Moving To Buy On Realty Income: Explaining The Safety

Summary

What makes Realty Income a safe dividend stock?

The net lease business model is inherently safer than shopping centers and malls.

Realty Income maintains a conservatively managed balance sheet.

Due to recent underperformance, the valuation has become compelling.

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NoDerog/iStock Unreleased via Getty Images Realty Income ( O ) performed strongly during the pandemic, but its stock still trades lower than pre-pandemic levels. I have previously made the argument that the stock is not priced attractively relative to the broader market, but recent underperformance has made it difficult to stand by such assertions. O trades at a 4.3% dividend yield which may grow at a solid pace courtesy of its recently closed acquisition of Vereit. I rate shares a buy with 15% upside over the next year. O Stock Price

O has underperformed the broader indexes by about 10% since I sold out of the company earlier in the year . The stock has more or less remained flat since then, and is still trading lower than pre-pandemic levels. My reasons for selling and staying on the sidelines since then were more to do with valuation and less to do with quality. The recent underperformance relative to the broader market has me building bullishness in the name. Realty Income’s Secret Sauce

Before I ever consider valuation, I always first analyze the business quality. Like many net lease REITs, O exited the pandemic stronger than it entered it. ( Investor Presentation )

Leverage has come down, cash flows have gone up, but the stock price is lower. Acquisition volumes have also fully recovered to beyond pre-pandemic levels – perhaps O is making up for lost time. (Investor Presentation)

In my view, the pandemic validated the safety of the net lease REIT model. Yet looking forward, I remain bullish on the sector – why?

Net lease REITs primarily grow through sale and leaseback transactions in which they acquire a property then simultaneously sign a long term lease with the seller. These transactions benefit both parties, as the seller can typically sell the properties at a lower cap rate than its stock price, making it a no-brainer decision to utilize sale-leaseback transactions to fund share repurchase programs. O, on the other hand, is able to create shareholder value due to the valuation premium placed on its shares by dividend investors. (Investor Presentation)

Both sides think they are getting a good deal, making this a sustainable avenue for growth. Because O’s tenants are responsible for the real estate taxes, insurance, and maintenance expenses, O is able to generate outsized profit margins and free cash flow. (Investor Presentation)

O has a large real estate portfolio which is diversified on tenants, industries, property type, and geographies. (Investor Presentation)

This is a critical moment to discuss how O differs from shopping centers and malls. While these all represent different types of the retail REIT sector, I view net lease REITs as being substantially less risky than shopping centers and malls. While one could make the argument that O’s convenience store tenants are not as sexy a tenant like Peloton, there is an important structural difference in the business models. Malls are large assets which do not have ready liquidity and thus cannot be easily sold. Shopping centers are smaller and can be sold or repurposed much easier than malls, while also having far fewer tenants – making it easier to fix struggling occupancy. Yet net lease properties excel on all fronts: because these are single tenant freestanding properties, it is exceedingly easy to re-tenant or dispose of such properties. This greatly reduces the downside risk of investing in such properties, as O can get rid of properties very quickly instead of having to suffer from opportunity cost. This important distinction is why I can be bullish on O and yet bearish on malls in spite of O trading at a noted premium. We can see below that O has realized a 6.7% cap rate on dispositions this year.

(Investor Presentation)

In comparison with many NNN REIT peers, O’s disposition activity relative to its overall portfolio size is very low, which indicates the high quality of underwriting. Ideally, NNN REITs do not seek to re-tenant or dispose of their properties and would prefer to just collect slow-growing rents indefinitely. Is Realty Income Stock A Buy, Sell, or Hold?

At recent valuations, O is not trading as cheaply as it did […]

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