Realty Income (O) is triple net lease REIT that presents an
excellent instrument to short commercial real estate, corporate defaults and a deep
For background on Realty Income please see the excellent write up by
msdonut940 on 12/27/2007.msdonut940 recommended a short in December 2007 with the stock at
$28.60.Today at $23.15, Realty
Income is still a good risk adjusted short opportunity.
Mis-pricing of Realty
Income Capital Structure
Realty Income equity is aimed primarily at retail investors who are
focused on receiving a monthly dividend.The company prides and sells itself as “a monthly dividend company” and
the whole investor relations focus is directed to retail investors.I don’t think issuing a monthly
dividend warrants any premium but retail investors and the company’s focus on
increasing the dividend multiple times a year for less than a fraction of a
cent each time builds the false halo of safety.
This retail investor base focused on dividend growth has created the
perfect instrument to short commercial real estate and indirectly corporate
base is focused only on dividends and looks at Realty Income as basically a
supercharged savings account paying 7% dividend without looking at risk of
Realty Income Capital
Realty Income capital structure has inverted with its senior bonds
trading at 12% YTM, its preferreds trading at 10% current yield and its equity
trades at 7% dividend yield.While
its long dated bonds trade at 50-60 cents on the dollar it equity is trading
only down about 20% over the last
The credit markets for Realty Income and commercial real estate in
general is basically frozen.It is
very unlikely O will be able to raise any new debt funding or sell properties
as buyers have minimal to access to capital.I don’t think the equity holders in O have any idea where
its credit trades at or what its holdings of real estate are worth.They are still operating under the
assumption that O is an investment grade company issuing 5.875% 30 year
[Long O bonds short the equity is an interesting capital structure
trade.It’s negatively biased and
has positive carry.]
Asset Valuation has
There is a retail investor myth that since O owns properties without
underlying mortgages it is immune from destruction in CMBS.O via its capital structure has
recourse debt instead of non-recourse mortgage debt. The maturity schedule for
the corporate debt of O is favorable for the company with no near term
maturities.But the destruction
CMBS has to negatively affect the prices of O underlying 2,200 properties.O cannot sell properties anywhere near
the cap rates the equity is currently valuing it at.
O indirect credit risk to the consumer economy has significant
upside to a short position in the equity.As the consumer and macro economy deteriorates there will be increased
corporate defaults.These defaults
will lead to restructuring of leases over the 2009-2011 timeframe.These restructurings should result in occupancy
rates declining below 96%.The
triple net lease business model is high leveraged to occupancy rates – any
decline in occupancy will directly impact FFO/AFFO and more importantly O’s dividend.msdonut940 discusses the likely default of Buffets.Buffets has since filed for bankruptcy
and renegotiated some leases with O.However, the Buffets bankruptcy has been an unmitigated disaster for
distressed investors.Buffets DIP
trades at 20 cents on the dollar and it is very likely Buffets is liquidated in
Given the state of the consumer economy, CMBS markets, corporate
credit spreads/defaults and the lack of a DIP market.I don’t see anything positive for the credit risk imbedded
in O portfolio.
Love the Retail Investor Base
The retail base is oblivious to all the issues raised above as long
as the dividend is paid.The best
thing about O is none of the credit and liquidity events of 2008 have been
priced in.The stock price has
minimal negative expectation built into it unlike O’s corporate bonds which
have declined 30 plus points since September 2008.As defaults in leases increases, declining occupancy, declining
FFO/AFFO, declining asset value and the recession impacts O performance through
2009-2011 the dividend will be cut.
The transition from retail to value in O equity will be very ugly.Will any value investor buy O equity
for 7% dividend yield when one can buy senior bonds for 12% YTM?
Irrationality of Retail
This company has issued shares at $26 with under a 7% dividend yield
in September 2008 to raise capital.If this management draws on the revolver/credit facility or some how
manages to increase dividends by 1/10 cent the retail base might be more
tempted by 7% dividend paid monthly versus a checking account paying 0%
interest and have no regard for safety of principal.The company is serial issuers of equity and would use any
pop in equity price to issue new equity.
In an irrational market in which O trades at 7% dividend yield
versus 12% YTM for its corporate debt there is no reason why the stock in the
short term cannot trade at 5% dividend yield.
Hedging the Short Position
I use O primarily as a hedge to offset a higher current yield
portfolio of distressed/high yield/cross over corporate bonds trading at
substantial discounts to par.
Reality of the recession is priced into Realty Income’s operating
results and dividend.
Reality of the recession is priced into Realty Income’s operating results and dividend