Realty Income Corporation: How This $10 Billion REIT Makes Its Money

Realty Income Corp. (O 0.55%) is one of the largest REITs in the market and has grown tremendously over the past several decades. Shareholders have been handsomely rewarded for their faith in the company, enjoying a spectacular 17.4% average annual total return for the past 20 years. Realty Income has achieved those remarkable returns with a low-risk business model many other companies could learn from. Here's how Realty Income makes its money and why it performs well no matter what the market is doing.

How Realty Income makes its money
Realty Income is a real estate investment trust, or REIT, that specializes in freestanding retail properties. Put simply, the company makes its money by purchasing retail stores and the land they sit on and then leasing the properties back to the business' operator.

Realty Income doesn't use mortgages to buy its properties, instead funding the acquisitions via debt offerings or issuing additional shares of stock. Because of its high credit rating, it has virtually unlimited access to cheap capital, and the company's profits come from the difference between the cost of that capital and the rent collected from the property. Even so, Realty Income strives to fund just one-third of its operations with debt and the rest with equity.

Unlike many other types of real estate, Realty Income's portfolio aims to produce consistent and predictable income thanks to its leasing structure. All tenants are on "net" leases, which means the tenant is responsible for paying the property taxes, insurance, and building maintenance costs. Realty Income doesn't have to do anything but sign a lease and collect the rent.

Plus, tenants sign long-term leases of 15-20 years, usually with annual rent increases built in. So, not only does Realty Income not have to worry about most of the variable expenses of owning properties, but its rental income rises steadily and predictably over time.

Realty Income also makes money through the appreciation of property values over time. While several variables determine real estate prices, commercial properties derive most of their value from their ability to generate rent. So, if market rent for commercial real estate increases by 5%, Realty Income could roughly expect its properties to increase in value by that amount as well.

Realty Income was founded in 1969 with a simple idea: acquire properties that can be leased to single tenants and use the income from these properties to create a monthly income stream for its investors that will increase over time. This simple business model hasn't changed much over the years.

Wait a second -- stores and restaurants close all the time. How is this a safe business?
Admittedly, retail real estate is historically a more risky investment than, say, residential properties. If you think back to the financial crisis, many retailers were forced to shut their doors permanently. Plus, with a clear trend toward online shopping, several high-profile retail businesses have disappeared in the past several years, such as Circuit City, Blockbuster Video, and Borders.

Source: Flickr user Mike Mozart.

However, Realty Income focuses on a specific type of retailer. First, its portfolio is focused on businesses that need a physical location, such as gas stations and restaurants. Plus, most tenants provide nondiscretionary (essential) goods and services; examples here include drugstores and convenience stores. Further, the company is only interested in investing in stores that are profitable enough to absorb a slowdown in sales and still have enough to pay the rent. In fact, Realty Income's former CEO once said he was only interested in stores that earn at least $2.50 for every $1 they pay in rent.

To give you an idea of the types of businesses Realty Income leases to, here's the list of the company's 10 largest tenants and the type of business they engage in.

Finally, the company's use of net leases eliminates virtually all of the uncertain expenses associated with owning properties, and the long-term leases keep turnover to a minimum. Realty Income maintains one of the highest occupancy rates of any type of REIT (currently at 98%), and occupancy never fell below 96.2% even during the depths of the crisis.

To sum it up, Realty Income acquires properties that are likely to produce decades of consistent, growing returns for shareholders, and it finances those deals with cheap capital -- not mortgages. The company's business is easy to understand, and it has a proven track record of delivering market-beating results no matter what the economy is doing.