Better Buy: Realty Income Corporation vs. Simon Property Group

Dollar General is among Realty Income's largest tenants. Image source: Flickr user Mike Mozart. 

Real estate investment trusts (REITs) that focus on retail properties can be a great investment, but not all types of retail belong in your portfolio. Two high-potential areas of retail include freestanding single-tenant buildings like those owned by Realty Income (O 0.52%), and modern mall properties like those in Simon Property Group's (SPG -0.68%) portfolio. Let's take a look at these two retail REIT giants to see which is the best buy now.

Meet the contenders

Realty Income primarily invests in freestanding retail properties, and currently has over 4,600 properties leased to 243 different commercial tenants. The company does have substantial holdings in industrial and office properties, but retail is the main focus.

Image source: Flickr user Prayitno.

On the other hand, Simon Property Group invests in mall properties, including those under their Premium Outlets and The Mills brand names. As of the first quarter of 2016, the company has 231 properties with a total of 191 million square feet of space. Although Simon may sound smaller by property count, remember that each of the company's properties are made up of hundreds of stores. In fact, Simon is the largest publicly traded REIT of any kind.

Differences between the property types

Realty Income's strategy is to invest in the most recession-proof and competition-resistant retail properties available. Basically, this means businesses that sell non-discretionary goods (such as drugstores), are service-oriented (fitness centers, movie theaters), or sell goods at low price points (dollar stores). In other words, these are businesses people have to physically go to and aren't vulnerable to online competition, which has led to the demise of many discretionary retailers.

Obviously, discretionary retail is a big component of shopping malls. While it's true that many of Simon's individual tenants are of greater risk than Realty Income's, there are some advantages to Simon's business model. The most obvious strength is its size -- with thousands of tenants, the business isn't too reliant on any one company's success. For comparison, Simon's 10 largest tenants make up 17.2% of the company's revenue, while Realty Income's top 10 account for nearly twice that amount. Simon also has the highest credit ratings in the industry (A/A2), which allows it low-cost access to virtually unlimited capital to pursue opportunities.

Growth strategies

These companies have completely different growth strategies. Realty Income's business model is to grow through acquisitions: The company purchases properties with high-quality tenants in desirable areas. The properties are then leased to the tenant on a long-term basis (15- to 20-year initial lease terms) on a triple-net basis, meaning the tenants are responsible for taxes, insurance, and building maintenance.

Simon also grows through acquisitions -- in fact, the company just made a major investment in The Shops at Crystals in Las Vegas. However, the primary basis of Simon's growth is through development. Many REITs are development-based, with the idea that building a desirable property from the ground up can create instant value. Simon has approximately $2 billion worth of development or redevelopment projects under construction at the end of the first quarter.

Both business models have been highly effective. Occupancy is high -- 98.2% for Realty Income and 95.6% for Simon, and both companies have an outstanding track record of creating value and income for shareholders, as we'll see shortly.

Dividend and growth history

This is another area where both companies excel. As of this writing, Realty Income pays a 4% dividend yield in monthly installments, and has increased its payout for 74 consecutive quarters. Since its 1994 IPO, Realty Income has grown its dividend by an average of 4.7% per year and is a member of the S&P High Yield Dividend Aristocrats Index.

Simon pays 3.3% per year on a quarterly basis, and while it has a strong history of dividend increases, it's not quite as impressive as Realty Income. However, the company has done a good job of emphasizing dividend growth in recent years, with a five-year growth rate of more than 18% per year.

Data source: YCharts.

As far as overall growth goes, these companies have two of the most impressive records of any companies in the market. Since its 1994 IPO, Realty Income has averaged a 17.8% total return, a remarkable level of performance to sustain for such a long time. Simon Property Group isn't too far off, with a 16.4% annual compound return during the same time period. To put this in perspective, consider that a $10,000 in each of these companies ($20,000 total) made at the time of Realty Income's IPO just over 21 years ago would be worth a total of $559,000 today.

Both companies are standouts in terms of dividends and growth, but because of its significantly more stable and predictable dividend, as well as its slight edge in performance, I'd call Realty Income the better of the two in this category.

Valuation

When evaluating REITs, it's important to use funds from operations (FFO) instead of earnings per share (EPS), as the former gives a much better picture of a REIT's profitability. Here's an in-depth article on why we use FFO, but for now, let's just say that it excludes certain expenses that the REIT doesn't actually have to pay.

Here's how these retail giants stack up side-by-side:

Data source: Company filings. Note: Adjusted, or normalized FFO guidance is used, as it's a company-specific measurement of ongoing profitability.

I wouldn't call either one of these REITs cheap right now, but Simon trades at a significantly lower valuation. Even though Simon has the size advantage, I do believe Realty Income's property types are safer investments, and therefore the company deserves to trade for a slight premium. Plus, Realty Income has a slight, but significant edge in dividend history and overall performance over the years. In a nutshell, the valuations seem a little expensive, but appropriate given the history of these companies.

Which is the better buy?

To be clear, I don't think investors will go wrong with either of these stocks. Both have the potential to produce market-beating returns in your portfolio for decades to come. And, I'd like to re-emphasize that neither one strikes me as a particularly good value. Personally, I would wait for a bit of a pullback before buying shares of either company.

Having said all that, my personal preference is Realty Income, and in the interest of full disclosure, it's one of the largest stock holdings in my personal portfolio. In my opinion, Realty Income is as close to a perfect combination of growth potential, income, and safety you're likely to find anywhere in the market, so it's worth looking into for a long-term investment -- especially if the share price drops.