Realty Income is a triple net lease REIT that’s grown too fast over the last couple of years. The downfall in the triple net lease structure is the cash flow sensitivity to occupancy rates.  15% of Realty Income’s revenues are exposed to Buffet (a steak buffet chain).  Buffet recently hired restructuring bankers, and may miss its January bond payment.  As Buffet rejects leases in bankruptcy, Realty Income will struggle to make its dividend payment. Realty Income signed this deal only a year ago, and the quick deterioration of this asset speaks to poor investment decisions made by the current management team.  Given recent cap rate compression, and a likely decrease in occupancy rate, fair value for this stock is around $19, well below the current $28/share level.

Realty Income is a triple net lease REIT.  For those that are not familiar with the business, triple net lease players enter into sale/leaseback transactions with operators who own their land ~ allowing them to monetize the real estate in exchange for a long term lease (generally 15-20 years) at a fixed rate. In addition the “renter” of the land is responsible for its upkeep, a certain amount of capital expenditure, and any insurance coverage needed.  In exchange for taking on most of the expenses of owning the land, the rent is usually at sub-market rates, fixed for a period of time, and has several multi-year extension options at a capped % increase. 

 

Realty Income has been in operation for 38 years and focuses on single-tenant, stand-alone consumer related properties (convenience stores, restaurants, theaters, auto dealers, etc.).  The company has doubled its asset base in the last three years, just as the real estate market was peaking so there is little embedded book value.  Current occupancy rates are 98.3%, and the company owns 2,181 properties.  Cap rate compression has been a large factor in this market in the last couple of years, as with all of real estate.  In addition, Realty Income has been facing increasing competition for the smaller deals which have historically been their strength from small players who have easy access to capital.  In order to maintain the same cap rates, I believe Realty Income has been forced to purchase lower quality properties.  For instance, Realty Income will buy up a package of 100 properties, 1/3 of which may not meet their credit criteria.  After buying the properties for between an 8-9% cap rate on average, they turn around and sell the questionable properties to doctors/dentists in the 1031 at around a 7% cap rate.  Therefore, they historically have booked gains on the sale of these assets. As financing has dried up, the 1031 market is slowing, leaving Realty Income with properties even they believe are questionable.

 

Realty Income’s portfolio is geographically diverse, with Florida and Texas being the two largest states in terms of revenue.  About 20% of revenues come from restaurants, 14% from convenience stores, 9% from theaters, and 9% from childcare.  Everything else is a mish mash of various retailers, ranging from home furnishings and pet supplies to automotive tire services. 

 

Realty Income’s shareholder base is largely the unsophisticated retail investor who is focused on his/her dividend payment, as well as the potential for dividend growth in the future.  Realty Income refers to themselves as “The Monthly Dividend Company” and their annual report literally has a board game inside.  Keeping the retail base happy has been important given the need for perpetual equity raises to keep growing the portfolio.

 

The triple net lease REIT business model is dependent upon keeping up a high occupancy rate.  Operationally, Realty Income is ill-equipped to deal with a large number of delinquencies given the total number of employees is only 70 people.  And the argument that the owners of the real estate feel little overall value impairment means little to a shareholder base whose only care is their dividend stream.  It becomes very difficult to maintain or grow a dividend as occupancy decreases.  The loss of rental income decreases cash flow on a more than one to one basis.  The rental income is not easily replaced as it typically takes at least 9 to 12 months to re-lease a property.  During this time, Realty Income is responsible for all of the property expenses and capital expenditures it typically foists on its renter.

 

There are a couple of examples of triple net lease players who have seen a drop in occupancy.  AFR (American Financial Realty) is a triple net least player that purchases empty bank branches.  As banks chose to walk away from their branches at the end of the contract, the dividend was no longer covered.  Their occupancy dropped from high nineties, to the low eighties over a couple of years.  The company was forced to lower its dividend and the stock traded at a perpetual discount to NAV thereafter. Realty Income saw a drop in occupancy of about 200 bps from ’98 to ’00, during which the stock lost about 40% of its value.

 

Given the current retail and restaurant environment, the 98.3% occupancy rate reported last quarter is simply unsustainable.  While everyone knows the consumer is slow, there are a couple of other factors that are worth mentioning in the restaurant/retail space.  Realty Income is exposed more to the casual dining sector than it is to fast food ~ a sector which is facing significant labor inflation costs as well as commodity inflation.  The casual dining sector has been unable to pass these costs through to the end customer, partly due to competition and partly due to a stretched customer.  As a result, the already thin restaurant margins may be cut in half over the next year as declining sales and increasing costs create the perfect storm.  (DRI’s recent results are an example of this pressure.)

 

Last year, Realty Income purchased the land from Ryan’s Restaurants, helping to fund Fortress’s take private transaction in late 2006.  This is the largest transaction that Realty Income has made to date, and it was timed at the peak of the market.  The company, now know as Buffet Holdings, operates 632 steak buffet restaurants.  Now, this is probably the worst place to be in the restaurant industry given the above comments ~ a place that is required to keep plentiful food available regardless of the amount of traffic in the store and has no price discretion.  Any change in the quality of the food will diminish the perceived value to the customer.  Since going private, Buffet’s financial results have been disappointing.  The company retained a financial advisor recently, and an ad hoc bond committee has been formed.  It is possible the company will choose to miss the 1/1/08 bond interest payment and start the process for a prepackaged bankruptcy.  With bank debt trading in the mid-eighties, and bonds around 43, the market is obviously predicting a restructuring in the near future.  Realty Income, however, is actually up 3.4% for the year.  Apparently the poor Buffet results that are well known in the debt markets have not been passed along to the retail shareholders of Realty Income. 

 

The current valuation is not dirt cheap.  Other triple net lease players (such as AFR and LSE), trade at 8-10% dividend yields and around 10-12x FFO.

 

Below is a basic FFO calculation for the last couple of years.  2007 estimates are from a JP Morgan Model.  Note that other than Interest and D&A, there are minimal expenses.  G&A for 2006 is only $17.5 mm and there is about $5 mm of other expenses. The effective EBITDA margin of these operations is extremely high ~ consistent with the triple net lease model

 

Below is a basic example demonstrating the FFO leverage in the event that Buffet’s files for bankruptcy and chooses to reject ½ of the leases that are held by Realty Income.  I’ve assumed that no real estate transactions occur in the next year, which is simplistic, but I have not assumed any additional delinquencies, which given the current environment is definitely conservative.

 

 

As you can see, with just ½ of the Buffet leases rejected, Realty Income will no longer be able to cover its dividend through FFO.  It seems unlikely that the stock will continue to be at a 5.7% dividend yield and close to two times book in that event.  The preferred equity is already trading with a yield greater than 8%, presumably in response to these credit concerns.   More realistically, I believe the stock should trade at around a 12x PF FFO level, which is approximately the NAV under the current market conditions.  That would give you a stock of $19, 35% below the current level.

 

Risk

-         occupancy declines are hidden by asset growth

-         lack of response to bad news given retail shareholder base

-         GE buys it.  They have purchased two triple net lease restaurant operations in the past five years; but, given the other opportunities for GE finance, I find it unlikely they will allocate more capital today to this area.