Why Realty Income Shareholders Have Nothing to Worry About

By Matthew Frankel Markets Fool.com

Freestanding net-lease retail real estate investment trust Realty Income (NYSE: O) is a favorite stock among income investors and growth seekers alike. However, there is concern among many people about the retail sector as a long-term investment, especially with increasing online competition and several high-profile retail bankruptcies in recent years. Here's why this logic doesn't apply to Realty Income, and why shareholders should do well for decades to come.

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Low-risk retail

Realty Income specializes in freestanding net-lease retail properties, and is the largest REIT of its kind in the market. While retail may seem inherently risky to you (and in many cases it is), not all retail is in the same boat when it comes to risk. Some types of retail are immune to online competition, others tend to do just fine during recessions, and others even do better when times get tough. And these are the types of retail that Realty Income focuses on.

Realty Income can grow your nest egg, while still allowing you to sleep soundly. Image source: Getty Images.

The vast majority of Realty Income's tenants can be classified into one (or more) of three business types:

  • Non-discretionary retail, which holds up well during recessions, and is resistant to online competition.
  • Service-based retail, which is virtually immune to online competition.
  • Deeply discounted retail, which has the potential to do even better during tough times.

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Consider Realty Income's eight largest tenants, and how they all fit into these categories.

Company

% of Realty Income's Portfolio

Type of Business

Walgreens

7%

Non-discretionary

FedEx

5.5%

Non-discretionary, Service-based

Dollar General

4.2%

Deeply discounted, non-discretionary

LA Fitness

4%

Service-based

Dollar Tree/Family Dollar

3.8%

Deeply discounted, non-discretionary

Circle K

2.6%

Non-discretionary, Service-based

AMC Theaters

2.6%

Service-based

BJ's Wholesale Clubs

2.4%

Deeply discounted

Data source: Realty Income investor presentation.

In addition, the portfolio is diversified across many different industries, with no single industry representing more than 11.4% of the rental income. The nearly 5,000 properties are also spread out geographically across 49 states and Puerto Rico.

Also, in addition to the vast retail portfolio, Realty Income has a smaller, but substantial amount of industrial, office, and agricultural properties. Most of these properties' tenants (about 90%) are investment-grade companies, so this adds diversification without excessive risk.

Long-term net leases minimize turnover

Realty Income's tenants sign "net" leases which require them to cover most of the costs of ownership of the properties they occupy, including property taxes, building insurance, and maintenance expenses. These leases generally have long (15+ year) initial terms, and have annual rent increases built in.

In a nutshell, Realty Income's lease structure is designed to minimize turnover and variable expenses, while providing a predictably growing income stream.

Thanks to this lease structure, and the careful selection of tenants, Realty Income's occupancy is consistently high. At the end of 2016, 98.3% of the company's portfolio was occupied, and this level has never dropped below 96%, no matter what the economy was doing. Also, same-store rent growth has consistently grown at a 1%-1.5% annual rate, thanks to the built-in rent increases.

The proof is in the performance

Over time, Realty Income has been less volatile than most other stocks, while generating some pretty impressive returns. Since its 1994 NYSE listing, Realty Income has produced annualized returns averaging 16.9% (including dividends), and has a beta of just 0.39. You can read a thorough discussion of beta here (LINK), but essentially, lower beta means lower volatility risk, and 1.00 is the S&P 500 average. In fact, this combination of high returns with little risk puts Realty Income in the 98th percentile of S&P 500 companies for returns per unit of market risk.

What about interest rates?

As a final thought, let's talk about interest rates. Many REIT investors are worried about rising interest rates, and the Federal Reserve has projected several interest rate increases per year for the next few years. And it's absolutely true that rising interest rates can put downward pressure on REIT shares.

However, as long-term investors, we should be more concerned with the company's earnings power and how it shrinks or grows during rising-rate time periods. Well, over the most recent period of rising rates (2003-2006), Realty Income grew its FFO per share at an 8.1% annualized rate -- above average for its peer group -- and its dividend grow at a 5.9% annualized rate.

Image source: Realty Income investor presentation.

In other words, don't be concerned if rates rise and Realty Income's share price drops. As long as the company's income-generating ability continues to grow as it always has, long-term shareholders will do just fine.

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Matthew Frankel owns shares of FedEx and Realty Income. The Motley Fool recommends FedEx. The Motley Fool has a disclosure policy.