The past year has been difficult for the real estate investment trust (REIT) sector. Rising interest rates, courtesy of the Federal Reserve's aggressive tightening policy, have raised financing costs for these companies. Because REITs often trade on the basis of dividend yield, determining the sustainability of the dividend is paramount. Realty Income (O -0.77%) is a classic triple-net lease with a 5.2% dividend yield. Is it sustainable?
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Realty Income is a classic triple-net lease REIT
Realty Income is a REIT that focuses on developing properties under an unusual lease structure. Most leases are gross leases, where the tenant is responsible for paying the monthly rent and little else. Realty Income uses a structure called a triple-net lease, where the tenant absorbs most of the operating costs of the property, including taxes, insurance, and maintenance. These leases generally last a long time and contain automatic escalators. Triple-net leases are also difficult (and expensive) to break.
Realty Income is a defensive stock
Realty Income's tenant base is generally defensive, which means they sell items or provide services that are less sensitive to the overall economy. During the course of a decade-long lease, it is likely the economy will go through a rough patch, and Realty Income needs to ensure the tenant can prosper in a recession. The typical tenant for Realty Income will be a dollar store, convenience store, or drug store.
During the COVID-19 pandemic, most REITs were forced to cut their dividend as many of their tenants suffered. Realty Income actually hiked its dividend three times during 2020. Most of Realty Income's tenant base was considered an essential business and permitted to stay open. That said, Realty Income's theater tenants did struggle, but the dividend was maintained.
Focus on funds from operations, not net income
Realty Income is guiding for 2023 adjusted funds from operations (FFO) per share to come in between $3.96 and $4.01 per share. REITs tend to describe earnings as funds from operations as opposed to net income as reported under generally accepted accounting principles (GAAP). Real estate companies have a lot of depreciation and amortization, which is deducted as an expense under GAAP. Since depreciation and amortization is a non-cash charge, net income tends to understate the cash flow of the company. For this reason, REITs often look expensive on stock screening apps because they focus on net income and not FFO.
Realty Income's value proposition could help companies facing refinancing sticker shock
On the earnings conference call, Realty Income CEO Sumit Roy made a good point about Realty Income's value proposition in the current market, where many companies are being forced to pay off maturing low-interest debt and replace it with high-interest debt. Companies can save on rolling over debt by selling property to a triple-net lease like Realty Income and then leasing it from them. This is called a sale-and-leaseback transaction, and it takes advantage of Realty Income's low borrowing costs. Realty Income does have about $1.5 billion in mortgages and debt maturing in 2024 that it will need to roll over.
At current levels, Realty Income is trading at a price-to-FFO ratio of 15 times, which is a reasonable multiple for a high-quality REIT. Realty Income pays a monthly dividend of $0.256 per share, which works out to an annual dividend of $3.07. The annual dividend is amply covered by FFO per share. Realty Income is a steady dividend payer and should be a core holding in an income investor's portfolio.
