Value Investing

Realty Income (O): A Premium Monthly Dividend Stock

The best monthly dividend stocks provide predictable, growing income. With 550 consecutive monthly dividends paid and 74 consecutive quarterly increases, Realty Income (O) is one of the most dependable dividend-paying stocks in the market.

If the valuation is reasonable, these are the types of companies I like to own in our Conservative Retirees dividend portfolio.

Let’s take a closer look at Realty Income to see if it can make the cut.

Business Overview

Realty Income was founded in 1969 and is a real estate investment trust (REIT) with more than 4,600 properties located across 49 states.

Almost all of the company’s properties are single-tenant and are leased to 243 different commercial tenants doing business in nearly 50 different industries.

Retail properties account for close to 80% of Realty Income’s total rent, and all of its properties are under long-term triple-net lease agreements, which provide solid cash flow visibility and shift property operating expenses such as maintenance, utilities, insurance and taxes to the tenant.

In other words, the rental revenue received by Realty Income has substantially fewer expenses and more stable net cash flow compared to REITs with a smaller mix of triple-net leases.

Business Analysis

It’s no secret that few companies have maintained as strong of a dividend growth track record as Realty Income.

The company’s success is driven by its diversified portfolio, disciplined capital allocation, focused business strategy, and strong financial health. These factors have combined to create an extremely resilient business.

Realty Income’s long-term growth has been nothing short of outstanding. Since 1994, the company has grown its real estate assets (at cost) from $451 million to $12.6 billion; expanded the number of industries served by its portfolio from 23 to 243; increased its number of commercial tenants from 23 to 243; and boosted its annual revenue from $49 million to over $1 billion.

Management’s growth strategy over this time has been very focused. The company leverages its relationships with tenants, property developers, brokers, investment banks, and other parties to source acquisition opportunities with strong initial cap rates and built-in rent growth.

Realty Income will only purchase freestanding, single-tenant properties located in big markets and/or key locations that it can lease to tenants with superior credit ratings and cash flows.

The retail business is very much driven by location, and Realty Income’s portfolio clearly plays to this critical success factor.

As seen below, Realty Income’s occupancy rate has never dipped below 96.6% going all the way back to 1992.

Realty Income Dividend Stock Analysis

Source: Realty Income

Sustained high occupancy rates signal the high quality locations of Realty Income’s properties and the financial strength of its tenants.

High occupancy rates are also indicative of the switching costs faced by consumer-focused retailers, who don’t want to risk disrupting their established customer base by moving to a new location to save a bit on rent.

Equally important, Realty Income is not betting on any one client or industry for its future success.

After all, a high occupancy rate is of little value if a single tenant accounts for a major portion of rent (e.g. 15%+ of total rent) and goes under or decides to walk away after its leases expire.

Realty Income’s largest tenants by rent are Walgreens (6.8%), FedEx (5.3%), Dollar General (4.5%), LA Fitness (4.2%), and Dollar Tree (4.1%).

Its largest industries by rent are drug stores (11%), convenience stores (9%), dollar stores (8.8%), health and fitness (8.3%), and theatres (5.2%).

By geography, no state accounts for more than 10% of total rent.

Importantly, Realty Income focuses on leasing to tenants that have a service, non-discretionary, and/or low price point element to their business.

Over 90% of the company’s retail tenants possess at least one of these components, which help them survive a variety of economic conditions and better compete with internet retailers.

Investment-grade-rated tenants also account for more than 40% of Realty Income’s total annualized rental revenue.

All of these characteristics combine to create a durable and stable stream of rental revenue.

Realty Income’s lease renewal schedule is also favorable. Less than 20% of its rental revenue is up for renewal over the next five years, and no more than 9% of its total rent is up for renewal any single year through 2030. The company’s weighted average remaining lease term is also 10 years.

By staggering lease renewals, Realty Income avoids the risk of needing to renew a substantial amount of its leases at potentially less attractive rates during a down economy.

A final strength of Realty Income’s business is its financial health. REITs are required to pay out almost all of their taxable income in the form of dividends, leaving very little capital for reinvestment. As a result, REITs primarily rely on external financing to fund their property acquisitions.

You can see that Realty Income’s share count has nearly tripled since fiscal year 2005 to help fund its property acquisitions:

Realty Income Dividend Stock AnalysisSource: Simply Safe Dividends

Realty Income targets a conservative capital structure with about two-thirds equity and one-third long-term debt. Nearly 90% of the company’s debt has a fixed interest rate, which protects near-term earnings from rising interest rates. Its debt maturity schedule is also well laddered.

The company’s debt ratios are also healthy. Realty Income maintains a fixed charge coverage ratio of 4.1 and an interest coverage ratio of 4.6.

Each of the major credit agencies has assigned Realty Income’s senior unsecured notes and bonds an investment grade credit rating, too. Strong credit ratings help the company secure low-cost funding to finance property acquisitions.

As long as Realty Income continues to have access to external financing for growth, there should be no shortage of properties for the company to acquire.

According to National Retail’s 2014 annual report, the total size of the single tenant retail property market is estimated to be approximately $1 trillion. Realty Income’s revenue last fiscal year was just over $1 billion, leaving plenty of room for future growth.

Overall, it’s hard not to like Realty Income’s business. The company owns thousands of extremely valuable retail locations; is diversified by tenant, industry, and geography; maintains a conservative capital structure; has plenty of opportunities for future growth; and has a long track record of creating value for shareholders.

These are many of the same factors possessed by Warren Buffett’s best dividend stocks, and Realty Income will likely remain a force for many years to come.

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Realty Income’s Key Risks

It’s challenging to identify many risks that could impair the long-term earnings potential of Realty Income.

The company’s diversification, financial conservatism, and focus on quality tenants and recession-resistant industries eliminate many fundamental risks faced by other REITs.

Realty Income is significantly exposed to the consumer retail sector (80% of total rent), which is constantly evolving due to changing consumer preferences and the continued rise of e-commerce.

However, Realty Income is not overly exposed to any single industry and derives the majority of its retail rent from tenants with business models that are less susceptible to online spending (e.g. dollar stores, services).

Simply put, it seems unlikely that the continued rise of e-commerce would materially impact demand across many of Realty Income’s tenants, much less jeopardize their ability to continue making rent payments.

Aside from analyzing the health of a REIT’s tenants, it’s always worth mentioning that REITs face higher capital market risk than most other types of business models.

REITs are required to pay out at least 90% of their taxable income as dividends, which means they have less capital at their disposal to grow their businesses.

As a result, they need to issue shares and raise debt to finance property acquisitions and grow their cash flow.

If capital markets freeze up and/or business fundamentals deteriorate, dividend cuts can become a real risk depending on the REIT.

Realty Income is conservatively financed and focuses on high quality tenants with less economy-sensitive businesses, helping mitigate this risk (Realty Income’s revenue declined by just 1% in fiscal year 2009, and the company recorded a 96% occupancy rate). However, it’s an important risk to remain aware of for other REITs.

Overall, Realty Income seems to have low fundamental risk.

Dividend Analysis: Realty Income

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Realty Income’s long-term dividend and fundamental data charts can all be seen by clicking here.

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Realty Income has a Dividend Safety Score of 72, which suggests the company’s current dividend payment is very safe.

One of the most important financial ratios for dividend investing is the payout ratio. While net income is used for most companies to compute the calculation, REITs face several complications.

Since REITs own a lot of property, they record substantial non-cash depreciation charges each year, reducing their net income. However, the value of real estate tends to rise over time, creating a mismatch between accounting and reality.

For this reason and others, real estate businesses use a supplemental measure called “adjusted funds from operation” (AFFO) in place of net income to get a better sense of their true dividend payout ratios.

AFFO measures cash flow by removing the non-cash impact of real estate depreciation along with several other adjustments to give a truer look at a company’s actual operating performance.

Realty Income expects AFFO per share of $2.85 to $2.90 in 2016, resulting in a payout ratio of approximately 83%.

I generally prefer companies with lower payout ratios to provide a greater margin of safety, but I will make exceptions for companies with extremely dependable earnings.

Realty Income seems to fit the bill. The company’s long-term leases, consistently strong occupancy rates, quality real estate locations, business diversification, and financially healthy tenants alleviate most of the concerns associated with a high payout ratio.

As seen below, the company has consistently grown its revenue and fared well throughout the last recession, seeing sales dip by just 1% in fiscal year 2009. A high payout ratio isn’t as much of a concern if a company’s results are stable throughout most economic environments.

Realty Income Dividend Stock AnalysisSource: Simply Safe Dividends

Realty Income’s solid Dividend Safety Score is further supported by its conservative capital structure and diversified mix of rent revenue.

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Realty Income’s Dividend Growth Score of 17 suggests that the company’s dividend growth potential is below average.

Despite management’s solid track record of paying dividends for 47 years and increasing the dividend 85 times since 1994, dividend growth has averaged around 4-5% per year over most time periods.

Realty Income Dividend Stock AnalysisSource: Simply Safe Dividends

While that is not bad growth, it is below the S&P 500’s long-term historical dividend growth rate.

Regardless, Realty Income’s commitment to its dividend is unwavering, and I expect the company to eventually join the dividend aristocrats list once it is qualified to do so in the next five years.

Going forward, I expect Realty Income’s dividend growth to average 3-5% per year – roughly in line with earnings growth.

REITs pay out almost all of their income as a dividend and are generally mature, capital-intensive businesses, so dividend growth is often relatively low but reliable.

Realty Income  – Valuation

O’s stock trades at approximately 20 times estimated 2016 AFFO per share and has a dividend yield of 4.0%, which is lower than its five-year average dividend yield of 4.9%.

Going forward, I expect Realty Income’s AFFO per share growth to average 4-6% per year. The company’s organic sales only grow 1-2% per year, driven by rent increases, so it will need to continue tapping external financing and acquiring new properties to grow AFFO per share beyond that rate.

Under my AFFO per share growth assumptions, Realty Income’s stock appears to offer total return potential of 8-10% per year.

Realty Income has performed very well recently, returning over 36% over the past year alone. Considering the stock’s relatively high cash flow multiple and relatively low dividend yield, I would prefer to wait for a better entry point – perhaps caused by Fed-induced volatility across higher-yielding stocks if additional interest rate hikes are announced later this year.

REITs can be one of the best stock sectors for dividend income and Realty Income is certainly a high quality business, but that doesn’t mean the stock is an attractively priced investment today.

Conclusion

Realty Income is arguably the most reliable monthly dividend stock in the market and certainly possesses many of the qualities I look for in a blue-chip dividend stock.

I like the company’s disciplined approach to acquiring properties, focus on leasing to high quality tenants, conservative capital structure, and thorough diversification by tenant, industry, and geography.

Realty Income should continue to enjoy consistent, albeit mild, dividend growth for many years to come. On a pullback, the stock will look really interesting as a potential investment opportunity, especially for those living off dividends in retirement.

Realty Income  – Boost Your Dividend Portfolio

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