Better Buy: Realty Income Corporation vs. National Retail Properties

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Realty Income Corporation (O -1.16%) and National Retail Properties (NNN -0.70%) are leading retail REITs, and are similar in many respects. Here's a look at some of their similarities and differences, as well as why both are relatively safe investments, so you can make the best decision for your portfolio.

About the contenders
Realty Income and National Retail Properties are two leading retail REITs that specialize in freestanding retail properties. Realty Income has 4,473 properties spread among 49 states and Puerto Rico, and National Retail Properties is about half that size with 2,231 properties in 47 states. Both companies least their properties to a diverse array of tenants operating in dozens of different types of retail.

In many ways, these companies have extremely similar business models. In fact, if you look at each company's "top tenants" list, there are several names in common -- LA Fitness, Camping World, AMC Theaters, and BJ's Wholesale Club are in both companies' top 20.

However, there are a few key differences between the two when it comes to evaluating their merit as investments. Before we get into those, here's why these retail REITs may belong in your portfolio.

Wait -- why would anyone invest in retail?
Many investors hear the word "retail" and immediately run in the other direction, and understandably so. There have been several high-profile retail bankruptcies in recent years, and many other retailers are struggling to survive. However, these stocks are different.

The first reason is the types of retail properties these companies invest in. They mostly buy freestanding, single-tenant buildings occupied by nationally known and stable tenants that fall into one of three categories:

• Service-oriented businesses: These are businesses that people have to physically go to, and hence there is little threat of online competitors stealing market shares. Fitness centers are a good example, as are movie theaters and auto repair businesses.
• Non-discretionary businesses: Not only are these not vulnerable to online competitors, but they're also are defensive businesses, meaning that they do well no matter what the economy is doing. Grocery and drug stores are a good example.
• Low-price-point businesses: Dollar stores are a great example and are the fastest-growing type of retail. Businesses with low-priced goods will always be attractive to value-conscious consumers.

It's also worth mentioning that Realty Income also has a significant amount of non-retail properties in its portfolio. These are primarily industrial buildings, occupied by investment-grade tenants in non-vulnerable markets.

In addition to the property types, both of these REITs are rather diverse, both geographically and tenant-wise. No tenant makes up more than 7% of either REIT's portfolio, and the properties are spread across dozens of retail sub-industries.

Finally, the lease structure of retail real estate is appealing for investors seeking stable income. These REITs use long-term net leases, which have initial terms of 15 to 20 years. Annual rent increases are typically agreed upon right from the start, and tenants are responsible for variable costs such as property taxes, insurance, and maintenance.

Who has the stronger balance sheet?
Both companies have a strong financial position, but I give the advantage to Realty Income here. Debt and preferred stock make up just 30% of Realty Income's capitalization, while they make up 44.8% of National Retail Properties'. As a result, Realty Income has a more attractive fixed-charge coverage (3.8 vs. 3.3), meaning that it could absorb more of a blow to earnings and still be able to pay its bills -- although it's tough to picture a scenario that would cause earnings to contract by enough to make either company unprofitable.

Both have identical credit ratings of BBB+/Baa1, which gives them access to virtually all of the capital they'll need to acquire new properties in the future. However, 14% of National Retail Properties' debt is at a floating interest rate, leaving it somewhat more susceptible to interest rate fluctuations, as 100% of Realty Income's debt is fixed-rate. Again, neither company has a debt problem or anything that scares me away, but Realty Income is just better positioned in this area.

Performance and dividend histories
It's hard to declare a winner in this category. Both companies have an outstanding track record of dividend increases, and National Retail Properties is one of about 100 companies in the market that have increased their dividend for more than 25 consecutive years. So National Retail has a slight edge in dividend history, but Realty Income currently has the higher yield (4.24% vs. 3.99% as of this writing).

Realty Income has the edge in performance, with a 17% average annual total return since its 1994 IPO. National Retail Properties has produced 14.8% total returns over the past 25 years, which is still incredibly impressive performance to sustain for such a long time -- the S&P 500 managed returns of 9.8% over the same time period.

Valuation
When it comes to valuing REITs, the traditional metric of price-to-earnings ratio doesn't cut it. For real estate-specific reasons, "earnings per share" doesn't give an accurate picture of a REITs true income.

Instead, we use funds from operations (FFO), which is the universal earnings metric of the real estate world. When evaluating similar companies, adjusted funds from operations (AFFO) can be an even better metric, as it gives the most accurate idea of how much money a REIT is generating that could be used to pay and increase dividends now and in the future.

With that in mind, let's see how Realty Income and National Retail Properties stack up side by side.

Note: Current as of 2/8/2016. P/FFO and P/AFFO calculated using the midpoint of guidance ranges.

A couple of things to notice from this data. First, strictly on a valuation basis, National Retail Properties is a better buy. However, when taking into account Realty Income's more attractive capital structure, larger and more diverse portfolio, and its slightly better performance history, I believe the small valuation premium is justified.

Second, you may be thinking that valuation multiples close to 20 seem expensive for any "income" stock. This may be generally true, but then again, most income stocks don't have a multi-decade history of market-beating performance.

And the winner is ...
It's tough to declare a winner here, and if you look at the disclosure at the end of this article, I'm actually a shareholder of both REITs. Having said that, if I had to pick one to buy now, it would be Realty Income. During turbulent market times like these, the lower debt level is an especially attractive quality I look for when choosing investments. However, if you're a long-term investor or a current income-seeker, you can't go wrong with either of these.