Description

Description

Realty Income (O) is triple net lease REIT that presents an excellent instrument to short commercial real estate, corporate defaults and a deep US recession.

For background on Realty Income please see the excellent write up by msdonut940 on 12/27/2007.  msdonut940 recommended a short in December 2007 with the stock at $28.60.  Today at $23.15, Realty Income is still a good risk adjusted short opportunity.  

Short Thesis

Mis-pricing of Realty Income Capital Structure

Realty Income equity is aimed primarily at retail investors who are focused on receiving a monthly dividend.  The company prides and sells itself as “a monthly dividend company” and the whole investor relations focus is directed to retail investors.  I don’t think issuing a monthly dividend warrants any premium but retail investors and the company’s focus on increasing the dividend multiple times a year for less than a fraction of a cent each time builds the false halo of safety. 

This retail investor base focused on dividend growth has created the perfect instrument to short commercial real estate and indirectly corporate defaults/distressed.  The investor base is focused only on dividends and looks at Realty Income as basically a supercharged savings account paying 7% dividend without looking at risk of capital.

Realty Income Capital Structure

Realty Income capital structure has inverted with its senior bonds trading at 12% YTM, its preferreds trading at 10% current yield and its equity trades at 7% dividend yield.  While its long dated bonds trade at 50-60 cents on the dollar it equity is trading only down about 20% over the last year. 

The credit markets for Realty Income and commercial real estate in general is basically frozen.  It is very unlikely O will be able to raise any new debt funding or sell properties as buyers have minimal to access to capital.  I don’t think the equity holders in O have any idea where its credit trades at or what its holdings of real estate are worth.  They are still operating under the assumption that O is an investment grade company issuing 5.875% 30 year paper. 

[Long O bonds short the equity is an interesting capital structure trade.  It’s negatively biased and has positive carry.]

Asset Valuation has Declined

There is a retail investor myth that since O owns properties without underlying mortgages it is immune from destruction in CMBS.  O via its capital structure has recourse debt instead of non-recourse mortgage debt. The maturity schedule for the corporate debt of O is favorable for the company with no near term maturities.  But the destruction CMBS has to negatively affect the prices of O underlying 2,200 properties.  O cannot sell properties anywhere near the cap rates the equity is currently valuing it at. 

O’s web site lays out 2008 versus 2007 financial metrics and every metric other than dividend is declining or negative!!! http://www.realtyincome.com/investing/summary_information.html

Corporate Default Optionality

O indirect credit risk to the consumer economy has significant upside to a short position in the equity.  As the consumer and macro economy deteriorates there will be increased corporate defaults.  These defaults will lead to restructuring of leases over the 2009-2011 timeframe.  These restructurings should result in occupancy rates declining below 96%.  The triple net lease business model is high leveraged to occupancy rates – any decline in occupancy will directly impact FFO/AFFO and more importantly O’s dividend.   msdonut940 discusses the likely default of Buffets.  Buffets has since filed for bankruptcy and renegotiated some leases with O.  However, the Buffets bankruptcy has been an unmitigated disaster for distressed investors.  Buffets DIP trades at 20 cents on the dollar and it is very likely Buffets is liquidated in CH 7. 

Given the state of the consumer economy, CMBS markets, corporate credit spreads/defaults and the lack of a DIP market.  I don’t see anything positive for the credit risk imbedded in O portfolio.

Love the Retail Investor Base

The retail base is oblivious to all the issues raised above as long as the dividend is paid.  The best thing about O is none of the credit and liquidity events of 2008 have been priced in.  The stock price has minimal negative expectation built into it unlike O’s corporate bonds which have declined 30 plus points since September 2008.  As defaults in leases increases, declining occupancy, declining FFO/AFFO, declining asset value and the recession impacts O performance through 2009-2011 the dividend will be cut. 

The transition from retail to value in O equity will be very ugly.  Will any value investor buy O equity for 7% dividend yield when one can buy senior bonds for 12% YTM?

Risk

Irrationality of Retail Investors

This company has issued shares at $26 with under a 7% dividend yield in September 2008 to raise capital.  If this management draws on the revolver/credit facility or some how manages to increase dividends by 1/10 cent the retail base might be more tempted by 7% dividend paid monthly versus a checking account paying 0% interest and have no regard for safety of principal.  The company is serial issuers of equity and would use any pop in equity price to issue new equity. 

In an irrational market in which O trades at 7% dividend yield versus 12% YTM for its corporate debt there is no reason why the stock in the short term cannot trade at 5% dividend yield. 

Hedging the Short Position

I use O primarily as a hedge to offset a higher current yield portfolio of distressed/high yield/cross over corporate bonds trading at substantial discounts to par. 

Catalyst

Reality of the recession is priced into Realty Income’s operating results and dividend.

Catalyst