Real estate investment trust (REIT) Realty Income (NYSE:O) recently consummated the huge $11 billion or so acquisition of peer VEREIT. The complementary acquisition has a lot of benefits, but one that investors should pay particular attention to is scale. Simply put, being materially bigger than its peers means that Realty Income can do things that others can't. And that could matter a lot.
The big deal
Realty Income is a net lease REIT. That means that it owns single-tenant properties, but its tenants are responsible for most of the operating costs of those assets. With a large enough portfolio, this winds up being a fairly low-risk approach in the REIT sector. VEREIT, though a bit smaller, used the same approach. Notably, both REITs had exposure to similar business sectors, including retail, industrial, and office. The combination was a fairly good fit.
The list of positives here included that Realty Income expected the merger to be 10% accretive to adjusted funds from operations (FFO) from day one, its ability to reduce costs, and the chance to reduce interest expenses over time by refinancing VEREIT's higher-interest rate debt. There's also the fact that Realty Income went from a portfolio of around 6,600 properties to one with over 10,000.
To be fair, just having a lot more properties isn't the real issue. It's a scale thing. Looking at it another way, Realty Income estimated that the VEREIT deal would increase its enterprise value from $33 billion to $50 billion. The next closest competitor, W.P. Carey (NYSE:WPC), clocks in at around a $20 billion enterprise value. In other words, Realty Income went from being just big to being gargantuan.
What's so good about being big?
There's a few things here that matter. First, for a net lease REIT, access to cheap capital is vital. The business model basically leaves Realty Income and its smaller peers making the difference between their cost of capital and the rents they charge, given that most operating costs are borne by tenants. So, being an industry giant gives Realty Income the ability to tap the debt and equity markets with relative ease, noting that it has an investment-grade-rated balance sheet and its stock has historically traded at premium valuations. On the equity front, Realty Income's current dividend yield is around 3.9%, near the lowest levels in its history.
Then there's the issue of scale. On the downside, Realty Income needs big deals to see any impact on its top and bottom lines. However, it now has the clout to take on deals that others couldn't even consider. And, most importantly, it can do big deals all on its own.
As CEO Sumit Roy explained during Realty Income's third-quarter 2021 earnings conference call: "In the past, we had to consider partners when we were coming across these multibillion-dollar sale-leaseback opportunities. But I think the need for that has diminished post this acquisition."
Here's a look at Realty Income's market cap now, compared to its closest peers.
In fact, the CEO went on to note that his team "had inbounds from investors who wanted to participate on these one-off transactions, larger transactions outside of the realm of the public eye. And we've largely stayed away from that because we felt like the transactions that we were actually seeing in the market that was near term, we could handle all on our own."
With the VEREIT deal completed, those giant deals, elephants if you will, are now back on the table, with Realty Income's newly enhanced scale giving the combined company the heft it needs to bring down this kind of big game single-handedly.
However, there's one more fact that's important here. At this point, taking on a huge deal now also won't upend the company's portfolio diversification by property niche. For example, before the merger convenience stores made up 12% of Realty Income's portfolio. That number dropped to 9% after the deal. The same trend was true among lessees, with the top individual names dropping by a percent or two.
All this means a billion-dollar deal would now be easier to absorb without it causing distorting portfolio concentrations. And that means Realty Income has much more leeway to make big deals.
In the pipeline
You shouldn't expect Realty Income to start inking billion-dollar deals every week. What's important is that Realty Income has been seeing deals of this size and, before now, didn't feel like it could take them on. Having gained more scale via the VEREIT merger, it is now comfortable with what would be massive transactions in the industry. And it is capable of doing these deals all on its own, which none of its peers would likely pull off. That puts Realty Income in a league of its own, giving it a notable competitive advantage. And, if the CEO's comments are any indication, there are some big opportunities like this in the pipeline.
In the end, being a single source for billion-dollar deals is yet another way that this well-run net lease REIT is distancing itself from its peers.