SRC - Realty Income: A Big Deal At A Curious Time

2023-11-01 00:21:04 ET

Summary

• Realty Income has been focusing on growth rather than growth per share.
• This growth has hurt the capital gains of the shares.
• With implied capitalization rates shooting higher, focus on shareholder value creation rather than unit growth would be welcomed.

In April, I believed that Realty Income ( O ) was continuing to focus on growth, as it added another episode to its aggressive acquisition strategy, focusing on growth rather than growth per share.

The REIT was suffering from higher interest rates, as it announced a big all-stock deal for its peer Spirit Capital ( SRC ) which makes sense, but is interesting as the focus on growth, rather than growth per share, has made me wonder the quality of the famous monthly paying REIT. That said, with shares trading near the lowest levels in a decade, current valuation start to look quite compelling here.

Some Perspective

Realty Income is a popular REIT as a result of its remarkable feature that it pays out monthly dividends to investors. This practice makes that dividends can be used for monthly expenses incurred by (retail) investors, providing a real mental accounting benefit.

At the time the company owned and leased out some 12,000 properties to a thousand customers, including names like Walmart, FedEx, CVS and Kroger, reporting occupancy rates in excess of 99%, with customer diversification being really good.

On top of the diversification across properties and tenants, Realty stresses that many tenants focus on lower-price customers, creating defensive qualities while much of the maintenance lies with the responsibility of tenants themselves. Long having focused on North American operations, Realty made a big move with the purchase of VEREIT in 2021 to grow the European exposure.

By April shares had fallen to the $60 mark, pushing up the dividend yield to 5% with the dividend payout reported at $3 per share, based on funds from operations trending at $4 per share. The company traded at a $12 billion premium compared to the book value (reported at $38 billion) with the equity commanding a $50 billion valuation on the stock market. With $889 million in quarterly rental income, the actual market value of the properties was a 7.1% cap rate based on annual rent, with recent debt issuances taking place at rates around 5%.

In April, Realty announced a 415 single store unit deal with EG Group in a $1.5 billion deal at a capitalization rate of 6.9% (at a premium compared to the cap rate at which the business traded) while notes carrying rates around 5% were issued to finance for the year. The deal added for some more growth, as a focus on absolute growth rather than earnings per share growth, was exactly the observation which made me a bit cautious.

Coming Down

Since April shares of Realty have gradually come down to the $50 mark as interest rates made another move higher in recent months and weeks, as shares have now fallen to the $46 mark amidst another sizeable deal.

By the summer, Realty has posted its result of the first quarters of the year, with normalized funds from operations (FFO) up two pennies to $2.06 per share, as adjusted FFO rose by four cents to $1.98 per share. This comes after second quarter rents rose as much as 25% on the back of a combination of rents being hiked as well as aggressive investments into new properties, with these gains offset by sharply higher interest rates.

Net debt ticked up to $19.3 billion as the share count ticked up further to 676 million shares with the company continuing to see dilution, as the business keeps growing, but not growing on a per-share basis.

In August, Realty announced a big $950 million investment into The Bellagio Las Vegas, acquiring common and preferred equity from BREIT at a $5.1 billion valuation.

With 676 million shares trading at $50, the equity value of $33.8 billion has approached the book value of the firm which reveals the extent of the increase in cap rates. After all, the book value of $41 billion on the balance sheet has been given a modest premium on the stock market as rents trend at $4 billion per annum, for cap rates in excess of 9%!

A Huge Deal

Towards the end of October, Realty Income announced a huge $9.3 billion deal to acquire Spirit Realty Capital in an all-stock deal which is set to boost adjusted funds from operations by some 2.5%, entirely the result of $50 million in anticipated synergy estimates. The deal terms grant investors in Spirit a combined 13% equity stake in the business.

If not for the size, both business look very similar with some 2,000 properties of Spirit bringing the total for the combination up to more than 15,000 properties, pushing up annual contractual rent to over $4.5 billion. The deal provides small benefits to the WALT and concentration of the portfolio, although that Spirit has a higher concentration of non-investment grade clients.

Irony will be that shares of Realty have fallen some 5% in response to the deal, losing close to $2 billion in value in response to a $9 billion enterprise deal which looks quite an overreaction. In fact, shares have fallen to their lowest levels since 2015 as the deal is quite neutral to most metrics, but shows that the focus remains on growth, rather than growth per share.

And Now?

Truth be told is that a current dividend of about $3.07 per share provides a higher 6% dividend yield, but for good measures as interest rates keep moving higher, pushing up capitalization rates.

The trouble is that while the company remains well diversified and has nicely staggered debt maturities, the issue is that of too much focus on growth rather than growth per share as implied capitalization rates here are much higher than actual recent asset purchases, as share buyback might be more accretive to dividends here (for long term investors). Of course, changes in the dividend policy are off the table, as the height and frequency are the desirable qualities of the business.

That said, at some point in time value is to be found as great diversification and scale make the REIT desirable versus other players, as the company has relatively lower leverage ratio to other REIT (categories) as well.

Given all this, I am only now starting to get more upbeat, considering shares on the dip here, albeit that greater focus on value per share would be welcomed to get really upbeat.

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