Realty Income (O) is dividend darling that needs no introduction. In this column we want to get right into a discussion of two risks associated with the company. The first is exposure to retail. The second is interest rates. The former could have an impact on the top line, while the latter impacts the trading of the stock as we will show you in this piece. It is in our opinion vital that you be aware of these issues so you can properly time your entry and/or add-on buys.
Let us first discuss the retail issue. While there is diversification, the bears will note that there is indeed overexposure to this sector for Realty Income. As anyone following our work, or really markets in general will know, retail has been crushed. While there seems to be some light at the end of the tunnel as management teams across the sector implement their corrective action plans to regain market share and loyal customers, sales continue to fall. Just today we learned that August retail sales fell, despite expectation for positive gains. The pain is real. Now, to manage expenses and protect the bottom line during these times of extreme revenue pressure, retailers have been attempting to slash costs. One of the ways that many retailers achieve this is to close down underperforming stores. While there are lease terms to be abided by and every lease is different, certainly we can see that if a retailer is struggling it may not renew, and shutter the storefront. While Realty Income is rather adept at maintaining an occupancy rate over 95%, it certainly is a risk. Pain in this sector 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, as has been detailed in several pieces.
When the economy was in the doldrums, occupancy remained solid. However, we must realize that there is a noticeable positive correlation between trading in the retail sector, and in the trading of Realty Income. Therefore, not only is retail weakness a risk factor for Realty Income’s top line, it is a clear risk factor for the stock as well. Keep this in mind. The astute investor that likes to trade around a core position in the name can leverage this fact. That said, the Street has definitely assigned some correlation between retail and Realty Income (figure 1). As you can see in figure one, when looking at the trading patterns year-to-date of the SPDR S&P 500 Retail ETF (XRT) and Realty Income, we notice the correlation. Overall, the retail sector got crushed and Realty Income is about flat. However, the sharp eye can detect similar moves in the charts of both. We have gone ahead and highlighted these correlations on the graph in green. This strongly supports our thesis that pain in retail, not only on the business operations side of the equation, but on the equity trading side, can move the stock of Realty Income.
Figure 1. Year-to-Date Trading History of Realty Income (blue) and the SPDR S&P500 Retail ETF (Red)
Google Finance, author modifications
Admittedly, the correlation identified above in our analysis is not a perfect/direct relationship, however there clearly is a positive correlation and it deserves to be acknowledged. The retail risk is real. Even though the portfolio mix of the company is strong (figure 2), the bulk of rents are from the retail sector, and therefore the correlation the market appears to be assigning is somewhat appropriate. That said, what we have identified as a key risk also has some bullish undertones. On the bullish side, we dug into recent presentations and have found that <1% of annualized rents came from retailers that were facing bankruptcy, ensuring the top line is protected (figure 3). To be clear, a bankruptcy does not mean rent isn’t paid (it can mean that, depending on the type of bankruptcy), so this fact is a key finding considering the overexposure to retail.
Figure 2. Percentage of Rental Revenues at Realty Income, By Industry, as of June 2017.
Source: SEC Filings
Figure 3. Realty Income Exposure to Retailers Facing Bankruptcy in 2017.
Source: Institutional investor presentation
One key takeaway from the above data, as well as what we saw after digging into call transcripts is that the present retail portfolio is resilient. What do we mean? CEO John Case stated in the Q2 conference call:
“Within our retail portfolio over 90% of our rent comes from tenants with a service, non-discretionary, and/or low price point component to their business. We believe these characteristics allow our tenants to compete more effectively with e-commerce and operate in a variety of economic environments. These factors have been particularly relevant in today’s retail climate, where the vast majority of U.S. retailer bankruptcy’s this year have been in industries that do not share these characteristics.
We continue to have excellent credit quality in the portfolio with 46% of our annualized rental revenue generated from investment grade rated tenants. The store level performance of our retail tenants also remains sound. Our weighted average rent coverage ratio for our retail properties remains 2.8 times on a four-wall basis, and the median remains 2.7 times. Our watch list has declined by approximately 15 basis points and remains in the low 1% range as a percentage of rent, which is consistent with our levels of the last few years.”
We take this to mean that despite the pain, the overall portfolio remains strong, and is on par with recent years. Further, the company’s tenants are well positioned to take on and adapt to an evolving consumer. Still, the retail risk must be on your radar at all times.
This takes us to our second identified risk that we feel is vital to having a grasp on when considering an investment in this name. Namely, there is a prevalent risk from interest rates, and specifically, volatility in those rates. Rising interest rates, especially when moving up or down can certainly impact REITs in several ways. What do we mean? Well if the company is borrowing money to invest, as rates rise, it has a higher cost of funds. This can impact every aspect of the business. The best way to look at it is from an elementary standpoint. If it costs more to do business, it can impact earnings and cash flow. That is an operational risk.
From an investment standpoint, we buy names like Realty Income for the dividend and yield. This is where rates really start to impact us. If the yield on a ten-year bond rises, it makes an investment in Realty Income and other REITs less attractive to big money investors because equities carry far more risk to the principal in most cases than a bond. So what does this mean? Put yourself in the role of the big money manager trying to squeeze out returns while limiting downside. Why take on additional risk for limited additional reward? We believe that we have identified a key pattern that you must be ware of. There is an direct trading correlation between O and the CBOE Interest Rate 10 Year T Note (TNX), as shown in figure 4. There is a clear strong negative correlation. Once again for the ease of your eyes and to highlight visually our thesis, we have marked several clear trends for you to focus on here. From an elementary standpoint, this should be your take home message. As rate rises, O falls. We believe this is less to do with operational risk above, and more of investor risk. Therefore, keeping an eye on interest rates is absolutely key. This is why REITs move so much after Fed meeting minutes, rumors, etc. Of course, for the long-term investor when these issues knock the stock down, possible buying opportunities arise.
Figure 4. Four Year Trading History of Realty Income (blue) Versus the CBOE Interest Rate 10 Year T Note (Red).
Source: Google Finance, author modifications
Now, we have had a great history of dividend raises with the company. The question is ‘are these risk factors above detrimental to the dividend?’ The answer is absolutely, though they would have to be far more exacerbated before the pinch was truly felt. Even with all of the pain in retail, revenues have continued to rise (figure 5). Revenue growth has not been an issue for the company. It grows revenues by developing new properties each year, carefully drafting tenants and calculating 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. Some may question whether the company has growth opportunities left. This is a risk, as the company is in 49 states and Puerto Rico. We would argue there is still state level growth opportunities, but in the long run, Mexico and Canada cannot be ruled out. This could be a huge potential source of growing revenues over the next decade. That said, we care whether our dividend is safe, and it can keep growing.
Figure 5. Realty Income Quarterly Revenue Growth Since Q4 2013
Source: SEC Filings, Seeking Alpha O Earnings Page (graph made in excel)
For REITs, we want to really have a sense of funds from operations. This is simply a 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. For this research piece, we compared the adjusted funds from operations per share on an annual basis, along with the dividends paid per share. We then took the ratio of the dividends per share paid, to the adjusted funds from operations. This calculation gives us a strong indicator of dividend coverage, sustainability and safety. In figure 6 we provide a nice visualization of what we are seeing. Here is the bottom line. The dividend is safe, and we see no reason the growth won’t continue in the near-term, provided retail doesn’t completely fall off a cliff performance wise. Why do we believe this? This is because 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 means perfect coverage. But wait, there’s more!
Figure 6. Annual Ratio of Dividend Payments to Adjusted Funds From Operations Since 2008
Source: Realty Income Annual Reports and author calculations (excel)
Not only is the dividend sufficiently covered year-after-year, but we have identified an important trend as it relates to an investment in the name longer-term. As you can see above the payout ratio is clearly trending lower, meaning the dividend has actually become more and more secure over time, at least in the time frame selected. This is a major strength. As we look forward and 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). Assuming things are about right on target we are looking at the payout ratio coming in around 0.84.
Going back to the two risk factors we have identified above, we can time a buy. Now, there is no easy answer to the question of ‘what price should I pay?’ Some investors like to compare REIT’s book or net asset values to trading price. Others examine things like the price per share relative to adjusted funds from operations on a per share basis. In this piece we have quantified the dividend’s security, as well as risks to both the business model on the retail end as well as risks to the equity’s trading value. Equipped with this information, our preferred measure the yield being offered by the name. Essentially, the higher the yield (provided it is safe, which we have shown it is), the better reward for our risk. As shares are now approaching $60 once again, now is not the time to buy based on our measure. A realistic entry point would be a 4.75% yield. This would suggest an entry point of around $53.45. These levels were hit this year, and that is where we think you are offered a strong opportunity in the name. Should it get there, be sure to keep a close watch on movement in retail, and interest rates, as these are very prevalent risks.