Monday, October 30, 2023

A look at the past decade at Realty Income

This morning, Realty Income (O) announced its intent to acquire Sprit Realty Capital (SRC) in an all-stock deal valued at $9.3 Billion. This deal is expected to be accretive to Realty Income (O), and help it grow funds from operations. Source: Press Release (Check out the Investor Presentation)

This news sent Realty Income stock price tumbling. Perhaps in an environment where investors are selling off REITs, any news is perceived as bad news. It looks like a lot of investors tend to look at share prices in isolation, and use them to determine if a company is "good" or "bad". This is speculation, and not really investing.

I took a quick look at the returns generated by Realty Income since the end of 2012.

Realty Income stock (O) sold at $38.96/share at the end of 2012. The stock is selling at $46/share right now.

The REIT managed to grow FFO/share from $2.02 in 2012 to $4.04/share in 2022.

The monthly dividend was at $0.147/share at the end of 2012, rising to $0.2485/share by end of 2022 and $0.256/share today.

The FFO payout ratio decreased from 87% in 2012 to about 76% in 2023.

The REIT managed to double per share Funds from Operations over the past decade. That's good growth.

In addition, it paid over $27.40/share in dividends over that time period (2012 - 2023).

If someone had bought 1 share in 2012, and reinvested dividends, they'd have 1.618469 shares today, worth $74.45.

That's a total return of roughly 91% since end of 2012.

As we have discussed before, total returns are a function of:

1. Dividends

2. FCF/Share Growth (in case of REITs - FFO/Share)

3. Changes in valuation

Long-term investors care about the fundamental sources of returns. Those are dividends and FFO/share growth.

In the short term however, changes in valuation could impact returns. Even if a business performs well, a shrinking in valuation multiples could pull returns down. If the valuation increases, then the returns are pulled forward. 

As a long-term investor, I care about fundamental returns, because ultimately, they drive long-term returns. Valuation multiples are affected by investor emotions, which are unpredictable. They are to be taken advantage of, but not really followed blindly.

You can see that the business doubled funds from operations, and with dividend reinvestment the number of shares increased by almost 62%.

However, the total return was less than 100%.

That's because the valuation multiple shrank between 2012 and 2023.

At the end of 2012, investors were willing to pay 19.29 times for each dollar in FFO/share. 

By 2023, investors are willing to pay only 11.39 times for each dollar in FFO/share

With the acquisition announced today, it is likely that Realty Income is on track to continue growing FFO/share over the next decade, which would likely mean that future dividends would grow as well

If shareholders manage to reinvest those dividends at a low valuation, that would further turbocharge their investment. The effect of DRIP is more pronounced at a lower valuation, because you buy more future income at a lower price.

However, we do not know what the valuation multiple would be in a decade. It could be higher or lower. If history is any guide however, I would imagine that a conservatively managed REIT like Realty Income would likely grow FFO/share over the next decade

Realty Income can grow FFO/share by a few levers:

1) Increasing rent to tenants

2) Buying new properties at a capitalization rate that is higher than the cost of capital ( debt or equity)

3) Strategic acquisitions where the acquisition cost is lower than cost of capital, after accounting for potential synergies

4) Cutting costs

I believe the stock is a good value at 11.40 times FFO and an yield of 6.65%.

There are risks of course, one being rising cost of capital. Rising interest rates make it costlier to take on debt to acquire new properties. The margin/spread between cost of capital and cap rates has been remarkably consistent however.

Realty Income is conservatively managed, meaning that roughly 2/3rds of acquisitions are paid for by equity (issuing stock) and the rest by issuing debt. The debt is issued on a long-term basis, and a significant amount is not due for several years in the future. Rates would change multiple times from there, unpredictable to most, even distinguished experts and economists alike.

Falling share prices increases cost of capital as well, because the yield on the stock gets higher. All of this rising cost of debt and equity capital means the company needs to continue being selective in the deals it pursues, and the CAP rate it pursues them at. Being the golden standard in Triple-Net Reits means that Realty Income has a lower cost of capital than competitors. As a result, it may be able to acquire others, which could be immediately accretive to FFO/Share. However, there could be integration risks as well. Realty Income has not had much issues in that regard, but that doesn't mean this cannot happen of course.

I believe that the dividend is well covered from funds from operations, especially given the expected growth in FFO/share over time. That doesn't mean that the stock price can't go lower from here. 

For some reason, investors are selling the stock off, because they perceive a fixed 5% return through CD's or Treasury Bills to be better. That's a good return in the short-term, and there is a guaranteed return on the original investment with bonds. The problem is that this coupon will not increase, and there is also reinvestment risk at maturity date. This means that when the bond matures at some specified time in the future (3 months, 12 months, 5 years, 10 years, 30 years etc) , the rate at which the money can be invested is unknown. It could be higher or lower. The purchasing power of that interest and the principal would likely decrease over time.

With Realty Income, there is a possibility of dividend income increasing to offset inflation. With that, the share price would likely grow to maintain purchasing power as well. However, there is the risk in the short-run that the price keeps going down. There is also a risk of total loss, because this investment is not guaranteed. But we already know that, because we know that buying Realty Income is not like buying a bond. And buying a bond is not like buying Realty Income stock. 

I hope you found this overview helpful. Thank you for reading!

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