Realty Income Corp's Business Model Explained in 6 Easy Steps

Realty Income (NYSE: O  ) is a well-oiled machine.

From 2005 to 2008, the company's business operations were depicted through several clever cartoons on its annual reports. Management wants its shareholders to understand the business operations better and know exactly how it creates shareholder value. 

The easiest way to understand the company's business model is to first understand what a sale-leaseback is and how it works:

A sale-leaseback is an arrangement where the seller of an asset leases back the same asset from the purchaser. The seller of the asset (the business) becomes the lessee and the purchaser (the REIT) becomes the lessor. 

Simply put, companies who feel they can grow their businesses faster if more cash was available and not invested in real estate prefer this type of arrangement. After all, a retail location, whether it is an apparel company, a restaurant, or a fitness center, is generally more focused on the core business operations and not managing or investing in the real estate it holds. 

There is another major benefit to a sale-leaseback. The seller generally receives tax deductions as well. The U.S. has the highest corporate income tax rate in the world and it is often complicated. Recently, several companies have reincorporated their company headquarters overseas via a tax inversion, which is essentially a restructuring that results in an overall lower tax rate. Companies will usually welcome any type of tax deduction it can get, and REITs provide tax incentives.

So how does the business generate revenue and increase shareholder value? Through six steps: discover, analyze, buy, own, manage, and cash. Here is a breakdown of each step:

Analyze: Look for a dependable company that has a long track record and will have predictable revenue for at least 10-20 years or more. In other words, a small independent pizza company that just started its business operations will not even be considered by Realty Income, regardless of its reputation and revenue generation.

Discover: Find enterprises with a high quality business that are freestanding. In other words, the business is not connected or shared with another business. Investment grade properties are preferred, but not required. Currently, around 44% of its properties are investment grade, a huge jump from only 2% at the end of 2009. Diversification by property type, industry, and location are important as well. No tenants represent more than 5.4% of revenue. While the company operates in 49 states, more than 20% of revenue comes from California and Texas. This might seem like a concern for investors, but keep in mind that the company was founded in California in 1969 and it knows the market extremely well after more than four decades of active investment.

Buy: Realty Income uses some of the cash on-hand to do this, or it will issue stock from time to time. If needed, the company will tap into its $1.5 billion credit facility as well.

Own: Realty Income will handle of all of the paperwork and legal documents. Its property management team will inspect the property periodically to ensure that the tenant is maintaining it properly. Since it is a net lease, this means that the tenant (let's say FedEx for example) will have to pay for all of the property taxes and insurance, etc. 

Manage: Realty Income will approach the tenants toward the end of their long-term lease, and discuss the options prior to the lease expiration. Whether a decision is made to retain the tenant, find a new tenant, or sell the property, the company works with the tenant closely to ensure that the transition is smooth and transparent.

Cash: Paying dividends to shareholders is essential to every REIT. By arrangement, REITs must pay at least 90% of their taxable income to shareholders in the form of dividends. What makes Realty Income unique is that it is one of the few public companies that pay monthly dividends, which is often an important consideration for income investors who are retired or semi-retired and looking to supplement their monthly incomes. 

Foolish Takeaways
A well-oiled machine indeed. By sticking to the same formula since its inception, the company has proven that the six step business model is successful. 

At the beginning of each year, management outlines its goals for the year and how it intends to accomplish each one. I like seeing that it continues to maintain a conservative balance sheet every year. A well-disciplined approach is a winning approach for investors.


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