Real estate is a classic wealth-building tool; getting that monthly rent check is a sweet feeling. Thanks to real estate investment trusts (REITs), you don't have to actually buy buildings to get that feeling. Realty Income (O +0.70%) holds a collection of retail properties and shares the rent money through monthly dividends. It also has proven it can take a punch.
REITs operate differently from a typical business. It's essential to understand how REITs work and what makes Realty Income such a robust dividend stock. Here is what you need to know.
How does the business work?
REITs are a particular type of business structure that Congress created in 1960 to hold income-producing real estate. They give investors the ability to participate in the benefits of owning real estate without having to own property themselves.
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A REIT receives special tax treatment and doesn't have to pay corporate income tax, as long as it meets the following condition: It must pass at least 90% of its taxable income to shareholders in the form of dividends.
Realty Income is a REIT that focuses on stores and quick-service businesses; its top tenants include 7-Eleven, Walgreens Boots Alliance, Dollar General, FedEx, Sainsbury's, and Dollar Tree.
These are generally steady businesses, and not very sensitive to economic ups and downs, producing reliable rent for Realty Income. During the spring of 2020, at the height of lockdowns that created unusually adverse operating conditions for businesses, Realty Income still collected 83% of the rent it was contractually owed in its worst month.
Its tenants enter into a triple-net lease. That means while Realty Income collects rent from its tenants, the tenants are responsible for the property's upkeep, including insurance, property taxes, and maintenance; this removes most of the variable expenses from Realty Income's books and leaves just the financing of the actual properties.
Dividends pay like clockwork
Steady and dependable streams of rental income make for an outstanding dividend stock. Most dividend companies pay a quarterly dividend, but Realty Income pays every month, making it a great stock if you're trying to live off the dividends.
The company went public in 1994 and has paid and raised its dividend each year since, a streak going on 28 years. At the stock's current price, the dividend yield is 4%, far more than any savings account will offer these days. A solid yield that increases each year? What's not to like?
While REITs pay out 90% of their taxable income as dividends, factors like depreciation affecting net income make it difficult to illustrate to investors how the business is performing. Instead, REITs detail adjusted funds from operations (AFFO), which is essentially the cash flow that the REIT produces. Investors can refer to AFFO to get an accurate sense of a REIT's operating performance, as well as how well it can afford its dividend.
Management is forecasting 2021 AFFO per share of $3.53 to $3.59, while the company's annual dividend is $2.83 per share. This means that the dividend payout ratio, the percentage of Realty Income's AFFO that is spent on the dividend, is 79%.
When we consider how resilient Realty Income's rental income is, this is a comfortable payout ratio. The company raised its dividend through both the pandemic and the financial crisis in 2008-2009; it seems safe to say that the payout is battle-tested.
The "secret sauce" of Realty Income
Since going public, Realty Income has outperformed the S&P 500 ; but how does it do it? Realty Income has a very high-quality management team, and the business enjoys some advantages that its peers may not be able to match.
To illustrate this, we need to look at how a REIT grows. Realty Income expands by acquiring new properties. Remember that most of the company's income goes to the dividend, so to fund expansion, REITs will raise capital by taking out loans, issuing debt or selling new shares -- or a combination of all three.
To make a profit, this means bringing in a higher return on assets (rent from tenants) than the cost of funding, expressed as the weighted average cost of capital, or WACC.
Realty Income's WACC is 5.3% over the long term, the combination of its rates on debt, and how much it raises when issuing shares. The company has a strong balance sheet; it's one of seven U.S. REITs with an "A-" credit rating or better.
The company can rent to high-quality tenants who pay lower rents, but still make money because of its low WACC. REITs with higher WACCs have to rent to riskier tenants, charging them higher rents to make a profit.
This competitive advantage shows in Realty Income's ability to increase its AFFO. The company's AFFO has increased at a historical median of 5.1% each year, compared to the average growth rate of 3.2% for its peers.
The higher growth and quality of tenants mean the stock trades at a premium valuation, enabling the business to continue raising low-cost capital when it issues new shares. It's a cycle that has powered the company's returns for years.
After raising its dividend for more than a quarter-century, I don't see why it can't continue to do more of the same.
