Realty Income Corporation: How a Taco Bell Evolved Into a $10 Billion REIT

By Markets Fool.com

Realty Income Corporation was founded in 1969 with the simple goal of providing an increasing stream of monthly income to its shareholders. The company has grown dramatically over the years but has remained true to its roots -- perhaps the biggest reason for its continued success.

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Here's how a single Taco Bell location evolved into one of the most impressive real estate investment trusts in the world, and how it has produced consistent, market-beating returns for its shareholders.

Founded on a two key objectives
Realty Income was founded in 1969 by William and Joan Clark, and it acquired its first property in 1970 -- a single Taco Bell.

The company was founded with two key objectives in mind, which are still in effect today.

  1. To grow and maintain a reliable real estate portfolio.This is achieved by focusing on retail and real estate properties that have strong long-term growth prospects, and that need their physical location.
  2. To maintain access to low-cost capital.In stark contrast to many other companies in the 1970s and 1980s, Realty Income's philosophy was to acquire properties without the use of mortgages. Even today, when Realty Income acquires a property, it finances the acquisition through low-cost debt offerings or by issuing additional common stock.

A strategy of safety and growth
The main reason Realty Income has thrived over the years is that it employs safe investment principles when acquiring properties.

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In addition to the "no mortgage" mentality, Realty Income has always grown in a manageable and sustainable way. In the early days, the company bought highly recognizable retail stores and the land the buildings were on, and then leased the properties back to the operators under long-term deals, which generally produced an initial return of about 8%.

Furthermore, the company's founders insisted on leases where the tenants were responsible for such variable costs as property taxes, insurance, and building maintenance. This type of arrangement is known as a "net" or "triple-net" lease, and it is now the industry standard for retail leases.

Plus, the tenants must be profitable enough to withstand a substantial drop in sales and still pay the rent. Former CEO Tom Lewis once said that he looks for businesses that earn at least $2.50 for every dollar they pay in rent. That way, if sales drop as a result of a recession or other slowdown, there is still more than enough money to cover the rent. And, since stores and restaurants can't really survive without a physical location, paying the rent is an extremely high priority.

Tough times are Realty Income's best times
Because of its strategy, Realty Income is in a good position to not only survive, but to thrive when the market takes a turn for the worse. There have been two notable examples of this throughout the company's history.

The first was during the 1980s. Thanks to the Economic Recovery Tax Act of 1981, commercial real estate was allowed to be depreciated more rapidly than ever before (over 15 years), and more of the value could be depreciated during the first few years of ownership. So, large corporations started purchasing commercial properties in order to take advantage of these tax breaks, and they were financing these properties with low down payment mortgages.

In 1986, there was another round of tax changes that eliminated these advantages as well as the ability for companies to use "tax losses" from commercial real estate investments to offset other income.

As you can imagine, the loss of these tax breaks meant corporations needed to increase rent in order to cover the expenses of holding all of their commercial properties, and the increase was in the 5%-10% range, according to the National Bureau of Economic Research. Since Realty Income didn't have any mortgages and wasn't trying to use its commercial property holdings to "off set" other types of income, it was able to benefit from the increasing market rental rates without the downside of increasing expenses. And, the company was able to experience a growth spurt in the years that followed, thanks to large corporations unloading commercial holdings.

More recently, because of its high credit rating and access to virtually unlimited low-cost capital, Realty Income was able to make $700 million in acquisitions in 2010, including $269 million in Napa Valley wineries, a new type of property for the company.

And, while the retail sector was getting clobbered during the crisis, Realty Income's tenants made it through largely unscathed thanks to the profitability criteria I discussed earlier. In fact, during the depths of the crisis, Realty Income's occupancy never fell below 96.2%.

In short, its lack of mortgages and strong tenant base allow Realty Income to have money to spend no matter what else is going on -- and this allows the company to score some great deals when times get rough.

Where does Realty Income go from here?
As you've probably noticed, there haven't been many major changes in Realty Income's history in terms of corporate strategy. The company was founded with a low-risk, high-reward strategy that has worked tremendously well for its investors over the years, and it continues to use the same strategy today (on a wider scale, of course).

So, why change a winning formula? Over the coming years and decades, I would expect Realty Income to continue doing what it's been doing -- using cheap financing to acquire high-return properties occupied by tenants who have a small chance of going anywhere.

The article Realty Income Corporation: How a Taco Bell Evolved Into a $10 Billion REIT originally appeared on Fool.com.

Matthew Frankel owns shares of Realty Income. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.