Despite recent forays away from the firm's core retail properties, Realty Income is positioned to produce solid dividend increases in the years to come.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Realty Income has been in the news as they've made some large acquisitions recently. I am here with analyst Todd Lukasik take a look at what they are buying, how it's different from their current strategy, and what it could mean for investors.
Todd, thanks for talking with me today.
Todd Lukasik: Hi, thanks for having me. It's good to be here.
Glaser: So I know that a lot of our users have looked at Realty Income before, but for people who haven't, can you give us a little bit of background about what this company does and how it might be different from some other REITs?
Lukasik: Sure. Well, you mentioned a large retail following for the stock. I think that may come from the fact that they pay monthly dividends, and they've been increasing those on a quarterly basis for 13-plus years. So for dividend-seeking investors, this has been a very interesting stock to own.
As a business, Realty Income has almost been historically 100% focused on sale-leaseback transaction financing with non-investment grade or non-rated retailers, and so over the course of the years they built the portfolio of about 2,500 locations. These are single-tenant, freestanding retail locations--it might be a Taco Bell, it might be your local movie theater, or it might be the local La Petite Academy, where your kid spends part of the day--across 49 states in the country. And just recently, they have announced a diversification strategy to bring on other types of assets, and these are non-retail assets, things like suburban office properties or manufacturing facilities or industrial facilities.
Glaser: So, this is a big change. I know in the past we thought that Realty Income really has some moat-worthiness around it that they can find these great retail properties that have a good cash flow. Are they going to be able to bring that competitive advantage to these different sectors like office?
Lukasik: That's difficult for us to see at this point. As you mentioned, they've been incredibly successful with their retail strategy, and for that we've grown to respect the management team and we've awarded them a narrow moat. We don't think that's changing with regards to their retail portfolio, but these non-retail assets are different. And the plan is to take it up to about 30%, perhaps, contribution to the overall business.
So, the fact that the majority 70% or more if their business is still going to be focused on these retail properties where we think they have a moat is not likely to change our overall moat assessment of the firm. We think it's going to be able to keep a narrow moat, but we do like these non-retail assets relatively less.
And so during the time when they're going from almost 100% exposure to these retail assets to up to 30% exposure of these nonretail assets, we think there is a negative trend. We think there is some potential dilution to the moat there, though overall we still expect them to always maintain their narrow moat if those retail properties maintain a majority of their portfolio.
Glaser: What was the impetus for this diversification?
Lukasik: The company wants to diversify away from a strictly 100% exposure to the U.S. consumer, and that's the main impetus behind it. So by getting into these other property types, it diversifies its revenue stream to some degree.
The other thing they have cited is that, through commercial real estate cycles, there may be certain properties that look more attractive relative to the retail properties at different times in the cycle. And so, if they do have exposure and experience that they built in these other assets, that will allow them to invest in the particular asset type that they think is most attractive at any particular time in the real estate cycle.
Glaser: So these new assets could grow to almost a third, but we still have two thirds of business that's focused on retail. How is that performing, and have you seen any major changes there recently?
Lukasik: You know their retail portfolio has performed relatively well throughout the downturn. They certainly had their share of problems from the tough economy, as well. A lot of their tenants as I said are non-investment-grade or non-rated tenants, and some of them came on hard times. And so, the internal growth of that portfolio has really slowed recently. It started to pick up again in the latest quarters, but relative to other retail landlords that saw declines in same-store performance, Realty Income's portfolio held up relatively well. And I think that is a reflection on their strategy, I mean in that particular business line they focus on their retailers' most profitable stores, and they are actually receiving financial information on a store-by-store basis in most cases. So, they can monitor their performance of stores in their portfolio and actually divest ones that look like they might be falling on hard times.
Glaser: And what about the dividend, do you think that they are going to be able to continue to raise it as they have been?
Lukasik: We do. In January of this year, we came out with an opinion that this year would be one where we saw a significant dividend increase. For the last two years, they have been giving shareholders quarterly dividend increases that over the course of the year still added up to less than 1% on an annualized basis. So, they have maintained their streak of dividend increases and over that time as I said, the performance of the portfolio came on some hard times, and so the cash-flow coverage of their dividend was under pressure. And it got pretty tight.
Now we see that changing, especially with acquisitions that they have done recently that are cash-flow accretive. We think the cash-flow coverage of the dividend is improving significantly this year, and we look for a more meaningful, probably along the lines of a mid-single-digit increase in the dividend in the third quarter of this year. And a mid-single-digit increase is sort of what we think the company can do on a sustainable basis.
Glaser: And finally at today's prices, does it make sense to buy now, or do investors need to wait for a pullback?
Lukasik: Our fair value estimate is $34 a share, and the stock trades around $35. So we think it's fairly valued. I guess what we would call a hold at this time. But a lot of the return is going to come through dividends with the 5%-plus yield at this point and a dividend that's likely to grow.
Glaser: Todd, thanks so much for talking with me today.
Lukasik: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
