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Amid Triple-Net REIT Craze, Realty Income Corp. Stands Alone

For all REITs the cost of capital is the "secret sauce" to investing, so it's important to examine the both the debt and equity details. When examining the cost of equity it's important to remember that the higher the price-to-funds from operations ratio, the lower the cost of capital: That translates into bigger margins. (Remember: The P/FFO ratio is to REITs what the price-to-earnings ratio is to stocks.)

Take for example Realty Income. The company's high P/FFO of 19.8 makes it the "low-cost producer," and that means higher profits and higher margins.

Think of it in a historical sense: The industrial model that is the low-cost producer always wins. Wal-Mart Stores (WMT), The Hershey Company (HSY) and Southwest Airlines (LUV) are all repeatable business models that are differentiated by their low costs.

It's easy to see why all of the triple-net REITs are competing with companies like Realty Income. But because the others have lower valuations, they have higher costs of capital. In other words, the others utilize more expensive equity and debt, and that's why Mr. Market sees the higher capital costs that gives them lower valuations.

Realty Income has a current P/FFO of 19.8, and all of the peers, except W.P. Carey, have P/FFO ratios less than 19.0. This means that Mr. Market sees value in the shares of "The Monthly Dividend Company" and although the current price ($45.90) is not a bargain, the company is trading at moderate valuation levels (compared with its peers). And compared with Realty Income's current dividend yield of 4.73%, I would argue that the shares are fairly valued.

Of course, the best indicator for dividend investors is the sustainability fundamentals, and that is especially true for the triple-net REITs. It's no fluke that Realty Income, National Retail Properties, and W.P. Carey have never cut a dividend. In fact, all three companies have increased their annual dividend while never cutting it once.

I heard an old saying when I was growing up: "The raised nail gets hammered." It's plain to see that Realty Income has built its success on investing in long-term contractual leases, and I'm sure that's why we're seeing strong growth in this bond-like sector. However, remember that simply investing in a triple-net REIT does not guarantee success.

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