Realty Income: Continued Focus On Growth

At the start of this year I concluded that REIT Realty Income (NYSE:O) was focusing on growth instead of growth per share. This came after the company was aggressively expanding the business through asset acquisitions, issuing shares in the meantime to preserve balance sheet strength.

With cap rates having moved up less than interest rates, I was a bit cautious amidst a focus on growth, instead of growth on a per-share basis.

A Recap

One of the compelling features of Realty is that it pays monthly dividends to investors, a feature well liked by many (retail) investors as these dividends coincide with monthly expenses and income, to thereby provide a real mental accounting benefit.

The company owns and leases out more than 12,000 properties to more than a thousand customers, with occupancy rates approaching 99%. Some key tenants include high profile names like Walmart, Dollar General, FedEx, CVS, Tractor Supply and Kroger, typically making up between 1 and 4% of rent.

The company stresses its defensive position by pointing out that properties are let out to strong and big name tenants, with many customers focusing on lower-price customers, creating defensive qualities for the properties. Another key item is that many of these properties are maintained by tenants, as Realty incurs very little capital spending itself.

Traditionally a North American business, the company has focused on expansion in Europe in recent years, having grown the operation there over time, as the company announced a large merger with VEREIT. With these deals complicating results for 2021 quite a lot, we move up to 2022.

2022 - An Active Year

Following the merger with VEREIT, Realty continued with elevated capital deployment in 2022. In February of the year, the company cut a big deal with Wynn Resorts (WYNN) by buying and leasing back the Encore Boston Harbor resort in a $1.7 billion deal with a 5.9% cap rate for 30 years to come. Outside the Wynn deal, the company deployed another $1.5 billion in the first quarter on acquisition volumes, as that number rose to $1.7 billion in the second quarter and $1.9 billion in the third quarter.

With the company recently (back in January) issuing 2032 notes at an effective yield of 5.6%, it was evident that borrowing costs were on the rise, creating a headwind to the profit and loss account, as average borrowing costs still come in a lot lower. That said, in evaluating recent acquisitions, one should look at the marginal borrowing costs.

With 619 million shares trading at $63 at the start of the year, the company commanded a $39 billion equity valuation, exceeding the book value of equity at $27 billion. The $12 billion premium added to the $34 billion book value for the properties suggests that the market valued these at $46 billion. With revenues trending at $3.3 billion a year, that implies a market cap rate around 7.2%.

With funds from operations trending at $4 per share and dividends coming in at $3 per share, the dividend yield looked compelling at nearly 5%. That dividend is a key reason for an investment, but note that the company has been diluting the share base to show growth, limiting the capital appreciation potential.

Moreover, the company kept acquiring at similar cap rates, announcing a $894 million deal to acquire 185 single tenant retail and industrial properties at a 7.1% cap rate in December. This shows that the company might be more focused on growth of the portfolio than growth on a per-share basis.

All of this made me cautious on Realty at $64 at the start of the year.

And Now?

Since the start of the year, shares of Realty have gradually fallen to the $60 mark, essentially losing the same amount of the annual dividend here.

Since the start of the year many developments have taken place. In February, Realty announced a strategic alliance with Plenty to develop up to a billion in vertical farms over time. Later that month the company posted its fourth quarter results with revenues reported at $889 million and adjusted funds from operations reported at a dollar per share. The company ended the year with $9 billion in investments for the year.

The company continues to trade at a roughly $12 billion premium to reported book value while the net value of the assets on the balance sheet trades is reported at $38 billion, for a market value of $50 billion. In comparison to $889 million in quarterly rental income (on an annualised basis), this works down to a 7.1% cap rate. While the company has been issuing more expansive debt around 5%, the effective annual interest rate only comes in around half a billion now, equal to about 3% of net debt.

For 2023, the company guided for funds from operations at just over $4 per share, targeting about $5 billion in acquisition volumes. The company delivered on a huge portion of this target already in March as the company announced a deal with convenience retailer EG Group.

Realty will acquire 415 single store units in the US at a $1.5 billion price, and while the cap rate only comes in at 6.9%, the units are leased on a 20-year lease term. This deal means that EG will make up nearly 3% of the portfolio here. To finance this deal, and other deals, Realty announced an unsecured note offering with maturities due between 2028 and 2033 on an effective interest rate around 5% already in April.

With the current dividend now coming in at $3.06 per share, the effective dividend yield comes in just over 5% which is a bit more compelling since January of course, certainly as we might see some less upward pressure on interest rates here. Hence, I am gradually warming up a bit to the shares here, although the focus on growth over growth per share remains, which is not really a desirable trait in my eyes.

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