Realty Income is the largest triple-net REIT in the United States, with more than 11,400 properties that mainly house retail tenants. The company describes itself as "The Monthly Dividend Company," and its line of business and operating metrics make its dividend one of the most stable sources of income for investors. Even though over 80% of Realty Income’s tenants are in retail, most are focused on defensive segments, with characteristics such as being service-oriented, naturally protected against e-commerce pressures, or resistant to economic downturns. Additionally, the triple-net lease structure places the burden of all operational risk and cost on the tenant and requires the tenant to make capital expenditures to maintain the property rather than the landlord. These leases are often long term, frequently 15 years with additional extension options, which provides Realty Income a steady stream of rental income. Coverage ratios are also very high, so tenants are healthy and unlikely to request rent concessions, even during downturns. The steady, stable stream of revenue has allowed Realty Income to be one of only two REITs to be members of the S&P High-Yield Dividend Aristocrats Index and have a credit rating of A- or better. This makes Realty Income one of the most dependable investments for income-oriented investors, even during the current coronavirus crisis.

Stability comes at the cost of economic profit, however. The lease terms include very low annual rent increases around 1%, which helps keep the coverage ratio high but severely limits internal growth for the company. Therefore, to grow, Realty Income must rely on acquisitions. The company has executed over $20 billion in acquisitions over the past decade at average cap rates around 6%. Given the access to cheap debt during this time, it has created a lot of value. However, increased competition has lowered cap rates, and the potential for rising interest rates could squeeze the company's spread and its ability to create value. We remain concerned that at some point, the valve for creating value will shut off and Realty Income will be left with just a low internal growth story.

We don't believe Realty Income has a moat. While its portfolio has more than 11,400 freestanding single-tenant properties and contains many healthy tenants that are largely insulated from the effects of e-commerce, the company does not benefit from moat sources, such as efficient scale or network effect, that we attribute to some retail property owners. The terms of the triple-net lease make the tenant responsible for the property's operating expenses, real estate taxes, maintenance, and insurance in addition to paying Realty Income rent. However, the annual rent escalators are only around 1% and, with long-term leases over 15 years with multiple extensions and total re-leasing spreads averaging below 5% over the past few years, the company sees very low internal growth. Instead, Realty Income must rely on acquiring new properties to increase cash flow. Given that it has generally acquired properties at mid- to high 6% cap rates, the combined returns from the internal and external growth do not exceed our estimated weighted average cost of capital, which leads us to conclude that the company does not possess an economic moat.

Realty Income primarily owns and manages freestanding single-tenant properties, with retail constituting roughly 84% of its portfolio. For retail companies to demonstrate an efficient scale moat source, they must dominate their submarket with high-quality properties in high-traffic areas with significant barriers to entry. The nature of Realty Income's portfolio makes it nearly impossible to achieve the market saturation necessary to drive pricing power while maintaining quality and preventing the threat of new supply. The company's portfolio diversification, with properties in 49 states and no single state representing more than 11% of the portfolio, provides stability of cash flow but prevents it from achieving pricing power in any single market. Even if Realty Income were to concentrate its portfolio, the number of freestanding single-tenant properties and junior-anchor spaces available in adjacent shopping centers provides tenants many viable alternatives. Given that the buildings are generally around 12,000 square feet and development costs are frequently under $5 million, the barriers to entry are very low, so development can easily match new demand. Finally, the net-lease structure places the burden of operating expenses on the tenant and reduces the asset management expertise required, increasing the pool of potential investors and developers. For these reasons, the nature of the industry prevents a freestanding, net-lease portfolio from ever realistically commanding excess economic returns over a long period.

Despite the tough environment that brick-and-mortar retail is facing as a result of e-commerce, Realty Income's tenant mix makes it more defensive than other retail REITs. The company's occupancy is over 98%, with 96% of its portfolio leased to tenants that are protected from e-commerce or economic downturns in industries like convenience stores (12% of the portfolio), drugstores (10%), dollar stores (7%), health and fitness clubs (7%), and fast-food restaurants (6%), or is nonretail (18%). Realty Income has steadily increased its exposure to investment-grade tenants, which should be healthy enough to withstand most economic downturns and continue to pay rent, to 51% of the total portfolio. Its weighted average EBITDAR/rent ratio on retail properties has also steadily increased over time to a very healthy 2.7. There is little uncertainty that Realty Income will continue to collect rents on its leases.

However, given the health of Realty Income’s tenants, we think the terms of its leases show that the major tenants possess the pricing power in lease negotiations. If the tenants are not threatened by e-commerce or the possibility of economic recessions, then they should be able to increase their cash flow at least at inflationary levels. But the average rent escalator on Realty Income’s triple-net lease is only 1%, well below the long-term historical average for inflation. Therefore, even average tenants should see their rent as a percentage of their total cash flows fall over the course of the lease. This makes a longer-term lease beneficial to the tenant, so the fact that most leases are typically 15 years in length with multiple extension options shows that the tenant has more power in negotiations. The high EBITDAR/rent coverage ratio provides Realty Income an enormous cushion to practically guarantee its own revenue stream, but beyond a certain point, any additional cushion adds little incremental value to shareholders. However, Realty Income has limited ability to push initial asking rents or rent escalators, which would directly translate to shareholder value. Re-leasing spreads to existing tenants are just north of 5%, showing that Realty Income is only able to make small gains in marking the leases to market when the leases do eventually come due, while it often must make rent concessions to attract new tenants to a property, given that the properties are just generic shells that face competition for tenants from a multitude of other locations. Therefore, despite the healthy and defensive nature of the businesses that operate out of Realty Income’s portfolio, tenants possess the negotiating power to demand lease terms that severely limit the company's internal growth prospects.

What has fueled the triple-net lease sector has been the enormous amount of external growth. Since 2014, Realty Income has made nearly $11 billion in net acquisitions, with most in the mid- to high 6% cap rate range, while dispositions have been at the 5% cap rate, as they have often included properties that were vacant and therefore not paying rent. Realty Income has increased the average quality of its portfolio by leasing to more investment-grade tenants, increasing the EBITDAR/rent coverage ratio, and diversifying across more defensive industries. Given the low-cost debt that Realty Income had access to over the past decade, the company was able to create significant value for shareholders through external growth. However, as we exit the historically low interest-rate environment of the past decade, we believe that the spread between the company's cost of capital and the initial cap rates will essentially close, eliminating external growth as a way to continue to create excess economic returns. Additionally, we consider most of the value created through external growth as a byproduct of excellent stewardship and not an inherent part of the company's business. Realty Income has sourced between $24 billion and $40 billion over the past six years, with over 80% of those deals sourced through existing management relationships, while executing on only 5% of those deals. We view the company's ability to create value through a large volume of external growth at attractive pricing while increasing portfolio quality as part of the skill of management and not as evidence of an economic moat.

We use an adjusted return on invested capital calculation to determine whether a company has shown or is forecast to have the characteristics of an economic moat. After adjusting the ROIC calculation to use maintenance capital expenditures instead of accounting depreciation, we calculate that over the past few years, Realty Income has averaged an adjusted ROIC approximately 20 basis points above our 7.1% WACC. The adjusted ROIC remains slightly below our WACC estimate through our forecast for the company, providing us quantitative evidence that Realty Income lacks an economic moat.

We are increasing our fair value estimate to $78 per share from $76 after incorporating second-quarter results and accounting for the time value of money. Our fair value estimate implies a 4.9% cap rate on our forward four-quarter net operating income forecast, an 18 times multiple on our forward four-quarter funds from operations estimate, and a 3.8% dividend yield, based on a $2.96 annualized payout.

The low annual rent escalators that average around 1% lead to same-store NOI growth averaging 1.2% across our 10-year forecast. We believe that Realty Income will continue to acquire new assets to drive growth, though the volume will slowly decline from $6.0 billion in 2022 to $1.2 billion by the terminal year. The company will also selectively dispose of assets to partially fund its external growth, though that amount will be limited to just $100 million-$200 million a year.

We estimate Realty Income’s net asset value to be approximately $59 per share based on a 6.0% cap rate assumption. We use NAV as an assessment of potential private-market value, essentially viewing the firm as a portfolio of assets. To calculate NAV, we use recent asset transactions to assign a cap rate to each segment of the portfolio, apply the cap rates to arrive at gross asset value for the real estate, put a multiple on the non-real estate assets, add the non-income-producing tangible assets, then net out liabilities (excluding corporate overhead considerations). We find NAV to be a useful data point in gauging the underlying value of the firm, especially the likelihood for realizing this value through potential asset sales, recapitalization, or mergers and acquisitions.

Realty Income has been increasing the average quality of its tenants, but about half are not investment-grade. The company has also reduced the overall concentration in its tenants over time, but more than half of its net operating income is still concentrated in its top 20 tenants, and 6 tenants represent more than 3% of its NOI, so issues at any of these top tenants could negatively affect Realty Income's revenue.

Realty Income's properties are generic shells that can attract a wide number of possible tenants. However, there is nothing unique about the properties that can't be recreated by other developers. Barriers to entry are very low, given the small size of the properties and that the cost to build is generally around $5 million. And the triple-net lease structure reduces the burden of management for the landlord, increasing the number of potential investors in the space.

Reality Income's dependence on acquisitions to drive growth makes it subject to changes in the private markets and capital markets. Additional competition from well-capitalized investors could drive up prices and force Realty Income to either pursue fewer acquisitions, acquire at lower cap rates, or reduce the quality of properties it acquires. On the other end, Realty Income depends on regular debt and equity issuances to fund acquisitions. A drop in stock price or a rise in interest rates will increase the cost to acquire, which narrows the spread between the company's weighted average cost of capital and the acquisition cap rate, and reduce the value it can create from external growth.

The company may face environmental, social, and governance risks that would negatively affect its portfolio or cash flows. These include properly maintaining the safety of the buildings, paying a competitive wage to employees, and accounting for the future impact of climate change.

We assign Realty Income a low uncertainty rating, which sets the margin of safety for our 5-star rating.

We give Realty Income an Exemplary capital allocation rating. In our opinion, the company’s balance sheet is sound, its capital investment decisions are fair, and its capital return strategy is appropriate.

We view Realty Income's balance sheet as sound as the company operates with a reasonable level of leverage for the industry. We project 2023 net debt/EBITDA to be roughly 5.2 times, which is within the company's long-term target, and we believe this metric will continue to improve as the retail environment recovers.

The company’s capital investment decisions are fair, with Regency growing predominantly through acquisitions rather than internal growth or development. However, the acquisitions the company has made in recent years have been at a large spread to the company's cost of capital, which has created value for investors.

We assess the company’s capital return strategy as appropriate, as Realty Income has averaged a dividend payout ratio of 80% of adjusted funds from operations the past several years. We think this is an appropriate level for a REIT and believe that Realty Income should be able to continue to grow the dividend each year while maintaining this payout ratio.

Sumit Roy was promoted to CEO in 2018 after serving as president, COO, and CIO at various points since joining the company in 2011. Christie Kelly became CFO in January 2021 and brings prior CFO experience from her time at Duke Realty. Most of the senior management team brings significant real estate and capital markets experience, mainly from positions in investment banks overseeing acquisitions of real estate. The board's directors have similarly solid backgrounds inside and outside the real estate industry and are up for election annually, giving us comfort that Realty Income has sufficient management resources available. Additionally, a significant portion of management and board compensation is in restricted stock, helping align their interests with those of shareholders.

We attribute most of Realty Income's growth to the skill of its management team. Even though the company's business drives only 1% internal growth per year, the company has quintupled in size and produced a total return on its common equity well above the U.S. REIT average since the end of 2009. This growth is a result of management's ability to consistently deliver accretive acquisitions. Management over the past six years has been able to source between $24 billion and $45 billion in potential deals with around 90% of these deals coming as a result of existing relationships between Realty Income's management team and the sellers. What truly distinguishes management's skill is the discipline they regularly show to only acquire properties that create value for the company. Realty Income is highly selective, acquiring only about $1.5 billion annually, or about 5% of the deals it sources, though it acquired approximately $3 billion in 2019 and over $2 billion in 2020 despite a small slowdown in acquisitions caused by the pandemic. While cap rates have come down over the past decade from the high 7% range to the low to mid-6% range due to increased competition, Realty Income is still able to acquire at a spread of 150-250 basis points above its cost of capital. With interest rates falling in 2020, we believe that short-term acquisition spreads could be even higher. We believe that management can continue to create value for shareholders through its external growth program as long as this spread between acquisition cap rates and financing costs remains.

What also impresses us is management's ability to significantly increase the portfolio's quality over the past decade. In 2009, only 3% of the top 20 tenants were investment-grade compared with over 60% of the top 20 tenants today and nearly 45% of the total portfolio. Realty Income has shifted its exposure away from economically sensitive retail segments like full-service restaurants, which represented over 21% of its rent in 2009, to retail segments that are much more insulated from economic downturns and e-commerce. Realty Income has increased its exposure to nonretail tenants to further diversify and stabilize its source of rental income. The company has also increased its EBITDAR/rent coverage ratio over time to 2.6. Increasing tenant quality and shifting to recession- and e-commerce-resistant industries should reduce the risk that a tenant would be unable to pay its rental obligations, but the high coverage ratio provides a further buffer that we think almost guarantees Realty Income a steady, stable stream of income. Management's ability to generate additional cash flow while also reducing the risk contained in those cash flows shows a real skill for identifying how to build and shape a triple-net portfolio.