Via SeekingAlpha.com

The sell thesis

Realty Income (O) is headed for more fundamental trouble than many realize. I agree with all the bulls that O is a well-managed company and has a great balance sheet, but their tenants are in trouble. We believe about a third of O’s tenants could be asking for rent concessions in the April-June period. Many will get rent deferred and a smaller portion of tenants will be gone permanently. We believe O’s second quarter dividend will not be covered by FFO as the coverage already was tight and revenue losses will be significant. Fair value, in my opinion, is around $43 a share.

Coverage imbalance

Sell side analysts as well as Seeking Alpha analysts are overwhelmingly bullish without a single bear to be found.

Source: SA

In fact, the last bearish article on O was an interview between Seeking Alpha and myself on 9/11/19. O is down 23% since that article was published, but I will fully admit that it was mostly luck. Coronavirus made my bearish stance correct. Regardless of the cause of the drop I stand by the idea that $73 per share was a ridiculously high price for O.

Given the overwhelming bullish sentiment, I would like to present the other side of the argument which I believe is getting overlooked. Quite simply – Realty Income is a retail REIT. I get that the triple net structure provides some protection that’s not shared by shopping centers and malls, and I’m generally bullish on triple net REITs, but even single tenant retail properties on triple net leases have retail tenants. Many of O’s tenants are struggling and we suspect a substantial portion of April-June rent will not be paid.

Rent cuts and deferrals

O has not yet provided any information on how many tenants are seeking rent relief. They have simply redacted their former guidance. Therefore, we do not know the exact amount of rent that will be deferred or foregone. We can, however, get a rough estimate based on some available information.

  • Clarity from peers
  • O’s tenant list

Spirit Realty Capital (SRC) provided some excellent clarity this week into their rent situation. They announced that 42% of tenants have asked for rent deferral and/or relief. Further color was provided as they broke down the deferral requests by tenant industry.

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Source: SRC

What I want to point out is how remarkably similar their tenant mix is to that of Realty Income.

The above data shows the portion of tenants in each industry that asked for rent relief so we can apply that portion to O using data from their 10-K. Let us break it down industry by industry. In some cases O classifies its tenants slightly differently so I have grouped them into the closest category. For example, I have included “Auto services” “Auto collision services” and “Auto tire services” under the auto services category.

Tenant industry

% of tenants asking for relief (SRC’s Data)

% of O’s revenue from industry

Impact on O’s revenue

Auto parts

100%

1.5%

1.5

Auto services

48%

5.5%

2.64

Convenience stores

15%

11.6%

1.74

Fitness/wellness

68%

7.3%

4.96%

Theaters

100%

6.7%

6.7

Education

94%

0.2%

0.19

Entertainment

60%

0.4%

0.24

Home Furnishing

61%

0.7%

0.43

Restaurant QSR

76%

6.2

4.7

Restaurant casual dining

89%

3.1

2.76

Apparel

33%

1.1

0.36

Sporting good

25%

1.0

0.25

Total

45.3%

24.73%

So from this 45.3% of Os revenue, we anticipate O losing about 25% of total revenue. There also are some potential problems in the industries that did not line up with SRC’s portfolio.

Transportation services, general merchandise and childcare, collectively 9.4% of revenue, seem to be at risk industries so we would anticipate another significant chunk from that.

All-in we anticipate revenue loss of around 30% in the second quarter. Given O’s current FFO payout ratio of 84%, a 30% revenue loss will send them well below dividend coverage.

Does this mean the dividend will be cut?

We see a dividend cut as highly unlikely as O has successfully built a reputation as a Dividend Champion. It will not give up this accomplishment over lack of coverage for a few quarters.

I believe the market is wrongly interpreting the lack of dividend risk to mean there’s no fundamental risk.

Lack of dividend cut does not mean lack of damage

O shares rose nearly 5% on 4/14/20 after its dividend was declared flat. This seems to have been interpreted to mean that it’s smooth sailing for O’s fundamentals.

Given what we know about O’s tenants, it’s clearly not smooth sailing. A potential 30% revenue hit is quite sizable and something that hasn’t been seen for O in the past few decades, if ever.

Instead, what the flat dividend means is that O will pay the dividend from cash on hand if/when it is not covered by FFO. Realty Income’s balance sheet is strong so they can certainly afford to do this, but over time, paying dividends beyond FFO begins to reduce the health of the balance sheet. The magnitude of damage will depend on how long the reduced revenues last and what portion of tenants leave permanently.

The permanently lost tenants are going to be substantially less than the roughly 30% asking for rent relief. Our estimate is around 7%, but given the uncertainty of the environment there are significant error bars around that.

Overall fundamental outlook

We project a 30% revenue hit in 2Q20 and perhaps 3Q20 with about a 7% revenue hit lasting well beyond the resolution of coronavirus. Eventually, some portion of that 7% can be replaced with new tenants as the real estate is still standing and still has value.

Realty Income will almost certainly survive and in the long run will likely return to thriving.

Valuation

Given the challenges facing a mostly retail portfolio, we would tend to value O a bit more cautiously. I would generally not want to own retail properties at anything under a 7% cap rate, but given the high quality of O’s management and its stellar track record, I could see buying it at a 6.5% cap rate which based on NOI (net operating income) of recent quarters places fair value at about $43.

Source: SNL Financial

In the near term, NOI will likely be significantly lower, but I think the historical data is more reflective of where NOI will stabilize long term.

With O trading at around $56, we see around 20% downside to fair value. If it gets to fair value I would strongly consider buying some shares. Until favorable pricing arrives, there are significantly more attractive alternatives.

As I said earlier, we are bullish on the triple net REITs and there are others with more opportunistic valuations and better properties. We like Gladstone Commercial (GOOD) and One Liberty Properties (OLP) for their higher FFO yields and industrial property focus.

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Disclosure: I am/we are long GOOD, OLP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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