Realty Income Corp (NYSE:O) prides itself on paying monthly dividends to shareholders. In fact, it has trademarked the phrase “the monthly dividend company” to highlight its commitment to these payments.
Realty Income’s monthly dividends currently pay out at an annual yield of 4.43%, slightly more than the S&P 500. This is because Realty Income is part of a real estate investment trust.
By law, REITS must distribute 90% of their taxable earnings to shareholders each year in the form of dividends. This also helps keep tax bills to a minimum.
Because most earnings must be paid out, REITs must rely on issuing debt and shares to get the capital to grow and maintain their businesses. In Realty Income’s case, the bulk of the company’s portfolio consists of freestanding commercial properties. As of the end of last year, Realty Income Corp owned nearly 5,000 properties.
Last year, O added another 500 properties to its portfolio. This steady growth is a key reason that revenue has nearly tripled in the last 10 years. Earnings are about flat, though, but only because the number of O stock shares outstanding has nearly tripled over that period. Again, that’s because it’s one of the only ways for a REIT to grow.
In 2016, Realty Income reported $1.13 in earnings per share, but paid out $2.40 in dividends per share. Operating cash flow was $804 million, but capital spending was $1.8 billion, which meant negative free cash flow.
REITs Must Issue Debt
To bridge this gap and also pay dividends, REITs also issue debt. Long-term debt has doubled to $5.8 billion since 2012. Most years, Realty Income issues more debt than it repays. Again, because it has to pay out most of its earnings as dividends, it has little other choice.
The nature of a REITs existence has always worried me. In periods of severe market dislocations, like occurred in 2008, issuing both debt and stock can become an issue. Realty Income has thousands of valuable properties it could theoretically sell, but that is also tough in a downturn.
REITS are also badly lagging the market over the past year. In the retail space, the growing dominance of Amazon.com, Inc. (NASDAQ:AMZN) is increasing occupancy rates from resulting retail bankruptcies. Purer play retail REITs including Simon Property Group Inc (NYSE:SPG) and GGP Inc (NYSE:GGP) are down more than 20% over the past year, while the market is up almost 14%.
O stock is also struggling, down almost 20% because nearly 80% of its properties have retail-based tenants. Walgreens Boots Alliance Inc (NASDAQ:WBA) is one of its largest tenants.
Bottom Line for O Stock
I am finding it difficult to get excited on REITs in general. Their business models are unique, subject to recession risk and the closure of capital markets. The demise of many weaker retailers is also worrisome.
I am actually more interested in Simon Property Group than Realty Income. Simon’s yield is only slightly less at 4.25%. Yet, it has significant and abundant free cash flow to more than cover its annual dividend payments. Last year, free cash flow was above $8 per share. I have yet to find another REIT that generates this much free cash flow.
That being said, Realty Income does have some positive qualities. It is well diversified across the U.S. The drug store space represents 11% of its rent, which is not economically sensitive or subject as much to online competition. Convenience stores are another 10%, followed by dollar stores at 8%. Grocery stores and wholesale stores represent another 7%.
Income-minded investors also likely appreciate the monthly payout from O stock, which can help a retiree supplement social security benefits. Realty Income is a steady grower, too, although with a somewhat unappetizing valuation — it trades at a forward P/E of nearly 47.
That’s not the best metric to value a REIT, but it is a metric yardstick nonetheless. Simon Property trades at a P/E of 26, and has the cash flow to back its dividend payout.
As of this writing, Ryan Fuhrmann did not hold a position in any of the aforementioned securities.