If the U.S. is heading into a recession, it pays to get defensive. Many sectors such as financial services will be hurt by increasing defaults, while consumer discretionary stocks will suffer as shoppers cut spending.
Historically, defensive stocks have generally meant stalwarts like utilities and consumer-products companies because people always need electricity and soap no matter how poorly the economy performs. There is another sector that should perform well, and that is triple-net lease companies like Realty Income (O 0.95%).
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Triple-net leases are different from the typical lease
Realty Income is a real estate investment trust (REIT) that focuses on single-tenant properties using an unusual lease structure called a triple-net lease. These leases are different from gross leases, which are typical for apartments or small stores. In this structure, the tenant is responsible for paying rent and not much else.
The triple-net structure requires the tenant to absorb almost all costs, including rent, taxes, insurance, and maintenance. These leases generally run for 10 years or more and contain automatic rent escalators. They are also notoriously expensive to break. This means that Realty Income needs to vet its tenants well and ensure they can perform over the entire economic cycle.
Realty Income's tenants are highly defensive
Realty Income's typical tenant is either a convenience store, a dollar store, or a drugstore. These are highly defensive industries. Even if the economy struggles, people will still buy paper plates, shampoo, and candy bars. During the COVID-19 pandemic, most of the company's tenants were considered essential businesses and permitted to remain open. That said, some of Realty Income's tenants did struggle, particularly movie theaters.
Realty Income has a long track record of steady dividend hikes
Despite an environment where most REITs were forced to cut their dividends, Realty Income was able to raise its dividend three times in 2020. The company has a long track record of steadily increasing monthly dividends. It has been around since the 1960s, so it has been through just about every economic cycle. Realty Income increased its funds from operations (FFO) forecast during its third-quarter 2022 conference call by $0.06 to a range of $3.87 to $3.94 per share, which represents a 9.1% increase year over year.
Realty Income also recently increased its dividend for the 117th consecutive time over the past 100 quarters. This represented a 5.1% increase over the past year. Chief Financial Officer Christie Kelly summed up Realty Income's dividend policy by saying: "As a monthly dividend company, Realty Income's dividend will remain sacrosanct to our mission. This is a testament to our confidence in the time-tested consistency of our business model."
The dividend is well covered
If you annualize the latest monthly dividend of $0.249, you get an annualized dividend of $2.99 per share. Using the midpoint of Realty Income's FFO projection, the dividend payout ratio (the dividend divided by earnings) comes out to 77%. This is just about right for a REIT, since they must pay out most of their earnings as dividends to avoid paying corporate income taxes.
Realty Income is a REIT, a structure that requires it to borrow a lot of money. The company's mortgage notes are all fixed-rate debt, so rising rates won't matter much in the very near term, although it will have to pay more in interest to roll over mortgage debt that is maturing in 2024. Rising rates will affect its credit lines, but these are much smaller than the long-term debt.
Given that the company's leases contain automatic rent escalators, rents will rise to meet increasing interest expense. Realty Income is a stalwart with a long record of dividend increases. The company is defensive and should be considered a core holding for an income investor.
