Power To The Elbow

Most commercial real estate REITs have gotten a bad reputation for trading down. Is it justified? This article will explore Realty Income (NYSE- O) and provide you with the information you need to make better investing decisions.

Cory Renauer’s article with The Motley Fool on Oct. 7, 2023 was about Realty Income (NYSE – O). He wrote that “Taking advantage of the unusually high yield this dividend payer offers right now and holding for the long run looks like a smart move.” Realty Income’s historically high dividend yield is a result of small increases but more significantly, a massive decline in the stock price. The price decline is inline with most other REITs and the Dow Jones U.S. Real Estate Index.

The reasons for this decline are also well documented. Elon Musk tweeted “Commercial real estate is melting down fast.” Giant office parking lots across the country are empty as employees prefer to work remotely. Interest rates have more than doubled in the past year making acquisitions expensive for landlords. Finally, growing the office footprint is less attractive for tenants with rents and employment costs inflating. Yet, Renauer made a persuasive argument that Realty Income (NYSE- O) was both a sound and profitable investment. Let’s dig into three big questions that might lead to Realty Income’s success or failure.

Will current tenants default or renegotiate their leases?

Realty Income says in their investor presentation on their website that their “superior real estate portfolio generates growing cash flows guaranteed by large, national, blue-chip operators.” Here is a chart of their top 20 clients.

• Dollar General – 3.8%
• Walgreens – 3.8%
• DollarTree – 3.3%
• 7-Eleven – 3.2%
• EG Group – 2.7%
• Wynn – 2.7%
• Fed Ex – 2.3%
• B&Q – 1.9%
• Sainsbury – 1.9%
• LA Fitness – 1.8%
• BJs – 1.6%
• LifeTime Fitness – 1.5%
• CVS Pharmacy – 1.5%
• Walmart – 1.5%
• Tractor Supply – 1.3%
• Tesco – 1.3%
• AMC – 1.3%
• Red Lobster – 1.2%
• Regal – 1.1%
• Lowes – 1.1%

Those companies are indeed large, diversified, and tend to be located in large strip malls. They are not located in empty office buildings with employees working from home. With the exception of the gyms and movie theaters, most of them stayed open during the pandemic and the Realty Income’s superior performance in 2020 proved how resilient this tenant base can be to an economic shock. However, large brands also have strong negotiators who could throw their weight around when it comes to renegotiating leases. Let’s look at a worst case scenario and see if Retail Income (NYSE – O) can stay profitable.

Dollar stores are illegal and must close immediately. (No news, just stress testing the portfolio)

Both the Dollar General and Family Dollar companies defaulted and stopped paying rent. This represents 7.1% of rental income. What would happen to Realty Income? Would they stay in business? 

In the 2022 annual report, Realty Income earned over 3 billion in revenues. If we reduced that by 7.1% because of our hypothetical collapse of the dollar store industry, the company would lose around 234 million dollars in top line rental income. The company’s bottom line net income available to stockholders of 869 million appears to be robust enough to cover such a catastrophe with plenty of contingency to spare.

Will Realty Income be able to renew current leases?

We can sort of answer this question by checking to see if the top tenants are growing or shrinking their store counts. If they are all shrinking, then it would appear unlikely that Realty Income will keep its currently high occupancy rates. However, if the store counts are growing, then it might prove likely that the store counts would increase.

Here are the top 6 on the list.

• Dollar General – Q2 2023 opened 215 new stores, remodeled 614, and relocated 20.
• Walgreens – Q3, 2023 year over year lease growth of plus 734 stores.
• Dollar Tree – Q2 2023 opened 118 new stores, remodeled 276.
• 7-11 – Not public and also not clear
• EG group – Actively divesting UK and US stores.
• Wynn- One giant casino in Mass.

With the exception of EG group, it doesn’t appear that any of the top 6 companies are actively reducing their footprint. EG groups properties appear to be sold to operators who are choosing to operate the stores rather than close them.

Will higher interest rate costs make profitability difficult?

I will stress test interest rate exposure by doubling interest expenses and seeing if Retail Income (NYSE – O) is still profitable. In the year ending 2022 interest expense was $465 million. If this doubled it would lead the company to only make around $404 million of operating profit for the year instead of $869 million. This shows that the company is much more sensitive to borrowing rate increases than deterioration in the company’s portfolio but still resilient enough to maintain profitability. At the end of 2022 the average rate they paid on fixed debt was 3.46% with over half of it coming due after 2027. 

It is hard to tell what interest rates will look like in 4 years. The good news is that the Retail Income (NYSP -O) could still maintain profitability if their borrowing costs increase significantly.

This is just some information that will help you decide if Retail Income is a good investment. I would recommend reading all the disclosures in the annual report along with looking into the future store count plans for the remaining portfolio companies. 

Tomorrow’s article will include a few ideas on how you might want to trade NYSP – O. See you there.