There are thousands of publicly traded stocks, but only a small portion have paid a dividend without interruption. Some eventually join the list of Dividend Aristocrats, those companies that have raised their dividend for 25 consecutive years or longer. Real estate investment trust Realty Income (O -1.90%) takes it a step further.
Calling itself the "monthly dividend company," Realty Income manages to pay a dividend every month of the year, something that not many dividend stocks can say. How does a company manage to keep shelling out cash to investors? Here's how Realty Income does it and why investors can feel comfortable about getting paid for years to come.
Understanding the "secret sauce" behind Realty Income
Realty Income is a real estate investment trust (REIT), a type of publicly traded company, which in this case acquires and rents out real estate, primarily in the retail sector. Congress created this business structure to allow shareholders to invest in real estate without owning properties outright. They are great dividend stocks because they're required to pay out at least 90% of their taxable income as dividends.
REITs typically acquire a property and then rent it to a tenant under a lease agreement. These companies will pay for real estate by issuing debt or new shares. Its weighted average cost of capital (WACC) is how much it costs the business to raise these funds. A company like Realty Income must acquire properties that generate a higher return than its WACC.
Here's where things get fun: Realty Income's balance sheet is rated firmly as "investment grade" by the major credit bureaus, carrying an A-rating from Standard & Poor's. A strong credit rating fetches lower interest rates when taking on debt. Additionally, the stock's popularity among investors often gives the shares a higher valuation relative to its many peers.
Compare the valuation of Realty Income with Simon Property Group, using a ratio of share price to cash flow. A more expensive stock will raise funds more effectively when issuing new shares. When the stock's doing well, management can issue shares to raise funds without severely diluting shareholders.
Cheap debt and expensive stock help produce a low 5.3% long-term WACC for Realty Income, which creates a significant advantage. REITs must create a "gap" or "spread" between the return on assets and the cost of capital; a higher cost of capital may require a company to chase riskier tenants because it must charge more to create a spread.
Realty Income can be pickier, acquiring higher-quality tenants that qualify for lower rent terms because Realty Income has that lower cost of capital as a buffer. It can underprice many competitors while still generating profitable and safe cash flow streams. It also uses net leases in which tenants pay for property maintenance, taxes, and insurance.
Where the dividend stands today
Realty Income's dividend continues flowing to this day; a Dividend Aristocrat, it's raised its payout for 26 years and running. The current dividend yield is just over 4%, which is right in line with the stock's long-term average.
The dividend payout ratio is about 82% of cash flow, which makes sense given that its payout is essentially the point of being a REIT in the first place. Realty Income is not a rapidly growing company, and investors might be better off looking at Realty Income as a long-term holding to buy steadily while letting the dividends begin to compound.
Want to boost your returns?
Reinvesting dividends is an underrated investment tool. Realty Income has averaged a total return of 10% annually since 1995, assuming you pocketed the dividends. But that annual return goes up to 15% if you reinvested those dividends instead, turning a $10,000 initial investment into more than $400,000.
Realty Income's proven ability to navigate challenging environments like COVID-19 and its prudent management could mean that investors are poised for similar success over the next two decades and beyond.