When I first started investing, I bought mutual funds. Then I had the good fortune of holding a job that allowed me to interview mutual fund managers, including some focused on real estate investment trusts (REITs). That was back before the turn of the century, when Realty Income (O 0.47%) was one of the first stocks I ever bought. It's been a journey, including me making the mistake of selling it.
In on the ground floor
Over two decades ago, the REIT world was not as prominent as it is today in investors' minds. In fact, the sector was only just starting to be recognized as an important one. At the time, I worked as a mutual fund analyst, interviewing mutual fund managers and writing about what I learned. It was a great time for me, as I got to pick the brains of people putting money on the line in the market. One fund family I had the pleasure of talking to regularly was Cohen & Steers, among the first shops to focus on REITs.
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Loving dividends even then, I was quickly enamored by REITs. And one name that stood out to me was Realty Income. A number of mutual fund managers I spoke with liked it and, well, it was yielding over 10%. I bought it for the high yield. There were better reasons to buy it, but the truth is, all I saw was that fat yield.
I happily owned it, not thinking much about it. The only thing I noted was that the dividend was increased regularly, which I liked. That said, Realty Income's stock price started heading up and, thus, its dividend yield started heading down, given the inverse relationship between the two. Basically, REITs were starting to become more mainstream. When the yield had sunk into the 4% range I decided to sell, having anchored my mind to the 10% rate when I bought it. That was a terrible mistake.
Missed opportunity
I was so focused on the yield that I didn't pay close enough attention to Realty Income's business model. It is a net lease REIT, which means it owns single-tenant properties for which the tenant is responsible for most of the operating costs of the properties they occupy. That sounds like a great deal for the landlord and a terrible one for the tenant, until you step back and look at the big picture.
Effectively, Realty Income is providing capital to property owners. Using a sale/leaseback transaction, the property owners are taking a building that is sitting on their balance sheets doing nothing and turning it into cash that can be used to help fund growth or pay down debt. Realty Income is giving them a chance to extract value from that asset while allowing the new tenant to maintain a significant amount of control over the property. It's as close to a win/win as you can get.
Realty Income, meanwhile, makes the difference between its cost of capital and the rents it charges. Which is the vital piece of the story that I didn't think enough about. REITs have to hand over 90% of their taxable earnings to shareholders as dividends. That doesn't leave a whole lot of cash left to invest in growth. Thus, REITs frequently sell stock so they can buy more assets. The dividend yield is a rough proxy for how much equity capital costs a REIT. The lower the yield, the cheaper equity capital is and the easier it is for a REIT to profitably grow its business.
Stepping back, I sold Realty Income just as it was getting to a point when it could more easily raise growth capital. And I made that mistake because I anchored to the 10% yield and didn't think about how a lower yield fit into the overall business model. It was a mistake that cost me years of dividend growth from a company that is now a Dividend Aristocrat, with over 25 years of annual dividend hikes under its belt.
I won't make that mistake again
This story, however, ends well. I again own Realty Income because it bought another REIT I owned. I have no intention of selling it, noting that the yield remains in the 4% range today. I made that mistake once and won't make it again now that I have a second chance in owning this great REIT. In fact, I now see the low yield as a competitive advantage that makes me even more confident in Realty Income's ability to keep growing in the future.
