Realty Income: Still A Crown Jewel Of The REIT Kingdom? (NYSE:O)

The REIT sector is vast and versatile, offering numerous opportunities in different property sectors, including:

• Industrial properties.
• Experiential properties.
• Casinos.
• Cell towers.
• Data centers.

However, investors especially favour one property sector – single-tenant, retail/service-oriented properties. Realty Income Corporation (NYSE:O) is one of the most popular REITs in the world and certainly the most popular one in this sector due to its size and excellent track record. Many investors consider O the go-to REIT and disregard other market participants.

It’s hard to blame them. I’ve also fallen under O’s charm and opened many positions throughout the years. I have never sold any shares I bought and don’t intend to.

I Passed On Recent O’s Dips

There was a lot of noise around O during the last couple of quarters as the Company’s stock price fell below $50 and hovered in the low 50s for quite some time. Lots of volumes have been realised on its shares, so many people have different opinions. I wasn’t a part of the volume realised in Q2 2024.

The last time I increased my position in O was in the first half of March 2024. It wasn’t a substantial addition – just a dividend reinvestment with a negligible capital addition. However, I stopped at that. I hadn’t been part of Seeking Alpha then, since I started my journey with SA in May 2024. The first time I covered O was in June 2024, before the REIT rally supported by the increasing probability of interest rate cuts.

For those unacquainted with the topic, the market expects interest rates to be noticeably lower by the end of 2024, which is a positive factor for REITs, as it decreases their cost of capital, narrows the gap between buyers’ and sellers’ expectations, driving the transactional market activity.

The first time I covered O, I assigned it a ‘hold’ rating. My decision to stop my reinvestments and further additions was driven primarily by the belief that there were more attractive opportunities in the market (from the total return perspective), even within the same property. As I stated:

I own a position in O and intend to hold onto it. I believe it will do relatively well in the future, however, I also believe that some of its peers will outperform (…) I will hold my position in O and possibly add in the future – I don’t intend to do it now, as there are more attractive investment opportunities

Now, after we witnessed a substantial REIT rally, I have a few conclusions regarding my thesis:

• without beating around the bush – I underestimated O’s potential for multiple expansion. Naturally, it was driven strongly by the improving expectations regarding the interest rate environment. There’s nothing left for me but to wonder whether my initial outlook on its valuation would be upheld without such market-related tailwinds
• I have no regrets, as I realized my goal of finding attractive opportunities around that time. My capital, like each investor’s, is limited. I decided to diversify away from O with other, potentially more attractive in the long term, retail players and top-tier players from other property sectors. At the end of the article, I will provide my Top 3 choices I invested in instead of O, in case that would interest you and to further justify my approach regarding O’s recent dips.

Now, without further ado, let’s jump into the analysis of Realty Income to determine its role in my, and probably many of your, portfolio.

Realty Income: Still A Crown Jewel Of The REIT Kingdom?

Analyzing any business, credit, or valuation metric without a comparable benchmark is often futile. Therefore, I’ve assembled a reference group to help us assess O’s performance and quality.

No peers are comparable to O in size, which is not necessarily bad. Still, let’s concentrate on the key market players with the highest reputation in the retail/service-oriented sector and owning at least 2000 properties. Therefore, we will refer many times to entities like:

• Agree Realty Corporation (ADC).
• NNN REIT, Inc. (NNN)
• Essential Properties Realty Trust, Inc. (EPRT).

Let’s kick it off with the business metrics

Please review the table below for selected business metrics and a summary of the tenant structure of O, ADC, NNN, and EPRT.

As mentioned earlier, O is by far the largest retail player, with 15,450 properties owned as of June 30, 2024. That has some positive and possibly some negative implications, which I will delve into in the following section (regarding investment activity and cost of capital).

Realty Income showcases a healthy weighted average lease term (WALT), reflecting its negotiating position and a solid IG tenants’ share. However, one has to be aware that the IG tenants’ share in O’s ABR has gradually decreased through its investment activity in recent years. For instance, O delivered the abovementioned metric at 50.5% before its increased M&A activity in Q4 2020 (while owning ‘just’ close to 6,600 properties).

It may indicate a worse portfolio quality than ADC, which records an outstanding IG tenants’ share of 68.4% of its ABR. Some investors will automatically respond that many tenants are not rated and can be considered at the IG level, but that is also the case for ADC, so I will still assume that ADC’s share is substantially higher.

Moreover, voices within the SA community have suggested the increasing risks accompanying some of O’s most crucial tenants.

Nevertheless, I am not concerned with O’s ability to collect rent and service potential defaults/payment delays, as the Company benefits significantly from strong tenant diversification. Its Top 1 represents just 3.4% of its ABR, and its Top 10 is just 23.9%, standing solidly compared to ADC or NNN.

Regarding the occupancy rate, while O recorded this metric noticeably above its historical median, there is room for improvement when comparing it to the levels recorded by each of its closest peers, exceeding 99% and getting close to 100% in the case of ADC and EPRT. However, the scale and robust M&A activity weigh down on O’s occupancy rate, and considering the above factors, 98.8% should still be regarded as a solid level, ensuring cash flow stability and predictability (especially considering high WALT).

Top-tier balance sheet – shareholders may sleep sound

Please review the table below for details regarding selected credit metrics.

Investors may sleep sound, as O’s dividends are well-covered and supported by:

• A- rated balance sheet.
• 4.7x fixed charge coverage.
• 93.7% share of fixed-rate debt in the total debt structure, limiting the negative impact of the high-interest rate environment.
• 5.6 years of weighted average debt maturity term.

Although some of its peers showcase even more reassuring metrics (in selected areas, such as debt maturity term for ADC and NNN, fixed charge coverage for EPRT, and the debt structure of each entity), Realty Income is well-capable of servicing its debt, and thus upholding and further increasing dividend payments.

It’s worth pointing out the debt maturity term, which is relatively short for O compared to its peers. This is especially true considering that ADC will face negligible debt maturities until 2028, while EPRT won’t have any debt maturing until 2027. As for NNN, the Company has the best-laddered debt maturity schedule with an outstanding weighted average term of 12.6 years.

To conclude, O certainly has a fortress-like balance sheet, but one cannot deny the quality of its peers. O’s scale and higher rating allow the Company to acquire debt at a lower cost, which may be considered a positive factor offsetting the impact of upcoming debt maturities.

Unveiling The Magic Of Investment Spreads

Firstly, let’s establish the principles

REITs can grow in various ways, but one path to growth remains leading – investing at positive spreads.

A positive spread is generally realized when the cap rate resulting from investment volume exceeds the cost of capital of utilized financing sources. Financing sources typically include:

• Equity.
• Debt.
• Free cash flow (incl. disposition proceeds).

Before we factor in free cash flow, let’s look at the cost of capital comprised solely of newly issued equity and debt. For instance, let’s assume the cost of equity as AFFO yield (2024 AFFO guidance divided by recent stock price) and the cost of debt based on a given entity’s credit rating.

The weighted average cost of capital was calculated based on the market weights of different financing sources. Please review the table below for details regarding calculated investment spreads.

Each entity showcases quality investment strategies, reflected in favourable spreads. However, as mentioned earlier, REITs don’t have to invest solely through external financing.

Let’s factor in free cash flow. Who is the King of investment spreads in retail?

Factoring retained cash flow into the investment spread calculation involves a few considerations. For instance, how much free cash flow does a given REIT spend on its investments? Some businesses, such as O and NNN, share that information. In such cases, we will base our calculations on their disclosures.

What will we do with REITs that don’t share such details? We will try to calculate it ourselves based on the methodology shared within NNN’s Q1 2024 Investor Presentation:

• Retained cash flow available for investment = AFFO – dividend payments + disposition proceeds.

Please find such a calculation in the table below.

As you can see, I included different periods for NNN. The result of the calculation for Q1 2024 is coherent with the level the management indicated, but the FCF to Investment volume ratio increased substantially when factoring in Q2 2024. For clarity, please review the assumptions I took:

• I stayed with O’s 27%, as the Company indicated in its Investor Presentation.
• I stayed with NNN’s 55%, as the Company indicated. I prefer to take a conservative approach, especially given the highest level of this metric for NNN anyway.
• I assumed 12.2% and 32.3% FCF to Investment Volume ratio for EPRT and ADC, respectively.

As a result of the abovementioned assumptions, please review the investment spreads with FCF factored in.

However, please remember that it’s a short-term, out-of-pocket perspective, and REITs often look at the long-term WACC without assuming a 0% cost of internally generated financing sources. Not only did Realty Income indicate that, but so did Agree Realty.

Valuation Outlook and Risk Factors

As an M&A advisor, I usually rely on a multiple valuation method, a leading tool in transaction processes. This method allows for accessible and market-driven benchmarking.

With that said, the forward-looking P/FFO multiple stood at:

• ~14.7x for O.
• ~17.8x for ADC.
• ~14.1x for NNN.
• ~16.8x for EPRT.

Each stock market investment is accompanied by risk factors, which in the case of O include:

• large scale M&A processes are far more complicated than small-scale property acquisitions, which may lead to integration issues
• high interest rate environment negatively impacts O’s cost of debt, especially given upcoming debt maturities
• with a lot of noise around FED policy, REIT stock prices are subject to high volatility resulting from interest rate communication and expectations

As mentioned earlier, Realty Income’s multiple appreciation exceeded my expectations. Should we really witness the expected interest rate cuts, O may exceed 15 P/FFO multiple and potentially reach 16, but I believe that to be the high end of the possible range for O. Moreover, the short-term expectations seem to be substantially priced in, so we may need more positive information and improvements in the market environment for O’s multiple to appreciate further. I consider O fairly valued in the 14x – 15x P/FFO range.

Investment Thesis and Key Takeaways

As a result of my investments during the last couple of months, O’s share in my portfolio reduced substantially. I’m glad it did, as I still believe that the market presents us with more attractive total return opportunities that will benefit shareholders in the long term. For clarity, I am a buy-and-hold investor, so I don’t care much about short-term noise.

I won’t go into much detail about my doubts regarding O again, as you can better grasp my views within the article I linked in the beginning. Regardless, Realty Income has a well-deserved place in my portfolio, and I don’t intend to sell it.

The Company showcases:

• a fortress-like balance sheet reflected in solid credit metrics like fixed charge coverage, credit rating, and maturity schedule.
• top-tier business metrics, considering the specific circumstances accompanying O with solid occupancy rate, healthy WALT and safe tenant structure (despite ongoing noise).
• fair valuation given the changed market environment.
• positive and attractive investment spreads (regardless of the approach), accompanied by O’s increasing activity in Europe, which I believe to be one of the best things going around in Realty Income.
• time-tested track record of substantial shareholder rewards and competence in utilizing different growth paths (even though I’m not a fan of each and every one of them).

Therefore, I consider Realty Income as a Crown Jewel of my portfolio with a safe position that won’t reduce. However, around half a year after my last addition, I’m still not resuming my dividend reinvestments or more capital allocation into O. Even though my decision to pass on O’s recent dips may seem unintuitive to some of you, it helped me to improve the overall structure and quality of my portfolio, and I believe that it will serve me greatly in the long term. I intend to continue searching for more attractive opportunities with solid risk-to-reward ratios to help me grow a significant pillar of my financial life – a dividend portfolio.

To put it briefly, Realty Income remains a ‘hold’ for me.

As Promised: What Did I Buy Instead Of O?

#1 Agree Realty Corporation (ADC)

One of O’s closest peers has even better business metrics and portfolio quality (we will examine that later). Thanks to passing on O, I built a significant stake in ADC at an attractive weighted average cost in the mid-50s. Since my first coverage of ADC (at a similar time to O’s coverage), the Company recorded noticeably higher total returns of ~24.2%. Through investing in ADC, I enhanced my position in non-Realty Income retail-oriented REITs (I own ADC and NNN REIT, Inc. (NNN) apart from O).

I had been ADC’s shareholder before realizing the abovementioned purchases.

#2 Prologis, Inc. (PLD)

Stepping outside of the retail property sector for a second, I invested in the most significant industrial REIT to capitalize on the ongoing oversupply headwinds that this sector was (and still is) facing. PLD is one of my favourite REIT holdings, recording ~17.4% total return since my first coverage.

I hadn’t been PLD’s shareholder before realizing the abovementioned purchases, so these were my entry levels.

#3 VICI Properties Inc. (VICI)

VICI operates within a specific property sector with unique value drivers: casinos. The sector features high barriers to entry, limited tenants’ ability to switch locations, non-commoditized trophy assets (unlike retail REITs), and immunity to some secular trends. VICI has outstanding business metrics across its property segment and the whole REIT sector. VICI is one of my favourite REIT holdings, recording ~18.6% total return since my first coverage.

I had been VICI’s shareholder before realizing the abovementioned purchases.