Retail REIT Realty Income Corporation (NYSE:O) has don't extremely well for its investors over the years, with an 18.2% average annual return since its 1994 IPO and a 76-quarter streak of consecutive dividend increases. However, performance figures like this raise the question: How risky is Realty Income?
Many investors automatically assume any retail investment is risky, and it's easy to see why. In addition to several high-profile retail bankruptcies such as Radio Shack and Aeropostale, many retailers have severely underperformed the market over the past few years and have struggled to remain profitable.
However, Realty Income's portfolio of properties is specifically designed to be competition- and recession-resistant. The majority of its properties fit into one or more of these three categories:
- Non-discretionary retail: Businesses that sell things that people need. Drugstores are a good example, and Walgreens is Realty Income's biggest tenant. Gas stations are another -- even in the worst recessions, people still need gas to get around. Plus, it's not like gas stations have to worry about Amazon.com stealing their customers.
- Service-based businesses: While these can be more recession-prone than the other two business types mentioned here, service-based businesses require people to physically go to them, making them immune to e-commerce competition. Fitness centers are a good example, as are movie theaters.
- Low-price retail: Dollar stores and warehouse clubs can offer bargains that even the best online retailers can't match. Plus, in recessions these businesses actually tend to do better as shoppers become more bargain-conscious.
As you can see, the majority of Realty Income's tenants fall into one or more of these categories.
Leases designed for predictable, growing income
In addition to the low-risk retail businesses occupying the majority of Realty Income's portfolio, the lease structure is designed to produce worry-free, growing income.
Tenants sign what are known as "net" or "triple-net" leases. Basically, this means that the responsibility for property taxes, building insurance, and maintenance (hence the "triple") are shifted to the tenant. In other words, the tenant pays the variable expenses -- if insurance rates spike, for example, it's not Realty Income's problem to come up with the extra money.
The leases have long initial terms, typically for 15 to 20 years. Unlike many other types of REITs, such as those specializing in apartment buildings, Realty Income doesn't have to worry about tenant retention too often. Because of this, the portfolio remains at high occupancy levels at all time. In fact, Realty Income's occupancy hasn't fallen below 96% no matter what the economy was doing.
Finally, the leases generally have annual rent increases built in. So, not only is the company's rental income predictable, but it grows without much effort. This is how the company is able to increase its dividend like clockwork.
What could go wrong?
Having gone through all of the reasons why Realty Income isn't risky, it's important to take a look at the other side of things. There are a few reasons Realty Income's profits could fall, and just to name a few of the biggest reasons:
- Interest rates could rise: Low interest rates are generally good for REITs. They make it cheap to borrow money, which typically leads to better profit margins on acquired properties. And, low interest rates make REIT stocks more appealing to income-seeking investors, which creates upward pressure on their share prices. If interest rates were to rise faster than expected, it could have the opposite effect.
- A major tenant could go bankrupt: As I mentioned, most of Realty Income's tenants are recession- and competition-resistant. However, this doesn't make them invincible. It's entirely possible that one of Realty Income's major tenants could go out of business and be forced to break its lease. This could lead to a spike in vacancies, which would likely be temporary but could certainly take a bite out of the company's profits in the meantime.
- Investment opportunities could dry up: Realty Income primarily grows through acquisitions, leveraging its access to cheap capital to acquire profitable properties. The company has said that there is an abundance of opportunities right now and increased its 2016 acquisition guidance by nearly 40%. However, if this were to change and investment activity was to slow down, it could cause shares to fall.
So, how risky is Realty Income?
The short answer is "not very", especially relative to its return potential. No stock that can produce double-digit returns is without risk, and Realty Income is no exception. However, the company has a recession- and competition-resistant business model that should allow the income and growth to continue no matter what the economy is doing.
Matthew Frankel owns shares of Realty Income. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.