Realty Income: Focusing On Growth, Instead Of Growth Per Share (NYSE:O)

I typically do not cover that many REITs. Yet, the fact that Realty Income (NYSE:O) announced a big asset deal during a time of turmoil and price discovery in real estate markets warrants an update. It has been a turbulent year for REITs at large, due to the massive move higher in interest rates of course.

The Business

Realty is perhaps best known from the fact that it pays a monthly dividend to its investors, a feature well liked by many of them as it coincides with their monthly income and expenses, a real mental accounting benefit.

The company holds and operates a very well diversified property portfolio which includes over 11,000 properties let out to more than a thousand customers, with occupancy rates approaching 99% and end industries being very diversified. Of these larger names, many of them show up more often as a tenant. Names like Walmart, Dollar General, Walgreens, FedEx, Sainsbury’s, CVS, Tractor Supply, Kroger, and many others make up between 1 and 4% of annual rent.

The company has many (big name) tenants and touts its defensive positioning with properties often let to service-oriented or low-price point tenants as the portfolio has proven to be resilient in the past. The recent investor presentation has been very informative to talk about the resilience of the portfolio, but also the stock in past downturns, while explaining the rationale for owning certain properties.

Another big benefit is the fact that a huge part of the portfolio is subject to maintenance by the tenant, with recurring capital spending coming at less than percent of gross rent, while many other types of real estate require 5-10% of gross income to be spent on the properties.

Largely still a Northern American business, the company has aggressively moved into Europe as well in recent years, albeit that this portfolio remains smaller with 250 properties and about $300 million in rent, just 10% of the US operations. The portfolio has seen quite some changes following the merger with VEREIT which closed in November 2021.

That deal complicated the 2021 numbers a bit as reported revenues and funds from operations were understated (with the deal closing late in the year), while the balance sheet reflected the deal. By year end the total net investment properties carried a $32 billion valuation, with total assets of $43 billion for the remainder being largely comprised out of goodwill and related items. The financing of this portfolio was quite defensive, supported by $25 billion in equity and the remainder in debt, and alike instruments.

2022 – Active

In February the company announced a big deal with Wynn Resorts (WYNN) to buy and lease back the Encore Boston Harbor resort in a $1.7 billion deal with a 30-year contract at a 5.9% initial cap rate.

First quarter results revealed $807 million in revenues on which $211 million in operating earnings were reported, but this comes after a $106 million quarterly interest bill and $404 million depreciation charge. Adjusted for these depreciation charges and some smaller items, adjusted funds from operations came in at $608 million, or about $0.98 per share with approximately three quarters of these earnings paid out as dividends.

Besides the shares issued in connection with the VEREIT deal the company has been incurring some dilution along the way, driven by the desire to grow the investment portfolio, for instance with deals like the one announced with Wynn. Excluding that of Wynn, some $1.5 billion in capital was deployed in the first quarter on more than 200 properties.

Second quarter sales rose to $810 million as adjusted funds from operations came in at $0.97 per share as investment volumes for the quarter totaled $1.7 billion. Third quarter adjusted funds from acquisitions come in at $0.98 per share on the back of $1.9 billion investment volume. These investments grow the business, not necessarily on a per-share basis as the company keeps issuing quite some shares along the way to fund the growth.

Moreover, interest expenses are creeping up, with third quarter interest expenses of $117 million having increased compared to the start of the year on the back of growth (and thus more borrowing) and higher interest rates. The maturity of the debt and indexation should soften the blow somewhat through the P&L, but investors are pricing in some of the headwinds. Interest rates will creep up, as the company recently issued three quarters of a billion in unsecured 2032 notes with an effective yield around 5.6%, a steep cost if you ask me.

Valuation Thoughts

With 619 million shares outstanding here, and these shares trading at $63 per share, the company commands a $39 billion equity valuation, exceeding the book value of equity at $26.8 billion by the end of the third quarter. Adding the $12 billion difference to the $34 billion book value of the properties, that implies that the market awards the properties of the company at essentially a $46 billion valuation. With revenues trending at $3.3 billion a year, that works down to a 14 times multiple rent, essentially a cap rate around 7.2%.

This valuation compares to shares starting the year around the $70 mark, when interest rates were still low and the economy was resilient, albeit that shares actually peaked around the $80 mark pre-pandemic. After a recent rout to $55 amidst concerns on borrowing markets, shares have recovered a bit.

With adjusted funds from operations approaching the $4 per share mark and dividends coming in around $3 per share, the yield is compelling, but the yield is why one invests in Realty Income, with dilution really having to pay for the growth ambitions, limiting the capital appreciation (as seen in recent years).

These growth ambitions are very much alive as the company closed the $1.7 billion Wynn deal in December, as the company announced another deal. The company reached a $894 million deal to acquire 185 single tenant retail and industrial properties, in a deal set to grow the portfolio by about 2%.

With a 7.1% cap rate, the acquisition yield is in line with the own valuation, as is the remaining lease term of just over 9 years to clients like Kroger, CVS, Car Max, Walgreens and Lowe’s. This deal is really about adding growth to the portfolio and not necessarily hugely accretive as the gap with recent rates at which could be borrows is closing rapidly.

Concluding Thoughts

Truth is that Realty is a bit too much focused on growth rather than growth per share if you ask me. The current 4.7% dividend yield looks reasonable, but only compares to risk free rates as investors have not seen capital gains since 2019. Rising rates hurt the shares a bit this year, but the extent of this has been eliminated given the modest leverage position and the duration of locked-in debt. On the other hand, some deals can be questioned, such as the Wynn deal (equal to 3-4% of the investment) which is a real outlier and looks expensive based on the low initial yield.

Given all of this, I think shares are fairly valued at best, but I see no compelling case to jump into the shares here, with many individual properties (which are similar) trading at higher cap rates. While Realty is a great long term allocator with a disciplined approach to grow the portfolio, I see no outsized risk-reward here.