Is Realty Income's Dividend Safe?

Few companies have a dividend history as solid as  Realty Income's (O). Its primary corporate objective is to pay a regular, monthly shareholder dividend. Realty Income has certainly lived up to its self-proclaimed moniker as The Monthly Dividend Company�--it's paid a dividend every month for 40 years and increased its payout every quarter for nearly 13 years and counting.

We've been convinced that Realty Income's dividends--including the regular, quarterly dividend increases--have been safe throughout the commercial real estate downturn, and we've been proven right so far. Its quality underwriting, long-term leases, superior portfolio management, and low leverage supported the company, even as conditions in the economy deteriorated, its own operating metrics faltered, and other publicly traded real estate investment trusts slashed their own dividends or replaced cash dividends with stock.

In the past couple of years, however, cash flow has stagnated while dividends continued to grow. Consequently, cash-flow coverage of dividends has become increasingly tight. With dividends representing 96% of reported FFO (funds from operations, a common cash-flow metric for REITs) through the first half of 2010, we wondered whether Realty Income's dividend is still safe.

While Realty Income's dividend/FFO coverage ratio has tightened significantly, so too has an important coverage metric associated with its revolving credit facility, which is designed to cap the size of Realty Income's dividend payments. Specifically, the revolver requires that the maximum combined amount of common and preferred dividends cannot exceed the sum of 95% of FFO plus the amount of preferred dividends (i.e., the threshold level) on a trailing four-quarter basis.

While Realty Income continued to have some clearance under this revolver requirement as of the end of the second quarter, its cushion has diminished.

However, in the last two quarters--on a stand-alone quarterly basis--the size of Realty Income's dividend payments has exceeded the threshold level. This alone is not a violation of the revolver requirement, but it is an indication that the situation will need to improve to prevent an eventual breach. Furthermore, the in-quarter cushions in the third and fourth quarters of 2009 were $1.2 million and $1.3 million, respectively. As these quarters roll out of the revolver requirement calculation, Realty Income will need to meaningfully improve its FFO to prevent itself from exceeding the revolver threshold.

A Number of Factors Are Likely to Impact Realty Income's FFO in the Third and Fourth Quarters
There are a number of factors that we expect will impact Realty Income's FFO, both positively and negatively, over the coming quarters. How these factors play out will determine how close Realty Income comes to this requirement threshold (on a trailing four-quarter basis) in the coming quarters.

 

Under These Assumptions, We Believe Realty Income Could Hit the Revolver Threshold in the Fourth Quarter
To estimate Realty Income's FFO prospects from organic growth and already-announced acquisitions, we adjust the second quarter's FFO for the net impact of each of the individual factors discussed above. We also assume that aggregate common dividend payments increase by $120,000 per quarter.

Re-examining the revolver requirement using these factors as adjustments to FFO in the third and fourth quarters, we see that Realty Income would exceed the revolver threshold limit in the fourth quarter.

Yet-to-Be-Announced Acquisitions Are the Big Swing Factor in Realty Income's Future FFO and Its Future Compliance with the Revolver Requirement
The aggregate 2010 FFO estimate in the above scenario amounts to $189 million. This is below the low range of management's expectations, which we attribute mainly to management's expected but yet-to-be-announced acquisitions, which can have a meaningful impact on FFO.

Through the first six months of the year, Realty Income has announced roughly $300 million in acquisitions. Acquisition opportunities seem to be plentiful, and we expect more such announcements through the end of the year. We ran a sensitivity analysis to determine the level of acquisitions Realty Income would need to complete by the end of the third quarter in order to stay within its revolver's threshold in the fourth quarter. Assuming Realty Income can buy assets at a 9% initial yield, we estimate that it will need up to $56 million in completed acquisitions by the end of the third quarter to generate enough incremental FFO (to fill the $0.4 million gap in the analysis above) to prevent a breach of its revolver requirement.

We think this is achievable. The firm has been working to close value-accretive acquisitions since the end of 2009, and we believe there are plenty of opportunities available for the firm to consider. Given Realty Income's liquidity position and the current acquisition environment, we don't expect Realty Income to have any problem closing enough acquisitions in the near term to prevent a breach of its revolver requirement. In fact, earlier this week, Realty Income raised $171 million in new equity, the majority of which we expect to fund already-announced but yet-to-be-completed acquisitions.

While our analysis suggests that Realty Income needs to make acquisitions in the near term, we don't think it will loosen its underwriting criteria to accomplish this. Additionally, we have seen no indication that Realty Income is trying to game this requirement of its revolver. If it were, it could have left the funding for its Diageo acquisition on its revolver for a quarter instead of immediately taking it out with more expensive permanent capital, We estimate that would have contributed another $3 million in quarterly FFO--enough to alleviate any worries about its near-term compliance with the revolver requirement.

Finally, if for some reason Realty Income cannot complete enough acquisitions, we expect that it could get a temporary waiver regarding this requirement from its lenders, considering the likely minimal degree of violation.

We Expect Slow, Steady Growth in Realty Income's Dividend to Persist for at Least Another Year, with Mid-Single-Digit Annual Increases Eventually Returning
A long-standing assumption in our analysis of retail real estate investment trusts has been that the operating environment would improve beginning in 2011. Realty Income's CEO, Tom Lewis, echoed this sentiment on the company's second-quarter conference call, citing a lack of tenants on its internal credit watchlist and the lapping of rent concessions to a large tenant, beginning in the fourth quarter. Absent a double-dip recession, Realty Income should be able to get back to the 1% or more rate of same-store rental growth it is accustomed to, which will add to organic FFO growth. Reducing its vacancy rate--currently 3.8%, high by Realty Income's historical standards--can also contribute to organic FFO growth.

With a more comfortable rate of organic growth of 1% or more supplemented by further acquisitions, Realty Income should be able to begin to build a larger buffer in its payout ratios over time, provided that its dividends grow at a slower rate than the rate of growth in its business.

We think a comfortable level of dividends/FFO for Realty Income is in the 85%-90% range, and our projections suggest that a return to the top end of this range could occur as soon as the second half of 2011. This depends, however, on the rate of recovery in Realty Income's operations and the acquisitions it completes. As such, over the next four quarters at least, and barring a double dip in the economy, we expect Realty Income to continue its slow but steady rate of dividend growth, even as its underlying FFO may be growing at much higher rates due to improved business fundamentals and acquisitions.

However, once Realty Income returns to a comfortable payout ratio level, we think dividends can once again grow at mid-single-digit rates over the medium term--driven by 2%-3% organic growth, combined with growth from acquisitions. Our current forecasts suggest this could happen as early as sometime in 2012, and we expect it to happen no later than 2013--again, barring a double dip in the economy.

In light of our expectation that Realty Income will use short-term increases in FFO to improve its dividend/FFO payout ratio, there may be opportunities to find faster-growing dividends among REITs in the near term. But when it comes to a reliable, steady-growing dividend, Realty Income remains the industry standard.