Friday, June 13, 2014

Realty Income - A dependable dividend achiever for current income

Realty Income Corporation (O) is a publicly traded real estate investment trust. It invests in the real estate markets of the United States. The firm makes investments in commercial real estate. This dividend achiever pays monthly dividends to shareholders, and has managed to increase them each year since going public in 1994. Many investors purchase REITs for high current income, stability of revenue streams, and diversification opportunities.

In an earlier article, I discussed the items I look for in Real Estate Investment trusts. I will cover those items in the stock analysis below.

The company has managed to increase its Funds from Operations (FFO)/share from $1.47 in 2003 to $2.41 by 2013. At the same time, dividends per share increased from $1.18 in 2003 to $2.15 by 2013. The FFO payout ratio has increased from 80% to 89% over the same time period, which is not something I would like to see. However, this ratio has been going down since hitting a high of 94% in 2010.  As you can see, there was a big jump in FFO/share and dividends per share in 2013, as a result of the $3.2 billion acquisition of American Realty Capital Trust. In addition, the company also invested $1.5 billion in 459 properties throughout the year.

Year
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
FFO
2.41
2.02
1.98
1.83
1.84
1.83
1.89
1.73
   1.62
  1.53
1.47
DPS
 2.15
 1.77
1.74
1.72
1.71
1.66
1.56
1.44
1.35
  1.24
1.18
DPR
89%
88%
88%
94%
93%
91%
83%
83%
83%
81%
80%
Occup
98.2%
97.2%
96.7%
96.6%
96.8%
97.0%
97.9%
98.7%
98.5%
97.9%
98.1%

The other metric I like to look at with REITs is occupancy ratios. As Realty Income has been expanding over the past decade, it is important to see that this has not resulted in additions of properties to mask a deterioration in existing locations. The occupancy levels dropped during the financial crisis, but then recovered and are close to where they were last year.

The Realty Income of today is much larger and more diversified that the Realty Income of 2003. The top ten tenants account for less than 45% of revenues:


The record low interest rates have been a boon for Real Estate Investment trusts. Investors have fled the sector, attracted by high yields relative to US Treasuries and CD’s. Realty Income has been able to sell $750 million worth of ten-year notes in 2013 at 4.65%/year, which is pretty low. However, this influx of capital has led to many companies competing for assets, which pushes the initial yields on those properties lower. As a result, when debts need to be refinanced in a decade from now, and interest rates increase substantially, it is quite possible that those result in lower profits down the road on those issues. This could be of particular concern since rents usually increase at slightly less than the rate of inflation. Another potential concern I see is the increased deal making in the sector, in an effort to build the largest triple-net company out there. With Realty Income, this is not an issue, although it is a risk I am watching carefully.

Of course, the risks that I am presenting are just something to watch out for. I truly believe that there is much more growth ahead for Realty Income. This would be fueled by property acquisitions that provide incremental free cash flow to grow dividends into the future. Historically, the company has done a good job in evaluating tenants, and filing in occupancies by getting new tenants or selling those properties.

The company has managed to earn a cap rate of 7.10% on its 2013 property acquisitions and a cap rate of 7.20% on its 2012 property acquisitions. This compares well relative to the interest rates on notes sold in 2013, and the average interest rate on its $3.20 billion in notes payable of 4.90%. In addition, it compares well to the 5.30% interest on its $755 million in mortgages payable. The company finds the cash necessary to grow by issuing common stock, preferred stock and debt to investors. Therefore, it is essential that there is a positive spread between cap rates on property investments and cost of capital.

I really like the stability of the long-term triple-net type leases that Realty Income uses to rent out its properties. The average lease term for the 3896 properties at the end of 2013 was 10.80 years, which should translate into stability in cashflows that are used to pay the monthly dividends to shareholders. Those leases provide for rent escalations over time, and also make the tenants pay for maintenance expenses, taxes, insurance, utilities.

I do not foresee dividends growing faster than 4%/year, unless of course another big accretive acquisition is made. This would be fueled by acquisitions as well as annual increases in rents from the properties that the company owns throughout the US.

Overall, I like Realty Income, and intend to hold my position for as long as possible. However, I would like to receive a higher starter yield on an investment in this REIT. Currently, the REIT yields 5.10%, although the yield was as high as 6% in December 2013. Given the low growth expectations, paying a lower entry price might be helpful in generating good returns from Realty Income. This is particularly true given the fact that W.P. Carey (WPC) and American Realty Capital Properties (ARCP) yield 5.50% and 8% respectively.

Full Disclosure: Long O and ARCP

Relevant Articles:

Five Things to Look For in a Real Estate Investment Trust
Four High Yield REITs for current income
Are we in a REIT bubble?
My Dividend Retirement Plan
Realty Income (O) Raises Dividends by a Record 19.20%

16 comments:

  1. Hi DGI,

    What are your thoughts about ARCP most recent decissions (common equity offering at 12$, purchase of Red Lobster restaurants and sale of multitenant portfolio)?

    Regards

    ReplyDelete
    Replies
    1. Hello,

      I am working on a post on ARCP. Since they have only been public for 3 years or so, most of it will be less heavy on data, more on qualitative factors. With ARCP, I have to weigh whether management wants to build and empire at all costs (not good) versus they want to gain scale and work for shareholders. The management comp proposal that had a hurdle rate of 7% was ridiculous, given the yield of 8%, so it didn't require much effort. Of course, ARCP is more of a value play vs Realty Income, as it's track record is much shorter. So the trade-off is if you think ARCP has waht it takes to become O - it is a great steal. If ARCP has grown too fast, too large, then one might abstain. I am holding onto my ARCP, and will hold as long as dividend is not cut. Sometimes the companies everyone hates tend to do well for shareholders.

      Delete
    2. Hi! Do you know how it was in the beginning for O? Is it any way comparable to ARCP or was O always a sure, safe, bet?

      Delete
    3. Hi Booban,

      In hindsight, Realty Income looks like a sure bet today. However, when I look at the past 20 years of history, it expanded much more slowly than ARCP. ARCP went from 100 million in assets in 2011 to tens of billions of assets within 3 years. Check pg 6 of the annual report:

      http://www.realtyincome.com/investing/2013-annual-report/index.html#/6/

      Best Regards,

      DGI

      Delete
  2. Isn't the payout ratio always going to be high for a REIT? Isn't there a regulatory requirement that REITs payout income in the year it is earned? I do KNOW you cannot make an apples to apples comparison of REIT dividends to dividends of ordinary common stock. This is not to say that this particular stock is a fine investment.

    ReplyDelete
    Replies
    1. This is what they have on the annual report:

      "In order to maintain our tax status as a REIT for federal income tax purposes, we generally are required to distribute dividends to our stockholders aggregating annually at least 90% of our taxable income (excluding net capital gains), and we are subject to income tax to the extent we distribute less than 100% of our taxable income (including net capital gains). In 2013, our cash distributions to preferred and common stockholders totaled $451.2 million, or approximately 161.4% of our estimated taxable income of $279.6 million. Our estimated taxable income reflects non-cash deductions for depreciation and amortization. Our estimated taxable income is presented to show our compliance with REIT dividend requirements and is not a measure of our liquidity or operating performance. "

      I generally do not like when the payout ratio is increasing. I want payout to be consistent over time, and dividend growth to come from increases in earnings/cash flow/ FFO/DCFetc

      Delete
  3. Thanks for the info. What are the tax implications related to owning stock in a REIT? My friend told me about O, and I ended up adding it to my Roth IRA portfolio. I was thinking about buying more shares for my regular portfolio, but my dad, who has been a dividend investor for decades, mentioned that owning stock in a REIT can make doing one's federal income taxes a real headache. So I'm glad I have it within my IRA.

    Thoughts?

    ReplyDelete
    Replies
    1. Hi Anon,

      REITs could complicate your tax returns a little bit, since different portions of their distributions are treated differently for tax purposes. In 2013, ~61% of dividend income was ordinary income, while the rest was treated as return of capital ( not taxable, but reduces your cost basis).

      http://www.realtyincome.com/pdfs/8937/2013-YearEnd-8937.pdf

      I am not a tax adviser, so I would definitely encourage you to either research the issue more or talk to a tax professional. Either way, putting REITs in an IRA or ROTH IRA might not be a bad idea.

      Delete
    2. No real headache, as long as you have a good broker that keeps track of your basis because that will change due to the return of capital. The return of capital reduces your cost basis as DGI said, and if your basis ever gets to zero any future return of capital will be treated as long term capital gains. You are not taxed on the return of capital portion until your basis is zero.

      Delete
  4. Long O and ARCP. I wasn't thrilled with some of the latest moves by ARCP, but am holding as long as the dividend doesn't get cut. I agree with your analysis on both companies. This is one of the two dividend growth sites that I stop by every day, and I appreciate your efforts.

    ReplyDelete
    Replies
    1. Hi Keith,

      Thank you for stopping by. If you have any questions/suggestions, I would love to hear from you.

      Anyway, ARCP is a relatively small position for me, and my holding period will be similar to yours. O is a much bigger position, which is why I might not be adding much ( unless they offer a really compelling value).

      Either way, based on your comments, it looks like you are less than 1 year away from reaching your FI date. Congratulations and wish you good luck in your FI journey!

      DGI

      Delete
    2. DGI,
      I usually don't have questions on your posts since they are very well written. I was interested in your perspective on O since I hold it. Both O and ARCP are relatively small positions for me, as is HCN. The total percentage of REITs in my portfolio is only 3.2%. To be honest, it was zero a year ago, but the drop in prices (and increase in yields) lead me to buy the 3 that I currently own. I put the same amount of money into both O and ARCP, but now that ARCP has dropped it is worth 20% less than O.

      What I really love about what you and Dividend Mantra are doing is educating the masses, particularly young people that are probably getting bad advice from other places. I have always loved dividend stocks and have held things like MCD, PEP, and DIS off and on over the years. But the brokers used to have much more information that I could find easily (Value Line was particularly valuable 30 years ago). Brokers tend to tell you to go after the hot stocks which is a great way to get you to churn and pay them commissions, but that is a tough way to build wealth. I got so discouraged by this that I ended up in index funds since the tech wreck in 2000-2002. Recently, I decided that I was smarter than just putting money into the broad market and started buying (and using DRIPs) for JNJ, PEP, PG, CVX, AAPL, T, UL, MAT, etc. Sites like yours encouraged me to look into even more stocks, using tools like the Dividend Champions list. If I had done this 30 years ago, I would have already reached FI! No regrets though, but I love what you are doing and wish you all the best.

      Delete
  5. Hi DGI,

    ARCP is trading at 52 weeks low, I think investors didn't appreciate its recent acquisitions. I guess it is the time to add some unit in my portfolio. REITs are very sensitive to interest rate, but every porfolio should have some portions for diversification.

    Best Regards

    ReplyDelete
  6. DGI,
    These aren't relevant to O in particular, but I am curious if you ever use other metrics such as the PEG ratio or Chowder factor? I like to see a PEG ratio no higher than 2. The Chowder factor intrigues me, but I only learned of it in the last 2 days because of dividendandwhiskey's screener (based on David Fish's CCC list). The Tweed factor is interesting too, but seems to be unduly influenced by a recent dividend hike that is larger than normal. You can find the screener here: http://dividendandwhisky.com/dividend-screener/

    ReplyDelete
    Replies
    1. I am not using PEG ratio, but maybe I should. I think Peter Lynch popularized this indicator in one of his books.

      Chowder rule is interesting, but it ignores things like payout ratios, earnings growth, and analysis of each company. I don't think I want to look at just dividends alone, especially if they are growing because payout ratio is expanding, not because of earnings growth.

      I actually do my screens, research companies in there, and then compare companies one at a time to come up with ideas:http://www.dividendgrowthinvestor.com/2014/03/why-do-i-use-pe-below-20-for-valuation.html

      Thank you for reading!

      DGI

      Delete

Questions or comments? You can reach out to me at my website address name at gmail dot com.

Popular Posts