Summary
- Realty Income has a cult-like following on Seeking Alpha.
- It is very popular because of its monthly growing dividend payments.
- The company recently again hiked its dividend. Most people celebrated this, but I see a red flag.
Realty Income ( O ) might be the most popular REIT ( VNQ ) on Seeking Alpha.
It is so popular because of one key reason:
It has managed to pay a growing monthly dividend for over 20 years in a row. That's despite the dot-com crash, the great financial crisis, and the pandemic.
If you had held shares of Realty Income since its IPO until today, you would have compounded your capital at ~15% per year all while getting steady dividend payments month after month:
Today, the company appears to be stronger than ever. It has an A-rated balance sheet, great diversification, and a long-lasting track record of excellent performance.
But here's the problem that most investors appear to be ignoring:
Realty Income's growth has slowed down even as inflation has shot up and as a result, it doesn't provide adequate protection against inflation anymore.
Just recently, the company announced a 2.4% dividend hike and this was celebrated by Seeking Alpha users with 75 comments:
Here are just a few of these comments:
"I'm going to build a small shrine to O in my home office."
"I'm going to hug my 1000+ shares."
"Gentlemen of dividend growth culture, we meet again! Loooooong O."
"Hell yeah brother let’s get nasty."
"Realty Income is one of the best, if not boring, long-term REIT investments."
I am not one to typically complain about a dividend hike, but I think that these investors are getting a little too excited here.
A 2.4% dividend growth rate is nothing exceptional when inflation is so high. Even after the recent cool-off in inflation, the year-over-year CPI is still nearly 3x higher than Realty Income's recent dividend hike announcement:
In other words, your dividend income is rapidly losing purchasing power, despite it being hiked.
And unfortunately, I believe that Realty Income's growth is likely to remain below average for a long time to come.
Here's why:
REITs like Realty Income can grow internally and externally .
Internal growth is the organic growth that REITs achieve in their same-property net operating income by hiking rents or growing occupancy rates.
External growth is the additional growth that they achieve by acquiring new properties at a positive spread over their cost of capital.
And Realty Income is inferior to most of its peers on both fronts. Here are two tables that I prepared to show you why:
Internal growth:
Realty Income | High-quality Net Lease Peer Group ( VICI , EPRT , WPC ) | |
Rent escalations | 0.9% | 1.6% - 2% |
Lease Length | 9 years | 11 - 43 years |
CPI adjustments | No | VICI and WPC: yes. EPRT: no, but it has larger fixed rent hikes to compensate |
Capex responsibility | Mostly triple net leases, but some double net leases with capex responsibility for roof/structure/parking | Only triple net leases with no capex responsibilities |
Realty Income's contractual rent hikes are materially smaller than those of its high-quality peers. Moreover, its leases are also shorter, which increases the risk of vacancy and the need for capex. It also doesn't have periodic CPI adjustments in its leases, unlike WPC and VICI, and finally, it seems that it has more leases with some capex responsibility than its peers. Most of its leases are "triple net" with no capex responsibility, but it also has some "double nets", which typically put the responsibility of the roof/structure and/or the parking on the landlord.
All in all, this should result in below-average internal growth. Historically, Realty Income has made up for this by having a sector-leading external growth rate, but even this is unlikely to be attractive going forward.
External growth:
Realty Income | High-quality Net Lease Peer Group ( VICI , EPRT , WPC ) | |
Size | Larger | Smaller |
Spreads | Smaller | Larger |
Payout Ratio | ~85% | ~75% |
Realty Income is by far the biggest net lease REIT and as a result, it is harder for it to grow externally by acquiring new properties. Since it has a $42 billion market cap, it must find a huge amount of new properties to acquire each quarter to keep the ball rolling and this is today especially difficult since few transactions are happening in the current marketplace and there is more competition than ever for good deals in the net lease sector.
Moreover, since Realty Income focuses on net lease properties that are occupied by big-name tenants such as Walmart ( WMT ) and McDonald's ( MCD ) , the cap rates of its targeted properties are also lower, reducing its investment spreads in today's higher interest rate environment.
Finally, Realty Income retains less cash flow than most of its peers, making it more dependent on capital markets to raise capital to acquire more properties.
This explains why Realty Income is expected to grow its AFFO per share by just 1.9% in 2023. That's less than half of the growth rate of Essential Properties Realty Trust ( EPRT ) , NETSTREIT ( NTST ) , and Getty Realty ( GTY ) :
Essential Properties Realty Trust
VICI Properties ( VICI ) is not included in this chart, but it is also expected to grow at ~5% in 2023, and W. P. Carey ( WPC ) just issued guidance that was materially higher than the consensus. It is expected to grow by nearly 4%.
So the takeaway here is that Realty Income is growing materially slower than its high-quality net lease peers and this is unlikely to change anytime soon.
Unfortunately for Realty Income, if we remain in a high inflation world, its dividend income is likely to rapidly lose purchasing power because its leases provide little protection against inflation.
Despite that, the company is today actually priced at a small premium relative to its high-quality net lease peers, which grow faster and provide better inflation protection:
Realty Income | High-quality Net Lease Peer Group ( VICI , EPRT , WPC ) | |
FFO Multiple | 17x | 15.5x |
Dividend Yield | 4.5% | 4.7% |
I think that it should be the opposite given what we described earlier. The market should punish Realty Income for its slower growth prospects, especially in today's inflationary environment.
Conclusion: For Who Is It & For Who Is It Not
After reading this article, you may now think that I am bearish on O stock, but that isn't the case.
We actually own a small position in our Retirement Portfolio at High Yield Landlord because we think that it remains a good choice for retirees. It provides safe monthly income, which is precisely what you need in retirement.
However, I think that Realty Income is a bad choice for all other investors.
Its growth is likely to remain among the worst in its peer group of high-quality net lease REITs, and it also offers some of the weakest defenses against the threat of inflation.
Therefore, we think that most investors should favor other net lease REITs.
A REIT like Essential Properties Realty Trust is very likely to continue delivering superior returns in the long run because it is able to grow at a far faster rate. Here is its performance versus Realty Income since going public:
You may argue that EPRT is riskier, but note that this time period includes the pandemic which was the worst possible crisis for net lease REITs. Despite that, it delivered more than 2x higher total returns. Moreover, I would argue that the biggest risk today is inflation for net lease REITs, and from that perspective, EPRT is actually the safer REIT.
Overall, it seems that Realty Income offers the worst risk-to-reward going forward. The only exception would be if you are a retiree and need safe monthly dividend to pay your bills. That's not the case for most investors here on Seeking Alpha.
For further details see:
Realty Income's Challenges: Should You Sell Or Hold Tight?