What’s Next for Realty Income’s 5.8%-Yielding Dividend?

When looking at income-oriented investments, consistency is one of the keys. And on that front, there aren’t many companies that have been as consistent as Realty Income (NYSE: O). The real estate investment trust (REIT) has increased its dividend for 29 straight years, announcing its 643rd consecutive common stock monthly dividend in January.

To determine whether Realty Income’s dividend is sustainable, let’s first look at what the company does and how it grows its distribution, and then address what risks its dividend could face.

How Realty Income makes money

Realty Income owns a portfolio of real estate assets, primarily serving the retail sector. It also owns some industrial and gaming properties.

The REIT’s main focus is leasing out its properties to economically resilient retailers that aren’t being disrupted by e-commerce. This includes grocery stores, convenience stores, pharmacies, home improvement centers, dollar stores, and restaurants. Walgreens, Dollar General, Walmart, and Tractor Supply are some of its notable tenants. Its properties are generally freestanding single units. It doesn’t own any malls, and its properties usually aren’t attached to other tenants in a strip mall.

Realty Income’s steady results can be attributed to its long leases, which typically have a 10-20-year initial term with rent escalators. It also employs what are known as triple net leases, in which the tenants are responsible for utilities, property taxes, and maintenance, shielding the REIT from unexpected cost increases.

Realty Income will add a bit more industrial exposure following the closing of its acquisition of Spirit Realty last month. The deal is expected to be immediately accretive because it will take out some overlapping corporate costs.

Realty Income generally finances the assets it acquires. As such, it makes money off the spread, or difference, between the cap rate on its properties and its funding costs. Cap rates are simply a lease’s yield, which is calculated by taking a property’s net operating income and dividing it by the purchase price of the asset. With higher interest rates, Realty Income is also able to get deals with higher cap rates, as cap rates tend to follow interest rates.

Growth opportunities

Acquiring properties — or entire property portfolios — is the primary way Realty Income grows its adjusted funds from operations (AFFO), which is one of the main metrics REITs use to measure the cash flow generation of their ongoing business operations, and thus their ability to maintain their dividend.

Going forward, Realty Income will fuel its growth via additional portfolio deals, as well as potential sale-leaseback arrangements, in which companies sell their real estate assets for cash and then lease them back from the new property owner. Of the $2 billion in real estate investments Realty Income made in the third quarter, $1.3 billion was in sale-leaseback transactions.

Another area of potential growth for Realty Income is Europe. It crossed the pond several years ago, opening a new market opportunity for the REIT. It benefits even more from inflation in Europe than in the U.S., because many of its agreements in Europe don’t have a cap on their inflation escalators.

In recent years, Realty Income also hasn’t been afraid to make investments in other areas as it looks to grow. It made a bet on the gaming industry recently, starting with a $1.7 billion sale-leaseback deal with Boston Harbor Casino in 2022. It then purchased a nearly 22% stake in the property of The Bellagio Las Vegas, which is operated by MGM Resorts. These deals got the REIT into a new vertical, and the Bellagio investment saw the company take a different approach to investing in real estate by acquiring an equity stake in a property.

Potential risks

Now, Realty Income and its dividend face risks as well. Sometimes tenants leave after leases are up, and sometimes they fail to pay rent or enter bankruptcy proceedings. The company recently dealt with this issue with Cineworld, and had to restructure its agreement with the European movie theater operator. At the end of the day, it says it will recapture 60%-85% of the rent it was owed. Given that the REIT owns properties, which can often be repurposed, Realty Income generally makes up much of the lost rent when it unexpectedly loses a tenant.

Another risk Realty Income faces is that as its debt matures, it could roll into higher interest rates. The company has a pretty steady amount of debt maturities over the next few years that it will need to refinance, including $1.8 billion coming due this year. In July 2023, Realty Income raised debt at an average annual yield of 5.08%, while its weighted average yield on fixed-rate debt maturing in 2024 is 4.48%.

The dividend is sustainable and likely to grow

As of right now, higher refinancing costs will likely be a headwind for Realty Income. However, its AFFO is set to solidly exceed its distribution next year. With AFFO projected to be around $4.00 based on company guidance and a dividend payout of about $3.08, the dividend is well covered.

As such, Realty Income’s dividend is not only sustainable, but the REIT has plenty of room to continue growing it in 2024 and beyond. This should be supported by a combination of property and sale-leaseback acquisitions, European expansion, and its foray into casino properties.

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Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Realty Income and Walmart. The Motley Fool recommends Tractor Supply. The Motley Fool has a disclosure policy.

What’s Next for Realty Income’s 5.8%-Yielding Dividend? was originally published by The Motley Fool