ONL - Realty Income: My Favorite High-Yield REIT In The Market Today

2024-01-11 00:23:23 ET

Summary

• I discuss my favorite REITs, Realty Income and Rexford Industrial Realty, and how they differ in terms of yield and growth.
• They emphasize the importance of simplicity and size, scale, and strategy when investing in REITs.
• I highlight the strengths of Realty Income, including its triple net lease agreements, strong occupancy record, and attractive valuation.

I'm often asked, "Nick, what's your favorite REIT?"

I think this is a pretty interesting sector for many investors because like me, they're not interested in becoming landlords, yet they'd like to expand their exposure to real estate assets.

Long ago, I made the decision to avoid investment properties because frankly, I'm too lazy to manage them. I'm not all that handy. And I've heard way too many horror stories about crazy tenants.

It's much easier for me to simply buy REITs. They're more liquid. They provide better diversification. I'm happy to sacrifice some of the return profile associated with leveraged real estate investments by allowing qualified professionals to manage their real estate portfolios for me.

As much as I like REITs, that question is a tough one to answer.

It's not tricky because there are a lot of viable considerations for the top spot.

There's only a handful of REITs that are worth owning, in my opinion.

And of these handfuls, two, in particular, stand out to me as the most reasonable candidates for the title of best-in-class.

Those two REITs are Realty Income ( O ) and Rexford Industrial Realty ( REXR ).

The problem is, comparing these two companies is like comparing apples to oranges.

Yes, they both own real estate and pay out reliable dividends…but the similarities basically stop there.

So, to me, the answer depends on my priorities.

Do I want yield or do I want growth?

If the answer is growth, then Rexford is my top pick.

Therefore, if I'm in a more income-oriented mindset, then Realty Income is the winner.

After all, Realty Income's 5.17% yield is nearly twice as high as Rexford's 2.69% yield.

Thankfully, when managing my portfolio I don't have to choose just one REIT to own.

I'm happy long both of these companies and plan to stay that way for years and years.

Since I can't answer that question in just one article, I decided to in two.

I'll start with Realty Income, which is my largest REIT position.

Let me explain why this company is my favorite high-yield REIT.

The Key To Success With REITs Is To K.I.S.S.

Unlike other areas of the market that I invest in, the real estate investment model is unlikely to be disrupted (new technologies, like iBuying could make things easier and cut out middlemen in the transaction process, but the general structure of generating cash flow by renting physical real estate is unlikely to change).

Why?

Because making money with real estate is not that complicated: you simply have to find the most desirable properties (location usually drives demand more than anything in this industry), do your best not to overpay for them, fill them with reliable tenants, and then collect checks.

This is a tried and true system that depends mostly on one's access to capital (and the cost of that capital; obviously, the lower the better).

I can't imagine a technological advancement/innovation that is going to disrupt the cap rate equation.

Yes, the desirability of a specific location can change over time. And that changing demand will change its cash flow prospects. But, the fact is, land is a scarce resource.

They aren't making any more of it.

And at the highest strategic level, the geological and climate-based features that lend themselves to popular human habitats generally change at such a slow pace that it isn't a concern for me (in terms of my own investing time horizon).

What's more, the risks that exist in the present, such as rising ocean levels along coastlines, are predictable, and therefore, avoidable.

With all of this in mind, I think a K.I.S.S. (Keep it simple, Stupid) mindset makes the most sense when investing in REITs.

To me, size, scale, and strategy are everything in the real estate sector.

And therefore, there's no need to get cute. I'm content to invest in proven winners.

I don't need to try and find the next best thing. I don't need to reinvent the wheel. Instead, I need to figure out which company has the most talented managers with the best ideas (what types of real estate to buy and where to buy it), the best existing portfolios, the strongest cash flows, and the easiest access to low-cost capital.

Furthermore, consolidation has been a constant theme throughout the industry in recent years and I expect to see this trend continue (M&A is the easiest way to significantly move the needle, in terms of acquiring large property portfolios at once).

There are not a lot of antitrust concerns in this sector because of how fragmented it remains.

Globally, REITs own roughly $4.5 trillion worth of real estate ( according to DoorLoop ), while the global real estate market is estimated to be worth upwards of $400 trillion ( according to Savills ).

I have to believe there's a lot of wiggle room when attempting to estimate the value of an asset class that is so large and diverse, but either way, REIT ownership of ~1% of global property value points towards a growth runway that is incredibly long, even for the largest REITs.

Simply put, I expect to see the rich get richer in this sector.

And that's where my bullish outlook for Realty Income comes into play.

It Doesn't Get Any Better Than Triple Net Lease Agreements

As I said, I'm too lazy to be a landlord…but if I could invest in income properties and get residential tenants to sign a triple net lease agreement, I'd do it in a heartbeat.

Realty Income is a triple net lease ((NNN)) REIT, which means that their lease agreements put the responsibility of paying taxes, insurance, and maintenance fees (on top of rent and utilities) onto their tenants.

In other words, basically, all of the costs associated with real estate ownership are passed along to their tenants, allowing Realty Income to generate adjusted EBITDA margins north of 95%.

Those margins and the reliable dividends that they generate are why I'm interested in owning NNN REITs. The NNN lease structure sets these companies apart from their peers in terms of the profit margins they can generate

They're not exciting companies. They're boring cash cows that throw off reliable high yields. However, I like to allocate a small percentage of my portfolio towards stocks like this to provide peace of mind during volatile market environments.

My History With NNN REITs

Now, Realty Income isn't the only REIT that benefits from these types of contracts.

It's my largest REIT position; however, over the years, I've owned a handful of NNN REITs because of their high margins, reliable cash flows, and durable dividends.

Yet, due to my desire to reduce redundancy across my portfolio, I've been pruning those holdings recently. And honestly, I'd be content to own just one: Realty Income.

Years ago, I owned a company named VEREIT, which Realty Income has since acquired.

I've never owned Spirit Realty ( SRC ) ; however, I'll soon have exposure to those assets in my portfolio as well due to the $9.3b SRC acquisition that O announced in October of 2023.

Moving forward, I wouldn't be surprised to see trends like this continue. As I said, I expect to see the rich get richer in this sector because of ongoing consolidation.

A NNN REIT that I recently sold was W. P. Carey ( WPC ). In September, I sold that position at $60.01 and $60.12.

I took a capital loss on those shares (the combined position was down 7.81%).

I'd owned these shares for years, so the dividends more and canceled out the losses; however, as I told subscribers at the time, this was still an underperforming asset for my portfolio and I was pleased to move on.

I typically hate selling stock at a loss, but I was happy to do so in this instance because I expected to see a dividend cut.

Here's an excerpt of that original real-time trade alert that subscribers received:

Well, as it turns out, I was right.

In December WPC reduced its dividend to $0.86/share (a 19.7% cut).

Since September WPC shares have risen by 11% or so. However, I don't regret the sale at all because of several reasons…

One, a dividend cut is a clear sell signal for me. It means that a company is no longer meeting my primary portfolio goal of generating reliably increasing passive income. And therefore, WPC no longer meets my acceptable quality thresholds.

Two, as I said before, I've been looking to reduce redundancy and make my portfolio simpler to manage (especially as I think about teaching my kids about stocks/portfolio management as they grow up), so this sale allowed me to kill two birds with one stone.

Three, I was looking for some tax-loss harvesting opportunities, so nix that, three birds with one stone.

And four, the stocks that I bought with the WPC proceeds are of higher quality and therefore, I expect that they will outperform over the long term.

It was a bummer to sell WPC because this was such a SWAN stock for me throughout the pandemic.

I loved its near-perfect rent collection scores back then and for years, despite its low dividend growth, it was my highest-yielding REIT.

What's more, I really liked WPC's diversification across its portfolio (in terms of both geographical diversification and a wide tenant base that represented a wide variety of industries).

Here's WPC's outlook for its portfolio diversification post-office spin-off.

I like the company's high exposure to industrial properties. I also like self-storage assets. Those are typically easy to manage, they throw off high margins, and it's an industry that has proven to be recession resistant. With that in mind, things like industrial and self-store properties typically demand higher multiples than retail properties and that's why for years, I believed that WPC was undervalued.

Prior to the spin-off, I said that WPC was like owning an attractively priced real estate ETF (just with better management).

Unfortunately, I lost faith in that management with the dividend reset…and thankfully, O's recent portfolio diversification measures have checked the same boxes.

In recent years O has built out a $9b European portfolio across 38 industries.

In the US, Realty Income has diversified its holdings as well.

The company made a big splash in the gaming industry with the $1.7b Boston Encore Casino deal back in 2022.

In 2023, we saw other new deals, such as partnerships in the data center space with Digital Realty ( DLR ) and a strategic alliance with Plenty Unlimited, worth upwards of $1b, in the vertical farming industry (industrial real estate).

Right now, the lion's share of Realty Income's NOI comes from its retail-centric portfolio. But, it's clear that O wants to continue to diversify into other areas of the real estate industry and there appears to be ample opportunity to do so with the company estimating that it has a $12t addressable market globally in the NNN space, specifically.

Realty Income has made a habit of increasing its acquisition guidance in recent years as it aggressively adds to its portfolio.

At the end of its most recent quarter, O's acquisition guidance was raised to $9b for the full year. That compares favorably to WPC, whose management mentioned ~$2b of liquidity coming online in 2024 that it could use for acquisitions.

Lastly, regarding WPC's office spin-off, I didn't think the dividend cut alongside the move was necessary.

Realty Income spun off its office properties a couple of years ago with Orion Office REIT ( ONL ), but it didn't cut its dividend in the process.

On the contrary, Realty Income continued to raise its dividend on quarter (O has now paid a dividend for 642 consecutive months and increased its dividend during 105 consecutive quarters).

O has called its dividend "sacrosanct" for years now and it continues to prove this. WPC, on the other hand, let down shareholders (in my opinion, at least).

This made the choice between WPC and O an easy one.

I also recently sold my position in Agree Realty ( ADC ). I highlighted that trade here .

In short, I needed to raise cash for a recent home purchase and I was pleased to sell ADC for several reasons:

One, the new property purchase increased my exposure to real estate, overall. So, I was happy to sell REITs to pay for it.

Two, I was looking to sell assets with relatively low growth potential since I don't expect the real estate to appreciate at a 10%+ rate.

And three, I was sitting on capital losses due to ADC's recent sell-off and selling shares generated some tax losses that I was looking to find to offset significant gains that I locked across my portfolio earlier in the year.

ADC was more difficult to sell than WPC because it is still growing its dividend.

Agree meets all of my quality thresholds and if I didn't need to write a large check in early November, I wouldn't have sold shares. But, life happens sometimes and when thinking about reducing exposure to real estate, Agree stood out as a stock to trim because while it's a solid company, it's no Realty Income.

For years, I've thought of ADC as a baby-Realty Income.

It has a $6.4 billion market cap, versus O's ~$42.5 billion size.

Recently I asked myself, "Why own the mini-me when you could just own the real thing?"

I didn't have a great answer to that question and therefore, Agree Realty was sold.

To their credit, it's clear that Agree's management is trying to emulate O's success.

ADC's website is basically identical to O's old website.

Like Realty Income, Agree pays a monthly dividend.

Also, Agree raises its dividend multiple times per year (usually every other quarter, as opposed to O's quarterly increases).

ADC's 5-year dividend growth rate (6.25%) is actually higher than Realty Income's (3.66%).

When it comes to developing a loyal investor base, a shareholder return program like this is a good place to start (it's certainly what attracted me to ADC in the first place).

But, O's dividend increase history is much longer (30 years versus 11 years). It has a higher yield presently (5.17% versus 4.65%). And, O has a better balance sheet (A- versus BBB).

The biggest edge that Agree Realty has over Realty Income is in its prioritization of investment grade-rated tenants.

ADC has focused on "fungible rectangles" - meaning, cookie-cutter buildings that are easy to maintain and rent to a wide variety of retail tenants - and grocery-anchored shopping centers. Overall, 69.1% of its tenants are investment grade rated. That compares favorably to Realty Income's 39%.

Also, I should note that ADC offers investors exposure to a ground lease portfolio that makes up about 12% of its rent total.

This land provides very reliable cash flow with 88% investment grade tenants (companies like Wal-Mart, Lowe's, Home Depot, and Wawa), has a weighted average lease term of 10.5 years, and adds additional peace of mind to the ADC investment thesis.

But, the strength of ADC's portfolio wasn't enough to cause me to favor ADC over O.

First of all, ADC doesn't provide the industry diversification that Realty Income does. Its portfolio is 100% retail/consumer focused.

Also it doesn't have the capital to quickly diversify (last quarter, ADC invested $411 million into new properties, compared to the billions that O puts to work each quarter).

Right now, the only other triple net lease REIT that I own besides Realty Income is NNN REIT ( NNN ).

Like Agree Realty, I believe this is a high quality company. It has a long history of raising its dividend (NNN's dividend increase streak is 34 years, compared to O's 30-year streak).

That's great, but NNN has long underperformed O from a capital gains and total return perspective, largely due to relatively slower growth.

Despite its slower growth, NNN has still been a solid investment for me. I'm up ~14% on my position (cost basis of $38.38), most of those shares are held in a taxable account, and that's the primary reason I decided to sell ADC rather than NNN. I didn't want more capital gains to deal with in 2023.

Also, NNN looks very cheap at the moment.

Its shares are trading for just 13x forward AFFO expectations.

That's a ~24% discount compared to the company's 10-year average P/AFFO multiple (17.1x) and a ~19% discount to NNN's 20-year average P/AFFO multiple (15.98x).

Although I'd like to prune down my holdings, I'm not interested in selling low.

Ideally, NNN will experience multiple expansions in the coming quarters as the sentiment surrounding the REIT space continues to shift and I'll be able to exit the position in a new tax year at a more reasonable valuation.

Realty Income: A Blue Chip And A Bargain

Over the years, Realty Income has developed a cult-like following, especially amongst income investors.

I think the fervor around this stock leads many to believe that it's irrationally loved.

And I get it…oftentimes, the hype around stocks isn't real. People get greedy. They chase momentum. They join a herd. They make uninformed decisions. And all of this leads to losses.

But in Realty Income's case, I think the hype is well deserved because it's based upon fundamental data and a sustainable dividend record that cannot be ignored.

For instance, look at O's occupancy record across its portfolio.

This company has consistently outperformed its peers for decades.

This shows that its management team does a great job selecting properties in high-demand locations and marketing them to potential tenants.

Not only does Realty Income acquire attractive buildings, but it buys them at attractive prices.

Here's a chart showing O's historical re-leasing activity.

As you can see, the company has a strong record of 100%+ rent recapture rates, meaning that it does a good job of acquiring buildings with lower than market rents (meaning good values, based upon initial cap rates that expand when leases expire).

You've got to love a disciplined property manager who can spot both quality and value.

I loved the chart below, from the company's Q3 earnings presentation, because it clearly rejected a notion that I read a lot from naysayers: this company has become too large to grow.

It's true that Realty Income needs to make larger and larger acquisitions to move the needle from a fundamental standpoint because of the large size of its portfolio. But, its management team continues to find them.

As you can see, O's AFFO growth rate has remained consistently positive over the year as its portfolio has grown. And while the past cannot predict the present, I find solace in this sort of data because looking at the company's most recent results, I see no reason for the trend to stop moving forward.

And neither do analysts.

Right now, the consensus AFFO growth rate for Realty Income in 2024 is 4.2%.

Yes, it appears as though the higher interest rate environment has slowed down expectations a tad from O's long-term average growth rate in the 5% area, but then again, this expected weakness has been priced into shares and therefore, the stock's dividend yield is much higher than normal right now.

Therefore, when looking at O shares from a value perspective, I still believe that they're very attractive at current levels.

That 4.2% growth rate is ~16% lower than the long-term average in the 5% area.

Well, it looks like the market is being pretty efficient these days, because O's blended P/AFFO multiple of 14.8x is roughly 16.5% lower than the stock's long-term P/AFFO average of 17.7x.

Therefore, at a minimum, I think there's an argument to be made that O shares are trading at fair value here…and anytime a blue chip like this is trading at fair value, I'm happy to channel my inner Warren Buffett and buy shares of a wonderful company at a fair price.

But, if you're someone who believes that O's P/AFFO multiple will eventually revert back to its historical mean, then shares appear to trade with a wide margin of safety.

I fall into this second category.

I think rising rates have hurt the cash flow multiples attached to REITs; however, if the Fed starts cutting rates in 2024/2025 as expected, then I suspect that equities with safe, high yields like Realty Income will catch a bid.

If O's multiple rises from the ~15x level to the ~18x level where it has traded history, then the stock has a significant upside.

As you can see, mean reversion would result in a total return CAGR of nearly 20% over the next 2 years.

Remember, Realty Income is an income play. This isn't a stock that's typically likely to provide outsized total returns…unless it's bought with a wide margin of safety attached.

When buying shares at a discount to fair value, it's possible to arrive at a scenario where double-digit total returns are likely (even with low-to-mid single-digit fundamental growth prospects in mind).

And that's the exact scenario that I'm looking at today with Realty Income trading at a discount to my fair value estimate.

I believe shares are worth approximately $71/share (based upon a 17x forward multiple; discounting growth prospects slightly, even though O has been incredibly reliable in the past, because of the inherent uncertainty of future estimates).

That price target points towards a total return potential of approximately 26% over the next 12 months.

Conclusion

Admittedly, for this price appreciation to occur, the sentiment surrounding the REIT sector will have to shift.

This remains a rate-sensitive stock and therefore, bulls are going to have to rely on macro catalysts to cause the market to realize its folly (with regard to O's historically cheap valuation).

Eventually, I think Realty Income will see multiples expand because its dividend is more attractive than bond yields (its yield is higher and compounds organically).

I can't say when that shift will happen. That's the worst part about relying on mean reversion. But in the meantime, I'm content to sit back and collect O's monthly dividend payments.

To me, when it comes to sleep well at night REITs, it doesn't get any better than The Monthly Dividend Company because of the reliability/predictability/proven longevity of its dividend.

O's dividend is what has set this company apart from its peers for decades. And it continues to do so today.

Remember, when it comes to blue chips, there's no need to get fancy. I'm happy to keep it simple and let top-notch companies work for me.

Stay tuned for my breakdown of Rexford showing why that's my favorite high-growth REIT.

For further details see:

Realty Income: My Favorite High-Yield REIT In The Market Today