Note: This article is third in a series of articles on Realty Income Corporation. For a thorough picture of the company, please read the previous articles on Realty Income's history and business model.
Realty Income Corp. (NYSE:O) is a real estate investment trust, or REIT, that specializes in a specific type of property: freestanding retail. Let's look at this segment of the industry, who Realty Income's competitors are, how to evaluate this kind of company, and what could make this company a good choice for your portfolio.
Freestanding retail real estate: A few big players and many smaller ones
Roughly 20 publicly traded REITs specialize in retail properties, but the majority of these develop and own malls and shopping centers. As far as freestanding retail real estate is concerned, there are only three big players.
Realty Income is the largest of the three by market capitalization ($10.9 billion) and owns approximately 4,400 properties. American Realty Capital Properties (NYSE:VER) has more properties (about 4,650) but is valued at a market cap of $7.8 billion thanks to some accounting issues from last year. Finally, National Retail Properties (NYSE:NNN) is about half the size of Realty Income with 2,100 properties and a market cap of $4.9 billion.
Aside from these three, many small, privately held companies own freestanding retail buildings. In this way, you could call the freestanding retail industry "top-heavy."
Evaluating retail REITs: Why EPS and book value don't work
One of the most important things for retail REIT investors to know is that some of the most common investment valuation metrics aren't all that useful here.
For starters, investors' favorite metric when valuing any stock is the price-to-earnings ratio, or P/E. However, REITs' earnings often appear low because a building's depreciation is considered a business expense, even though the REIT isn't actually paying anything.
A much better metric to use for valuation is "funds from operations," or FFO. Essentially, this includes all of the company's earnings as they would normally be calculated, but adding back in the depreciation expense. This is a much better indicator of how much money is actually flowing into a REIT -- and thus how much is available to distribute to shareholders.
To illustrate this concept, consider that when you look at Realty Income's earnings, its P/E works out to 42.3, which looks extremely expensive for a stock whose main purpose is to produce income. On the other hand, when you look at price-to-FFO, the ratio of 17.7 looks much more reasonable for a solid high-income stock.
Many stocks are also valued by comparing the share price to the company's book value, which is the value (on paper) of the business's assets. However, for real estate investment trusts, this erroneously reflects the depreciation "expense" and is therefore not a great indicator of the actual value of a REIT's assets. After all, the value of a property tends to rise over time. A $1 million property is unlikely to lose half of its value after, say, 10 years, but this is what a REIT's book value would have you believe.
For that reason, a REIT's net asset value is a much better indicator of its intrinsic value, as this metric takes into account the current market value of its properties -- not the misleading depreciated value.
How Realty Income stacks up to the competition
As I mentioned earlier, the two REITs that have the most in common with Realty Income, at least in terms of the types of properties they target, are National Retail Properties and American Realty Capital Properties. However, as I alluded to before, American Realty Capital is having some issues that are distorting its valuation. So the best comparison is Realty Income and National Retail Properties.
National Retail Properties has essentially the same business model as Realty Income. It focuses on freestanding, single-tenant properties that are leased to high-quality companies at locations the tenants have selected. And, just like Realty Income, National Retail Properties has seen success with this strategy.
Valuation aside, there are some characteristics of each company that could make one more appealing than the other. For example, Realty Income pays its dividends more frequently (monthly versus quarterly) and also has a slightly higher dividend yield. On the other hand, National Retail has a slightly higher initial cap rate (rate of return on invested capital) on newly acquired properties.
Having said that, let's take a look at how Realty Income and National Retail Properties compare in some key metrics and see whether we can declare one a better value than the other.
|Metric||Realty Income||National Retail Properties||Advantage|
|Property occupancy %||98%||98.8%||National Retail Properties|
|Lowest occupancy (historic)||96%||96.4%||National Retail Properties|
|Average initial cap rate (2014)||7.1%||7.5%||National Retail Properties|
|Debt + preferred stock as % of total capitalization||31%||43.2%||Realty Income|
|Fixed-charge coverage||3.4x||3.3%||Realty Income|
|Price-to-FFO (Q1 2015 annualized)||16.3||16.2||National Retail Properties|
|Dividend yield (current as of 6/25/15)||5.04%||4.77%||Realty Income|
|20-year average annual total return||17.4%||14.4%||Realty Income|
The main takeaway from the table above is that the two companies are extremely close in virtually every metric -- and with nearly identical business models, they should be. Personally, I own both, but I tend to favor Realty Income for its slightly lower debt percentage, slightly higher dividend, and more impressive track record, which I consider an indicator (but not a guarantee) of the company's future success.
A solid investment with a promising future
Realty Income is a leader in a lucrative corner of the real estate market, and it should produce excellent income and market-beating returns for decades to come thanks to its ready access to cheap capital and portfolio of rock-solid retail tenants.
When evaluating Realty Income relative to its peers, it's important to use the correct metrics (as discussed here) in order to make an informed investment decision. However, remember that quality comes at a price, so even though Realty Income may be more "expensive" than its rivals, that doesn't necessarily mean it's a bad time to buy, and we'll explore this in greater depth when we analyze Realty Income's valuation later in this series.