Will 2016 Be Realty Income Corporation's Best Year Yet?

Image: 401kcalculator.org via Flickr.

Realty Income (O 0.11%) is one of the most popular REITs on the market, and for good reason. Since going public in 1994, the company has averaged a 16.6% total return each year -- a remarkable level of performance to sustain for more than 20 years. Even considering this record of performance, 2016 has the potential to be Realty Income's best year yet.

Strong results in 2015
Realty Income has performed well in 2015. The company has completed $1.1 billion in new acquisitions with an average initial lease term of 16.7 years and is on pace for one of its most active years so far.

Despite the rapidly growing portfolio, occupancy remains strong at 98.3%, and the average same-store rent increased by 1.3% from last year. In fact, all of the properties acquired so far in 2015 are 100% leased. Further, the company has sold 22 of its properties for $52 million, resulting in a $17 million profit.

Because of all these factors, funds from operations (FFO -- the "earnings" of the REIT world) for the first nine months of the year increased by 6.2% over the same period in 2014, and the company expects to finish the year with FFO as much as 7.4% greater than that of 2014.

In addition, Realty Income continued its outstanding dividend history, having recently announced its 73rd consecutive quarterly dividend increase. In all, the dividend has grown by an average of 5% per year since the 1994 IPO.

Source: Realty Income.

The 2016 outlook is strong, but not quite as strong as 2015
In its most recent quarterly report, Realty Income estimates that its FFO will increase by 2.7% to 5.3% over 2015's expectation. The company also announced that it anticipates acquiring approximately $750 million worth of properties, which would be the lowest since 2010.

However, it's important to point out that Realty Income has a strong history of under-promising and over-delivering. For example, at this time last year, the company's 2015 FFO guidance range was $2.67 to $2.72 per share, which has since been increased to a range of $2.72 to $2.77.

Even more of a departure from the company's projections was the 2015 acquisition guidance. During the 2014 third-quarter conference call, Realty Income CEO John Case announced expectations of $500 million to $800 million in acquisitions for 2015 -- a number the company has already handily exceeded, as I mentioned earlier. In fact, Realty Income is now projecting a total of $1.25 billion in acquisitions by the end of 2015, 56% more than the highest end of its estimate.

My point is that investors shouldn't read too much into the lower acquisition projection. It's abundantly clear that if attractive investment opportunities present themselves, Realty Income will pounce. It wouldn't surprise me in the least to see another year of acquisitions in the billions -- and another upward revision in the FFO guidance along the way.

What about rising interest rates?
One wild card to keep an eye on is interest rates, which could have both positive and negative effects on REITs such as Realty Income.

First, the bad. Rising interest rates increase the cost of borrowing, which can cut into the initial profit margin when a REIT acquires a new property. However, Realty Income doesn't rely heavily on debt to finance its acquisitions -- the company's debt represents just 28% of its total capitalization. Think of this as if you were to obtain a mortgage on a new home, but with a 72% down payment. Would a slightly higher mortgage rate be a deal-breaker?

Also, rising rates do create some selling pressure on REITs as other, "safer" investments such as bonds and CDs pay higher yields and can become more attractive to income investors.

However, I believe that a rising interest-rate environment does more good than harm. Specifically, the Federal Reserve has said time and again that it wouldn't raise rates unless the economy was clearly improving. An improving economy means job and wage growth, as well as a healthy inflation rate, which translates not only into higher demand for commercial properties, but also the ability to charge higher rent on existing real estate.

Historically, REITs have done quite well in rising-rate environments. According to the National Association of Real Estate Investment Trusts, the current interest rate environment has similarities to the 2004-2006 period. During this time, the Fed began raising after a long period of low rates, and the REIT sector delivered a 69% total return during these years. In fact, there have been 16 periods of rising rates since 1995, and equity REITs produced positive returns during 12 of them.

The potential is there
While nobody has a crystal ball that can tell us how many properties Realty Income will acquire in 2016, how many of its tenants will renew their leases, or how much money it will make for the year, there is definite potential for a great year. Throughout 2016, keep an eye on the company's acquisitions, occupancy rate, same-store rent increases, and initial returns on new properties as good indicators of whether the company is having an exceptionally good year.

Regardless of the year's exact results, Realty Income is a long-term winner, as I've written many times before, and I'm eager to see what the future holds.