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Realty Income's Secret to Success

By Sean Williams - Jan 5, 2015 at 7:31AM

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Realty Income has seen a lot of changes since the Great Recession, but one factor has played a critical role in pushing its dividend to record highs.

Real estate investment trust Realty Income (O 1.10%) is far from a household name, but this $10 billion company represents something of a "Holy Grail" type of investment for dividend seekers.

The Holy Grail of dividend stocks
You see, Realty Income pays out a monthly dividend, which is already something of a rarity on Wall Street, and it's boosted that dividend with incredible regularity since going public in 1994. According to the company's aggregate statistics, it has increased its dividend 77 times in the past 20 years, has increased its payout an astonishing 68 consecutive quarters, and has delivered a compounded average dividend growth rate of 5%. In other words, it's not increasing its payout a fraction of a penny at a time to keep its streak alive. These are meaningful increases in shareholder stipends. All told, since 1969 the company has paid out more than $3.1 billion in dividends.

Source: Realty Income.

Part of Realty Income's growing dividend comes down to its status as an REIT. In the U.S., REITs are given preferential tax status that allows them to pay less in taxes. In return, REITs like Realty Income, which purchases commercial spaces and leases them out to generally larger corporations, have to pay shareholders a minimum of 90% of their earnings per share in the form of a dividend each year. It basically means that if the company's business is growing then shareholders should be seeing a more bountiful dividend.

Realty Income's secret ingredient
But there's a bigger part of the equation that explains why Realty Income has been able to handily outperform for two decades.

Nominally, Realty Income's performance since it debuted in 1994 would look unimpressive next to the S&P 500's better than 300% return over the last two decades. However, factor in dividends and Realty Income is up around 2,200%!

Source: Realty Income.

And what does Realty Income have to thank for this incredible growth? The answer is its tenants.

The secret ingredient to Realty Income's success is the growing quality of its tenants, which allows the company to count on predictable cash flow year in and year out, as well as lock in long-term leases without the fear of tenants running into financial trouble. This is why Realty Income ended 2013 with an occupancy rate of a whopping 98.2%, its highest level since 2006 and the third straight year occupancy rates have increased.

Realty Income's gem of a property portfolio
As of the end of 2013, Realty Income's commercial property portfolio looked markedly different than it did at the end of 2009. The number of tenants had grown by 74% to more than 200, its property count is now close to 4,200 from just 2,339 at the end of 2009, and the company's top 15 tenants only made up 44.6% of revenue as of the end of 2013, compared to 53% of revenue at the end of 2009. Combined, this all translates to a more diversified cash flow stream. It allows Realty Income to be less reliant on its largest retailers and to instead spread out its risks in case a recession rears its head in the U.S. once more.  

Source: Flickr user Mike Mozart.

Even more importantly, the quality of Realty Income's portfolio has improved by leaps and bounds. As of 2009, just 2% of its revenue came from investment-grade tenants. Today that figure sits at 40%, with drugstore Walgreen currently occupying the lead spot in Realty Income's revenue generation column. Investment-grade businesses rarely have sizable enough "hiccups" to require store closures; thus they're often a great source of predictable income.

Finally, Realty Income's leases are for the long term, which further supports the idea that it can count on its tenants to continue to deliver steady cash flow. Through 2020 Realty Income will see just 22.5% of its roughly 4,200 leases expire -- and these tenants might even renew. On the back end, 22.2% of Realty Income's leases expire between 2029 and 2043, and a whopping 54.7% of its leases are still a minimum of 10 years away from their expiration.

This combination of long lease life, high-quality tenants, and a more diversified tenant base is the secret sauce that allows Realty Income to succeed in any economic environment.

One more thing to keep in mind
One final thing investors may want to keep in mind that could be beneficial to Realty Income is the expectation of rising interest rates.

Source: Realty Income.

On one hand, rising interest rates can be troublesome since Realty Income has thus far been able to turn to the debt market to finance new acquisitions. If that debt carries a higher interest rate, it can weigh down the ability of Realty Income to expand. Yet higher lending rates can also lock existing renters into place. It makes a business purchasing a building outright less attractive, since the interest costs would be higher, which could coerce tenants to rerent in high numbers going forward.

Based on its current yield of 4.8%, and assuming Realty Income sticks to its historical average for annual dividend growth of 5%, an investor who chooses to reinvest their dividend into additional shares of Realty Income stock could double their money in just 11 years if the share price remains unchanged. All told, that's a 6.5% annualized return, which I suspect most investors would welcome with open arms.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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