Real estate investment trusts are a staple in income investors' portfolios because they're required to distribute at least 90% of their income as dividends, producing yields well in excess of the market's average. And they thrive best when interest rates are falling, as their costs to borrow fall but the rents they collect do not.
Realty Income (NYSE:O) and Store Capital (NYSE:STOR) are both REITs in the net-lease space (more on that shortly), but with very different histories. One has existed for half a century and has a steady record of increasing dividends -- in fact, it's trademarked the name "the Monthly Dividend Company." That's Realty Income. The other went public in 2014, but has the endorsement of legendary investor Warren Buffett. That's Store Capital. Which is better for your portfolio?
The net-lease REIT model
Generally speaking, there are two basic types of leases for retail REITs. The typical type is the gross lease, where where the tenant simply writes a monthly rent check and the REIT is responsible for maintenance and taxes. If you've ever rented an apartment, you signed a gross lease. The landlord paid the property taxes, and if you had any issues with the apartment, you called the superintendent. Gross leases are generally higher-risk for the landlord, but they usually have higher rents.
The other type is the net-lease model, where the tenants don't just pay rent -- they also cover costs like maintenance, insurance, and taxes. These leases are generally longer-term and include built-in rent increases. These arrangements put most of the risk on the tenant. And this is how both Realty Income and Store Capital operate.
Realty Income and Store Capital focus on sale-and-leaseback transactions in which the owner of a retail development sells it to the REIT, which then leases it back to the former owner. This provides the seller with cash it can use for expansion or operations, and is more efficient since REITs can often borrow on better terms than other businesses. In many ways, net-lease REITs are really in the financing business (which is what a sale-and-leaseback transaction essentially is).
You just have to be there
Both companies have taken steps to avoid some of the "Amazon effect" that has been plaguing retail. They focus on tenants whose business models are relatively recession-proof and insulated from online competition. Service providers are ideal -- for example, fitness centers, child care, and medical offices. Retailers with less of a focus on discretionary spending also fit the bill -- like drug stores, convenience stores, truck stops. Realty Income's top tenant is Walgreens, which accounts for about 6% of rental revenue, while Store Capital's is Midwestern discount chain Fleet Farm, at less than 3%.
Given that the business models of both companies are relatively similar, what are their differences? The biggest is size: Realty Income has 6,843 properties some of which are in international markets, while Store Capital has 2,504, all of them domestic. Realty Income's market cap is proportionally larger as well -- more than three times the size of Store Capital's.
Another difference is tenant mix. While retail and services are key for both companies, Realty Income gets about 17% of its rental income from industrial, office, and agriculture. FedEx is a major non-retail / service tenant. About 16% of Store Capital's rent comes from manufacturing and metal fabrication.
Catering to businesses that depend on in-person visits is a double-edged sword today, with fear of the coronavirus (COVID-19) causing people to avoid going out in public and to pull back on discretionary spending. Store Capital takes a greater share of its rent from tenants that are more likely to be affected -- restaurants, child care, health clubs, and theaters and other entertainment centers will be some of the first businesses to feel the pain, and these contributed roughly 33% of Store's total rent last year. Realty Income was a little more insulated, coming in around 25%.
On the other hand, if you want to Amazon-proof your business, in-person services are probably the surest way, and this was likely one of the reasons Buffett's team at Berkshire Hathaway bought a nearly 10% stake in Store Capital in 2017. Buffett is famous for investing in companies with durable models that will weather all economic cycles, along with good corporate governance, and presumably Store Capital fits the bill.
So which should you buy?
As you might expect when comparing a company that's more than 50 years old will one that's less than 10, size and revenue growth are key differences between Realty Income and Store Capital. But other key metrics are closer. Here's a quick look:
|Company||Market Cap||Price-to-FFO Ratio||Revenue Growth Rate||Dividend Yield||FFO Payout Ratio|
|Realty Income||$25 billion||22||12%||3.6%||82%|
|Store Capital||$7 billion||15||22%||4.6%||70%|
On a valuation basis, Store Capital gets the nod as the better buy. Its dividend yield is higher, its payout ratio is lower, its growth rate is almost twice Realty Income's, and it trades at a cheaper multiple of funds from operations (FFO -- the REIT equivalent of earnings). Realty Income probably trades at a higher multiple due to its greater size and lower exposure to manufacturing. Store also has a slightly higher interest coverage ratio, 3.6 to 2.8, which means it has more leeway if FFO falls. Both companies are well-run and should provide the investor with income and capital preservation, so it is hard to go wrong with either, especially in the current environment of falling interest rates.
At the end of the day, it comes down to investment tolerance. Realty Income is a dividend machine -- it's raised its dividend every quarter going back to late 1997 -- with good insulation from the economic swings of the market. It isn't necessarily cheap, but you are paying for safety and a track record. Store Capital is so new it wasn't around during the past recession. However, it has about the strongest investor endorsement there is in Berkshire's ownership. Store trades at a cheaper multiple, and it has faster growth and a better dividend. That said, if more people stay at home to prevent the spread of COVID-19, the company could more vulnerable.