Realty Income: Does This $17 Billion REIT Still Have Room To Grow?

Note: This is the sixth article of an eight-part series on Realty Income Corporation. Previous articles have discusses the company's history, business model, industry, income statement/balance sheet, and management.

Realty Income Corporation (NYSE: O) is the largest real estate investment trust (REIT) specializing in free-standing retail properties in terms of market cap, and has a $17 billion real estate portfolio spread among 49 states and Puerto Rico. With its enormous size, it's only natural to ask whether or not Realty Income still has room to grow -- especially in today's retail environment. Here's what you need to know about Realty Income's growth opportunities now and in the years to come.

Sustainable competitive advantages
Realty Income has a few competitive advantages over its peers that investors should be aware of.

 Obviously, larger companies have the advantage of economies of scale -- that is, the efficiencies that come from running larger operations. Realty Income's size allows it to handle virtually every aspect of its business internally. It has its own research, legal, accounting, and IT divisions -- things smaller companies often have to pay outside firms to handle.

Another competitive advantage is access to capital. Because of a few factors, including its history of high-quality investments and the diversity of its portfolio, Realty Income has an investment-grade credit rating (Baa3), which allows for nearly unlimited access to cheap capital to finance construction of new properties and to make acquisitions. Realty Income just received a new $2.25 billion unsecured credit facility, an increase of $750 million over the existing one, and at a 20 bps lower interest rate.

Realty Income's size and access to capital also allow it to pursue acquisitions that are out of the realm of possibility for its competitors. If there is an attractive, multi-billion dollar portfolio available, Realty Income can acquire it without too much hassle, like their acquisition of American Realty Capital Trust in 2013.

Finally, a big competitive advantage for Realty Income is its strong relationships with its tenants. Realty Income's portfolio, while diversified, does have substantial exposure to its largest tenants. These relationships play a major role in not only creating future opportunities for the company, but also in helping to produce investments with higher than average capitalization rates (initial rates of return).

Focused on the right type of properties for growth
Many investors are hesitant to get involved in anything having to do with retail, and for good reason. After all, many retailers have been forced to dramatically downsize their operations in recent years, and some high-profile retailers have been forced to shut their doors entirely.

Realty Income focuses on a specific type of tenant: the retail portion of the portfolio -- which makes up 78% of the total -- consists of companies that provide a service, sell non-discretionary goods, or sell goods at a low price point. Over 90% of the retail portfolio falls into one of these categories. Look at some of Realty Income's largest tenants:

Also, consider the industries that make up the majority of the portfolio:

Source: Realty Income June 2015 investor presentation

Convenience stores and drug stores combine for nearly 20% of the portfolio, and these are businesses that by definition need a physical location. The same can be said for health & fitness businesses (6.8%) and quick-service and casual restaurants (8.4% combined).

Also note that a substantial portion of Realty Income's properties are dollar stores, which is perhaps the fastest-growing type of retail there is. In fact, the two major dollar store companies on the above list were ranked among the top 40 fastest-growing retailers in the U.S. in 2014. Dollar General plans to open about 700 new stores this year, and expects to invest more than $1 billion in capital expenditures by the end of 2016.

The rest of Realty Income's portfolio (22%) is made up of industrial, office, manufacturing, and agricultural properties -- mainly leased to large, investment-grade tenants, such as FedEx, which is currently building new distribution centers.

To sum up, while a large portion of the retail industry is indeed susceptible to online competition and economic fluctuations, the vast majority of Realty Income's portfolio is not. This is especially evident when you consider that Realty Income's occupancy is a stellar 98%, and hasn't fallen below 96.6% no matter what the economy was doing. Most of the company's tenants are strong businesses that are well-positioned to survive in any type of economic climate, and many are currently expanding at a rapid pace.

Relationships are everything
One growth opportunity Realty Income has is continuing to capitalize on its relationships with existing tenants. On the whole, relationship-driven deals produce about 20 bps-higher returns, and there is a particularly strong opportunity in "build-to-suit" retail. When building properties to tenants' specifications -- an area of the business that management has said it would like to expand -- tenants choose the location and property, which reduces vacancy and default risk.

Not only is built-to-suit retail more predictable than acquiring existing properties, but it can be more profitable as well. On the company's latest conference call, CEO John Case said that built-to-suit properties can produce cap rates in excess of 9%, as opposed to around 7% for acquisitions.

Most importantly, Case said that the built-to-suit business is scalable, meaning the company sees plenty of opportunities going forward. Building to suit obviously requires more time and effort on the part of the company, but can pay off nicely in the long run.

Lots of room to grow
The freestanding retail REIT industry is highly fragmented, meaning that there are few "big players" and most properties of this type are held by smaller companies. Besides two other heavyweights (National Retail Properties and American Realty Capital Properties), there really aren't any other major REITs with this type of specialization.

In other words, there is no shortage of properties (and smaller firms) that are potential acquisition targets for Realty Income. The company plans to acquire up to $1 billion in properties this year, and has been quite successful at finding suitable opportunities in the past.

Note: 2013 data excludes the American Capital Realty Trust acquisition

Geographically, although Realty Income owns properties in nearly every state (except Hawaii), it is rather concentrated in a few areas. In fact, six states make up more than 40% of Realty Income's rental income.

On the other hand, several populous states make up relatively little of the portfolio. (Note: Realty Income owns a total of 4,378 properties as of 3/31/15)

So although the company is "geographically diverse" in the sense that it has a presence in most states, there are plenty of areas where it has room to grow.

The bottom line
Realty Income not only has lots of room to grow in the freestanding retail real estate business, it has the financial resources to pursue attractive opportunities and the advantages to do so in a more profitable manner than its competition. So if you're worried that Realty Income's days of rapid growth and the excellent returns that came with it might be nearing an end, relax -- there will be plenty of opportunities in the years ahead.