Investors who are looking for safe income should take a long look at the real estate investment trust (REIT) sector. These companies invest in commercial real estate, such as apartments, shopping malls, and warehouses. They develop properties and then rent out the space under long-term leases. It is a relatively easy-to-understand business model.
REITs generally pay high dividends due to their structure, which legally requires them to distribute most of their earnings as dividends. This allows them to avoid paying income tax at the corporate level, which means more of the earnings go to the investor.
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Realty Income focuses on triple-net leases with defensive companies
Realty Income (O 0.11%) is a REIT that focuses on single-tenant operational real estate under an unusual lease structure. Realty Income uses a lease structure called a triple-net lease. Under triple-net leases, the tenant is responsible for paying rent, taxes, insurance, and maintenance. These leases generally last for more than a decade and contain automatic annual rent increases. They are notoriously hard (and expensive) to break as well. In many ways, they are a substitute for a tenant who would otherwise consider buying. These leases differ from gross leases, which are the most common type of lease, where the tenant is responsible for rent and little else. If you've signed a lease for an apartment, it was a gross lease.
Realty Income's secret is a function of its lease structure. To enter into a long-term contract such as a triple-net lease, the tenant needs to have a robust and solid business that can weather recessions. Retailers can make good tenants, however not all retailers are the same. Retailers that focus on necessities are generally thought of as defensive businesses. The best defensive candidates are convenience stores, drug stores, or dollar stores. Even if the economy weakens, people still buy gasoline, over-the-counter medications, and other household essentials.
Realty Income's tenant base is relatively well diversified, with no one tenant accounting for more than 4% of rent. The biggest tenants include Dollar General, Walgreens Boots Alliance, and 7-Eleven. Realty Income also has some service companies such as logistics companies, fitness centers, and restaurants. Even during the COVID-19 pandemic Realty Income was able to increase its dividend, when most REITs were cutting theirs. It helped that most of Realty Income's tenants were considered essential businesses and permitted to remain open.
Realty Income has a long history of steady monthly dividend increases
Realty Income has a long history of dividend increases. Note that Realty Income pays a monthly dividend and has trademarked the name The Monthly Dividend Company. The COVID-19 recession was so short (only two months) that very few companies hiked their dividends during that period. That said, during the Great Recession of 2007-2009, Realty Income increased its monthly dividend three times. The prior recession lasted from March to November 2001 and Realty Income increased its dividend three times. The company has been around since 1969 and has weathered plenty of difficult economies.
Realty Income earned $4.06 per share in normalized funds from operations (FFO) per share in 2022. REITs generally use funds from operations to describe their earnings instead of net income (or earnings per share). This is because depreciation and amortization is such a large component of costs, though these aren't a cash expense. Because generally accepted accounting principles (GAAP) require companies to deduct depreciation and amortization to arrive at net income, companies with a lot of real estate will appear to generate less cash than they really do. For example, Realty Income's net income in 2022 worked out to only $1.42 a share, while FFO was almost triple that. If you use a stock screening tool to look at REITs, most will look super expensive until you look at FFO per share.
At current levels, Realty Income is trading at 15.4 times 2022 FFO per share, which is a reasonable multiple for a high-quality REIT. The stock also has a dividend yield of 4.9%, almost triple the level of the S&P 500 average. Realty Income is a highly conservative dividend stock and should be considered as a core holding for any income investor.
