Realty Income stock – 5% dividend in monthly rates – How much longer?

The Realty Income stock is very popular among dividend fans. The reasons for the extraordinary popularity of REITs are a respectable dividend of currently about 5 percent as well as a reliable dividend history with 25 years of consecutive dividend increases.

Realty Income Dividend History

In addition, the dividend is paid out monthly . This is why Realty Income is also known as “The Monthly Dividend Company”. 25 years of dividend growth suggest an excellent business model that works in both good and bad economic times. Accordingly, the company has mastered the previous audit, including the competition from online retail by Amazon & Co, relatively well.

Realty Income stock
Logo
Country	USA
Industry	REIT Retail
Isin	US7561091049
Market cap.	19,2 billion $
Dividend yield	4,8%
Dividend stability	0,99 of max. 1.0
Earnings stability	0,96 of max. 1.0

In this stock analysis you will learn whether Realty Income will also master the Corona crisis, is currently favorably valued and whether it is a buy for me.

The business model: How Realty Income earns money

Realty Income is a real estate investment trust or REIT that invests primarily in commercial real estate and leases it to individual tenants on a long-term basis, primarily to large chains in the retail sector. Realty Income is similar to the STORE Capital Corporation, which I introduced in the previous article, a triple-net lease REIT. This means that the tenant pays for both the rent and all operating and maintenance costs, so Realty Income generates high margins and at the same time only needs to make minimal investments to lease and maintain the property. Advantages for the tenant are lower rents as well as a high degree of predictability due to very long-term rental contracts, usually over 10 years.

Realty Income boasts a huge real estate portfolio consisting of over 6,500 assets. I approach such a huge portfolio from three angles: by tenant, by sector and by location.

The Tenants

From a tenant perspective, the Walgreens drugstore chain dominates with a 6% rent share, followed by other larger chains such as 7-Eleven (4.7%), Dollar General (4.4%) and FedEx (4.0%). With the exception of Walgreens these tenants have been minimally or not at all affected by the Corona crisis, while other major Realty Income tenants such as LA Fitness (3.4%) and AMC Theaters (2.9%) are in serious trouble – but more on this later.

Top 20 tenants of Realty Income

In total, the 20 largest tenants contribute 53.1% of annual rental income, with 12 of the 20 tenants having an investment-grade rating indicating a high degree of creditworthiness. Overall, Realty Income thus has a financially strong tenant base. Maintaining a diversified portfolio of quality properties leased to strong tenants helps to ensure the stability of income, which in turn ensures the payment of monthly dividends.

The Sectors

When looking at the sector, it is noticeable that Realty Income is primarily a so-called retail REIT. The retail segment contributes 84.1% of annual rental income while the remaining 15.9% is distributed among the industrial (10.7%), office (3.5%) and agriculture (1.7%) segments.

Portfolio composition by segment

Within the retail segment, the dominant sectors are small grocery stores (11.9%) such as 7-Eleven, which are often located at gas stations. In addition, there are drugstores (9%), dollar stores (8%) as well as supermarkets (7.7%), fitness studios (7.2%) and cinemas (6.3%). In total, Realty Income’s portfolio contains 51 retail sectors, which means that the company is excellently positioned throughout the economic landscape.

Top 6 industries of Realty Income

The Locations

Realty Income is represented in all U.S. states except Hawaii and also has select properties in Puerto Rico and the United Kingdom, with the latter two regions contributing less than 4% of total rental income.

Portfolio composition by geography

Within the USA, the portfolio is concentrated across the 6 key states of Texas, California, Illinois, Florida, Ohio and New York. Together, these markets account for around 40% of total rental income. In these metropolitan regions, Realty Income is positioned across the board, while huge areas in the countryside, mainly in the north, which are not directly located on the coast or at the Great Lakes, account for only a very small share of annual rental income.

The current quarterly figures as of 31 March 2020 do not yet reflect any burden from the pandemic. In order to measure the financial health and earnings power of a REIT, the following two key figures are indispensable: the “Funds from Operations” (FFO) and the “adjusted Funds from Operations” (AFFO). Both ratios look at the REIT’s profit adjusted for depreciation and amortization, with AFFO also taking into account the impact of recurring capital expenditure, for example property maintenance costs. Both ratios are relevant for the fundamental analysis of Realty Income, whereby I personally prefer AFFO, as this ratio also adjusts FFO for special impacts on sales and costs. As these occur relatively rarely, the two ratios are mostly very close to each other for Realty Income. Compared to the previous year, AFFO achieved a very solid increase of 7.3%.

Realty Income is in a strong financial position and was able to increase AFFO in 23 of the last 24 years – the only exception was 2009, when the financial crisis was raging. However, the dividend was even increased during the financial crisis and has grown by an average of 4.75% annually over the last 10 years. Largely isolated from economic crises, Realty Income can boast a permanently high occupancy rate. Since 1996, this ratio has never fallen below 96%. At the end of the first quarter of 2020, the occupancy rate is at 98.5%.

Multi-year historical financial performance

Similar to the STORE Capital Corporation, the significance of AFFO figures for Realty Income only plays a secondary role in the midst of the corona crisis. In the midst of the crisis, it is more important to look at monthly rent collections and the burden of COVID-19 on individual tenants and entire sectors in Realty Income’s portfolio. Recently Realty Income released the relevant figures for the second quarter (during normal times, 100% of the rent is usually collected). Overall, 85.7% of the contracted rent was collected (86.9% in April, 83.5% in May and 85.7% in June). This outstanding level of rent collection is primarily due to the fact that only a few industries in Realty Income’s tenant base have encountered payment difficulties. Reason of concern are the usual suspects in the health & fitness, cinema chains, restaurants and child care sectors.

Q2/2020 rent collections from top 20 industries

In the event of non-payment of rent for the months April to June 2020, Realty Income will either enter into deferral discussions with the tenants or has already concluded deferral agreements with them. Overall, Realty Income’s management is optimistic about the future and believes that the majority of tenants in trouble will recover.

Although I am also convinced of Realty Income’s tenant portfolio, it is currently completely unclear whether and how the troubled sectors will recover, especially as it is uncertain how consumer behaviour will change in the long term as a result of Corona. Those used to go to the gym might have enjoyed a home workout during the lockdown and do not intend on going back to the gym. Those who used to go to the cinema may now enjoy spending a nice video evening at home with friends or prefer streaming rather than going to the cinema. Although rental income from cinemas and fitness studios is not vital for Realty Income, it still accounts for around 13.5% of total rent. Nowadays this portion of income is deemed to be very vulnerable.

How safe is Realty Income’s dividend?

Within the REIT universe, Realty Income has probably the most symbolic dividend of all stocks. An impressive dividend history with monthly distributions and continuous dividend growth for 25 years in a row makes Realty Income a dividend aristocrat.

Earnings, FFO and dividend development over time of Realty Income stock

As of Q1/2020, the AFFO-based payout ratio is approx. 80%, which should come fairly close to 100% soon due to the already realized rent losses in Q2 and the expected rent losses in Q3. There is probably hardly a company that is more associated with its dividend than Realty Income. There is a reason why the name “The Monthly Dividend Company” is a registered trademark of Realty Income. Management is aware of this and emphasized the importance of dividends in the last earnings call:

Yes, it is our brand. We are the monthly dividend company. It is very much part and parcel of how we operate our business. It is our mission. And so, this is one of those tools that we certainly have available to us, we manage liquidity.

But one that we feel, at least given the lay of the land today and despite all of the things that you have laid out, we do not need to pull on and part of that goes back to the liquidity strength that we have to be able to withstand disruptions, even medium term disruptions and still be able to maintain a profile of the business that continues to be very strong and continues to support the dividends.

In other words, I deduce the following:

Yes, that’s our brand. We are “the monthly dividend company”. The dividend is an essential part of our business. We have a very strong liquidity position and see no reason to resort to outside capital to support the dividend, neither now nor in the medium term.

At the end of the first quarter of 2020, Realty Income had cash and cash equivalents of 2.7 USD billion, of which the majority (2.4 USD billion) is an existing credit facility. This cash reserve covers the total annual operating expenses of approximately 830 USD million and the annual dividend of approximately 960 USD million and leaves sufficient room for unforeseen costs or lucrative investment opportunities.

Is the Realty Income stock fairly valued?

Prior to the corona outbreak, the Realty Income stock reached a record high of 84.82 USD. Afterwards it plummeted as low as 38 USD. Ever since the stock price has recovered noticeably and currently stands at around 58 USD, which is still well below its all-time high.

Despite the pandemic, analysts estimate Realty Income’s FFO for the 2020 financial year at 3.29 USD per share, which is roughly equivalent to the previous year’s FFO of 3.27 USD. Moderate growth of around 5% is even expected again for 2021 and 2022.

However, due to the ongoing corona pandemic, these estimates must be treated with great caution. Nevertheless, I still consider the Realty Income stock to be fair or even slightly undervalued at present.

The Dynamic Fair Value Calculation currently quantifies various fair values for the stock. It is noticeable that these are all relatively close together (between USD 60 and USD 62.30) and computed close to the current price (approx. 58 USD), which makes the stock appear to be fairly valued or even slightly undervalued. Overall, the historical multiples appear to be meaningful for the fair value valuation of Realty Income, as the stock has repeatedly adjusted to these levels over the long term on average after phases of over- and undervaluation.

Realty Income Dynamic Fair Value Assessment

Currently, Realty Income is valued with a P/FFO ratio (price divided by FFO) of approximately 17.9, which is slightly below the historical multiple of 18.8. Similar results can be obtained by using AFFO and the historical dividend yield. They all point to a slight undervaluation of the stock.

All in all, I agree with the result, but this assumes that Realty Income will be able to return to its old track record by 2021 at the latest. Otherwise there is considerable potential for devaluation, as Realty Income has historically been valued at significantly higher multiples than the sector as a whole (P/E ratio of 18.8 for real income vs. P/E ratio of 12.8 for the sector). Realty Income has earned this valuation premium through its outstanding performance and flawless dividend history. However, should the pandemic lead to permanent and significant rent losses or lower rents, the market will have to revalue sooner or later.

Realty Income is strongly positioned, but the stock is not cheap

Realty Income has already survived numerous crises and I am confident that this time will be no different. The company will react accordingly if consumer behavior changes fundamentally and permanently. Realty Income has a solid balance sheet and a broadly diversified portfolio with long-term leases which has now generated over 550 consecutive monthly dividends.

Despite a slight undervaluation based on historical “pre-corona” multiples, the stock is not exactly cheap in my view, as the present uncertainty has not yet been sufficiently priced in in my opinion. And if you consider the impact COVID-19 is likely to have on the company’s results, the stock price doesn’t seem quite so attractive today, especially since the virus is getting out of control in the USA, especially in states like Florida and Texas –  in those states where Realty Income is strongly represented. That’s why the stock is currently recommended for long-term investors as part of a savings plan rather than as an individual purchase. The former is also my personal strategy to build up and expand my position, while at the same time keeping the stock on my watchlist in order not to miss a better buying opportunity.

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