Realty Income stands tall with freestanding holdings

In the opinion of company CEO Tom A. Lewis, what most distinguishes Realty Income, an Escondido, Calif.-based real estate investment trust specializing in freestanding net lease retail properties, from its competitors is its in-house retail analysis department.

"We are a research-driven company," he states unequivocally. "We have three full-time retail analysts, whose sole job is to conduct a fundamental analysis of retailers and the retail industry."

Lewis considers Realty Income's in-house retail analysis department equivalent in scope and capability to the analytical divisions of Wall Street investment firms and major venture capital companies. The analysts examine the overall retail market, look to see which sectors have growth potential, then look for the individual retailers with the greatest likelihood of meeting that potential.

Such detailed attention to retail analysis has clearly paid off. When the 29-year-old company went public in 1994, the stock traded at $16 a share. Today it trades at $29.75, and Lewis reports the dividend has gone up each year. At the end of '97 Realty Income reported a record 156% increase in property acquisition dollar volume growth, and for the first quarter of '98 it reported a 189% increase in volume compared to the first quarter of '97. Today the company owns and manages a $750 million real estate portfolio consisting of 855 retail properties in 43 states.

Realty Income was founded in 1969 as a California corporation by William and Joan Clark, who put together an investment partnership to buy triple-net lease retail property. Between 1969 and 1992, the company formed a total of 22 partnerships, which controlled 628 properties and involved 68,000 individual partners.

The decision to go public in '94 was a more or less natural response to Realty Income's growth, according to Lewis. "Essentially we were quasi-public already," he remarks. "We served as a fiduciary to the partnerships. All partnerships were fungible and all properties were owned without debt. We never had a mortgage on any property."

Rather than issue an IPO, the company simply rolled the individual partnerships into a single entity and issued stock to the individual partners. Lewis says only a few hundred of the original 68,000 partners declined to participate. Today, he adds, the number of partners has shrunk to approximately 45,000, about 80% of whom have been with the company since it went public.

Although Realty Income's business technically entails real estate investment, Lewis says, in effect, the company functions as an investment bank.

"Most people look at us as a real estate company, but our customers would tell you we're a bank. Our real business is providing them expansion capital," he declares.

The way this works, he explains, is that Realty Income acquires properties in locations where a retailer wants to expand and offers them to the retailer on long-term leases. The sites are selected in concert with the retailer to ensure they meet the retailer's criteria, and the leases are arranged prior to acquisition to eliminate risk for Realty Income.

Lewis says the company traditionally has bought already-developed sites, but within the past year it has begun to acquire undeveloped sites as well and either develop them itself or hire developers to do build-to-suits. The change in strategy was prompted by both a shortage of developed properties that fit the criteria of Realty Income's client retailers and the desire to tie up prime sites before competing companies got hold of them.

Realty Income, he says, concentrates on retail categories that currently are dominated by mom-and-pop operators but that have begun to see the emergence of regional and national chains. In addition, the retailer focus should be on meeting basic human needs to ensure long-term viability.

"We want to find chains that have grown large enough to demonstrate the potential for success but not so large they need to look for increasingly more sophisticated strategies to find new markets," Lewis explains.

Despite the fact the market Realty Income targets consists almost entirely of less than investment grade retailers, Lewis says tenants rarely default on their lease obligations. "The default rate has been about 1.8%," he reports.

Working with a company like Realty Income has numerous advantages for the retailer. As Lewis points out, the company has a better debt rating than most of its retailer clients. It also has a $150 million unsecured line of credit. Consequently, he says, Realty Income can provide access to capital for clients unable to get money through more conventional means.

"When a retailer is a startup, it's hard to get capital. Once they prove themselves, Wall Street gives investment ratings, which then opens the doors to getting funded. But until then it is difficult for them to raise money," says Lewis.

Realty Income, however, does not need Wall Street ratings because of its in-house capabilities. "We do our own credit underwriting. Our retail research department does classic unsecured credit underwriting, and we have developed our own rating system," he says.

According to Lewis, the strength of the company's retail analysis department is matched by that of its real estate analysis department, which has the capacity to examine both general and specific sites and determine their appropriateness for a particular retailer.

Unlike most other net credit lease investors, which turn over their properties on a fairly steady rotation, Realty Income prefers to hold on to its real estate. "We do sell off if we see a neighborhood changing significantly, but we've sold only 80 buildings over our entire history," says Lewis.

About 80% of the time, existing tenants renew when their original leases come due, he says, and in the 20% of cases where they do not, the company has so carefully selected sites that finding replacement tenants willing and able to pay a viable rent has proved no problem.

Realty Income further insulates itself from risk, Lewis adds, by setting rents for most tenants at the low end of the market. For tenants with weaker credit, the rent is sometimes well below market. Although this reduces potential profit in the short run, in the long run it helps ensure that tenants can keep up with the rent even if they hit a difficult period.

All this means Realty Income tends to have slower growth in funds from operations than REITs involved in other areas of real estate. Returns to shareholders, however, have sometimes run quite high. For 1994 the total return to shareholders was 28.5%. In '95 it was 42%. On the other hand, returns for '96 and '97 ran 15.5% and 14.5%, respectively. The stock is currently trading about 11.3 x FFO. Lewis reports cap rates range from about 9.5% for the highest-grade tenants to 12% for the lowest. The average cap rate on new acquisition runs about 10.25%.

Over the next couple years, Lewis says the company expects to add another dozen or so retail categories to its repertory. Six categories were added last year and an additional three or four will be added in '98. Currently under examination are drugstores, supermarkets, movie theaters and shoe stores. "It's a matter of beefing up our research department," he says.

The CEO believes the growth potential for the net lease retail segment of real estate is exceptionally strong, and the company's growth backs him up. Realty Income went from $65 million in new acquisitions in '95 to $142 million last year. It did $51 million in the first quarter of this year, and Lewis anticipates going above $200 million by year's end.

"There are about eight REITs who invest in freestanding retail, but despite the impression given by the media, all together they own less than 1% of the total stock of this type of property," Lewis says. "A few small private companies also own some properties and occasionally you'll see a bank or insurance company, but the majority of buildings are owned by individual investors with fewer than a half dozen properties. So there's a lot of room for growth."

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