Realty Income Stock Is A Buy For Its Inflation Protection (NYSE:O)

Realty Income Corporation (O) has consistently produced annual adjusted funds from operations growth in excess of 5% and has been able to increase earnings-per-share during the Great Recession. The acquisition of VEREIT last year is said to be AFFO accretive and will lower the REIT’s costs in the future. Realty Income is a consistent source of dividend income, and despite rising inflation, the REIT can deliver strong total returns.

Acquisition of VEREIT Is A Game Changer

In 2021, Realty Income made a game-changing acquisition. Realty Income, which primarily invests in net lease retail properties, made a bid for another commercial real estate investment trust, VEREIT, in 2021, and the acquisition will result in significant synergies in Realty Income’s portfolio, improved REIT diversification, and increased adjusted funds from operations.

VEREIT was a single-tenant REIT that made significant investments in the retail, restaurant, office, and industrial real estate sectors. Because of the unique structure of rental contracts, some trusts are referred to as ‘net lease’. Tenants are required to pay property expenses such as maintenance, taxes, and insurance under these contracts. The triple-net lease structure significantly simplifies the business for landlords by effectively shifting all costs to the tenant who leases a (commercial) property.

The merger of Realty Income and VEREIT was completed in November 2021, with VEREIT shareholders receiving 0.705 shares of Realty Income common stock for each share of VEREIT common stock.

Realty Income has a history of acquisitions, with the REIT frequently acquiring more than a billion dollars in new properties each year. The VEREIT acquisition, on the other hand, is a different animal, owing to Realty Income’s immediate acquisition of VEREIT’s more than 3,800 properties. The merger of Realty Income and VEREIT has resulted in the formation of a new trust with a $50 billion enterprise value, over 10,000 properties, and $2.5 billion in annual contractual rent. After accounting for property dispositions, the VEREIT acquisition will add $0.8 billion to Realty Income’s pre-transaction contractual rent.

The merger of the two real estate investment trusts significantly improves Realty Income’s diversification mix. Because both companies are in the retail landlord business, the merger will have significant synergistic effects. As industry and tenant concentrations decline, the combination of real estate portfolios will also stabilize rental cash flows.

To give just one example, Realty Income’s top ten tenants account for 36% of the trust’s rent prior to the transaction. Following the merger, these tenants will account for only 31% of Realty Income’s revenue. The lower the percentage of tenant concentration, the less risky Realty Income’s cash flows are.

Realty Income will benefit from cost synergies in the range of $45 to $55 million per year as a result of the merger, which is critical to the trust’s projection that the acquisition will be accretive to adjusted funds from operations. On a leverage-adjusted basis, Realty Income anticipates at least a 10% increase in adjusted funds from operations from the acquisition in the future.

The acquisition increases Realty Income’s AFFO potential in the future by allowing the trust to collect rental income from a larger, more diverse portfolio. The acquisition also contributes to Realty Income’s already impressive track record of generating market-independent adjusted funds from operations growth. In the last twenty-four years, Realty Income has grown adjusted funds from operations at a rate of about 5% per year. During the pandemic, Realty Income’s AFFO growth rate was 5.1%, and past portfolio acquisitions have also contributed to the trust’s growth.

During 2020, the quality of Realty Income’s portfolio really shone through. Despite significant uncertainty about lease payments during the Great Recession, Realty Income outperformed its peers by generating 2.1% earnings-per-share and 3.1% dividend-per-share growth. The outperformance of peers is due to Realty Income’s portfolio strategy of focusing on long-term lease contracts with tenants who have strong cash flow and credit ratings.

The Number One Reason To Invest In Real Estate Income Right Now: Inflation Protection

While the acquisition of VEREIT is truly transformative and creates the industry’s leading net lease trust, anti-inflation features are an even stronger reason to buy Realty Income.

Realty Income invests in real estate to create an inflation-protected business model. Real estate values rise in tandem with inflation rates, providing inherent protection against rising consumer prices. Inflation rates are currently at their highest in decades, posing a serious problem for investors: how do you protect yourself from a loss of purchasing power?

Inflation erodes purchasing power, which means that during periods of accelerating inflation, every dollar not invested loses value. Because the trust’s contracts include rental escalators, Realty Income’s business model provides inflation protection. The vast majority of Realty Income leases (85%) include some form of inflation protection.

Inflation protection is also provided by the trust’s consistent dividend growth. Realty Income has been increasing its dividend since the 1990s, and it is highly unlikely that the trust will stop increasing its payout anytime soon. Realty Income has increased its dividend during all of the last three decades’ crises, and even higher inflation is unlikely to change the trust’s track record.

Preliminary Guidance And AFFO Multiple

According to preliminary guidance issued in November, Realty Income expects $3.84 to $3.97 in adjusted funds from operations in 2022. This AFFO per-share guidance assumes a 17.8 AFFO multiple and 9.2% AFFO growth YoY. The trust’s AFFO is expected to grow 9.2% YoY due to the merger with VEREIT and $5 billion in anticipated property acquisitions this year, which is significantly higher than the long-term average growth rate of around 5%.

My Conclusion

Realty Income’s growth in the retail property market is underpriced, given that the REIT’s acquisition of VEREIT results in a trust that is more diversified, has lower operating costs due to synergies, and has the potential to grow AFFO above long-term rates. The hidden benefit of Realty Income is the inflation protection provided by its rental contracts and dividend growth.