O, O, O, It's Magic

by: Brad Thomas


- All triple-net REITs grow earnings by utilizing spread investing.

- The higher the multiple, the lower the costs of capital, and that translates into BIGGER MARGINS.

- The low cost of capital (high equity multiple) is the most important competitive advantage in the net lease industry.

This article is one in a sequence of articles that I refer to as “If I Had To Own Just One REIT” series. As you may recall, I recently wrote on the Healthcare REIT sector and I selected Ventas, Inc. (VTR) as my top pick. I summed up my BUY recommendation as follows:
VTR is my favorite Healthcare REIT and one of the best managed REITs overall. While I don't consider the shares anywhere near bargain-pricing levels, I consider the stock soundly valued and worthy of an entry position. For a deep value investor, I would wait on a pullback, but I have no problem recommending shares at the current price point.
I also wrote on the Shopping Center REIT sector and I explained that “after surveying the list of vetted retail REITs and considering which of the companies are worthy of ownership, I find Retail Opportunity Investments Corp. (ROIC) one of the best REITs to own.”
Given the more recent news and powerfully disruptive force in the retail sector – Amazon (AMZN), it’s critical that investors focus on QUALITY. As I explained in a recent Forbes article,
The best quality real estate with the highest sales productivity should thrive as successful retailers want to drive sales and inventory turnover..., Amazon is recognizing that to build a successful mousetrap, the blueprint must include REAL ESTATE.
In other words, it’s now more critical than ever to own Retail REITs that have the highest quality assets. There is no reason to be cute, hoping to capture outsized returns by investing a REIT like Spirit Realty (SRC) that leases to Shopko and formerly invested in a struggling grocer, Hagen. I summarized my thoughts in a recent article,
The cream always rises to the top, and today REIT investors have an opportunity to pick up shares in a stalwart REIT that has a superior low cost of capital advantage. It’s critical to always examine the underlying revenue generators of a REIT and remember that “quality is not free.
Now it’s time to continue the “If I Had To Own Just One REIT” series and today I’m writing on the Net Lease REIT sector. I’m sure you already know the company but in case you don’t here’s a clue…. O, O, O, It’s Magic.
The Basic Net Lease REIT Overview
Before I start on the discussion of Realty Income (O), let’s begin with a general overview of the Net Lease REIT sector. Net Lease REITs are different from Shopping Center REITs because their lease structure and growth drivers support a predictable revenue stream relative to other forms of retail real estate. This snapshot below compares Realty Income (and Net Lease REITs) with Shopping Center/Mall REITs:
One of the most important differentiators for Net Lease REITs is that they drive growth through acquisitions. When is the last time you saw a Mall REIT acquire a Mall? Net Lease REITs like Realty Income have a large pool to fish in – the sector is highly fragmented and there are opportunities to invest in practically every state in the U.S. (Realty Income owns properties in 49 states).
Here is a snapshot comparing Realty Income’s market capitalization with the Net Lease REIT peers:
Over the years, Realty Income has evolved into a massive Net Lease REIT with 4,980 properties located in 49 states and Puerto Rico. As you can see below, the company has a highly diversified portfolio spanning 49 states (not in HI):
It’s hard to fathom how much Realty Income has grown over the years, from one Taco Bell site to over 4,900 properties. The company now has incredible scale, well diversified by tenant, industry, geography, and to a certain extent, property type.
No tenant represents more than 6.8% of revenue as Realty Income has 250 commercial tenants, 45% are investment-grade rated (including 9 of the top 20 tenants):
As you can see, Whole Foods is not on the list of Top 20 tenants. During the first quarter, Realty Income added Kroger (NYSE:KR) to its top 20 tenants, representing 1.2% of annualized rental revenue. But more importantly, the top 15 tenants represent higher quality credit, less cyclical industries and greater diversification vs. 2009:
No industry represents more than 11.1% of rent and the company has considerable exposure to defensive industries: Top 10 industries represent strong diversification, significant exposure to non-discretionary, low price point, service-oriented industries:
Realty Income’s roots are in retail with growing exposure to mission-critical industrial properties:
Realty Income’s management team is highly experienced at sourcing deals and when the company invests in retail it seeks strong unit-level cash flow coverage (specific to each industry). The company seeks tenants with service, non-discretionary and/or low price point components to their business with favorable sales and demographic trends.
Keep in mind, there have been 13 retail bankruptcies in 2017 and 12 of them were related to apparel, electronics, and general merchandise. Realty Income has little exposure to these categories: 5 apparel BKs and O has 1.8% of ABR in apparel, 3 sporting goods BKs and O has 1.3% of ABR in sporting goods, and O has .30% exposure in electronics, 1.7% in general merchandise, and just .65% exposure in shoes (i.e. Payless BK).
Also, Realty Income has 3.67% exposure (based on ABR) to the grocery sector. The company has Wal-Mart and Kroger as Top 10 tenants. As I said earlier, it’s critical to invest in quality retail and that means avoid REITs that have exposure to weaker chains like Shopko (i.e. SRC) and Bi-Lo (i.e. WHLR).

What about Rite Aid (RAD)?
Of all of Realty Income’s tenants, Rite Aid is, in my opinion, the biggest watch list candidate. There is doubt regarding the Walgreen merger and RAD is highly leveraged (rated B by S&P). Realty Income has 69 RAD stores but I don’t consider this dire news given the fact that Realty Income has cherry-picked the real estate and the pharmacy sector is growing.
Who knows, maybe the RAD leases become Amazon leases… I’ll save that article for another day…
Realty Income remains comfortable with the momentum in the drugstore industry and continues to view the exposure favorably given the industry’s attractive demographic tailwinds, non-discretionary nature and continued growth from in-store pharmacy pickup.
Additionally, Walgreens and CVS (the top two drugstore tenants) have generated 15 consecutive quarters of positive same-store pharmacy sales growth.
Most importantly, over 90% of Realty Income’s retail portfolio has service, non-discretionary and/or low price point components. The Non-Retail-focused investments are Fortune 1000, primarily investment-grade rated companies.
The Magic Starts Right Here
All triple-net REITs grow earnings by utilizing spread investing; this simple formula is described as follows:
Cap Rate - Cost of Capital = Spread
By using this example, assume a triple-net REIT acquires standalone buildings at a 7% cap rate, and then, after subtracting the cost of capital (~5%), arrives at a spread (that's the profit margin) of ~2% (or 200 bps).
Over the years, I have been reading many articles on Seeking Alpha and other investing websites, and I'm amazed that most analysts miss the "most important thing" when it comes to net lease investing:
The Low Cost of Capital Advantage.
Let's consider the equity details related to spread investing.
To arrive at the earnings yield, one must divide the P/FFO ratio into 100. For example, a P/FFO of 21x divided by 100 is a 4.7% earnings yield. Since assuming Wall Street charges around 6.5% for equity, the earnings yield after issuance costs is .935 (100% - 6.5% = 93.5%).
So, the Nominal Cost of Equity is arrived at by dividing the 4.7% earnings yield by .935, or 5%.
With a 7% cap rate (on a purchase), the 5% NCE is equal to 2.0%. Thus, on a $100 million investment, there is $2 million in new profits for all shareholders. The same thing at 25x P/FFO equals a 4.27% NCE that translates into around $2.73 million (in profits) on a $100 million acquisition.
So, very simply, the higher the multiple, the lower the costs of capital, and that translates into BIGGER MARGINS.
AFFO yield = Annualized 2017 estimated AFFO ($3.06) divided by $56.67 stock price = 5.39%
Estimated cost of 10-year debt = 3.60%
Nominal Cost of Free Cash Flow = 0%
66% equity = 5.39% * (0.66) = 3.56%
34% debt = 3.60% * (.33) = 1.22%
WACC = 3.56% +1.22% = 4.78%
(In reality, it's actually lower than that, because O uses free cash flow instead of equity. Cash has a 0% nominal cost.)
Realty Income’s investment spreads relative to its weighted average cost of capital remained healthy in the first quarter, averaging 170 bps, which were well above the historical averages. Realty Income defined investment spreads as initial cash yield less the nominal first year weighted average cost of capital.
As illustrated below, the low cost of capital (high equity multiple) is the most important competitive advantage in the net lease industry:
Low cost of capital allows Realty Income to acquire the highest quality assets and leases in the net lease industry:
Realty Income avoids lease structures with above-market rents, which can often inflate initial cap rates:
Assuming identical real estate portfolio, consider two different lease structure scenarios...
Realty Income’s cost of capital advantage drives ability to source, fund, close on accretive M&A deals, like the ARCT transaction that closed in 2013:
Large, diversified portfolio offers capacity to absorb co-mingled portfolio opportunities, like the Inland portfolio that closed in 2014:
Realty Income’s property diversification, cost of capital, and willingness to acquire $250mm+ transactions with diverse property types provides unique growth opportunities in addition to traditional single-asset or retail sale-leaseback pipeline.
The Fortress Balance Sheet
In the first quarter, Realty Income issued approximately $800 million in common equity at an average price to investors of approximately $62 per share (trading at $53.76 now).
Realty Income has the highest credit rating in the net lease sector, the company issued $700 million in fixed rate unsecured debt with a weighted average term of 18.3 years and a yield of 4.1%.
The company’s credit spreads remain among the lowest in the REIT industry and leverage continues to decline with net debt to total market cap of approximately 26% and debt to EBITDA of approximately 5.5x. Realty Income currently has approximately $1.5 billion available on its $2 billion line of credit. This provides ample liquidity and flexibility as the company continues to grow.
The company is rated BBB+ by all three major rating agencies (Moody's, S&P, and Fitch), and is likely to become an A- rated REIT soon. Key metrics include: 93% fixed-rate debt, weighted average rate of 4.15% on debt, staggered maturities (8.1 year on average), and ample liquidity ($1.68 available on revolver (L+90bps) with $120 million (annually) of free cash flow.
O, O, O, It’s Magic
What company would copyright the name, “the monthly dividend company” if they did not intend to generate reliable monthly dividends?
As you can see, Realty Income has had Zero dividend cuts in 22 years as a public company:
The “Magic” of Rising Dividends: Yield on Cost, Dividend Payback long term, yield-oriented investors have been rewarded with consistent income. There are potential benefits to investing long term in a company that regularly increases its dividend. The longer you hold your shares, the higher the yield you will receive on your original investment, assuming dividends increase over time. Additionally, the compounding of reinvested dividends could generate increased investment returns over time.
Investors who have elected to reinvest their dividends have enjoyed the following returns over time (as of 3/31/2017):
Buy, Sell, or Hold?
Keep in mind, Realty Income’s share price (of $72.00) is down considerably over the last 11 months.
The dividend yield has compressed by 230 bps, representing a cushion for investors (Note: I had a “Trim” on shares at $72.00).
Let’s examine Realty Income’s dividend yield, compared with the peers:
Now let’s examine the AFFO Payout Ratio:
Realty Income's Payout Ratio is higher than most peers, but the company does not have considerable office exposure and the quality of the income stream justifies the low 80% ratio. Now let’s examine the P/FFO multiple:
As you see, Realty Income trades at the highest P/FFO multiple in the Net Lease REIT sector, but that does not mean shares are expensive. I would argue that shares are now “soundly” valued and that the premium valuation (relative to the peers) is warranted based on management’s skillful strategy for managing risk. Obviously, I would encourage investors to buy Realty Income if the price drops, but I consider fundamentals sound and I’m maintaining my BUY recommendation.
Although the Amazon/Whole Foods deal was a surprise last week, it should be no surprise that Realty Income has been able to successfully manage risk for more than two decades. The fact that Amazon is betting on brick and mortar serves to validate the argument that real estate is an essential asset class for delivering goods and Realty Income remains in an enviable position to be the dominant Net Lease consolidator.
In conclusion, if I had to buy just one Net Lease REIT, it would be Realty Income... O, O, O, it's magic!
AFFO per Share Forecaster (powered by FAST Graphs):
Author's note: Join me at the DIY Investor Summit where I share detailed tips on my core investment strategies, top advice for DIY investors, and specific ways I'm positioning for the second half of 2017.
Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors, if they are overlooked.
Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).
Sources: FAST Graph and O Investor Presentation.

Argentina’s 100-year bond cannot defy EM playbook forever

If the Fed is proved right on growth and inflation, then EM assets are likely to suffer

by: Jonathan Wheatley

Gauchos: saddle up. Argentina, one of the world’s most notorious serial defaulters, came to market on Monday with a 100-year sovereign bond, and investors snapped it up with all the macho bravado of the legendary horsemen of the pampas.

Really? A dollar-denominated bond that pays back 100 years from now, from a junk-rated country that has barely managed to stay solvent for more than half that time in its entire history as a creditor?

While there is certainly an investment case for taking part, several analysts warn that this issue is a classic sign of a market getting ahead of itself.

The point, though, is not the 100 years. The complexities of bond maths mean that, once maturities go beyond 30 years, the investment case barely changes. Barring default, with a yield of nearly 8 per cent, the bond will repay investors in full in about 12 years, all else (such as inflation) being equal — and that’s leaving aside its resale value. Many investors will have much shorter horizons.
In a world starved of yield, the 7.91 per cent on offer proved to be quite a pull and the bond attracted orders of $9.75bn for the $2.75bn issued. “People are looking out over the next 12 to 24 months and see a pretty positive outlook [for Argentina],” says David Robbins, head of emerging markets at TCW in New York. “Duration in high yield is something they are more comfortable with.” Argentina, he notes, is in effect selling equity in its economic recovery.

With so much else priced to perfection on global markets, this may seem to go with the territory. But others warn that we have been here before.

Sérgio Trigo Paz, head of emerging market fixed income portfolio management at BlackRock, says the rationale and the pricing are all good. But, he adds: “When you put it into perspective, it gives you a sense of déjà vu.”

Argentina’s is not the only noteworthy sale this week. Russia reportedly attracted demand of more than $6bn for 10-year and 30-year eurobonds expected to be priced later on Tuesday at yields of about 4.25 per cent and 5.25 per cent respectively.

This is happening just as the US Federal Reserve has embarked on “quantitative tightening”, raising interest rates last week for the second time this year and preparing markets for an announcement on how it will begin shrinking its supersized balance sheet later in the year.

It is not hard to see parallels between today and 2013, when the Fed announced the approaching end of quantitative easing just as investors were piling with enthusiasm into a series of high-profile eurobond issues by African governments. Some of those went badly wrong as investors fled emerging markets in the subsequent “taper tantrum”.

Investors may feel Argentina is less vulnerable this year to the dangers of “original sin” — issuing debt in dollars that must be serviced from revenues in your own, potentially weakening currency.

Last year’s dollar strength has faded and the peso has weakened against it by only about 1.5 per cent this year.

While a repeat of the taper tantrum is not expected, Mr Trigo Paz is among those warning that we are nevertheless at an inflection point.

He sees two scenarios. In one, the Fed is right about inflation and rates will continue to rise.

This would turn the Argentine bond into “a bad experience”. In the other, markets are right, US inflation and payrolls will disappoint and we will be back in a low rate environment, which will be good for the bonds — until deflation rears its head again, hurting the Argentine economy and its ability to pay.

In the meantime, he says, there is a “Goldilocks” middle ground in which investors can suck up an 8 per cent coupon. Beyond that: “It doesn’t look good either way — which is why you get an inflection point.”

Jim Barrineau, co-head of EM debt at Schroders, agrees. “Issuance like this will be the most volatile when the market cracks,” he says. “You do well until you don’t.”

At bottom, the question is whether the strong flows into EM assets this year, more than $35bn into EM bond funds alone, will continue to cushion investors from upsets down the road. It may be that the sheer quantity of money in search of yield will overpower events.

“You’re getting a ton of inflows, including passive inflows, compression of yields and compression of default risk,” says Mr Barrineau. “And people need to put money to work.”

However, he added: “History shows in EM that this type of environment doesn’t last for ever.

“This is the type of thing that when the tide turns is just poised to underperform. We’d rather pass on issues that appear to be the product of a frothy market.”

Britain’s Deepening Confusión

Robert Skidelsky
. theresa may

LONDON – “Enough is enough,” proclaimed British Prime Minister Theresa May after the terrorist attack on London Bridge. Now, it is clear, almost half of those who voted in the United Kingdom’s general election on June 8 have had enough of May, whose Conservative majority was wiped out at the polls, producing a hung parliament (with no majority for any party).

Whether it is “enough immigrants” or “enough austerity,” Britain’s voters certainly have had enough of a lot.
But the election has left Britain confusingly split. Last year’s Brexit referendum on European Union membership suggested a Leave-Remain divide, with the Brexiteers narrowly ahead. This year’s general election superimposed on this a more traditional left-right split, with a resurgent Labour Party capitalizing on voter discontent with Conservative budget cuts.
To see the resulting political terrain, imagine a two-by-two table, with the four quadrants occupied by Remainers and Budget Cutters; Remainers and Economic Expansionists; Brexiteers and Budget Cutters; and Brexiteers and Economic Expansionists. The four quadrants don’t add up to coherent halves, so it’s not possible to make out what voters thought they were voting for.
But it is possible to make out what voters were rejecting. There are two certain casualties. The first is austerity, which even the Conservatives have signaled they will abandon. Cutting public spending to balance the budget was based on the wrong theory and has failed in practice. The most telling indicator was the inability of George Osborne, Chancellor of the Exchequer from 2010 to 2016, to achieve any of his budget targets. The deficit was to have vanished by 2015, then by 2017, then by 2020-2021. Now, no government will commit to any date at all.
The targets were based on the idea that a “credible” deficit-reduction program would create sufficient business confidence to overcome the depressing effects on activity of the cuts themselves. Some say the targets were never credible enough. The truth is that they never could be: the deficit cannot come down unless the economy grows, and budget cuts, real and anticipated, hinder growth. The consensus now is that austerity delayed recovery for almost three years, depressing real earnings and leaving key public services like local government, health care, and education palpably damaged.
So expect the ridiculous obsession with balancing the budget to be scrapped. From now on, the deficit will be left to adjust to the state of the economy.
The second casualty is unrestricted immigration from the EU. The Brexiteers’ demand to “control our borders” was directed against the uncontrolled influx of economic migrants from Eastern Europe. This demand will have to be met in some way.
Migration within Europe was negligible when the EU was mainly West European. This changed when the EU began incorporating the low-wage ex-communist countries. The ensuing migration eased labor shortages in host countries like the UK and Germany, and increased the earnings of the migrants themselves. But such benefits do not apply to unrestricted migration.
Studies by Harvard University’s George J. Borjas and others suggest that net immigration lowers the wages of competing domestic labor. Borjas’s most famous study shows the depressive impact of “Marielitos” – Cubans who immigrated en masse to Miami in 1980 – on domestic working-class wages.
These fears have long underpinned sovereign states’ insistence on the right to control immigration. The case for control is strengthened when host countries have a labor surplus, as has been true of much of Western Europe since the crisis of 2008. Support for Brexit is essentially a demand for the restoration of sovereignty over the UK’s borders.
The crux of the issue is political legitimacy. Until modern times, markets were largely local, and heavily protected against outsiders, even from neighboring towns. National markets were achieved only with the advent of modern states. But the completely unrestricted movement of goods, capital, and labor within sovereign states became possible only when two conditions were met: the growth of national identity and the emergence of national authorities able to provide security in the face of adversity.
The European Union fulfills neither condition. Its peoples are citizens of their nation-states first. And the contract between citizens and states on which national economies depend cannot be reproduced at the European level, because there is no European state with which to conclude the deal. The EU’s insistence on free movement of labor as a condition of membership of a non-state is premature, at best. It will need to be qualified, not just as part of the UK’s Brexit deal, but for the whole of the EU.
So how will the shambolic results of the British general election play out? May will not last long as Prime Minister. Osborne has called her a “dead woman walking” (of course without acknowledging that his austerity policies helped to seal her demise).
The most sensible outcome is currently a political non-starter: a Conservative-Labour coalition government, with (say) Boris Johnson as Prime Minister and Jeremy Corbyn as his deputy.

The government would adopt a two-year program consisting of only two items: the conclusion of a “soft” Brexit deal with the EU and a big public investment program in housing, infrastructure, and green energy.
The rationale for the investment program is that a rising tide will lift all boats. And an added benefit of a thriving economy will be lower hostility to immigration, making it easier for Britain to negotiate sensible regulation of migrant flows.
And who knows: if the negotiations force the EU to re-cast its own commitment to free labor movement, Brexit may turn out to be a matter less of British exit than of an overhaul of the terms of European membership.

 Is Amazon/Whole Foods This Cycle’s AOL/Time Warner – A Sign That The Party’s Over?  

Towards the end of the 1990s tech stock bubble, “new media” – i.e., the Internet — was ascendant and old media like magazines, newspapers and broadcast TV were yesterday’s news.

This was reflected in relative stock valuations, which gave Internet pioneer AOL the ability to buy venerable media giant Time Warner for what looked (accurately in retrospect) like an insane amount of money.

Now fast forward to 2017. Online retailing is crushing bricks-and-mortar, giving Amazon all the high-powered stock it needs to do whatever it wants. And what does it want? Apparently to run grocery stores and pharmacies via the acquisition of Whole Foods, the iconic upscale-healthy food chain.

The two deals’ similarities are striking, but before considering them here’s a quick AOL/Time Warner post-mortem:

15 years later, lessons from the failed AOL-Time Warner merger
(Fortune) – The landscape of mergers and acquisitions is littered with business flops, some catastrophic, highly visible disasters that were often hugely hyped before their eventual doom. Today marks the 15th anniversary of one such calamity when media giants AOL and Time Warner combined their businesses in what is usually described as the worst merger of all time. But what happened then will happen again, and ironically for the exact same reasons. 
A lot of people thought that the merger was a brilliant move and worried that their own companies would be left behind. At the time, the dot-coms could do no wrong, and AOL (AOL) was at the head of the pack as the ‘dominant’ player. Its sky-high stock market valuation, bid up by investors looking for a windfall, made the young company more valuable in market cap terms than many blue chips. Then CEO Steve Case was already shopping around before the Time Warner opportunity came up. 
On the other side, Time Warner anxiously tried, and failed, to establish an online presence before the merger. And here, in one fell swoop, was a solution. The strategy sounded compelling. Time Warner (TWC), via AOL, would now have a footprint of tens of millions of new subscribers. AOL, in turn, would benefit from access to Time Warner’s cable network as well as to the content, adding its layer of so-called ‘user friendly’ interfaces on top of the pipes. The whole thing was “transformative” (a word that gets really old really fast when reading about this period). Had these initial assumptions been borne out, we might be talking today about what a visionary deal it was. 
Merging the cultures of the combined companies was problematic from the get go. Certainly the lawyers and professionals involved with the merger did the conventional due diligence on the numbers. What also needed to happen, and evidently didn’t, was due diligence on the culture. The aggressive and, many said, arrogant AOL people “horrified” the more staid and corporate Time Warner side. Cooperation and promised synergies failed to materialize as mutual disrespect came to color their relationships. 

A few scant months after the deal closed, the dot com bubble burst and the economy went into recession. Advertising dollars evaporated, and AOL was forced to take a goodwill write-off of nearly $99 billion in 2002, an astonishing sum that shook even the business-hardened writers of the Wall Street Journal. AOL was also losing subscribers and subscription revenue. The total value of AOL stock subsequently went from $226 billion to about $20 billion.

Now back to Amazon/Whole Foods. Amazon is going to apply its advanced technology – online ordering, fast delivery, drones, autonomous cars, whatever – to the quintessentially meatspace business of selling groceries. And it’s paying $13 billion to find out if this is a good idea.

Whether it is or isn’t is less important than what this type of M&A says about the mindset of a given cycle’s favored companies. When undreamed-of amounts of money start pouring in (as with the dot-coms of old and today’s Big Tech) it changes the perception of risk. $13 billion is a terrifying amount of money to bet on a new and untested idea – except in the context of a near-trillion dollar market cap, where it seems downright modest.

When the next bear market hits, though, that kind of money might seem a bit hubristic.

As with so many other extraordinary recent market events (record-high stock prices combined with record-low volatility, negative yields on government bonds, soaring debt/GDP combined with falling inflation), Amazon/Whole Foods might or might not be the bell that rings at the top. But when the history of this time is written, there’s a good chance that it will be somewhere on the list.