Realty Income, self-proclaimed “The Monthly Dividend Company,” is a revered dividend aristocrat with a 5.2% dividend yield and it has delivered for many investors for decades. But it’s still a retail REIT, and the impacts of COVID-19 social distancing are different than anything the company has experienced in the past. The shares have sold off hard, and some investors are left wondering if this a big warning or a big opportunity? This article reviews the health of the business, valuation, risks, dividend safety, and concludes with our opinion on investing.
Overview:
Realty Income Corp is Retail REIT focused on acquiring and managing commercial real estate properties. The company is a member of the S&P 500 Dividend Aristocrats index for having increased its dividend every year for the last 25 consecutive years. The company’s portfolio consists of 6,483 properties that generate rental revenue from long-term lease agreements with commercial tenants. The property portfolio is well diversified with 301 different commercial tenants across 50 different industries in 49 states in the US. 83% of its rental revenue is from traditional retail properties. It has high-quality tenants, such as FedEx and Walmart.
(source: Company Data)
According to the company, nearly 96% of its rent is protected against e-commerce threats (i.e. the whole “internet is killing brick-and-mortar” narrative). This is primarily due to exposure to non-discretionary, low price point and service-oriented businesses. These account for nearly 79% of the total rent while the remaining 17% is from non-retail tenants (which are also supposed to be largely ecommerce resilient). To give a couple of examples, drug stores (such as Walgreens, CVS) make up more than 20% of total rent; Dollar stores make up ~7.3% of total rent. These businesses are typically resilient against e-commerce (however, COVID-19 is something different—more on this later).
Importantly, given company’s portfolio it is not materially impacted by recent retailer bankruptcies. The company notes that 60 of 79 US retailer bankruptcies since 2017 were associated with companies lacking a non-discretionary, low price point, and / or service-oriented component to their business.
(source: Company Presentation)
Important to note, we are encouraged by the credit quality in the portfolio, with nearly half of total annualized rental revenue generated from investment grade rated tenants. Also, the company’s tenant profile has become far superior compared to the last financial crisis of 2009. We think, it is far better positioned to handle the current the COVID-19 crisis. For instance, in 2009, Realty Income’s investment grade tenants in the top 15 were just 3.2% of revenue and the company had high exposure to highly cyclical sectors such as casual dining and quick service restaurants (QSRs). Today, 29% of its top 15 revenue comes from investment-grade tenants, and the share of defensive and less cyclical sectors such as convenience stores and drug stores has increased considerably.
This diversification has helped it to maintain steady cash flows and reduce its sector downturns. This also explains its high occupancy rates which has never fallen below 96% since listing which in itself is an unbelievable track record. Currently, the occupancy rate is nearly 98.6% and it is expected to be around 98% in 2020. We note that the entire period includes many recessions (such as dot-com bubble, financial crisis) and yet the company has stood strong. While the ongoing COVID-19 pandemic will have a negative impact on Realty Income as well but given its inherent portfolio strength we expect the damage to be limited and the bounce back to be much quicker.
Strong, Sustainable and Growing Dividend
Realty Income is a monthly dividend paying REIT and has a history of raising the dividend every year since 1994. Over this period, it has paid 89 consecutive quarterly dividend and increased the dividend 105 times. Realty Income increased dividend five times during 2019 and has already increased twice during 2020. The current monthly dividend of $0.2325 per share represents annualized dividend per share of $2.79 and an annualized yield of ~5.2% based on the current market price. We think the dividend is extremely strong and sustainable given the history of continuous FFO per share growth. Additionally, the payout ratio for the company is around 80% which further bolster its ability to continue paying dividends. This means even if Realty Income experiences reduced payments from some tenants, it has extra cushion to not only keep paying the dividend but also to consider increasing it.
(source: Company Data)
We are impressed by its conservative capital structure which further provides flexibility to fund any dividend shortfall. And the overall debt maturity schedule remains in excellent shape as the weighted average maturity of debts is 8.3 years, and only $334 million of debt is due in 2020. Realty Income has investment-grade credit ratings from various rating agencies (Moody’s, S&P and Fitch). This leads to lower cost of capital and improved ability to raise capital. Importantly, less leverage and easy access to capital supports its ability to sustain and grow its dividends.
(source: Company Data)
Historical Track Record Bodes Well for Current Crisis
When looking at the performance of Realty Income during the financial crisis of 2007-2009, we are encouraged to see outperformance again versus other peers. This shows that the company has a proven track record of managing significant downturns and gives us confidence that it is likely to again outperform during the current COVID-19 crisis as well.
(source: Company Data)
Realty Income has a strong history of delivering superior returns to its shareholders since listing in 1994. It has meaningfully outperformed all well-known indices over the long-term with much lower stock price volatility and consistent earnings growth. The company has delivered positive earnings growth in 23 out of 24 years as a public company. Since becoming a publicly traded entity, Realty Income has delivered compounded average annual returns of nearly 16.5% to its shareholders, outperforming S&P 500 by 640 bps, Dow Jones by 620 bps and US Equity REIT Index by 570 bps.
(source: Company Data)
Notably, since 1994 NYSE listing, Realty Income’s annual total shareholder return (TSR) downside volatility is one of the lowest in the S&P 500. Realty Income’s return per unit of market risk is in the 98th percentile of all S&P 500 companies suggesting that it has delivered higher returns and lower volatility than majority of S&P 500 companies since 1994. These higher returns have been delivered with relatively much lower risk. Comparing return per unit of risk relative to other large S&P companies and also the REIT Index, the company again stands out having delivered more return per unit of risk versus the top 10 largest S&P companies, for example.
(source: Company Data)
Valuation:
From a valuation standpoint, we compare Realty Income to other retail-focused REITs. Specifically, on a Price to Adjusted Funds from Operations basis (“AFFO”) basis, Realty Income is trading at ~16.1x TTM AFFO (a premium to the peer group average). However, thispremium is well-justified (in our view) considering its large size, strong balance sheet and proven success during previous downturns. This is also reflected in the dividend yield which is the at the lower end of the peer group suggesting that Realty Income is considered one of the safest among the group by the investors. This is crucial in the current environment where survival and capital preservation has taken precedence over growth and we think Realty Income offers a safe haven to investors looking to protect capital while earning reasonable monthly returns. Plus, the dividend yield is still relatively attractive and quite high as compared to historical levels (i.e. an increasingly attractive entry point for long-term investors, in our view).
(source: Blue Harbinger Research, Yahoo Finance)
Risks:
Interest rate risk: Even though we expect interest rates to remain relatively tame (i.e close to zero), dramatically rising rates could create challenges. As REITs are often seen as an alternative to bonds, higher interest rates could mean decreased demand for REITs, thereby causing a decline in the share price. Also, higher interest rates put downward pressure on earnings as interest costs rise. Nonetheless, given the current environment, this is not overly concerning.
Tenant bankruptcies/ Rent Concessions: Realty Income earnings could be impacted by bankruptcies that continue to hit the retail sector. Though, the company has a diversified tenant base which is weighted towards non-discretionary and low-ticket items, and as such is more immune compared to many of its peers. Nonetheless, considering the current crisis, tenant bankruptcies (and the treat of needing to grant rent concessions) remains a risk.
For example, as you saw in an earlier graphic, tenants that were already struggling (such as AMC and Regal movie theaters) as well as Fitness Centers (e.g. LifeTime Fitness) are going to be hit hard. Realty Income is by no means perfect, but it is much better positioned in aggregate than most of its retail peers.
Lower consumer spending: With projections pointing to a global recession, we think consumer spending and confidence will be hit hard and (in general) will be negative for retail-focused REITs. However, here again we point out the resilient nature of Realty Income business due to its high percentage of rent generated from non-discretionary (drugs) and low-ticket items (Dollar Stores), as well as strong investment-grade tenants. Although, Realty Income is much better positioned that many, a global recession is likely to cause a negative impact on it’s business.
Conclusion:
If you are going to invest in retail REITs, Realty Income is a very good way to do it, relatively speaking. It has a well diversified portfolio of many strong tenants and considerable financial strength. Further, the dividend yield is currently significantly higher than its historical levels, and now could turn out to be an extremely attractive time to buy if you are a long-term income focused investors. We are not pretending the risks are not real (they are very real) and there will certainly be negative impact on tenants (some more than others). But in aggregate, Realty Income looks decidedly attractive at these levels if you are income-focused and take the long view. We currently own shares of Realty Income and have no intention of selling.