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Here's Why the Best Is Yet to Come for Realty Income

By Reuben Brewer – Nov 4, 2021 at 6:30AM

Key Points

  • Realty Income just bought VEREIT, increasing its size and the benefits it gets from its huge scale.
  • Meanwhile, it is starting to expand in a vast new market where there's limited competition.
  • Although the stock isn't cheap, that gives Realty Income an advantage in financing growth.

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Realty Income has an incredible history, but here are a few reasons why the future looks set to get even better.

Real estate investment trust (REIT) Realty Income (O 0.49%) is a bellwether in one of the most resilient niches of the commercial real estate industry. Investors have long given it a premium price because of its impressive dividend-paying history, including monthly dividend payments and almost 28 consecutive years of annual hikes. The REIT's strong history backs up the stock market view here, but here's why Realty Income's prospects do, too.

1. Bigger is better

Realty Income not only is one of the largest net lease REITs, but it just consummated a major acquisition: buying peer VEREIT in an all-stock deal for about $11 billion. That pushes Realty Income's portfolio to more than 10,000 properties and gives it an enterprise value that's more than twice that of its closest competitor. It was already the biggest name in the market -- now it's simply an industry Goliath.

A person pointing to a lit chalk lightbulb above their head.

Image source: Getty Images.

This is notable because scale confers some benefits in the net lease sector. Essentially, Realty Income owns properties, but its tenants are responsible for most of the operating costs of those assets. In other words, the REIT gets to collect all of the rent without having to do all of the work that a landlord would normally do, like maintaining the facility and paying taxes. This is not a particularly labor-intensive process, so the more properties a company owns, the more it can spread operating costs over its employee base and improve its efficiency.

In addition, the increased scale allows Realty Income to take on deals that smaller peers simply couldn't manage. And given its investment-grade rated balance sheet, increased size also comes with greater access to capital markets (more on this below).

2. Europe is a major opportunity

In 2019, Realty Income followed peer W.P. Carey across the pond. While the core of Realty Income's portfolio is domestic, it is branching out. The start of the process was buying some grocery stores in the U.K. The goal was to learn about a new market. It has since expanded into Europe, recently buying some more grocery properties in Spain. 

Realty Income believes that Europe is a huge, largely untapped region with only a couple of competitors in the market and little use of the net lease approach. Although this is probably an unrealistic expectation, the company notes that matching the U.S. level of penetration in Europe would require expanding its European holdings by about 25-fold. Could Realty Income do this? Maybe, but it would take time. The real takeaway is directional, because it hints that there's a long runway ahead in this relatively new market.

O Dividend Yield Chart

O Dividend Yield data by YCharts

3. A mixed blessing

The last item here is one that takes a moment to digest. Realty Income, given its historical and current success, has been rewarded with a premium stock price. The dividend yield today is about 4%, which is about middle-of-the-road for the past decade, but toward the low side historically speaking. Times are different now from what they were 20 years ago when REITs were still an obscure corner of Wall Street, so this decline makes some sense. However, it would be hard to suggest that Realty Income's stock is cheap.

Here's the thing: The richly valued stock actually is a benefit for the company as it undertakes expansion, because it reduces the cost of its equity-financing efforts. REITs must pay out 90% of their taxable earnings as dividends and, thus, don't have a lot of internally generated cash to fund growth. So, they are always borrowing and issuing debt and stock as they expand. Simplistically, the dividend yield is the cost of selling equity. Although a high stock price may deter value-conscious investors from buying shares, it also accounts for the low yield. And that means Realty Income is benefiting from a low cost of capital, which it can use to its advantage as it expands domestically and in Europe. So the pricey shares are much more of a positive than negative when it comes to future growth prospects.

I lucked out

I owned Realty Income years ago and sold it to lock in capital gains when the stock had appreciated and the yield had fallen to about today's level. In hindsight, that was a mistake, given point three above -- something I hadn't given enough thought to when I sold the shares. However, I owned VEREIT, so I'm a Realty Income shareholder once again as a result of the takeover. Given the positive outlook for the future here, I have no plans to sell Realty Income again. I'll watch happily as it uses its scale to expand domestically and abroad, taking advantage of its ability to sell premium-priced shares to fund growth. This is a backdrop for a bright future that I expect will be even better than the recent past.

Reuben Gregg Brewer owns shares of W. P. Carey and Realty Income. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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