Occupancy is a key metric when you examine a real estate investment trust (REIT) like Realty Income (O -0.17%). The logic is pretty simple: Vacant properties don't generate any revenue. So it might seem troubling that Realty Income is warning investors to expect weaker occupancy metrics in the future. But the truth is, it is actually a good thing. Here's why.
What did Realty Income's CEO just say?
Realty Income's occupancy was 98.8% at the end of the third quarter of 2023. That was down from 99% at the end of the second quarter and 98.9% in the third quarter of 2022. That's not a great sign, as it suggests the REIT is having trouble keeping tenants.
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To be fair, 98.8% is still a very high figure. So there's no need for investors to worry too much. However, during the REIT's third-quarter 2023 earnings conference call CEO Sumit Roy made some comments that might raise some alarm. For example, he noted that "we may have a bit of a negative drag on occupancy levels," and that "we are more than comfortable taking a little bit of a hit on the occupancy side." These are potentially troubling words.
However, there's a nuance here that is very important. In the third quarter, Realty Income was able to recapture 106.9% of the rents on renewal leases. That basically means it was able to increase the rents it charged at renewal, something it has been able to do fairly consistently over time. Put simply, its properties are so desirable to tenants that they're willing to pay up to stay.
Realty Income is getting more aggressive
The company's occupancy levels and rent recapture have an important interplay between them. According to CEO Roy: "[W]e are looking at a particular real estate through the lens of maximizing revenue. And the revenue maximization strategy, by its very definition, will mean that we are more than comfortable holding on to certain assets that are vacant for longer."
Put another way, Realty Income knows it has desirable properties and isn't willing to compromise on rents just to keep a tenant. It's confident that it will, eventually, get the rent it believes a particular property is capable of generating. And that basically means it has to play hardball and accept that some tenants won't renew.
Adding to the REIT's ability to take this stance is its giant portfolio of over 13,000 properties. Although it owns some large assets, most -- making up around 75% of rents -- are fairly small, generic retail properties. Such single-tenant retail buildings, assuming they're well located, are pretty easy to release or sell. So there doesn't appear to be too much risk in having management take a tougher stance. And since no single property in this category is all that important to the overall portfolio, it probably makes sense to go down this path.
Realty Income knows getting small things right adds up
The counterargument is that if no single retail property is that important, why bother playing hardball? The answer is that pushing for the highest possible rent across all of the portfolio's individual assets rolls up to a big improvement for the entire company. Investors should probably be happy to see the REIT do this, even if occupancy could slip a little along the way.
If you own Realty Income, this is just another example of the REIT's impressive management culture. If you don't own Realty Income, the dividend yield is near decade highs at 5.6%, suggesting now could be a good time to buy this well-run landlord that recognizes that a little near-term pain is worth the long-term gain it can achieve.
