When investors think about net-lease real estate investment trusts (REITs), one name is likely to jump to the top of their minds -- Realty Income (NYSE:O). There are some very good reasons for this, but there's one big problem, too. Here's what you need to know about Realty Income and the big question the REIT needs to -- and is trying to -- answer.

Goliath 

Realty Income owns roughly 6,600 properties and sports a $23 billion market cap, making it one of the largest net-lease real estate investment trusts around (in the net-lease model, most of the operating costs are paid by the REIT's tenants). That alone is enough to garner investor attention, but it's not the only thing. Investors looking to dividend stocks as a way to replace their paychecks will also like the monthly dividend on offer here, even more so when they consider that Realty Income has increased its dividend annually for 28 consecutive years, putting it into the highly respected Dividend Aristocrat realm. 

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Dividend growth hasn't been incredible, coming in at around 5% a year annualized over the last decade (it has been lower in recent years). But you have to be doing something right to build a long-term dividend streak like the one Realty Income has created. That's why investors usually give the REIT a premium valuation. For example, its yield is roughly 4.6% today, which is lower than those of peers that also have strong histories behind them -- like W.P. Carey, which yields 6.2%. 

The property portfolio backing Realty Income's business, meanwhile, is largely focused on single-tenant retail properties. That segment makes up a huge 85% of the REIT's portfolio. The rest is in the industrial (10% of rents), office (3%), and "other" (2%, mostly an opportunistic investment in vineyards) spaces. This breakdown should raise a red flag today.

Where to from here?

Realty Income is a conservative REIT that tries to grow slowly over time. But with so much emphasis on retail assets, a sector that's facing material headwinds right now from the coronavirus pandemic -- and, longer-term, from the increasing use of online shopping -- investors should be wondering how this REIT will grow in the future. There are a couple of additional concerns here, too. 

For starters, there are a lot of net-lease REITs that own retail assets. And while the United States has a lot of retail properties, perhaps too many, competition for net lease assets is notable. Finding properties worth buying is no easy task, and smaller, more aggressive REITs might be willing to offer sellers better deals so they can expand more rapidly. 

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Then you have to consider the REIT's size. Simply put, it takes larger transactions to move the needle here than it would at a REIT with a smaller portfolio. One-off deals may not be enough, which means portfolio acquisitions could become more prominent. But when you buy a portfolio, you have to take the good properties with the bad and weed them out after you own them. That's more complex than cherry-picking properties one at a time.

To Realty Income's credit, it has been trying to address the growth issue. For example, it ventured into the United Kingdom a few years ago, and that country now represents around 4% of its rents. That's not huge, but as Realty Income gets a better handle on property markets across the pond, it opens up a whole new region for investment. 

Then there's the REIT's industrial and office exposure. These aren't areas where the REIT is highly focused today, with most of its time spent discussing the larger retail segment. That makes sense, given industrial and office are less than 15% of the rent roll. However, it would be nice to see management talk more about the diversification benefits and growth opportunities that these non-retail sectors offer. Some peers, notably W.P. Carey, look at diversification as a net benefit because it allows them more opportunities for investment on top of the fact that it reduces the risk of a downturn in any one sector.

Looking for growth

Investors seeking a fast-growing REIT probably won't be pleased with Realty Income, which is more like a conservative tortoise than a hare. But even growing slowly requires a game plan, and Realty Income's historical focus on retail assets looks increasingly problematic. Pushing into Europe is a good start, but there are still big questions it needs to answer on the growth front, including the role that other property types might play.

As you watch this well-run REIT, what drives growth from here is a key question you need to be thinking about. Right now the answer may not be broad enough to fully justify the premium valuation investors afford it.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.