Realty Income Too Rich For Your Blood? Here’s A Great High-Yielding, Faster Growing Alternative
In the past few days Realty Income (NYSE:O) has pulled back 7.6% from its all time high of $72.3. Yet, thanks to an epic run up over the past year, far in excess of most REITs and the market in general, this blue chip dividend champ remains highly overvalued.
O Total Return Price data by YCharts
Read on to find out what buying Realty Income shares at today’s price might mean for your returns going forward. But more importantly, learn why Spirit Realty Capital (NYSE:SRC), a higher-yielding, faster growing alternative to Realty Income, represents one of the market’s best kept secrets. One that with a strong potential for market beating returns in the years, and decades to come.
Three ways to look at Realty Income’s valuation
| REIT | Yield | 5 Year Average Yield | P/AFFO | Historical P/AFFO | Average Historical Premium |
| Realty Income | 3.6% | 4.6% | 23.6 | 18.3 | 25.4% |
| Spirit Realty Capital | 5.3% | NA | 15.1 | 12.7 | 18.9% |
Looking at a company’s historical valuation multiples is a good way of gaining a sense of context about whether or not a stock is fairly priced today. As you can see, on a yield, and Price/AFFO basis, both Realty Income, and Spirit Realty, are moderately overpriced.
Of course, given that investment returns are based on future growth, we also need to consider a forward looking valuation model. In my opinion, Morningstar’s fair value estimates are the gold standard of conservative, fundamentals driven, two stage discounted cash flow, or DCF based intrinsic value estimates.
| Morningstar Fair Value Estimate | Current Share Price | Sell Price | Premium To Fair Value | Distance To Sell Price |
| $51 | $66.80 | $68.85 | 31.0% | 3.1% |
That’s not to say that you can, or should, rely purely on Morningstar’s five year fair value estimates. For one thing they are limited to only the most popular and most followed companies. However, they are also predicated on certain growth assumptions, as well as key multiples that affect profitability, such as weighted average cost of capital, or WACC.
For example, the above intrinsic value estimate is from Morningstar analyst Edward Mui, who has some extremely conservative forward assumptions about Realty Income. Now don’t get me wrong, given the uncertainty involved with long-term modeling, erring on the side of caution is generally a good thing.
However, if you go overboard by assuming too low of growth in a company’s fundamentals then you can also end up pricing yourself out of a quality dividend growth stock like Realty Income. That’s because your intrinsic value estimate might leave you sitting on the side lines waiting for a price that may never come.
In Mr. Mui’s case he assumes that Realty Income’s average acquisition over the next few years will be at an average cap rate of 5.6%, implying inflated asset prices due to a growing bubble in commercial real estate. However, this estimated forward cap rate may be too pessimistic, as Realty Income’s $663 million in acquisitions in the first half of 2016 was for properties with an average cap rate of 6.5%.
In addition, the company’s management has shown a very disciplined strategy of not reaching for growth at any price. Rather management only acquires properties, or even other REITs, at what it feels are highly favorable terms that are immediately accretive to AFFO/share, and thus help make continued strong dividend growth possible.
Source: Realty Income investor presentation.
In addition, a major flaw in Morningstar’s valuation is Mui’s assumption that Realty Income, due to its 80% reliance on single tenant properties, has no moat. Specifically this means a lack of pricing power due to low switching costs on the part of major tenants such as Walgreens, (NASDAQ:WBA) as well as low barriers to entry that allow construction of competing buildings for around $5 million.
Now here Mui has a point. As great as Realty Income is, it does lack strong pricing power, as seen in the fact that it’s annual rental increases are only around 1.5%, pretty much matching inflation. However, what Morningstar doesn’t seem to take into account is that Realty Income’s competitive advantage lies not in non-existent brand power, but rather economies of scale.
Specifically, its giant size means that SG&A expenses can get distributed amongst cash flow from over 4,600 properties. In addition, because of its giant size, Realty Income has greater access to, and lower costs of capital than many of its rivals. And unlike Morningstar’s assumed 7% weighted average cost of capital, or WACC which implies that the company can’t earn sufficient returns to justify a higher valuation, it’s likely that Realty Income is far more profitable than Mr. Mui assumes.
For example, Gurufocus uses the standard CAPM formula to calculate a cost of capital for Realty Income of just 3%. While my own method of determining cost of capital is a bit different, as it uses Brad Thomas’s cost of equity formula of AFFO/share/Share price, none the less it results in a WACC of 4.4%; far lower than Morningstar’s estimate.
The reason this matters is because if Realty Income’s long-term cost of capital is actually only about 50% of what Morningstar is estimating going forward, then its ability to generate additional AFFO, which is what funds the dividend, is far greater than Mui estimates. And since the fair value estimate is ultimately a result of discounting future AFFO, then this potential underestimation of Realty Income’s AFFO generating capacity could explain why my own DCF model shows Realty Income, while still overvalued, worth far more than Morningstar’s $51 estimate.
| REIT | TTM AFFO/Share | Projected 10 Year Growth Rate | Intrinsic Value Estimate | Growth Baked Into Current Price | Margin Of Safety |
| Realty Income | $2.79 | 4.2% | $62.85 | 5.4% | -6% |
| Spirit Realty Capital | $0.83 | 5.0% | $20.18 | -4.5% | 34% |
As you can see, my 30 year DCF model, which assumes a 4.2% AFFO/share growth rate for the first 10 year, and then a extremely conservative 3% for the next 20 years, reveals Realty Income to be just 6% overvalued at the present time.
Now, understand that, despite the seemingly exact nature of this fair value estimate, no DCF estimated intrinsic value should ever be the sole basis of an investing decision. After all, one’s fair value depends largely on the growth assumptions and discount rate used. That being said, given Realty Income’s strong recent quarter, I consider my growth assumptions highly conservative. In addition, the 9.1% discount rate, which is the market’s historical CAGR since 1871, is reasonable, as it allows us to estimate how likely Realty Income is to match the market’s historic total returns from today’s price.
Of course, the ultimate goal of dividend growth investors isn’t to merely come close to matching the market, but to beat it. At least that should be the goal given that a low cost index ETF such as the Schwab US Dividend Equity ETF (NYSEARCA:VNQ) offers far lower risk, for a nearly as generous 2.8% yield, and very low 0.07% expense ratio. Since I consider this ETF as the ultimate “default” investment option for dividend growth investors, I expect any individual company to provide at least a reasonable chance of generating superior long-term total returns to the general market’s.
Which is why my favorite way of determining whether a stock is a buy is to use the Gordon dividend growth formula, which models long-term total returns as being equal to yield + dividend growth, to see how likely a given company is to outperform the market.
| REIT | Yield | Dividend Growth Needed To Beat Market | Required 2025 Dividend | Required AFFO/Share | TTM AFFO/Share | Required AFFO/Share CAGR |
| Realty Income | 3.6% | 5.6% | $4.18 | $4.92 | $2.79 | 5.8% |
| Spirit Realty Capital | 5.3% | 3.9% | $1.03 | $1.21 | $0.83 | 3.8% |
As you can see, in order to deliver at least 9.2% projected total returns, Realty Income would need to grow its dividend at 5.6% CAGR over the next decade. Assuming that management maintains a reasonable 85% AFFO payout ratio, this would mean that Realty Income needs to grow its AFFO/share by 5.8% annually for the next 10 years.
While this is far from impossible, especially after Realty Income’s impressive performance last quarter, given the REITs large size, it does seem rather improbable. At least it’s unlikely barring a major acquisition spree, including potential purchases of major rivals such as W.P Carey (NYSE:WPC), which I actually view as a very good use of Realty Income’s premium priced shares.
Which brings me to Spirit Realty Capital, which has a far lower bar to clear in order to beat the market, and thus meet my definition of a fairly valued, quality dividend growth stock.
Why you should consider Spirit Realty Capital as an alternative to Realty Income
Source: Spirit Realty Capital investor presentation.
Spirit Realty Capital, while not nearly as well known as blue chip triple net lease REITs such as Realty Income, W.P Carey, or National Retail Properties (NYSE:NNN), is actually one of America’s largest owners of single tenant buildings, with 2,610 properties in 49 states, rented out to 435 tenants representing 28 industries.
More importantly, Spirit’s management has proven that it is able to grow quickly while maintaining a strong focus on high quality customers, and diversification of cash flow.
For example, while Spirit started out with the majority of rent concentrated with a single client, today its revenue diversification, at 26.1% of rent coming from its top ten customers, is better than even Realty Income’s, who gets 37.7% of rent from its largest 10 tenants.
That being said, Spirit and Realty Income do have slightly different business models. Specifically, Spirit targets mainly small and medium sized companies, from which it can negotiate higher rents, and achieve superior cap rates. For example, in Q2 of 2016 Spirit acquired 125 properties for $241 million at an average cap rate of 7.76%, about 110 basis points higher than Realty Income’s latest purchases.
The key to Spirit’s success is the fact that its target customers have larger unmet capital needs, making them more likely to agree to long-term sale-leaseback deals at favorable terms. In addition, Spirit’s management likes to negotiate as many of its contracts as master leases, in which several properties exist under the umbrella of a single lease agreement. This helps to keep occupancy extremely high, even in times of economic distress when individual properties may struggle.
Combined with a large number of properties, with average remaining lease of 10.6 years, Spirit Realty has extraordinarily consistent cash flow with which to fund its generous 5.3% dividend, which is secured by a conservative 79.5% payout ratio.
That low payout ratio, when combined with Spirit’s skill at big acquisitions, such as the $7.4 billion purchase of Cole Credit Property Trust II in 2013, along with a recent upgrade of its credit rating to investment grade by both Fitch and S&P should help it to continue growing strongly for many years to come. As will the 33% increase in its credit facility. In fact, analysts expect Spirit Realty to have one of the fastest growing dividends in the industry over the next 10 years.
| REIT | Yield | AFFO Payout Ratio | 10 Year Projected Analyst Dividend Growth | 10 Year Projected Total Return |
| Realty Income | 3.6% | 85.4% | 3.7% | 7.3% |
| Spirit Realty Capital | 5.3% | 79.5% | 12.9% | 18.2% |
| S&P 500 | 2.0% | 39.1% | 6.2% | 9.1% |
Now don’t get me wrong, all long-term analyst forecasts need to be looked at skeptically. In this case, I think that the estimated 12.9% dividend growth rate is likely overly optimistic. However, if Spirit can achieve even half of, meaning 6.5% payout growth, then it should be able to generate close to 12% total returns over the coming years, making it one of America’s top dividend growth stocks.
Overseeing this aggressive growth potential is one of the most veteran leadership teams in the industry, with a combined 95 years of experience overseeing a total of $115 billion in real estate deals, as well as both private, and public capital raises.
Risks to consider
Don’t get me wrong, though I’m bullish on Spirit Realty Capital, and plan to buy shares in the near future, there are three risk factors that need to be addressed.
First, though management has generally been good about holding the line on debt, and avoiding getting into trouble with excessive leverage, none the less Spirit’s balance sheet is weaker than Realty Income’s.
| REIT | Debt/EBITDA | EBITDA/Interest | Debt/Equity | S&P Credit Rating |
| Realty Income | 5.30 | 4.02 | 0.77 | BBB |
| Spirit Realty Capital | 6.83 | 2.53 | 1.0 | BBB- |
| Industry Average | 6.57 | NA | 1.30 | NA |
Now in fairness to management, prior to the acquisition of Cole Credit Property Trust II, the REIT’s Debt/EBITDA ratio was a very low 3.0; among the best in the industry. And management has been very aggressive in paying down the debt in order to gain an investment grade credit rating. In fact, since the end of 2015 the Debt/Adjusted EBITDA ratio has declined from 6.9 to 6.0.
That being said, remember that the niche in which Spirit operates involves higher credit risk than Realty Income’s, and future big deals may involve taking on a substantial amount of debt, with no guarantee that the integration of new assets will go smoothly. Which brings me to risk number two.
Because Spirit is a fast growing REIT there is a lot of execution risk that investors need to deal with. For example, the company’s recent acquisition of 20 grocery stores operated by Haggen Holdings for $224 million has hit a snag with Haggen filing for Chapter 11 bankruptcy. Management has thus far been successful at minimizing the fallout from this deal gone wrong, selling 2 stores, re-leasing or planning to re-lease another 13, and suing Haggen for $21 million in damages. Management is confident that it will receive at least $15 million of that in the final settlement with the company.
However, the Haggen debacle shows exactly the kind of risks that any aggressively acquisitive REIT faces, especially if it lacks the same economies of scale as Realty Income, that can serve as a large buffer against such unfortunate events.
Finally, speaking of smaller scale, Spirit Realty Capital still lacks the superior economies of scale enjoyed by Realty Income, which can be seen in its inferior margins and returns on capital.
| REIT | Operating Margin | Net Margin | Return on Assets | Return on Equity | Return on Invested Capital |
| Realty Income | 26.3% | 25.4% | 2.3% | 4.5% | 4.51% |
| Spirit Realty Capital | 8.9% | 15.4% | 1.3% | 2.8% | 3.91% |
| Industry Average | 42.1% | 26.6% | 3.4% | 10.6% | NA |
While I fully expect those metrics to rise over time as Spirit grows larger, none the less investors will want to carefully watch those to make sure that management is as good as they appear to be. After all, because all REITs must continuously issue new equity to raise growth capital, it’s extremely important that management proves itself an efficient, and wise steward of shareholder funds.
Bottom line: Realty Income’s recent pull back still leaves it extremely richly priced, so consider Spirit Realty Capital as a higher-yielding, faster growing alternative
Don’t get me wrong, I love Realty Income, and consider it the gold standard of triple net lease REITs. In fact I plan to own shares in my own portfolio should the price come down a bit more. However, given its still low-yield, relative to its historical norms, I feel that it’s worth looking at high-quality alternatives such as Spirit Realty Capital for one’s dividend growth needs.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Stock Plaza). I have no business relationship with any company whose stock is mentioned in this article.
