Realty Income (NYSE:O) is a REIT that has thousands of properties across the U.S., Puerto Rico, and U.K. It is an integrated real estate company with in-house finance/accounting, tenant research, portfolio management, and capital markets expertise. We like the REIT’s solid investment grade credit ratings from the big rating agencies (A3/A-), which gives us confidence that it can tap the external capital markets when, if ever, in need.
Realty Income’s stated goals are simple: generate dependable monthly cash dividends from a consistent and predictable level of cash flow from operations. Convenience, grocery, dollar, and drug stores represent a key focus for the REIT. Going forward, the REIT wants to become a top 5 U.S. REIT, and continue to consolidate the ~$12 trillion global net lease addressable market.
The coronavirus (‘COVID-19)’ pandemic created some serious hurdles for its operations, though Realty Income has put many of those obstacles behind it as the financial health of its tenant base has staged a meaningful recovery (generally speaking) in recent quarters. When Realty Income reported third-quarter 2021 earnings in early November, the REIT beat consensus estimates for revenue and matched consensus estimates on the bottom line (specifically for its AFFO per share performance).
The company’s adjusted funds from operations (AFFO) per share rose by 12% year-over-year last quarter, as Realty Income’s financial performance has rebounded with almost all its tenants having resumed making contractual rent payments, after some of its tenants (particularly in the movie theater space) stopped making payments during the worst of the COVID-19 pandemic.
In the third quarter of 2021, Realty Income collected 99.5% of its contractual rent across its portfolio including 100% of the contractual rent owed from its tenants with investment-grade credit ratings. This speaks favorably towards Realty Income’s ability to push through rental rate increases in the future, which in turn supports its cash flow growth outlook.
Realty Income is also steadily expanding its overseas footprint and has built up a robust investment and development pipeline in the U.K. and more recently, Spain. We appreciate its push overseas as that supports its cash flow growth trajectory. As of the third quarter of 2021, its U.K. footprint represented almost one-tenth of its annualized contractual rental revenues, before taking its VEREIT merger and office property spinoff into account.
The “Sacrosanct” Dividend
As it has been for some time now, Realty Income is considered a great dividend growth opportunity, and the REIT has not disappointed. Its international expansion plans support its longer-term growth trajectory, and recent guidance increases indicate that Realty Income’s property portfolio is once again firing on all cylinders.
As of December 2021, Realty Income had paid out monthly dividends over the past 615+ consecutive months (51+ years) and the REIT last increased its payout (as of this writing) in December 2021. We expect Realty Income to continue to steadily grow its payout going forward, and we continue to like the REIT as a dividend growth idea. Management has noted in the past that it treats “the dividend as sacrosanct to (its) mission.”
Image Source: Realty Income
We also applaud management for its poise during the COVID-19 pandemic with respect to dividend policy, while other REITs, especially mortgage REITs were forced to cut their payouts. This was a tremendous feat, and one that shareholders have definitely appreciated. Here’s what management had to say when it raised its common stock monthly cash dividend to $0.2465 per share in December 2021:
As we approach the end of 2021, I’m pleased that our Board of Directors has once again determined that Realty Income can increase the amount of the monthly dividend. This will be our 114th dividend increase since 1994 and is in line with our mission to invest in people and places to deliver dependable monthly dividends that increase over time. With the payment of the January dividend, we will have made 618 consecutive monthly dividend payments throughout our 52-year operating history.
To balance our optimistic dividend analysis, we must caution that Realty Income remains capital market dependent, however. What does this mean though? Well, REITs pay out 90% of annual taxable income and therefore are unable to meaningfully reinvest internally-generated funds, resulting in external capital-market dependence (i.e. the need for external capital, new debt or equity).
The weak internal cash-flow retention of most REITs translates into poor Dividend Cushion ratios, which could become severe during the depths of the real estate cycle (as was witnessed during the COVID-19 meltdown). Even though a REIT’s operating cash flow may be robust, the lack of cash accumulation on the balance sheet and the massive debt needed to purchase/develop new properties can become restrictive.
Let’s examine this risk more closely with respect to Realty Income. During the first nine months of 2021, Realty Income generated sizable negative free cash flows given its large capital expenditure obligations. This means that the REIT must continuously tap debt and equity markets to fund its growth ambitions, make good on its dividend obligations, and refinance maturing debt. This is not inconsistent with respect to its operating history, however, where traditional measures of free cash flow have been negative (as shown below).
Source: Valuentum. Image Shown: This is traditional free cash flow analysis, as performed as if Realty Income was a general industrial operating company. Though most REITs report funds from operations (FFO) and AFFO numbers, it’s important to be aware of traditional free cash flow numbers, especially in times of tight credit market conditions where a company may need to rely only on internally generated funds. Realty Income’s large investment program means that it needs assistance from the capital markets to not only continue to invest in new projects but also pay its dividend. This means its dividend is not ironclad, even if it may be “sacrosanct.”
That said, there’s not much to worry about Realty Income’s ability to tap the external markets for capital at this time, if recent activity is any indication. During the third quarter of 2021, for example, Realty Income raised ~$1.6 billion through its at-the-market (‘ATM’) equity issuance program and a secondary offering in July 2021. Additionally, the REIT noted in its earnings press release that “in July 2021, we issued [GBP]£400 million of 1.125% senior unsecured notes due 2027… and [GBP]£350 million of 1.750% senior unsecured notes due 2033” and that these “issuances represented our debut green bond offering.”
Green bond issuances are growing in popularity in the REIT world as ESG investing continues to proliferate. The proceeds from these types of bonds, generally speaking, need to be allocated towards projects that are considered green. In return, REITs can modestly lower their cost of capital, but nonetheless, the constant need for more capital is an innate and risky part of any REIT’s business model.
Image Source: Valuentum’s estimate of Realty Income’s weighted average cost of capital within its enterprise free cash flow process.
Merger and Spinoff
On November 1, Realty Income Corporation completed its stock-for-stock merger with VEREIT, a deal that according to an April 2021 press release had an enterprise value of ~$50 billion. When the merger closed, shareholders of Realty Income owned ~70% of the new entity and shareholders of VEREIT owned the remainder. As part its merger strategy, Realty Income combined the corporate office property portfolio of both firms and spun that unit out as a standalone REIT under the name Orion Office REIT Inc. (NYSE:ONL).
The rationale for the spinoff is straightforward. In the wake of the COVID-19 pandemic and the acceleration of the work-from-home (‘WFH’) trend, the outlook for the broader office property industry was no longer as attractive as the outlook for other parts of Realty Income’s property portfolio. Here, we must stress that plenty of office properties remain attractive and that as the pandemic fades, many will return to the office in some form, whether that be full-time or through a hybrid work schedule. However, some office properties may become obsolete, and Realty Income wanted to pivot towards its best growth opportunities.
For Realty Income, the REIT wanted to streamline its operational focus. According to its April 2021 press release announcing the VEREIT merger, Realty Income noted that the pro forma company (post-merger, post-spinoff of office properties) would generate ~37% of its annualized contractual rent from convenience store, grocery store, dollar store, drug store, and home improvement tenants combined. Furthermore, another ~23% of its annualized rent on a pro forma basis was expected to come from casual dining and quick service restaurants, health & fitness, and movie theater tenants combined along with another ~4% from transportation services tenants. Around 45% of its annualized rent on a pro forma basis was expected to come from tenants with investment grade credit ratings.
Pivoting to Orion Office REIT, that spinoff’s portfolio consists of ~100 office properties. For every ten shares of Realty Income, investors received one share of Orion Office REIT. Roughly three quarters of the new REIT’s contractual annualized rent is expected to come from tenants with investment-grade credit ratings and around two thirds of its combined annualized rent is expected to come from the healthcare, telecommunications, insurance, financial services, and government services industries. The office REIT has an attractive and financially strong tenant base, though its growth outlook is limited to a degree by factors outside of its control, keeping the WFM trend in mind.
Looking ahead, Realty Income expects to retain its investment grade credit rating (A3/A- as of the end of September 2021). The REIT intends to try to refinance VEREIT legacy debt at lower rates over the coming years to reduce its interest expenses. Additionally, Realty Income aims to generate ~$45-$55 million in annualized corporate cost synergies from the merger (inclusive of stock-based compensation). Around three quarters of those annualized synergies are expected to be realized within the first twelve months post-closing. Improvements in Realty Income’s cost structure will support its future cash flow generating abilities, which we appreciate.
Realty Income views the VEREIT merger as highly accretive to its non-GAAP adjusted funds from operations (‘AFFO’) per share performance. For reference, AFFO is an industry-specific metric that acts as a useful gauge to measure the trajectory of a REIT’s financial performance. The REIT’s April 2021 press release noted that “the transactions are expected to be over 10% accretive to Realty Income’s AFFO per share in year one, add meaningful diversification that further enables new growth avenues, strengthen cash flow durability, and provide significant financial synergies, particularly through accretive debt refinancing opportunities.”
Realty Income offered preliminary near-term guidance in conjunction with its latest earnings report that was favorable, in our view. The REIT aims to generate $3.84-$3.97 in AFFO per share in 2022 (taking the spinoff of Orion Office REIT into account) and is forecasting to generate $3.55-$3.60 in AFFO per share in 2021 when including the impact of the VEREIT merger.
At the midpoint of guidance, Realty Income aims to grow its AFFO per share by ~9% in 2022 versus expected 2021 levels. Without taking the VEREIT merger into account, Realty Income aims to generate $3.53-$3.59 in AFFO per share this year and using that as a baseline would result in the firm’s AFFO per share growing by ~10% in 2022 versus expected 2021 levels at the midpoint of guidance.
Please note that Realty Income boosted its full-year guidance during the second quarter of 2021 (which included the firm raising its expected AFFO per share performance for 2021). Next year, Realty Income’s forecast for its acquisition volumes is to exceed $5.0 billion. We appreciate Realty Income’s improving near-term outlook.
Our discounted cash flow process values each stock on the basis of the present value of all future free cash flows. Although we estimate Realty Income’s fair value at about $74 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers such as future revenue or earnings, for example.
After all, if the future were known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock.
In the graph below, we show this probable range of fair values for Realty Income Corp. We think the firm is very attractive below $59 per share (the green line), but quite expensive above $89 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion. At $71 per share, shares of Realty Income look quite favorable, with more potential upside than downside, in our view.
Image Shown: We view Realty Income’s fair value estimate as a range of probable fair value outcomes. Shares are trading below our point fair value estimate of $74 per share at the time of this writing.
Future Path of Fair Value Estimate
We estimate Realty Income Corp’s fair value at this point in time to be about $74 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below captures the future path of Realty Income Corp’s expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm’s shares three years hence.
This range of potential outcomes is also subject to change over time, should our views on the firm’s future cash flow potential change. The expected fair value of $81 per share in Year 3 represents our existing fair value per share of $74 increased at an annual rate of the firm’s cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range. Things are looking up and up at Realty Income, in our view.
Image Shown: We expect Realty Income’s intrinsic value to continue to advance in coming years.
Realty Income’s deal with VEREIT and its international endeavors add increased complexity to the analysis, and while we’d like to see traditional free cash flow measures improve, we understand that material capital-market dependency risk is a natural part of a REIT’s business model and a key reason why investors are offered a decent-sized dividend yield (the risks of a payout cut are larger than that of a general operating company that has material net cash and significant free cash flow in excess of the dividend payout).
In light of Realty Income’s improving outlook, investment-grade credit rating, and recent capital market activity, however, we expect that the REIT will be able to continue tapping capital markets at attractive rates as needed going forward to continue paying out a healthy dividend. We’re excited about the Realty Income’s international growth runway and synergies related to its VEREIT deal. A positive risk/reward breakdown, a nice ~4.2% dividend yield, and a committed management team make Realty Income one of the top considerations for dividend growth investors, in our view.