Realty Income (O) is a high-quality retail REIT that was recently trading at its cheapest valuation in a long time. Now, the company has agreed to purchase Spirit Realty Capital (SRC) in an all-stock transaction worth about $9.3 billion (including the assumption of Spirit’s debt), explains Scott Chan, editor of The Complete Investor.

This is O’s largest transaction since its 2021 all-stock merger with VEREIT. Spirit owns a portfolio of more than 2,000 properties, concentrated in retail but also with a sizeable portion (about 25% of annualized contractual rent) in industrial real estate, such as manufacturing facilities and distribution centers. Over the years, Realty has forayed more into industrial properties, so this purchase continues that strategy.

Spirit boasts an occupancy rate of 99.8%, which would improve Realty’s own already impressive rate from 99.0% to 99.1%. The weighted-average lease term also lengthens from 9.6 years to 9.7 years. Assuming the deal goes through (closing date expected to be in the first quarter next year), Realty will have more than 15,000 properties in its portfolio.

The new portfolio will also be more diversified in terms of exposure to the top tenants and top industries, though one could argue that is not necessarily a great thing since Realty’s tenants have traditionally been resilient. Moreover, the percentage of rent from investment-grade tenants will go from 40% to 37%. In other words, the overall credit profile takes a slight hit though it’s not something to be overly concerned about at this point.

According to Realty’s estimates, the deal will result in synergies of $50 million per year and be immediately accretive to AFFO (adjusted funds from operations, a measure of available cash for dividend distribution) by 2.5%. These are quite modest figures, but it’s likely Realty’s management is trying to be as conservative as reasonable amidst economic uncertainties and high interest rates.

Without the tough environment for REITs today, Realty probably wouldn’t be able to buy Spirit at the valuation it did – 9.7x AFFO. SRC was trading at a multi-year low level at the time of the deal announcement. Of course, so was O, valued at about 11.7x.

This difference in valuation is important because when Realty acquires additional AFFO from Spirit, this additional AFFO should now be valued at a higher multiple under Realty. Put another way, because O trades at a premium to SRC, if $1 of AFFO under SRC is worth X, then that same $1 is worth X + a premium under O. Additional value is unlocked.

Recommended Action: Buy O.

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