rise of e-commerce.

However, Realty Income is not overly exposed to any single industry and derives the majority of its retail rent from tenants with business models that are less susceptible to online spending (e.g. dollar stores, services).

Simply put, it seems unlikely that the continued rise of e-commerce would materially impact demand across many of Realty Income’s tenants, much less jeopardize their ability to continue making rent payments.

Aside from analyzing the health of a REIT’s tenants, it’s always worth mentioning that REITs face higher capital market risk than most other types of business models.

REITs are required to pay out at least 90% of their taxable income as dividends, which means they have less capital at their disposal to grow their businesses. As a result, they need to issue shares and raise debt to finance property acquisitions and grow their cash flow.

If capital markets freeze up, interest rates rise quickly, and/or business conditions deteriorate, dividend cuts can become a real risk, depending on the REIT. Growth plans can also slow down significantly when a REIT's cost of capital rises. 

Realty Income is conservatively financed and focuses on high quality tenants with less economy-sensitive businesses, helping mitigate these risks. However, it’s an important risk to remain aware of for other REITs.

Overall, Realty Income seems to have low fundamental risk.

Closing Thoughts on Realty Income

Realty Income’s predictable cash flow, strong balance sheet, disciplined approach to acquiring properties, portfolio diversification, and access to low cost capital make its dividend among the safest of any REIT’s. These factors also help ensure that management can keep growing the business (and the payout) for the foreseeable future – regardless of where interest rates or the economy turn.

Simply put, Realty Income is arguably the most reliable monthly dividend stock in the market for conservative investors seeking a blend of current income and moderate but dependable payout growth.

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