Realty Income Positions Its Portfolio for Challenges Ahead

Todd Lukasik, CFA

Realty Income (O) has reached an agreement to acquire 84 single-tenant net-leased properties for $503 million from Inland Diversified Real Estate Trust. This pending transaction, expected to close in early 2014, changes neither our narrow moat rating nor our $44 fair value estimate for the real estate investment trust, although we are increasing our 2014 acquisition volume assumption to $1 billion from $700 million.

Consistent with prior deals, this portfolio appears to be reasonably diversified, with retail, industrial, and distribution assets in 22 states and leased to 16 tenants in 12 industries. The initial average lease term is 13.7 years, and 68% of the rental revenue is generated by investment-grade tenants. Although Realty Income did not disclose the initial yield it will receive on this deal, we estimate it will come in near 7%, consistent with pricing over the past few quarters; however, there is risk that the initial yield will be lower, as portfolios such as this have generally commanded premium pricing in recent years, one of the reasons we have been less enamored of these portfolio deals than Realty Income's historical preference to acquire properties via sale-leaseback transactions negotiated directly with tenants.

We expect to get more information during Realty Income's fourth-quarter earnings call in February 2014 regarding this transaction as well as the firm's expectations for acquisition volume and pricing in total for fiscal 2014. But this $503 million is an early indication that 2014 may well be another year of strong acquisition activity for Realty Income, which could position it to contemplate a larger dividend increase near the end of the year.

Changing Environment Presents New Challenges
After riding a decades-long tailwind of falling interest rates and rising consumer spending, Realty Income is positioning its portfolio for a more challenging environment, leading it to investment-grade tenants and nonretail assets. Relative to its traditional non-investment-grade retail tenants, investment-grade tenants should be even more likely to honor lease commitments during the initial lease term, but we think the nonretail tenants may present greater risk when leases expire because there is often not the same direct economic incentive to re-lease Realty Income's property, as opposed to another. If we're right, this might lead to higher re-leasing costs or more vacancies longer term than Realty Income has experienced historically, although we wouldn't expect this to play out until the nonretail tenant leases begin expiring, which is still many years away.

The potential for rising interest rates may weigh on investment spreads on new acquisitions, although we expect management to adhere to its historically disciplined approach and only consummate deals with positive spreads.

With its huge acquisition growth recently, Realty Income will require an increasingly large deal flow to close enough transactions to have a meaningful impact on its dividend growth. Meanwhile, competition in the net-lease space has intensified. Although Realty Income was one of the few net-lease REITs to emerge from the downturn unscathed, large flows of capital have found the net-lease sector since. Plus, Realty Income's diversification into nonretail property types and investment-grade tenants places it in direct competition with other net-lease REITs it hasn't run into historically. Nonetheless, we think the pool of potential properties is large enough to provide acquisition growth for years to come.

High Occupancy and Tenant Demand Result in Sustainable Cash Flow
Realty Income owns and manages retail properties, mainly. When making property purchases, the firm applies the same Warren Buffett- and Benjamin Graham-inspired investing principles that Morningstar espouses, and its narrow moat stems from its successful implementation of these conservative investing principles. We attribute its moat to the intangibles associated with owning retail properties in locations where its tenants can operate profitable stores, resulting in very high levels of occupancy and tenant demand, which in turns results in cash flow that is sustainable beyond the initial decade-plus lease terms.

The firm builds a margin of safety into its property purchases by demanding that its retail tenants generate sufficient cash flow to more than cover rent payments, allowing for some deterioration in store performance before its rental stream could be compromised. Furthermore, Realty Income requires its retail tenants to supply it with property-specific financial information that allows it to monitor each property's rent coverage over time and dispose of assets if the tenant's operating fundamentals suggest rent coverage has become insufficient. By using conservative underwriting practices when acquiring properties and then actively monitoring and managing its operating properties, Realty Income has been able to maintain impressively high average occupancy exceeding 98% since 1970.

The firm also signs triple-net leases with its tenants, which leaves the tenants--not Realty Income--responsible for property taxes, insurance, and maintenance, resulting in recent average EBITDA margins of 92%. The leases generally run between 15 and 20 years and require regular, albeit modest, increases in rent. The combination of high occupancy, low operating expenses, and long-term leases with rent bumps results in a reliable cash flow stream that should increase modestly over time.

Realty Income has recently ventured into nonretail property types as well, including industrial space, manufacturing and distribution facilities, and suburban office properties. We like the competitive dynamics of this nonretail portion of its portfolio relatively less, and we think it is very difficult to build moats in these areas. In our opinion, the nonretail properties lack many desirable characteristics of Realty Income's retail portfolio. Specifically, Realty Income does not get property-level financial information on nonretail assets. There is no obvious equivalent property-specific metric for rent coverage. The money the tenant earns is not necessarily linked strategically or specifically to the particular property. And, consequently, there doesn't seem to be as strong a tie between the tenant and the particular Realty Income property it leases. We also expect the nonretail assets to exhibit greater operational and cash flow variance, given their relatively higher exposure to economic cyclicality, and we think they have more risk around lease expiration.

If any management team can build a moat around these nonretail property types, Realty Income's is probably it. But we don't think these nonretail assets are obviously moaty, so we'll wait for management to demonstrate success. Although we think the nonretail assets are generally less desirable, Realty Income plans to keep at least 70% of its portfolio in retail properties, so we don't think this nonretail diversification threatens Realty Income's overall narrow moat rating.

Tenant Distress and Customer Concentration Are Risks
Realty Income's long-term leases can be canceled if a tenant files for bankruptcy or rewritten via bankruptcy or during times of tenant distress, and its tenants are generally non-investment-grade credits. Recently, the firm derived 11% of its revenue from convenience stores, 9% from restaurants, 9% from drugstores, and roughly 6% each from theaters, dollar stores, health and fitness centers, and transportation facilities. Many of these types of industries could suffer from any slowdown in consumer spending.

Realty Income's customer concentration is high, with its top 15 customers providing 44% of revenue and its top five tenants contributing between 3% and 5% each, which is higher than many other retail landlords we cover. Rent recovery on tenant bankruptcies has historically been around 80%, but some bankruptcies, such as those by Hometown Buffet, could be worse.

Because Realty Income's tenants' rent bumps are usually capped, it could take years for the firm's rental revenue to reflect market rates when inflation is high. Moreover, there are new risks with Realty Income's move into nonretail assets (including industrial, office, distribution, and manufacturing properties); the underwriting is different from its traditional retail base, and the strategic shift adds uncertainty, mainly at lease expiration, in our opinion.

Realty Income's largest portfolio deal, its acquisition of American Realty Capital Trust, gives us pause. It appears to carry a very slim margin of safety, and it carries a low acquisition yield and may introduce slightly lower long-term portfolio operating metrics. Competition for the types of triple-net-leased assets Realty Income likes has intensified since the global financial crisis, which may pressure future investment returns.

Stewardship Is Exemplary
New CEO John Case has more than 20 years of experience in real estate and has been with Realty Income since 2010. CFO Paul Meurer has been with the firm since 2001 and was an investment banker to the real estate industry at Goldman Sachs and Merrill Lynch before joining the firm. Management's interests are well aligned with those of shareholders. Executive compensation is weighted toward performance bonuses, including stock awards, and directors' pay is heavily weighted toward stock.

We think Realty Income's historical sale-leaseback underwriting has been outstanding. Although the firm's traditional client is a non-investment-grade or non-rated retailer, Realty Income has experienced little disruption from tenant troubles. While not immune to tenant bankruptcies, the firm has underwritten transactions to anticipate them, and those it has experienced have not had a material negative impact on its cash flows or dividend-paying ability. In an industry where many financiers have come and gone over the years, Realty Income has not only persevered, but thrived. We attribute this to its conservative policies and best-in-class underwriting.

Recent forays into nonretail property types give us pause. We largely view the individual transactions as value neutral, but they are cash flow accretive, supporting dividend growth, consistent with the company's longstanding strategy. Management has made several portfolio shifts in the past that have generally proved successful in retrospect. Time will tell if the benefits of its most recent diversification into nonretail assets and investment-grade tenants outweigh the negative implications to Realty Income's operating and acquisition environments, but given its historical record, we're inclined to give management the benefit of the doubt.

Realty Income has a long history of doing well by shareholders. Since its New York Stock Exchange listing in 1994, it has delivered a total return that has far outpaced the returns on the Dow, S&P 500, Nasdaq, and FTSE NAREIT US Equity REIT Index, beating each index by roughly 600 basis points or more annually, on average.