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Lewis: Realty Income Aims to Deliver Returns in “Excruciating” Yield Environment

Lewis: Realty Income Aims to Deliver Returns in “Excruciating” Yield Environment

Realty Income Corp. describes itself as “The Monthly Dividend Company”, and the Escondido, Calif.-based REIT has paid more than 503 monthly dividends to its shareholders—most of them retired Americans.

The company, which invests in net lease assets, was founded in 1969 by Bill and Joan Clark with the simple goal of owning commercial real estate under long-term leases with companies to generate monthly income. Their idea was that investors could use this monthly income to pursue their dreams and perhaps achieve financial freedom.

Realty Income’s monthly dividend, which was increased earlier this year to an annualized dividend amount of $1.7535 per share, is supported by lease revenue from over 2,600 properties. The REIT’s consistent and growing dividend has caught the attention of yield-hungry investors. It’s currently trading at about $42—about 55 percent above its 52-week low of just more than $27.

Under the guidance of Vice Chairman and CEO Tom Lewis, the $5.6 billion market cap REIT implemented a new strategic plan that takes advantage of the liquidity it created during the credit crisis and emphasizes investment-grade tenants and non-retail properties.

Lewis, who joined Realty Income in 1987 and served in a variety of executive positions before assuming the CEO role in 1997, sat down with NREI to talk about how the REIT weathered the credit crisis, its new strategy and the attention it’s getting from baby boomers.

An edited transcript follows.

NREI: How have things changed for Realty Income since the credit crisis?

Tom Lewis: The period since the credit crisis has turned out to be excellent for Realty Income. It has been a very good time for the company to make acquisitions. We were well prepared—and that was a strategic decision.

We often talked internally about how credit based the boom was and how long it could go on. In 2007, we started seeing things in the market that convinced us that an event was coming, and we started taking action to put ourselves in a very liquid position.

We thought, “If we’re right, we’ll be in good shape, and if we’re not, we’ll still be fine, just a little too liquid.” In 2007, we liquidated one of our subsidiaries that held non-strategic assets and raised $550 million.

In early 2008, we got a new $355 million credit facility and raised another $100 million in equity. That allowed us to jump out very quickly in 2009 and make some acquisitions. Since the credit crisis, we’ve made $2 billion in acquisitions. Last year, we bought $1 billion, and we’ve told the Street to expect $650 million this year.

NREI: Realty Income has a long track record of increasing its dividends. How is the current economic environment impacting your ability to do so?

Tom Lewis: We’ve now paid 503 consecutive monthly dividends. And, we just raised our dividend last month—the 59th quarter in a row that we’ve done so. Historically, we’ve raised our dividend four times a year, and we like to pay out 86 to 87 percent of our cash flow.

We think our dividend growth should accelerate due to our acquisitions. It’s a very profitable time for our company to make acquisitions because the cost of capital has dropped so dramatically.

We have long-term leases, and the spread between what money costs us and the yield that we can achieve when we invest it is the widest in history. Our mission is to pay monthly dividends that go up over time. Everything we do starts there and flows back to the assets and the cash flow they generate to pay the dividends.

NREI: Have you noticed a shift in the type of investors who are attracted to and interested in investing in Realty Income?

Tom Lewis: The credit crunch really taught investors a big lesson about risk, and investors today are much more risk averse and more yield-oriented. In fact, I’d say they’re starving for yield.

For retired people who are trying to replace their salaries, this yield environment is excruciating. In the past, they would have turned to CDs, money-market funds and bonds, but in this environment, there is very little yield to be found in those traditional vehicles.

If you look at our stock, it’s been on a run this year because we’re very attractive to investors seeking yield. We have always attracted retired investors, and as the baby boomers enter retirement in large numbers, we’re all that more attractive. It’s funny because 15 years ago when baby boomers were in their peak earnings years, there wasn’t anything we could do to get their attention.

NREI: What is Realty Income focused on from a strategic standpoint?

Tom Lewis: We’re definitely focused on acquisitions, but our strategy has changed significantly.

When the credit crisis occurred, we were just beginning a new strategic planning session. We spent eight months looking at the last 20 to 30 years of our company, our previous strategy and putting our past performance in context. We ended up focusing on three things: 1) everything we ever bought was retail and non-investment grade; 2) for 30 years interest rates have been going down; and 3) reviewing our tenants and their industries.

Our decision to purchase only retail net-lease assets was driven by the great GDP growth that our country experienced, which led to great personal income. Baby boomers were in their peak earning years, and it was a great time to be a retailer.

But, when we looked out at the next 20 years, we saw that GDP was going to be more muted, as would personal income. Baby boomers have moved out of their peak spending, and the consumer is levered up. We think the experience in retail over the next 20 years is likely to be more muted. We think upper income consumers will be fine; middle income consumers will have less discretionary spending; and lower income consumers will be very stressed. We decided that we don’t want to be with retailers that sell discretionary goods to low income consumers.

NREI: What else has informed your strategy?

Tom Lewis:We also decided that we wanted to go up the credit curve and work with investment grade tenants. We realized that in order to do that we would have to work with the Fortune 1000, and their assets would not be retail.

We like industrial, manufacturing, distribution and agricultural assets quite a bit and are less interested in office. Since implementing this new strategy, we’ve purchased about $1.2 billion in non-retail assets, about $1 billion with investment grade tenants.

We did our first investment grade transaction with Diageo [the global alcoholic beverage firm], paying $300 million for wineries/vineyards in California’s Napa Valley and leasing it back to the company for 20 years. Diageo is an investment-grade rated credit and now represents about five percent of our revenues.

Over the last year, we’ve done work with FedEx, Boeing, Caterpillar, International Paper, and Coca-Cola. Today, our portfolio is 18 percent investment grade, and we expect that in three to five years, 60 to 70 percent of the portfolio will be leased to investment grade tenants.

NREI: How do you deal with the interest rate environment?

Tom Lewis: When you’re in an environment of constantly decreasing interest rates, everything is about financial engineering and using debt. In this environment, even marginal business models can survive because they use leverage.

Basically, the decreasing interest rates acted like wind at our backs. Looking forward, however, those companies that need leverage to survive will be in a different environment if and when interest rates increase. For us, that means that our tenant default characteristics might be different than in the past based on how dependent our tenants are on debt.

Finally, we re-underwrote every industry and tenant we had in our existing portfolio. We rated every asset as a strong buy, buy, hold and sell. About 21 percent of the portfolio was in the sell category and about 16 percent was in the hold category. We started this January with planned property sales of about $121 million, and we’ll probably sell $300 to $500 million to over the next three to five-year period.

NREI: What are the biggest opportunities and challenges for Realty Income today?

Tom Lewis: Right now there’s a window of opportunity to take advantage of the low cost of capital. There’s a 220 basis point difference between the cost of capital and the cap rates today. This environment is a product of the Fed and its monetary policy, so it won’t last forever. If we get some inflation, the window will close. We have to make sure that we’re running as hard and fast as we can during this window.

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