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Building a Moat Around Monthly Income

Todd Lukasik, CFA

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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Meurer: I appreciate the question and to be perfectly honest, I wouldn't just be giving this answer if it was a Morningstar interview. This is how we think about our business. And it really is how our business model has evolved and been created over the years. Having a margin of safety gives us the ability to protect those cash flows, from which we pay out the monthly dividends to our shareholders. So it's critical to our business model that we think about it that way and protect those cash flows.

I describe it kind of in four different ways. The first two really relate to how we underwrite and how we invest, the second two are our own capital structure and how we protect ourselves.

So the first one is how we underwrite, upfront, looking at good real estate underwriting credit in industries that we invest in, but most importantly within that, underwriting cash flow coverage at the unit level. Something we've talked a lot publicly through the years about. And what we're referring to there is what operating profit is the tenant obtaining at the unit level in their business, and how much are they making in order to support the rent payment that they have to make to us?

Our top 15 tenants represent about 50% of our rent. Cash flow coverage today is 2.41 times. So what that means is, they are making $2.41 in operating cash flow profit, or EBITDA, at the unit level to support every dollar of rent that they pay us. That's important; that’s a margin of safety by itself. Their business could be impacted, their EBITDA could go down by 50%, and they would still have enough cash flow at the unit level in order to support that rental payment to us. So that's the first part of it, is that cash flow coverage in our upfront underwriting.

The second part is having a diversified portfolio. No matter what you do to underwrite, choose good tenants, you don't want to be overexposed anywhere, and I've already talked about that geographically by tenant, by industry. Most recently, we've added property type to that. We've considered moving a little bit outside of the consumer retail area, very gradually, very carefully as a way to also diversify with respect to our portfolio.

But then, we also try to protect ourselves. So how we underwrite and how we invest, but we also think about ourselves and our capital structure to make sure that we're insulated.

And the first portion of that is in the income statement. We have a very low dividend payout ratio. We only pay out 85% of our earnings, or FFO in REIT parlance, in the form of dividends, and that gives us--it kind of goes without saying, if you will--that gives us an insulation if our operating cash flow is temporarily impacted for some reason. An 85% payout ratio gives us a lot of safety there.

And then the last area is the balance sheet. At the end of the day, if you do nothing else right, at least have you balance sheet be safe, and make sure that it's in good shape so you can withstand the storm, if you will, and our balance sheet is low leverage, 28% today, debt to EBITDA of about 5.1 times. Those are good metrics. They are usually going to be around that area. That's just how we run our company, and so that gives us a lot more flexibility, gives us a lot more ability to respond if things happen in the business, if you will.

So, underwriting well, cash flow coverage, portfolio diversification, low dividend payout ratio at the end of the day, and having a safe capital structure and low leverage really make up our margin of safety. And again it protects those cash flows from which we pay our monthly dividends to our shareholders.

Lukasik: Now, it appears that margin of safety really helped your business successfully navigate the most recent downturn. Could you talk a little bit more about that, and how your business performed over the last few years?

Meurer: I appreciate the question. Most might fear the question, but actually we enjoy answering how we performed these past couple of years. We're very proud of that and how we protected our shareholders through this process.

In order to comment on the last couple of years, I need to go back a little further and talk about what we did in that 2007 to 2009 timeframe--or Great Recession or whatever we want to call it relative to the economy and the difficulties that everyone had.

We think we took a lot of good proactive steps. We got very liquid. We raised a lot of new capital. We recast and upsized our credit facility. We sold properties, which not only raised new capital, but also allowed us to reduce some tenant exposures. And we stopped making acquisitions. We took a step back, and we thought that was the conservative and proper approach was to preserve liquidity. So, we maintained our balance sheet in a conservative manner.

We also successfully navigated through several tenant bankruptcies. That's a normal course of our business. Tenants are going to have difficulties in different economic cycles at times, more so as a result of leverage at times in their balance sheet structure. It's a normal course of our business. We're used to dealing with it.

In this case, during that timeframe, '07 to '09, we had 10 tenant bankruptcies. Our rent recovery or the rent we had going in that we came out with was about 84% on those 10 tenant bankruptcies. So, we did very well in that process.

At the end of the day, '07 to '09, we maintained earnings, we maintained our cash flow, and we increased the dividend every quarter. So, we continue to meet the mark in terms of what the investor expects from us.

And then that positioned us coming out of it, the last two years as you had a little bit more recovery in the economy, 2010 and 2011, we got aggressive again. We saw a lot of good opportunities to grow cash flow more aggressively. So, we have purchased over $1.5 billion of new properties at good yields, investment yields at a spread to our cost of capital--average investment yields of about 8% going in.

We've raised $1.5 billion of match-funding for that, or permanent capital on the balance sheet long-term, either common equity or debt. We've maintained a safe balance sheet in that process. High portfolio occupancy has maintained in the portfolio. Same-store rents have been growing in the portfolio. So, the portfolio itself has been performing well.

At the end of the day, we're able to increase earnings significantly, not just maintain them through a storm, but take advantage of the opportunities. And our earnings per share, or FFO per share, growth in 2011 as compared to 2010 will be 8% this year, which is a number we're very proud of.

So to summarize that '07 to '11 timeframe, at the end of the day what are we measured by? Our dividend in 2007 was $1.56 per share. In 2011, it's $1.74, and that by itself is a pretty good statement as to how we weathered the storm these past couple of years.

Lukasik: Now, one of the things that you talk a lot about on your website and in company presentations is the magic of rising dividends. Tell me a little bit more about that, and why is that an important message that you convey to investors?

Meurer: Well, as I mentioned upfront, we are the monthly dividend company. That's not just a phrase. It's not branding, it's not marketing, it's truly who we are.

Our mission is to provide dependable, and growing, monthly dividend income to our income-oriented investors. I mentioned we've paid 495 consecutive monthly dividends since 1969. That's over $2.1 billion in cash dividends paid back to our shareholders over that timeframe.

But importantly, we've continued to grow that income as well. We have increased our dividend 56 consecutive quarters as I sit here today. That's 14 years where we've increased the dividend every quarter. So that sort of track record, that sort of dependable monthly dividend, and the ability to grow that dividend is what the magic of rising dividends is all about.

As an investor holds our stock, their yield on cost, or the original cost of their shares, will go up over time, if we're able to continue to increase the dividend, and that's the magic of rising dividends. Let me give you an example. If someone had purchased 1,000 shares of our company in December, end of 2003, December 31, 2003, we were trading at $20 a share that day. That would have cost them $20,000 as an investment. Our dividend at the time was $1.20 per share, or $1,200 a year, or an initial yield on their investment of 6%, 6.0%.

Today that dividend is $1.74, their dividends are $1,740 on that original investment, or a yield on that original investment or a yield on cost of 8.7%. So their yield on cost has increased over time by holding our shares. That's important to people in their portfolios today. There are a lot of people seeking--and just think about demographics today--folks either entering retirement age or planning for that stage and trying to build income into their portfolios that they want to grow over time in their portfolio. We think that's very important to be able to provide an investment product for them.

The last thing I'll say on this, I think it's important to mention, I encourage people to take a look at our website. We've put a lot of thought into our website, which is www.realtyincome.com. We have a lot of discussion in there for an income investor, helping them plan for income investing, understanding how dividends work, and then understanding Realty Income, of course, as an investment alternative in their income portfolio.

Lukasik: Well, thanks again for joining us today, Paul.

Meurer: Thanks, Todd. My pleasure.

Lukasik: I'm Todd Lukasik with Morningstar and thanks for watching.