mStar of Realty income

Over $1 Billion in Acquisitions for Realty Income in 2Q

Kevin Brown

Equity Analyst

Analyst Note | by Kevin Brown Updated Aug 07, 2019

Realty Income executed on over $1 billion in acquisitions in the second quarter, but the timing of the financing for the acquisition caused the company to miss our estimate for the quarter. Still, we don't see anything from this quarter that is likely to cause a material change to our $59 fair value estimate for the no-moat company. Economic occupancy dropped 30 basis points year over year to 98.6%, in line with our estimate. Contractual rent growth was 1.1% for the quarter, 10 basis points ahead of our estimate, but total releasing spreads saw new rents only increase 0.4%, 3.9% below our estimate. Net operating income growth for the same-store portfolio was higher than expectations, up 1.5% compared with our 0.9% assumption. Realty Income also executed on $1.1 billion in acquisitions at an average 6.1% cap rate, well above our $557 million at 5.3% cap rate assumption. We continue to be pleased by Realty Income's execution on large portfolios at good cap rates. To finance the acquisition, Realty Income issued 14.4 million new shares and the timing of the share issuance compared with the execution of the acquisitions led to Realty Income missing our adjusted funds from operations estimate by a penny with a $0.81 figure for the second quarter.

One cause for concern this quarter was the percent of the acquisitions leased to investment-grade tenants. Only 12% of the properties acquired this quarter are currently leased to tenants who have an investment-grade corporate credit rating. As a result, Realty Income's percent leased to investment-grade tenants dropped to 49% from 51% at the end of the first quarter. Having tenants with an investment-grade credit rating makes them more likely to continue paying rents, a necessary safety feature for a triple-net landlord. While we are pleased by the volume and price of the acquisitions, we worry about the tenants being brought into the portfolio as part of the transaction.

Business Strategy and Outlook | by Kevin BrownUpdated Feb 23, 2019

Realty Income is the largest triple-net REIT in the U.S., with more than 5,000 properties that mainly house retail tenants. The company describes itself as "The Monthly Dividend Company," and its line of business and operating metrics make its dividend one of the most stable sources of income for investors. Even though over 80% of Realty Income's tenants are in retail, most are focused on defensive segments, with characteristics such as being service-oriented, naturally protected against e-commerce pressures, or resistant to economic downturns. Additionally, the triple-net lease structure places the burden of all operational risk and cost on the tenant and requires the tenant to make capital expenditures to maintain the property rather than the landlord. These leases are often long term, frequently 15 years with additional extension options, which provides Realty Income a steady stream of rental income. Coverage ratios are also very high, so tenants are healthy and unlikely to request rent concessions, even during downturns. The steady, stable stream of revenue has allowed Realty Income to be one of only two REITs that are both members of the S&P High-Yield Dividend Aristocrats Index and have a credit rating of A- or better. This makes Realty Income one of the most dependable investments for income-oriented investors.

However, the promise of stability comes at the cost of economic profit. The lease terms include very low annual rent increases around 1%, which helps keep the coverage ratio high but severely limits internal growth for the company. Therefore, to grow, the company must rely on acquisitions. The company has successfully executed on over $12 billion in acquisitions over the past decade at average cap rates above 6%. Given the access to cheap debt during this time, the company has created a lot of value. However, increased competition has lowered cap rates, and interest rates have recently increased, squeezing the company's spread and its ability to create value. We remain concerned that at some point Realty Income's valve for creating value will shut off and it will be left with just a low internal growth story.

Economic Moat | by Kevin Brown Updated Feb 23, 2019

We assign Realty Income a rating of no moat. While its portfolio of freestanding single-tenant properties is enormous, with more than 5,000, and contains many healthy tenants that are largely insulated from the effects of e-commerce, the company does not benefit from moat sources such as efficient scale or network effect that we attribute to some retail property owners. The terms of the triple-net lease make the tenant responsible for the property's operating expenses, real estates taxes, maintenance, and insurance in addition to paying Realty Income rent. However, the annual rent escalators are only around 1% and, with long-term leases over 15 years with multiple extensions and total re-leasing spreads averaging below 5% over the past few years, the company sees very low internal growth. Instead, Realty Income must rely on acquiring new properties to increase cash flow. Given that it has generally acquired properties at mid- to high 6% cap rates, the combined returns from the internal and external growth do not exceed our estimated weighted average cost of capital, which leads us to conclude that the company does not possess an economic moat.

Realty Income primarily owns and manages freestanding single-tenant properties, with retail constituting roughly 82% of its portfolio. For retail companies to demonstrate an efficient scale moat source, they must dominate their submarket with high-quality properties in high-traffic areas with significant barriers to entry. The nature of Realty Income's portfolio makes it nearly impossible to achieve the market saturation necessary to drive pricing power while maintaining quality and preventing the threat of new supply. The company's portfolio diversification, with properties in 49 states and no single state representing more than 11% of the portfolio, provides stability of cash flow but prevents it from achieving pricing power in any single market. Even if Realty Income were to concentrate its portfolio, the number of freestanding single-tenant properties and junior-anchor spaces available in adjacent shopping centers provides tenants many viable alternatives. Given that the buildings are generally around 12,000 square feet and development costs are frequently under $5 million, the barriers to entry are very low, so development can easily match new demand. Finally, the net-lease structure places the burden of operating expenses on the tenant and reduces the asset management expertise required, increasing the pool of potential investors and developers. For these reasons, the nature of the industry prevents a freestanding, net-lease portfolio from ever realistically commanding excess economic returns over a long period of time.

Despite the tough environment that brick-and-mortar retail is facing as a result of e-commerce, Realty Income's tenant mix makes it more defensive than other retail REITs. The company's occupancy is over 98%, with 96% of its portfolio leased to tenants that are protected from e-commerce or economic downturns in industries like convenience stores (12% of the portfolio), drugstores (10%), dollar stores (7%), health and fitness clubs (7%), and fast-food restaurants (6%), or is nonretail (18%). Realty Income has steadily increased its exposure to investment-grade tenants, which should be healthy enough to withstand most economic downturns and continue to pay rent, to 51% of the total portfolio. Its weighted average EBITDAR/rent ratio on retail properties has also steadily increased over time to a very healthy 2.9. There is little uncertainty that Realty Income will continue to collect rents on its leases.

However, given the health of Realty Income's tenants, we think the terms of its leases show that the major tenants possess the pricing power in lease negotiations. If the tenants are not threatened by e-commerce or the possibility of economic recessions, then they should be able to increase their cash flow at least at inflationary levels. But the average rent escalator on Realty Income's triple-net lease is only 1%, well below the long-term historical average for inflation. Therefore, even average tenants should see their rent as a percentage of their total cash flows fall over the course of the lease. This makes a longer-term lease beneficial to the tenant, so the fact that most leases are typically 15 years in length with multiple extension options shows that the tenant has more power in negotiations. The high EBITDAR/rent coverage ratio provides Realty Income an enormous cushion to practically guarantee its own revenue stream, but beyond a certain point, any additional cushion adds little incremental value to shareholders. Unfortunately, Realty Income has limited ability to push initial asking rents or rent escalators, which would directly translate to shareholder value. Re-leasing spreads to existing tenants are just north of 5%, showing that Realty Income is only able to make small gains in marking the leases to market when the leases do eventually come due, while it often must make rent concessions to attract new tenants to a property given that the properties are just generic shells that face competition for tenants from a multitude of other locations. Therefore, despite the healthy and defensive nature of the businesses that operate out of Realty Income's portfolio, tenants possess the negotiating power to demand lease terms that severely limit the company's internal growth prospects.

What has fueled the triple-net lease sector has been the enormous amount of external growth. Since 2014, Realty Income has made nearly $7 billion in net acquisitions, with most in the mid- to high 6% cap rate range, while dispositions have been at the 5% cap rate, as they have often included properties that were vacant and therefore not paying rent. Realty Income has increased the average quality of its portfolio by leasing to more investment-grade tenants, increasing the EBITDAR/rent coverage ratio, and diversifying across more defensive industries. Given the low-cost debt that Realty Income had access to over the past decade, the company was able to create significant value for shareholders through external growth. However, as we exit the historically low interest-rate environment of the past decade, we believe that the spread between the company's cost of capital and the initial cap rates will essentially close, eliminating external growth as a way to continue to create excess economic returns. Additionally, we consider most of the value created through external growth as a byproduct of excellent stewardship and not an inherent part of the company's business. Realty Income has sourced between $24 billion and $40 billion over the past six years, with over 80% of those deals sourced through existing management relationships, while executing on only 5% of those deals. We view the company's ability to create value through a large volume of external growth at attractive pricing while increasing portfolio quality as part of the skill of management and not as evidence of an economic moat.

We use an adjusted ROIC calculation to determine whether a company has shown or is forecast to have the characteristics of an economic moat. After adjusting the ROIC calculation to use maintenance capital expenditures instead of accounting depreciation, we calculate that over the past few years, Realty Income has averaged an adjusted ROIC approximately 20 basis points above our 7.1% WACC. The adjusted ROIC remains slightly below our WACC estimate through our forecast for the company, providing us quantitative evidence that the company lacks an economic moat.

Fair Value and Profit Drivers | by Kevin BrownUpdated Feb 23, 2019

We are decreasing our fair value estimate to $59 from $60 after updating our internal growth framework for our model and re-evaluating the company's acquisition volume. Our fair value estimate implies a 5.3% cap rate on our forward four-quarter net operating income forecast, an 18 times multiple on our forward four-quarter funds from operations estimate, and a 4.5% dividend yield, based on a $2.65 annualized payout.

The low annual rent escalators that average around 1% lead to same-store NOI growth averaging 1.2% across our 10-year forecast. We believe that Realty Income will continue to acquire new assets to drive growth, though the volume will slowly decline from $1.8 billion in 2019 to $800 million by the terminal year. The company will also selectively dispose of assets to partially fund its external growth, though that amount will be limited to just $100 million a year.

We estimate Realty Income's net asset value to be approximately $50 per share based on a 6.0% cap rate assumption. We use NAV as an assessment of the firm's potential private market value, essentially viewing the firm as a portfolio of assets. To calculate the NAV, we use recent asset transactions to assign a cap rate to each segment of the portfolio, apply the cap rates to arrive at gross asset value for the company's real estate, put a multiple on the company's non-real-estate assets, add the non-income-producing tangible assets, then net out the company's liabilities (excluding corporate overhead considerations). We find NAV to be a useful data point in gauging the underlying value of the firm, especially as the likelihood for realizing this value through potential asset sales, recapitalization, or mergers and acquisitions.

Risk and Uncertainty | by Kevin Brown Updated Feb 23, 2019

Despite the defensive nature of most of Realty Income's tenants, they are still subject to changing consumer tastes and economic situations. Realty Income has been increasing the average quality of its tenants, but about half are not investment-grade. The company has also reduced the overall concentration in its tenants over time, but more than half of its net operating income is still concentrated in its top 20 tenants, and seven tenants represent more than 3% of its NOI, so issues at any of these top tenants could negatively affect Realty Income's revenue.

Realty Income's properties are generic shells that can attract a wide number of possible tenants. However, there is nothing unique about the properties that can't be re-created by other developers. Barriers to entry are very low given the small size of the properties and that the cost to build is generally around $5 million. And the triple-net lease structure reduces the burden of management for the landlord, increasing the number of potential investors in the space. Any economic gains created by a specific property will likely attract competitors that will quickly eliminate those gains.

Reality Income's dependence on acquisitions to drive growth makes it subject to changes in the private markets and capital markets. Additional competition from well-capitalized investors could drive up prices and force Realty Income to either pursue fewer acquisitions, acquire at lower cap rates, or reduce the quality of properties it acquires. On the other end, Realty Income depends on regular debt and equity issuances to fund acquisitions. A drop in stock price or a rise in interest rates will increase the cost to acquire, which reduces the spread between the company's weighted average cost of capital and the acquisition cap rate and reduce the value it can create from external growth.

Stewardship | by Kevin Brown Updated Feb 23, 2019

We assign Realty Income an Exemplary stewardship rating. Sumit Roy was promoted to CEO in 2018 after serving as president, COO, and CIO at various points since joining the company in 2011. CFO Paul Meurer has been with the company since 2001. Most of the senior management team brings significant real estate and capital markets experience, mainly from positions in investment banks overseeing acquisitions of real estate. The firm's board of directors has a similarly solid background inside and outside the real estate industry and is up for election annually, giving us comfort that Realty Income has sufficient management resources available. Additionally, a significant portion of management and board compensation is in restricted stock, helping align their interests with those of shareholders.

We attribute most of Realty Income's growth to the skill of its management team. Even though the company's business drives only 1% internal growth per year, the company has quintupled in size and produced a total return on its common equity of over 300% since the end of 2009, both significantly greater than the U.S. REIT average over the same period. This growth is a result of management's ability to consistently deliver accretive acquisitions. Management over the past six years has been able to source between $24 billion and $39 billion in potential deals with around 90% of these deals coming as a result of existing relationships between Realty Income's management team and the sellers. What truly distinguishes management's skill is the discipline they regularly show to only acquire properties that create value for the company. Despite sourcing such a large volume of deals, Realty Income highly selective, acquiring only about $1.5 billion annually, or about 5% of the deals they source. While cap rates have come down over the past decade from the high 7% range to the low- to mid-6% range due to increased competition, Realty Income is still able to acquire at a spread of 150 to 200 basis points above its cost of capital. We believe that management can continue to create value for shareholders through its external growth program as long as this spread between acquisitions cap rates and financing costs remains.

What also impresses us is management's ability to significantly increase the portfolio's quality over the past decade. In 2009, only 3% of the top 15 tenants were investment-grade compared with over 30% of the top 15 tenants today and over 50% of the total portfolio. Realty Income has shifted its exposure away from economically sensitive retail segments like full-service restaurants, which represented over 21% of Realty Income's rent in 2009, to retail segments that are much more insulated from both economic downturns and e-commerce. Realty Income has also increased its exposure to nonretail tenants to further diversify and stabilize its source of rental income. The company has also increased its EBITDAR/rent coverage ratio over time to 2.9. Increasing tenant quality and shifting to recession- and e-commerce-resistant industries should reduce the risk that a tenant would be unable to pay its rental obligations, but the high coverage ratio provides a further buffer that we think almost guarantees Realty Income a steady, stable stream of income. Management's ability to generate additional cash flow while also reducing the risk contained in those cash flows shows a real skill for identifying how to build and shape a triple-net portfolio.