Realty Income (NYSE:O) exhibits a number of manifest strengths, and those positives have translated into shareholder gains for decades.
Its status as the largest triple-net lease REIT in the US means its tenants are responsible for the property's operating expenses, real estate taxes, maintenance, and insurance. Consequently, only 0.6% of the company’s net operating income is spent on recurring capex.
The company is one of only three REITs in the S&P 500 that is a Dividend Aristocrat. With a rating of A3 by Moody’s and A- by S&P, management boasts that Realty is one of only 8 US REITs with that level of credit.
A review of the firm’s history provides evidence the stock has outperformed the market during good times and bad.
However, nearly 13% of the company’s tenants are health clubs or theaters, businesses hit particularly hard by COVID-19 restrictions and coronavirus related trends.
The Samson Of REITs
The management of Realty Income focuses on retail sectors resistant to e-commerce competitors and businesses that fare well during economic downturns. This is reflected in a client list heavily tilted towards dollar stores, convenience stores, drug stores, and grocers. Those four categories provide 37% of the REIT’s rental revenue.
In addition to retail stores, nearly 11% of the REIT’s tenants are industrial companies, and another 3.5% of the portfolio is leased as office space. Aside from offering a degree of diversification, over 80% of those tenants have investment grade debt ratings. In fact, 48% of Realty’s rents stem from investment grade businesses.
When reviewing past results, one can conclude the company has superior leadership.
Source: Institutional Investor Presentation
Over the last 24 years, Realty provided positive earnings growth in every year save one, and has an earnings growth rate more than 50% higher than the average REIT.
The company never registered an occupancy rate below 96%, and in the third quarter of this year occupancy stood at 98.6%. As is reflected in the following chart, the strength of the company’s tenant list is reflected in Realty’s ability to collect rents at a level surpassing that of its peers.
Source: Q3 Investor Presentation
In fact, since its initial listing on the New York Stock Exchange in 1994, the shares have appreciated at a compound annual growth rate of 15.3%. This compares favorably to an average 10.9% return from the NASDAQ, a DOW return of 10.4%, and an average growth in the S&P 500 of 10% during the same time period.
Realty Income’s Achilles' Heel
While many of Realty’s tenants fared relatively well during the pandemic, the Q3 report listed three industries, casual dining, theaters, and health and fitness, that failed to pay rent.
Combined, the three account for nearly 16% of contractual rent, with the latter two categories of particular concern as combined they account for approximately 80% of uncollected rents in Q3.
I’ll address the health and fitness industry first.
My primary concern regarding fitness clubs is that many Americans may have developed exercise habits that will have lingering negative effects on that industry.
Initially, closures caused many gym rats to purchase exercise equipment. I know, I was one of them. Devout physical fitness enthusiasts won’t let a life threatening plague stand in the way of a good workout.
In fact, a study by Mindbody determined 73% of physical fitness enthusiasts now turn to pre-recorded fitness videos for their workouts. This compares to 17% pre-COVID.
Among those surveyed, 46% say they will continue with virtual classes after gyms have reopened.
One has to wonder how habits learned over the length of this pandemic will affect the industry.
My guess is that there are many that will return to gyms for social reasons. However, there has to be that fraction of the population that will prefer working out at home, particularly after they invested in exercise equipment and/or suffered a COVID related loss of income.
I will also posit that the work-from-home trend may result in a small but significant percentage of those that will prefer exercising at home.
Another concern is a survey conducted in the middle of last year by Harrison Company. It determined 34% of gym goers intend to cancel their memberships.
My best guess is that this is more of a speed bump than a roadblock for the gym industry. However, I will also believe it will continue to present a short to mid-term drag on Realty.
I view the headwinds faced by the movie industry with a degree of trepidation. Like exercise habits, COVID-19 shaped consumers' approach to entertainment in general and the movie industry in particular.
Well before the pandemic hit, the cinema business was suffering a bit of malaise.
Source: World Economic Forum
With the exception of China, movie admissions have been on the decline for two decades. With the advent of COVID-19, that trend has been greatly exacerbated.
Source: The Hollywood Reporter
There are reasons to believe Realty’s movie tenants will recover. Reports from China indicate theater attendance has returned to 2019 levels. Additionally, the REIT estimates that 41% of the leased assets are in the top quartile of theaters in the US, and another 18% are in the second quartile.
However, there are other concerns that are difficult to weigh. One is the advent of streaming services competing directly with theaters. A second is the pandemic related shutdown of production facilities.
The lack of production of movies in general, and blockbuster films in particular, combines with restrictions on theaters that creates a vicious circle. The badly wounded theater industry must struggle with a lack of new movies. This drives down attendance which in turn lessens production companies' ardor for creating new films.
Add to that a long-term trend of the window narrowing between the introduction of new releases and the time frame in which theaters must compete with DVD releases (and now streaming services).
Source: World Economic Forum
Realty Income Stock Dividend
Realty’s ever growing, safe, and fairly robust yield entices investors. Furthermore, in a year wracked by COVID, the company increased the dividend four times.
If that isn’t enough to calm investor’s concerns regarding the safety of the REIT’s dividend, consider the following two charts.
Source: Institutional Investor Presentation
Source: Q3 Earnings Call Presentation
During the Great Recession, the REIT reported positive earnings growth and continued to grow the dividend. Even with the COVID related disruptions, as of Q3 2020, Realty has grown AFFO per share from $2.46 during the first nine months of 2019 to $2.55 in the first three quarters of FY 2020.
Realty pays dividends on a monthly basis. Management’s emphasis on dividend payment is such that it has a registered trademark for the phrase “The Monthly Dividend Company.”
I can say without reservation that the dividend is safe and will likely grow at the company’s current target rate of 4% per year. Undoubtedly, Realty Income will remain a Dividend Aristocrat for years to come.
Valuation And Debt
As I type these words, O trades for $61.65 per share. The 12-month price target 1 of 16 analysts was recently raised from $64 to $67; however, a Goldman Sachs analyst provided a conviction buy for the stock following Q3.
Seeking Alpha’s Factor Grades rates the valuation as a C+. My own valuation system ranks the stock with a C- valuation score.
As I previously reported, Realty has a strong credit profile. The company also has well laddered debt with a 3.5% weighted average interest rate.
Source: Q3 Earnings Call Presentation
My Perspective
Realty Income is an outstanding company in every respect. The REIT weathered the coronavirus headwinds well. Even with a number of tenants failing to pay rents for an extended period, it increased AFFO and continues to raise the dividend.
Management is exemplary, the business model has withstood the test of time; and while investors should have concerns regarding the REIT’s movie and fitness tenants, those problems are headwinds, not hurricanes.
I will add that I have one additional worry. Realty has long term contracts with tenants that provide for minimal rent growth. While the length of those contracts provides the REIT with a great deal of stability, I have some concerns considering it appears we may be entering a period of high inflation.
Where I pause when considering an investment in O is when I consider the current valuation. There is nothing in the share price that leads me to believe I found a bargain. As I nearly always require a margin of safety in the price of a stock, I will not increase my position in Realty Income at this juncture.
Consequently, I rate the stock as a HOLD.
One Last Word
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Chuck Walston
Chuck Walston is a U.S. Army veteran and a retired law enforcement officer with approximately 20 years of experience as a retail investor. He focuses on dividend stocks and concentrates on companies with competitive advantages and strong balance sheets.
Chuck is a contributing author for the investing group The Dividend Kings which focuses on helping investors safeguard and grow their money in all market conditions through the highest-quality dividend investments. Features include: 13 model portfolios, buy ideas, company research reports, and a thriving chat community for readers looking to learn how to invest more intelligently in dividend stocks. Learn More.
Analyst’s Disclosure: I am/we are long O. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
I have no formal training in investing. All articles are my personal perspective on a given prospective investment and should not be considered as investment advice. Due diligence should be exercised and readers should engage in additional research and analysis before making their own investment decision. All relevant risks are not covered in this article. Readers should consider their own unique investment profile and consider seeking advice from an investment professional before making an investment decision.
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