The past two years have been difficult for the big dividend stocks, especially those in the real estate investment trust (REIT) business. The COVID-19 pandemic forced many businesses to close at least temporarily, and stores that are not open are less likely to pay rent.
No REITs escaped the pandemic unscathed, though one stock fared much better than its competitors: Realty Income (O 1.46%). This is due to Realty Income's focus on long-term leases with highly creditworthy tenants. This business model is a big part of why you can count on this dividend stock to produce month in and month out.
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Triple-net leases are different
Realty income is a REIT that focuses on single-tenant real estate. REITs like Realty Income are often referred to as "triple-net" lease companies, which describes the type of leasing arrangement it has with its tenants.
A triple-net lease requires the tenant to cover most expenses, including taxes, insurance, and maintenance. These leases are generally long-term (between five and 10 years) and contain automatic escalators on rent. The most common type of lease is the gross lease, which would resemble the typical contract a renter would enter into with a landlord. The lease generally lasts one year, the tenant is responsible for rent and utilities, and if the sink backs up, the landlord is responsible for fixing it.
Because triple-net leases have longer terms, the financial capacity of the tenant to make that sort of commitment is a big consideration. Most of Realty Income's tenant base is investment-grade, and their biggest tenants are large national drugstore chains, convenience stores, and dollar stores. During the pandemic, Realty Income's tenants were largely considered essential services and permitted to remain open.
Realty Income navigated COVID-19 without cutting its dividend
Given Realty Income's tenant base, the company was much less affected by the pandemic than office REITs or mall REITs. While many REITs were forced to cut dividends to conserve cash, Realty Income hiked its dividend three times during 2020. Realty Income has been in business since 1969 and is considered a Dividend Aristocrat for its long history of raising dividends every year. Unlike most stocks, Realty Income pays a monthly dividend as opposed to quarterly payouts.
Look at funds from operations, not earnings per share
Last year, Realty Income earned $3.59 per share in adjusted funds from operations (AFFO). Real estate investment trusts use funds from operations rather than earnings per share to more accurately gauge their ability to produce for shareholders.. This is because depreciation and amortization is a huge expense under generally accepted accounting principles (GAAP). Depreciation and amortization isn't an actual cash expense -- in other words, the company doesn't write a check for depreciation and amortization. Funds from operations more closely represent the actual cash flow of the company.
Last year, Realty Income paid $2.86 in dividends, which gives the company a payout ratio (the amount of earnings that is paid out as dividends) of 80%. This is about right for a mature REIT that isn't plowing a lot of earnings back into the business. At current levels, Realty Income's dividend yield is a healthy 4.4%.
Realty Income was able to continuously increase its dividend during the COVID-19 pandemic, which demonstrates the resiliency of its business model. It also demonstrates why this stock is worthy of addition in a dividend investor's portfolio.
