You Can Still Make Money in Real Estate!

04/30/2008 12:00 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Not all real estate investments are duds. This one is a profitable survivor, according to Josh Peters, editor of Morningstar DividendInvestor.

Realty Income (NYSE: O) owns real estate generating consistent cash flow, which it returns to shareholders as steadily growing monthly dividends. It owns nearly 2,300 freestanding retail properties occupied by a diverse set of retailers, from convenience stores to restaurants. Most of its properties were acquired directly from retailers in sale-leaseback arrangements, in which Realty Income retains a 20-year net lease.

That means the retailer is responsible for covering all operating expenses and taxes, while Realty Income collects monthly rent checks, pays interest on borrowings, and distributes the remaining funds to shareholders via a monthly dividend. For the past four decades, this strategy has earned Realty Income a narrow economic moat. Its competitive advantage stems from identifying profitable real estate locations in which the retailer would be unlikely to close during a downsizing or reorganization.

The company also doesn't overpay for a property, paying no more than the cost of replacing the building. This gives it the ability to replace a tenant, in the rare case that one vacates, at the same rent as the prior retailer. The company has a stellar record of keeping its assets occupied, averaging 98% occupancy during the past 10 years, giving it the ability to deliver uninterrupted monthly dividends.

Realty Income's focus on owning high-quality assets at the right price, as well as its stable monthly dividend, make this company unique among peers. We believe Realty Income is a business with low uncertainty, given the steady stream of income and its underwriting processes. Furthermore, debt and preferred equity account for only 40% of the capital base and are financed at fixed rates, ensuring that interest rate changes don't affect the free cash flow available to pay dividends. The company has built in an additional margin of safety by paying out just 85% of its free cash flow, providing a cushion for the dividend in case of a large tenant bankruptcy.

Realty Income's lease portfolio is structured to provide annual rent bumps of about 2%, which drops to shareholders' bottom lines quarterly in 0.5% doses. Once a year, management passes through earnings growth from portfolio acquisitions in a larger increase. Market conditions are far from optimal these days, but even a modest level of acquisition activity would be enough to round out our expectation of 4.5% annual dividend growth.

At a recent price of $25.24, Realty Income offers a well-protected yield of 6.5% and the prospect of annual total returns around 11%.

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