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Leading net-lease retail REIT Realty Income (NYSE: O) has had a pretty strong 2016 so far. Even after a recent pullback, shares are up nearly 25% year to date. One big reason for this has been the company's low cost of capital, which has led to more acquisitions, and at record-high spreads. Here's what you need to know about it, and whether or not it will continue.
Two ways Realty Income funds its growth
REITs like Realty Income get the cash to expand in two main ways -- taking on debt or issuing equity. On occasion, there can be other financing methods used, such as excess cash flow that wasn't paid out to shareholders, or by issuing preferred stock, but these are the primary ways of obtaining capital.
In Realty Income's case, most of the company's acquisitions are made with equity, at least in the past few years. During the first six months of 2016, Realty Income invested $662.9 million in new properties, and raised $487.2 million by issuing new shares -- so the newly issued equity covers about 73% of the company's acquisitions.
Overall, Realty Income's balance sheet is even more equity-oriented. Just 23% of the total capitalization comes from debt or preferred stock.
Source: Realty Income investor presentation
Low interest rates help REITs in two big ways
One of the main reasons for Realty Income's soaring stock price in 2016 is that the low-interest environment has lasted longer than most experts had expected. Low interest rates are good for both ways REITs acquire properties.
Obviously, low interest rates make it cheaper for the company to borrow money, which typically leads to higher profit margins on acquired properties. To put this in perspective, Realty Income's revolving credit facility currently has a 1.35% interest rate -- far below the weighted average interest rate of 4.19% on all of the company's debt.
Also, low interest rates can cause REIT share prices to move higher, particularly those with high and reliable dividends like Realty Income. When rates are extremely low, like they are now, REIT dividends look attractive to income-seeking investors. Dividend investors buy more shares, which creates upward pressure on the price.
On the other hand, rising rates can create selling pressure on REITs. At a time when 10-year Treasuries pay just 1.7%, Realty Income's consistent 3.8% yield can look extremely appealing. However, if the 10-year yield were to shoot up to, say, 4%, it might not seem worth the additional risk to buy a REIT as opposed to a Treasury security with guaranteed income.
Low cost of capital leads to better acquisition opportunities
The result of these low-interest benefits is a lower cost of capital, which produces an increase of acquisition opportunities at attractive investment spreads. Not only is borrowing cheaper, but when the share price is higher, the company needs to issue less new equity to raise the necessary capital.
Think of it this way -- if Realty Income's share price is $50, it needs to issue 200,000 new shares to raise $10 million. If the share price rises to $70, the company only needs to sell about 143,000 shares to accomplish the exact same thing.
Because of the low cost of capital, Realty Income has increased its full-year acquisition guidance twice this year already. In its first-quarter earnings report, the company raised the full-year projection from $750 million to $900 million, and then raised it again with its second-quarter results, this time to $1.25 billion.
As CEO John Case said in a statement, "In the second quarter, we completed $310 million in acquisitions and through the first half of the year we completed $663 million in acquisitions at record-high investment spreads relative to our weighted average cost of capital." He also stated that the company continues to see an "ample pipeline" of acquisition opportunities, so I actually wouldn't be surprised if the full-year guidance was raised again in the third quarter.
Will it continue?
I don't foresee the record-low interest rates hanging around for too much longer, but then again, I would have predicted that the Federal Reserve would have raised rates several times by now. Essentially, we're stuck at crisis-level interest rates at a time when we haven't been in a financial crisis for years. So, there's no telling how much longer this excellent situation for REITs will last.
One thing is for sure, however. Interest rates will normalize, it's just a question of when. And a gradual increase in rates is certainly preferable to a spike. When interest rates do begin to normalize, it's likely to hurt REIT prices in the short-term, but that's nothing to worry about. Realty Income has delivered strong results for its shareholders during periods of rising rates in the past, and will continue to do so. If anything, weakness caused by interest rate hikes (or better yet, by speculation of future rate hikes) should be looked at as nothing more than a nice opportunity to buy shares of one of the best REITs in the market at a discount.
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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.