SRC - Realty Income: A Great Spirit Realty Deal Creating Massive Value

2023-10-30 11:30:03 ET

Summary

• Realty Income Corporation is set to acquire Spirit Realty Capital in a $9 billion deal, which is expected to be immediately accretive and improve Realty Income's scale.
• The deal will result in dilution for Realty Income shareholders due to the issuance of new shares, but the company's profits and cash flow per share are expected to rise significantly.
• Realty Income's aggressive growth strategy has been successful in the past, and the company believes the Spirit Realty acquisition will be similarly accretive and synergistic.

Article Thesis

Realty Income Corporation ( O ), one of the biggest real estate investment trusts ("REITs"), has agreed to another huge deal: It will acquire Spirit Realty Capital, Inc. ( SRC ) in a $9 billion deal. It looks like this deal will be immediately accretive while also improving Realty Income's scale. Synergies can be captured over time, and the deal also adds diversification. With Realty Income stock trading at a pretty low valuation even before this deal was announced, the real estate investment trust looks like an appealing investment at current prices, I believe.

What Happened?

Net lease real estate investment trust Realty Income Corporation has agreed to acquire its smaller competitor and peer Spirit Realty Capital in an all-stock deal that values the target at $9.3 billion -- debt included.

The shareholders of Spirit Realty Capital will receive 0.762 shares of Realty Income per share of Spirit Realty that they own when the acquisition closes. This does, of course, result in a rising share count for Realty Income, which would result in dilution -- each share representing a smaller portion of company-wide profits and cash flows. But thanks to the fact that Realty Income's company-wide profits and cash flows will rise significantly once the acquisition has closed due to Spirit's results being part of Realty Income's results as well, profits and cash flow per share will not decline in the long run.

When a company acquires another company, which has to be profitable, at a valuation that is not higher than the acquirer's valuation, the deal generally is accretive on a per-share basis even when new shares are being issued to pay for the deal. This holds true in this case as well, as Realty Income is forecasting that its adjusted funds from operations ("FFO") will rise by at least 2.5% on a per-share basis thanks to this deal.

A quick calculation suggests that this makes sense: Even including the takeover premium, Spirit Realty is trading at just below 10x this year's funds from operations ("FFO"), while Realty Income trades at around 11.5x this year's funds from operations. Issuing equity at an 11.5x multiple to purchase assets for a 9.8x multiple should be accretive for the acquirer.

Shareholders of Spirit Realty got a takeover premium in this deal, but not an overly large one -- at the time of writing, shares are up 9%. There's some additional potential until the deal closes, but the share price performance for Spirit Realty also depends on the share price performance of Realty Income due to the fixed exchange ratio. Compared to the highs that Spirit Realty traded at over the last couple of years -- more than $50 at times -- the current implied takeover price of around $35 is not overly compelling for Spirit shareholders. That being said, REIT valuations and share prices have declined over the last couple of months due to macro worries and rising interest rates. Thus, it has to be expected that takeovers in the current environment will not happen at the share price highs seen over the last couple of years.

Realty Income and Spirit Realty believe that this deal will close at some point during the first quarter of 2024, which seems reasonable for a deal of this size.

Realty Income: The Growth Story Continues

Realty Income has an excellent track record when it comes to generating shareholder value over time, at least when we take a long-term view. The last year has, like with many other REITs, not been great.

Realty Income has always been a REIT that puts a lot of focus on growing the business, which has happened in two main ways: by acquiring assets and asset portfolios; and by acquiring entire companies. While some investors do not like a strong growth focus when it comes to income investments, Realty Income's aggressive growth strategy has worked very well for investors so far.

In the above chart, we see that Realty Income's share count has risen by a hefty 240% over the last decade -- there are 340 shares today for every 100 shares that existed ten years ago. Still, Realty Income's funds from operations per share -- one of the most important metrics for a REIT -- have moved in only one direction. Thanks to the takeovers and asset purchases over the last decade, combined with organic rent growth, Realty Income has managed to grow its funds from operations by more than 450% over the same ten years, resulting in a nice 60%+ increase when it comes to Realty Income's funds from operations per share. For a real estate investment trust with a nice dividend yield, this growth rate is rather appealing, I believe.

Some bearish analysts and investors have believed that Realty Income would have a hard time keeping the growth rate at an elevated level, arguing that growing at a specific relative growth rate becomes harder over time as the company itself becomes larger. But Realty Income has, so far, been able to continue the aggressive growth strategy without problems. The company pursued a major takeover a couple of years ago when it acquired VEREIT, and that acquisition has proven that these major deals can be highly accretive -- despite new shares being issued, Realty Income saw its FFO per share climb to a new record high following the closing of the deal. I expect that this deal could be a good example of what Realty Income plans to do with the pending Spirit Realty acquisition -- and thanks to the successful integration of VEREIT, I believe that the chance of success is quite high for the Spirit Realty deal as well.

Realty Income should also be able to capture some synergies once the deal has closed, e.g., by reducing the headcount in areas such as management and investor relations. Over time, the accretive nature of the deal should thus increase, I believe.

Realty Income: Trading At A Bargain Price

Realty Income Corporation has seen its share price pull back substantially this year, in line with what happened to many other real estate investment trusts. And yet, it is expected that Realty Income's FFO per share will hit a new record high this year. The combination of rising profits and a falling share price has resulted in a steep contraction of Realty Income's valuation: Today, the company trades for just 11.3x forward (2023) FFO. This does not yet account for the boost to Realty Income's FFO per share that the Spirit Realty acquisition will cause, and it also does not yet account for the organic growth that Realty Income will experience over the coming quarters.

When we look at the current FFO per share estimate for 2024, which starts in just two months, and when we further adjust this estimate upwards by 2.5% (the lower end of the Spirit Realty FFO impact guidance), then we get to a 2024 FFO multiple of just 10.6, which equates to an FFO yield of 9.4%. While that could very well be appropriate for a weaker REIT with questionable assets, this seems like a pretty high FFO yield for a quality REIT such as Realty Income. After all, the company combines an excellent growth track record, strong recession resilience, a healthy balance sheet , Dividend Aristocrat status, and an asset footprint that is not focused on higher-risk sectors such as offices or malls.

In the past, Realty Income has traded at FFO multiples of as much as 20. I do not believe that this will happen again in the foreseeable future -- higher interest rates, compared to where they were over the last decade, mean that income investors don't have to chase equities. But a high-quality REIT such as Realty Income could easily trade at 12x - 15x FFO in the longer run, even if interest rates remain at elevated levels for some time.

If Realty Income were to trade at just 13x FFO in 2025, its share price could climb to just below $60 over the next two years, using the 2025 consensus FFO estimate and adjusting it upwards by 2.5% to account for the Spirit Realty deal. That would make for a share price gain of around 30%, with a dividend yield of 6.6% on top of that. Even without aggressive assumptions, Realty Income could thus be a quite rewarding investment over the coming years.

Of course, there is no guarantee that this will happen, and if sentiment remains bad, Realty Income Corporation shares might even head lower in the near term. But at current prices, with a pretty low valuation and a high starting yield, Realty Income looks like a highly appealing longer-term investment to me.

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