Income investors who are looking for yield should take the time to understand the real estate investment trust (REIT) sector. These companies are required to invest in real estate or real estate assets and are required to distribute most of their earnings as dividends. Provided that the REIT follows the guidelines, it can avoid paying corporate income taxes. These companies generally have high dividend yields, but investors should understand how to determine whether these yields are sustainable. Realty Income (O -0.17%) is one of the most conservative REITs, with a 5% dividend yield. Is this dividend sustainable?
Image source: Getty Images.
Realty Income is a triple-net-lease REIT
Realty Income is a REIT that focuses on single-tenant properties under an unusual lease structure called a triple-net lease. Most leases are gross leases, which require the tenant to pay rent while the landlord absorbs the other operating costs. Under the triple-net lease structure, the tenant is responsible for taxes, insurance, and maintenance. These leases generally last a long time (over a decade) and contain automatic escalators. They are also extremely expensive to break.
Triple-net leases are a big commitment, and vetting tenants is crucial
Triple-net leases are such a large financial commitment that vetting potential tenants can make or break the business model. Retailers that sell discretionary goods, such as fashion retail, are generally not good candidates. The ideal tenant is a company in a defensive industry, which means the business is at least somewhat insensitive to the economic cycle. The ideal tenant is a drugstore, dollar store, or convenience store. Realty Income's biggest tenants include Dollar General (DG -0.41%), Walgreens (WBA 0.57%), and 7-Eleven.
Realty income has a long record of dividend hikes
Realty Income pays a monthly dividend and has a long record of dividend hikes. Even during the COVID-19 pandemic, Realty Income continued to increase its dividend. Many REITs were forced to cut or suspend dividends. Most of Realty Income's tenants were considered to be essential businesses and were permitted to stay open. That said, some of Realty Income's service tenants, such as movie theaters and fitness centers, did encounter financial difficulties, but they were limited enough that Realty Income could keep hiking the dividend.
The dividend is well covered
Realty Income has guided for 2023 adjusted funds from operations (AFFO) to come in between $3.94 and $4.03. REITs usually use funds from operations to describe earnings because net income, as reported under generally accepted accounting principles (GAAP), tends to understate the cash-flow-generating capacity of the company. This is because depreciation and amortization (D&A) is a big expense for REITs under GAAP, though it is a non-cash charge. Funds from operations adds back the depreciation charge and other non-cash charges. For this reason, many REITs might look expensive on a price-to-earnings basis, but if you look at price to FFO, they are valued much more reasonably.
Based on Realty Income's guidance range, the annualized dividend of $3.07 is well covered by FFO per share. At the midpoint of guidance, Realty Income's payout ratio is 77%, which is pretty conservative. At current levels, Realty Income is trading at 15.3 times 2023 funds from operations per share, which is a reasonable multiple for a high-quality REIT. The dividend yield of 5% is attractive and can be supported by funds from operations per share. Realty Income is a classic conservative REIT and should be considered a core holding for income investors.
