Realty Income (O -0.17%) is roughly three times as large as its next closest competitor in the net lease niche of the real estate investment trust (REIT) sector. That gives it a scale advantage and sets it up as an industry consolidator. It bought VEREIT in 2021, and just recently has agreed to buy Spirit Realty (SRC). But big acquisitions lead to portfolio changes. There's one change that Realty Income wishes investors would stop worrying about.
Realty buying Spirit comes with a number of positives
Realty Income owns a bit over 13,000 properties. Spirit has roughly 2,000 assets in its portfolio. Put the two together and Realty Income's scale will grow to more than 15,000 properties. That's gigantic relative to the company's net lease REIT peers. A net lease requires the tenant to pay for most property-level operating costs.
Image source: Getty Images.
But there are even more positive changes that go along with the new properties. For example, Realty Income's average remaining lease term is roughly 9.6 years, while Spirit's is 10.3 years. Adding the two together, recognizing the size difference in the portfolios, will increase Realty Income's remaining lease term to 9.7 years. Occupancy will improve slightly, too. Realty Income's is roughly 99% while Spirit's is 99.8%, leading to a combined occupancy figure of 99.1%.
Realty Income's top 10 tenants account for around 27% of its rents. Spirit's figure is 22%. The combined portfolio will end at roughly 25%. And leases expiring through 2026 for Realty Income will drop from 15.4% to 15% thanks to Spirit's lease expirations of just 12.8% over that span.
One number gets worse
So far the changes are largely positive even though they are mostly modest. When you own 13,000 properties these types of data points don't usually change quickly. That said, there's another number that Wall Street has focused on: investment-grade tenancy.
There's a preference for a higher percentage of investment-grade tenants, because investment-grade tenants are financially strong. Thus, it is assumed that they will be able to continue paying rent in good times and bad. More below-investment-grade tenants suggests increased risk during recessions.
Currently, 40% of Realty Income's rent comes from tenants with investment-grade ratings. Spirit's figure is far lower at just 19%. Adding the two together will reduce Realty Income's figure to 37%. While not a massive drop, more conservative investors might look at the change and come away with a negative opinion. Only Realty Income is very clear that it doesn't target investment-grade tenants. During the REIT's third-quarter 2023 earnings call, CEO Sumit Roy stated:
I think we've tried to answer this question before that we do not target investment grade. What we are looking for are assets that we believe are priced and have a profile of generating a return that is on a risk-adjusted basis, the right return profile. That is how we think about the world.
This is an important clarification for conservative income investors to remember. Essentially, Realty Income isn't targeting investment-grade-rated tenants, it is targeting deals with attractive risk/reward characteristics. So it will happily take on a non-investment-grade tenant so long as it's getting paid appropriately for the risk it's willing to take on.
Watch it, but don't worry about it
The risk with any one net lease property is high because they are single-tenant assets. But when you get as large as Realty Income, no single asset is all that important to the whole portfolio. It's worth keeping track of Realty Income's investment-grade tenancy, particularly if you're a conservative investor. But it probably isn't worth fretting about the figure trending lower after the Spirit acquisition. It isn't a management focus, and the risk isn't nearly as large as it might feel emotionally. In other words, there's no reason to expect this 6.1%-yielding REIT's 29-year streak of annual dividend increases to come to an end anytime soon.
