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By Todd Lukasik, CFA | 11-10-2011 12:00 AM

Building a Moat Around Monthly Income

Realty Income focuses on prudent underwriting, portfolio diversification, a low dividend payout ratio, and low leverage to maintain a consistent and growing dividend, says CFO Paul Meurer.

Todd Lukasik: Hi, I'm Todd Lukasik. I'm a senior analyst here at Morningstar, covering the real estate sector.

We're fortunate again this year to have Realty Income join us at our Management Behind the Moat Conference.

I'm joined today by Paul Meurer of Realty Income to talk about his business. Paul is executive vice president, the chief financial officer and treasurer of Realty Income.

Paul, thanks for joining us today.

Paul Meurer: Thank you. I appreciate being here.

Lukasik: Now as you know Realty Income has been a Morningstar favorite for quite some time. Not all of our viewers may be very familiar with Realty Income. Could take a few moments at the start here to tell us about Realty Income's business?

Meurer: Sure, Todd, I'd be happy to. We're a public real estate company. We're traded on the New York Stock Exchange under the ticker symbol O, which is a ticker that people tend to remember.

We are in the business of providing dependable monthly income for income-oriented investors, or investors looking for dependable income in their investment portfolios. We're headquartered in Escondido, Calif., which is in the San Diego area, but we own 2,600 properties located throughout the United States.

We were founded in 1969 to really do exactly what we still do today. So, our business model hasn't changed very much. We've been doing the exact same thing, and that is to own standalone, freestanding, single-tenant commercial properties, which we lease back to tenants under long-term net leases.

And by long-term, I mean 10 to 20 years plus renewal options, so they stay in the property a long time. And by net leases, importantly, I mean that the retailer pays for the expenses at the property level--taxes, maintenance, insurance--we collect a net rent from them.

So our business is providing them capital that they can use in their business by purchasing their real estate from them. They pay us monthly rent, we pay monthly dividends. We are the monthly dividend company, which is the mission of our company, and we've paid over 490 consecutive monthly dividends to investors every month since 1969.

Lukasik: Now you mentioned 2,600 properties. Tell us a little bit more about your real estate portfolio, touching on both the properties themselves as well as the tenants that occupy them?

Meurer: We have 2,600 properties that are located in 49 U.S. states, that are leased to 134 different tenants who operate in 38 different industries. We've always felt that owning a diversified portfolio was important. It insulates us from any downturns geographically in the economy or in the business of a particular industry sector or in the business of a particular tenant.

Geographically we're well diversified--49 states. Only one state represents over 10% of rent, that being California, 10.5% of rent. That's a little misleading because half of that exposure is with one tenant, Diageo, which I'll talk about in a minute, and their business is more national, almost international, and really not dependent on the California economy. But in any event, California is 10.5% of our rent. Then Texas is 9%, Florida 7%, Minnesota 6%, Illinois 5%, and then every other state is below 5% of our rent. So we're not over-exposed anywhere in the country.

In terms of tenants, we only have two tenants that are over 5% of rent in the portfolio. Both of them are just over 5% of rent. One is AMC Theaters, which is the number two movie chain operator in the country with over 5,200 movie screens throughout the country, and the other is Diageo that I mentioned.

Diageo is a terrific company. They are global, A rated, a leading global premium drinks company. They are in 180 different world markets. They have terrific brands in the spirits, beer, wine industry. Their wine brands are BV and Sterling. That's the wineries and associated vineyards that we own that they lease from us in the Napa Valley area of California.

Industry-wise we're diversified as well. We've always tried to hold any one particular industry sector under 20% of rent, and we've always thought that's very important. Only two right now are even over 10% of rent. Convenience stores, at 18%, and restaurants, at 17%. When you look at our industries, you look at our tenants, what you're going to find is lower-price-point goods and, importantly, a service component, something where the consumer needs to go to that property to obtain that service. Something they can't get over the Internet. We've always felt that's very important.

Gasoline, you've got to purchase your gas. Car repair, tires for your car, heath and fitness. Theaters, which is a pretty low price point entertainment option today. Child care. Beverages. Low-price-point food, if you will. All of these are industry sectors where we think we're fairly well insulated, because it's lower price point, and there's a service component involved, and you just can't do that over the Internet--[which is] something that's important to consider in your portfolio today.

Our performance has been good. Our portfolio occupancy today is 97.7%, and it's actually never been below 96%, for over 42 years. So, I think this strategy has held up well for us, and the portfolio has performed very well over the years.

Lukasik: As you know, we like to think about companies' economic moats, and try to understand what competitive advantages a company may have, which will allow it to earn consistent returns over time. And an important component of our moat analysis for Realty Income is your ability to build the margin of safety directly into your business, which over time has helped you earn profits in both good and bad economic environments.

How would you describe Realty Income's competitive advantages, and how do you build the margin of safety principals throughout your business?

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