Real estate investment trusts, or REITs, offer some of the best yields in the market. The key to this sector is finding a name that offers a safe, sustainable yield while entering at a price point that your ‘on-paper’ principal is relatively limited on the downside. In addition, we ideally want to find a company that is growing revenues, earnings and the dividend. This will usually lead to a premium valuation being assigned relative to book value, and lead to capital appreciation of the name. Of course, finding this combination and timing a purchase correctly is easier said than done. We do not know what the future holds, but when it comes to REITs, there are several risk factors to be aware of. These include interest rate risks, tenant portfolio mix and associated risks, as well as general stock market malaise. We believe that based on these measures, we have found a strong candidate for a long-term investment in Realty Income (O).
In full disclosure, we exited a position from the company when the stock was trading in the mid-$60 range. But at the time, we bought it for a short-term momentum trade, and not an investment. Today, we are looking at the name for an investment with the long-term investor in mind. Prior to discussing the qualities that we seek in an ideal candidate that we alluded to above, let us first tell you specifically about how Realty Income Income operates.
ABOUT REALTY INCOME
Based out of San Diego, CA, Realty Income was started in 1969 with the goal of providing investors regular dividend income that stems from revenue generated from net-leased real estate related assets. The name has been public since 1994 and has been adding properties to its portfolio every year. Since going public the number of properties has grown from just over 600 to over 5,000, with real estate asset values growing from $450 million to over $14 billion. The company has interests in every state but Hawaii, as well as in Puerto Rico (figure 1).
Figure 1. Geographic Diversification of Realty Income’s Portfolio Interests, As a Percentage Of Revenue Sources, as of June 2017.
Source: Company presentation
With this growth, the company has diversified tremendously with no industry representing more than 11% of the portfolio (figure 2), which we believe makes the company resilient in both good economic times and bad. It is also insulated from sector specific woes, as diversification helps protect the top line. At first glance it may appear that the name is only exposed to retail, however the reality is that the name is also exposed to industrial companies, basic office rentals (think corporate offices), as well as agriculture (figure 3). What we mean is that pain in one sector would not cause catastrophe for the name. It is a small but significant strength. What is more, the company seeks long-term leases of 10-20 years on average, which helps limit turnover in occupancy.
Figure 2. Top Ten Industries Within the Realty Income Portfolio, as of June 2017.
Source: Company presentation
Figure 3. Percentage of Rental Revenues at Realty Income, By Industry, as of June 2017.
Source: Company website and author calculations (graph made in Excel)
While there is diversification, the bears will note that there is indeed overexposure to overall retail. As anyone following our work, or really markets in general will know, retail has been crushed. Retailers have been attempting to slash costs. One approach has been to close down underperforming stores. This could also lead retailers into potentially renegotiating leases at renewal, particularly when we consider retailers’ falling sales over the last two years leading to higher tenant occupancy costs. This could hit the top line for Realty Income longer-term, by leading to less favorable lease terms, or by lower occupancy. That said, occupancy remains strong, and has been strong, even through the Great Recession (figure 4).
Figure 4. Historical Percentage of Available Space Occupied by Tenants at Realty Income Properties.
Source: Company presentation (linked in figure 1)
As you can see, when the economy was at its worst, occupancy remained solid. That said, the Street has assigned some correlation between retail and Realty Income (figure 5). When looking at the trading patterns year-to-date of the SPDR S&P 500 Retail ETF (XRT) and Realty Income, you can see the retail sector has been pounded while Realty Income is about flat. That said, you can see similar trading patterns in the movement of the stocks which we have circled on the graph in green, suggesting that pain in retail can move the stock of Realty Income. While there is not a direct correlation, clearly there is a loose correlation. We believe this is one risk that we must acknowledge, even though the portfolio mix is strong. On the bullish side, according to the company <1% of annualized rents came from retailers that were facing bankruptcy, ensuring the top line is protected (figure 6).
Figure 5. Year-to-Date Trading History of Realty Income (Blue) and the SPDR S&P500 Retail ETF (Red)
Figure 6. Realty Income Exposure to Retailers Facing Bankruptcy in 2017.
Source: Institutional investor presentation
ASSESSING THE INVESTMENT
Now that we have an idea of how the company operates and where it has exposure, let us discuss the quality of an investment here based on the qualities we highlighted in the opening that we look for. That brings us to the dividend, which is why we invest in any REIT, longer-term. Let us first say this. When you visit the company’s website, it is crystal clear that the company’s business plan is to pay 12 monthly dividends, and to grow the dividend. That is a lofty goal, but it has successfully raised the dividend on a regular basis (figure 7). There are regular monthly raises, and generally speaking a big bump at the start of a new year. So, this meets our criteria for growing dividends. But is it secure?
Figure 7. Realty Income Dividend Payment History Since 2008.
Source: Realty Income investor relations dividend history, author calculations (graph made in excel)
Depending on the company, there are a number or ways the dividend could be impacted. To ensure that the dividend is going to continue to grow and be secure, we want to look for two things. First, growing revenues (figure 8). Revenue growth has not been an issue for the company. How is the company able to continue growing revenues? Well it does so by growing the number of properties it possesses and rents each year. At the same time, it has built in to many leases regular rental increases for tenants to help ensure a growing a top line.
Figure 8. Realty Income Quarterly Revenue Growth Since Q4 2013
Source: Seeking Alpha Realty Income earnings summary page (graph made in excel)
Of course, whenever the top line grows we have to be on the lookout for rising expenses offsetting these revenue gains. However, the company has been able to consistently grow earnings (figure 9) in addition to growing revenues, suggesting a strong history of managing expenses in a conservative fashion. While growing earnings per share strongly suggests the dividend is covered effectively, thus providing evidence that our payout is secure, earnings per share is not always the most effective route to gauging dividend coverage. This is something we have discussed in many, many articles. There are better metrics to assess the dividend safety and coverage.
Figure 9. Realty Income Quarterly Earnings Per Share Since Q4 2013
Source: Seeking Alpha Realty Income earnings summary page (graph made in excel)
For a REIT, including Realty Income, we want to really have a sense of funds from operations. This special measure of cash flow into and out of the business, which includes expenses like depreciation and amortization can be compared again what is being paid out as a dividend. Depending on special circumstances and expenditures, an adjusted funds from operations may be reported. For our purposes, we will look to these adjusted figures but bear in mind they may be identical to as reported funds from operations depending on the quarter. For this research piece, we will compare the adjusted funds from operations per share on an annual basis, along with the dividends paid per share. If we take the ratio of the dividends per share paid to the adjusted funds from operations, we have a strong measure for dividend coverage, sustainability and safety. Figure 10 has the details of this analysis. As you can see, adjusted funds from operations have consistently outpaced the dividend. Expressed as a payout ratio, the result has always been comfortably under 1.0, which suggests the dividend is covered and then some. A ratio of 1.0 would suggest that the dividend is perfectly covered by funds from operations. Further, the trend is clearly lower, meaning the dividend is more secure overtime, at least in the time frame selected. This is a strength. Projecting for the rest of 2017, the dividend looks to be between $2.53 and $2.55, while the company expects funds from operations to come in over $3.00 (last update was for $3.03 to $3.07). Even allowing for a $0.28 miss here on the low end, we would still have a payout ratio of just 0.92 at the highest payout and a dismal funds from operations performance. Assuming things are about right on target we are looking at the payout ratio coming in around 0.84.
Figure 10. Annual Ratio of Dividend Payments to Adjusted Funds From Operations Since 2008
Source: Realty Income Income historical earnings and author calculations (excel)
INTEREST RATE RISKS
One issue we have not touched upon yet but have highlighted in many other pieces is the risk from interest rates. We are not going to reinvent the wheel in this analysis, nor repeat information covered previously in detail. What we will say is this. Rising interest rates, especially when they are volatile can hurt REITs in several ways. If the company is borrowing money to invest, it has a higher cost of funds. From an investment standpoint, we buy names like Realty Income for the dividend and yield. If the yield on a ten-year bond rises, it makes an investment in Realty Income and other REITs less attractive because equities carry far more risk to the principal in most cases. Thus, why chase a higher risk yield if you can be assured a safer payout? If you do not believe us take a look at the trading correlation between O and the CBOE Interest Rate 10 Year T Note (TNX) in figure 11. There is a strong negative correlation. We have circled clear trends for you to hone in on. When the rate rises, O falls. Therefore, keeping an eye on interest rates is key. By extension, listening to the Fed is paramount to investing in REITs, as they give clues as to the motion in rates. Such chatter can knock the stock down, providing possible buying opportunities.
Figure 11. Four Year Trading History of Realty Income (Blue) Versus the CBOE Interest Rate 10 Year T Note (Red).
Source: Google Finance
WHEN TO BUY
The last item on our list is timing the buy. There is no perfect answer here. There are so many moving parts. Some like to compare REIT’s book or net asset values to trading price. Some like to look at the price per share relative to adjusted funds from operations per share. In a recent analysis trying to pinpoint fair value, Sovereign Investment Insight looked to several metrics, including considering the bond rating on the name. All things being equal, considering we have quantified the dividend’s security, as well as risks to both the business model and the equity’s trading value, we believe the best measure to utilize is the yield. When we bought this name for a trade, we were simply following momentum, along with movements in the Ten Year. As shares are now approaching $60 once again, now is not the time from a yield perspective. We believe the closer you can get the name to where it is offering a high-yield, which we personally define as 5% or more, you should do some buying. As of June 30, 2017, the annualized dividend was $2.538. At a 5% yield, this would necessitate shares would need to trade at $50.76. However, we recognize that the market does not want to let the stock yield that level. Therefore, a more realistic entry point would be a 4.75% yield. This would suggest an ideal entry point of $53.45. These levels were hit this year, and that would remain our buy point. At 5% or more, assuming the model of the business remains unscathed, we’d be heavy buyers.
WE WANT YOUR THOUGHTS
This research piece is part of a change in direction for Quad 7 Capital as a long-term contributor and provides insights into how we invest our in our own portfolio. As such, we want to hear from you. What have we missed that might be glaringly obvious? While we cannot cover every detail in just one piece, are there oversights? What do you think of the future for Realty Income? Let the community know below.