Very Bad News For Realty Income (2024)

Lately, I have written a few negative articles on Realty Income (NYSE:O) and this has led some of its bulls to label me as a "hater".

But the reality is that I have no dog in this race. I am not shorting Realty Income, and I don't stand to benefit in any way by criticizing the company. I could just as well write positive articles on the company, and that would probably earn me even more money if it pleased Realty Income investors.

But I am trying to remain objective and if that leads you to calling me a "hater", then so be it. I actually owned a position in Realty Income for years, and I finally sold it in December 2023 at $56.76 per share due to all the bad news that I will discuss below.

Bad news #1: Its Portfolio Quality Has Greatly Deteriorated

Realty Income used to be perceived as a net lease REIT that focused on higher quality net lease properties. It even had a slide in its investor deck (which I believe has been removed since) that would explain how they are able to buy higher quality properties at lower cap rates because of their lower cost of capital, and they would explain that these higher quality assets would provide more consistent and predictable returns over time.

But those days are over.

As Realty Income grew larger in size, single asset acquisitions were not moving the needle as much anymore, so they began to target accretive M&A deals to grow at a faster pace.

They first acquired VEREIT. They then bought a big portfolio from CIM Real Estate Finance Trust. And more recently, they acquired Spirit Realty Capital.

These deals were accretive on day 1 and nicely expanded Realty Income's FFO per share, since these were big acquisitions and they came with a positive spread.

But the cost of these deals is that I think that they greatly reduced the average portfolio quality of Realty Income. VEREIT, CIM Real Estate, and Spirit Realty were all famous for owning lower quality net lease properties as they both suffered significant tenant difficulties during their existence as publicly listed REITs.

That did not stop Realty Income from buying them out, and I believe that this diluted its portfolio quality. This is evident when you compare some of its main characteristics relative to its close peer, Agree Realty (ADC), which is another net lease REIT that has historically focused on higher quality assets.

This, of course, does not mean that those buyouts were poor investments. At the right price, any property can become a good investment.

But it diluted its portfolio quality, which will increase risks going forward, and therefore, Realty Income does not deserve to trade at the premium valuation of a "higher-quality net lease REIT" any longer.

Bad News #2: It Has Gotten Too Big For Its Own Good

Another issue of these M&A deals is that they massively increased the size of the company, and I believe that it has now become so big that it will suffer diseconomies of scale going forward.

To understand why, you need to consider that acquisitions are one of the main sources of growth for net lease REITs. Typically, their rent escalations are limited to just 1-2% per year, and to grow faster, they need to acquire new properties. They raise new capital at cost X and attempt to reinvest it at return Y, hoping to earn a spread that results in growth on a per share basis.

But this also means that the size of the portfolio is a limiting factor. The bigger you are, the harder it becomes to grow because new acquisitions don't move the needle as much anymore.

You then need to acquire a huge volume of assets each year to keep the ball rolling, and you lose in flexibility, bargaining power, and cannot be as selective about your investments anymore.

Just consider the following example:

• Realty Income owns $65 billion worth of assets.
• NNN REIT (NNN) owns just about $11 billion.

This means that Realty Income will need to acquire roughly 6x more assets than NNN REIT just to achieve the same result. That makes their job a lot harder, and it is a major disadvantage because there are only so many assets available for sale at any given time.

It means that Realty Income is likely to perpetually face slower growth going forward and on top of that, its portfolio will only keep getting diluted in quality because the REIT will lose in flexibility and not be able to be as selective anymore.

Bad News #3: It Is Losing Its Focus

Realty Income started with the acquisition of a Taco Bell property in 1969 and for most of its existence, it has focused primarily on similar service-oriented net lease properties. It became an expert in this niche of commercial real estate market and was highly successful.

But in the past years, Realty Income has had to step out of its main circle of expertise because there wasn't enough acquisition opportunities in its niche to reach its huge acquisition volumes.

This pushed Realty Income to invest in a casino, vertical farming properties, data centers, industrial properties, and in Europe.

I view this very negatively because you cannot be a jack of all trades and expect to earn superior returns.

For this reason, the REIT market has historically priced specialized REITs at a premium relative to diversified REITs. There is value in being specialized as it results in having competitive advantages.

I fear that if Realty Income continues down this path, it may start to be classified as a "diversified REIT" by increasingly many investors, and this will cause it to persistently trade at a discounted valuation, increasing its cost of capital, and hurting its growth prospects even further.

This is another consequence of the company's size issue.

Bad News #4: Its Cost of Capital Is Too High To Pursue Accretive Growth

Realty Income has crashed along with the rest of the REIT market, and it is today priced at a historically low valuation, increasing its cost of equity.

Then on top of that, interest rates have surged, also increasing its cost of debt, and as a result, it is not able to earn a spread on new acquisitions today.

According to its own assumptions, its weighted average cost of capital is today at about 7% and this is in-line with the company's own estimates:

The issue is that their cap rates are right around the same level, so there is no spread.

This explains why the REIT has guided to only acquire $2 billion worth of assets in 2024, down from nearly $10 billion in 2023. It also explains why they guided to grow their FFO per share by just ~2% in 2024 (adjusted for the impact of the merger with SRC). They are still growing thanks to their lease escalations and the reinvestment of their retained cash flow, but their growth rate is now far below its historical average, and since I don't expect that to change, the REIT deserves to trade at its now lower valuation.

Bad News #5: Overall, It Offers Worse Risk-to-Reward Than Its Close Peers

This is the ultimate reason why I sold Realty Income.

I think that some of its peers are likely to earn higher returns with lower risk than Realty Income going forward.

A great example of that is Agree Realty (ADC), which is a smaller (but still large and well-diversified) peer of Realty Income.

It is safer because it owns better properties, it has less debt, it is specialized, can be more selective, and enjoys faster growth prospects, which should limit the risk of a further deterioration in its market sentiment.

But despite being safer, I would also expect it to be more rewarding going forward because it is smaller in size, enjoys a lower cost of capital, is less impacted by the surge in interest rates, and earns larger investment spreads, which should result in faster growth in the coming years.

Despite that, they trade at similar valuations if you adjust for Realty Income's lower quality of assets, higher leverage and payout ratio:

And in case you don't believe me, just consider that ADC has massively outperformed O over the past decade. I believe that this is because O's size became an issue, and it couldn't keep up with ADC. I am simply predicting that this will continue going forward:

So with that in mind, why would you own Realty Income?

How I see it is that it offers lower returns with higher risk than ADC, and I would add that ADC is not an isolated case.

Some of its other peers also offer better risk-to-reward.

If you are primarily interested in dividend income, then NNN REIT (NNN) is arguably the best pick today. It offers a similar dividend yield as Realty Income, but has an even longer dividend growth track record at 34 years, and its smaller size and lower payout ratio should allow it to grow faster going forward.

If you are going after total returns, then Essential Properties Realty Trust (EPRT) has consistently been able to grow far faster because of its small size and unique focus on middle market tenants. Some argue that this is a riskier approach, but even through the pandemic, which was the worst possible crisis for EPRT, it kept growing at a faster pace and here are the results relative to Realty Income:

So again, why buy Realty Income if there are arguably better options for your capital whether you are going for safety, income, or growth?

Tell me in the comment section below because I just don't get it.

I would much rather own Agree Realty (ADC), NNN REIT (NNN) or Essential Properties Trust (EPRT) because I expect them to do far better than Realty Income (O) over the long run.

My capital is limited, so I need to be selective.

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