A Monthly Dividend Machine Shifts into Higher Gear

We've long admired  Realty Income's (O) impressive dividend history, which includes 40 years (and counting) of monthly dividend payments and 13 years (and counting) of quarterly dividend increases. However, in the commercial real estate downturn from 2007 through mid-2010, Realty Income's cash flows stagnated (and even declined in some quarters), yet the firm continued its impressive streak of quarterly dividend increases. Thus, the cash-flow coverage of its dividend payments deteriorated, rising from 83% in 2007 to 96% in the first half of 2010, casting doubt on the continuation of Realty Income's quarterly dividend increases. We took an in-depth look at the sustainability of Realty Income's dividend last August and concluded that Realty Income's dividend--including the regular quarterly increases--was safe. Thus far, the Monthly Dividend Company� has proven us correct.

Instead of Dividend Sustainability, We're Now Focused on Realty Income's Dividend Growth Prospects
Since our August analysis, however, Realty Income's cash-flow prospects have improved substantially, to the extent that our interest in Realty Income's dividend has changed. Whereas we previously examined Realty Income's dividend sustainability, we are now more interested in its prospects for dividend growth. Specifically, in this analysis we attempt to assess when Realty Income may be able to reinstate its historical level of mid-single-digit dividend growth instead of the sub-1% growth investors have experienced recently.

The main factor affecting our changed perspective is Realty Income's sizable recent acquisition activity. The firm has closed $390 million of cash-flow accretive acquisitions since our August analysis (compared to roughly $290 million for the first half of 2010). But there are also other factors that we expect to make positive contributions to Realty Income's cash flow in the coming quarters, including higher same-store (i.e., organic) rent growth, more normalized levels of other revenue, and yet-to-be-announced acquisitions. We expect these positive factors to be offset only slightly by the negative impact of Hollywood Video store closings and lower levels of lease termination fee income as the economy gradually improves.

We Expect Cash-Flow Coverage of Dividends to Improve Substantially
Using these assumptions, and incorporating the effect of Realty Income's recent share issuances (which were used to fund acquisitions) and dividend growth of 0.9% in 2011 (in line with recent history), we can examine recent historical and projected cash flows, dividends, and coverage ratios.

This analysis shows that Realty Income's projected cash-flow coverage of dividends may improve dramatically over the course of the coming quarters. 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 first quarter of 2011.

 

We Expect a Meaningful Dividend Increase in 2011
Given this anticipated improvement in Realty Income's cash-flow coverage of its dividend, we expect the firm to reward shareholders with a more substantial dividend increase in 2011, along the lines of its historical mid-single-digit norm. This could happen as early as the second quarter of 2011, and we would expect it to happen no later than the fourth quarter of 2011, but the most likely quarter for a meaningful increase in the dividend is the third quarter of 2011, in our opinion.

Of course, our analysis incorporates a lot of assumptions that need to come true for our prediction of a return to mid-single-digit dividend growth at Realty Income to materialize. For example, if Realty Income's expected $250 million in acquisitions is weighted toward the back half of 2011 or its same-store rent growth doesn't pick up as quickly as we expect, improvements in dividend coverage will shift toward the back half of 2011, suggesting more substantial dividend increases would likely occur later in 2011. And the reverse is also true, as quicker-than-expected closings of cash-flow-accretive acquisitions or faster-than-expected same-store rent growth would quicken the improvement in dividend coverage.

There are other factors we have not considered here that may also have an impact on future quarters' cash flows:

• The potential boost/hit to FFO from selling properties out of Crest at values that exceed/are lower than their current carrying values;
• Portfolio occupancy gains/losses;
• Higher/lower levels of general and administrative expenses, which can fluctuate with acquisition activity;
• Acquisitions greater than/less than the $250 million level we assume;
• The mix of debt versus equity used to finance acquisitions.

However, if we stick with our original assumptions, we believe Realty Income could close 2011 with an annualized dividend rate of $1.80 per share, which represents a 4% increase over 2010's annualized rate of $1.73. Furthermore, we think this payout represents a comfortable dividend coverage level (roughly 85%-90%), such that its dividends could once again grow thereafter at a mid-single-digit rate, driven by ~2% same-store rental growth combined with growth from acquisitions.