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Morningstar | Realty Income’s Triple-Net Leases Provide Stability, but Growth Depends on Acquisitions

Realty Income is the largest triple-net REIT in the U.S., with more than 5,000 properties that mainly house retail tenants. The company describes itself as "The Monthly Dividend Company," and its line of business and operating metrics make its dividend one of the most stable sources of income for investors. Even though over 80% of Realty Income’s tenants are in retail, most are focused on defensive segments, with characteristics such as being service-oriented, naturally protected against e-commerce pressures, or resistant to economic downturns. Additionally, the triple-net lease structure places the burden of all operational risk and cost on the tenant and requires the tenant to make capital expenditures to maintain the property rather than the landlord. These leases are often long term, frequently 15 years with additional extension options, which provides Realty Income a steady stream of rental income. Coverage ratios are also very high, so tenants are healthy and unlikely to request rent concessions, even during downturns. The steady, stable stream of revenue has allowed Realty Income to be one of only two REITs that are both members of the S&P High-Yield Dividend Aristocrats Index and have a credit rating of A- or better. This makes Realty Income one of the most dependable investments for income-oriented investors.However, the promise of stability comes at the cost of economic profit. The lease terms include very low annual rent increases around 1%, which helps keep the coverage ratio high but severely limits internal growth for the company. Therefore, to grow, the company must rely on acquisitions. The company has successfully executed on over $12 billion in acquisitions over the past decade at average cap rates above 6%. Given the access to cheap debt during this time, the company has created a lot of value. However, increased competition has lowered cap rates, and interest rates have recently increased, squeezing the company's spread and its ability to create value. We remain concerned that at some point Realty Income’s valve for creating value will shut off and it will be left with just a low internal growth story.