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

NEW YORK ( TheStreet) -- The declining cost of debt and equity has spurred companies to consolidate all the real estate they own and convert themselves into publicly traded real estate investment trusts.

Amplified by investors' demand for high-quality income, this trend has extended into all sorts of industries.

Take for example, Penn National Gaming ( PENN). The Wyomissing, Pa.-based gaming company announced last year that it was considering a plan to separate its gaming assets and real estate assets into two publicly traded companies.

One company, a REIT, would own Penn's real estate assets. The other, the casino operating company, would lease the real estate from the REIT under what is known as a "triple-net" lease.

In such a lease, the tenant pays rent on the property, as well as net real estate taxes, net building insurance and net common area maintenance.

In Penn's case, the REIT would also lease some real estate assets to other tenants.

As of November 2012, Penn Gaming operated 29 facilities with around 36,800 gaming machines, approximately 850 tables, 2900 hotel rooms, and approximately 1.6 million square feet of gaming floor space.

Other new REIT subsectors that are being driven by long-term triple-net leases include data storage, billboards, cell towers, prisons, farms (even possible solar farms) and document storage.

Over the last year, REIT-dom has seen an array of new publicly-listed entrants including Spirit Realty ( SRC), American Realty Capital Properties ( ARCP), Healthcare Trust of America ( HTA), CyrusOne ( CONE), Gladstone Land Corp. ( LAND) and W.P. Carey ( WPC).

Other companies that have announced plans to convert to a REIT include Iron Mountain ( IRM), Equinix ( EQIX), Lamar Advertising ( LAMR) and CBS Corp. ( CBS).

Elsewhere in the REIT world, Cole Credit Property Trust III announced that it had executed a definitive merger agreement to acquire Cole Holdings Corp. Both companies are private, but the combined entity will go public, taking the ticker symbol COLE.

Timing looks good for this Phoenix-based nontraded REIT as the majority of the 1,014 properties (in 47 states) are pure single-tenant buildings (49%), while the other properties are made up of multitenant retail (18%), single-tenant office (17%), single-tenant industrial (7%), debt (4.8%) and joint ventures (2.8%).

With debt and equity capital at record lows, Cole has hit the market perfectly as the two companies intend to combine the management platform -- consisting of $12 billion of assets (managed) and 160,00 individual investors -- and the nontraded REIT, which has around 43.1 million square feet in 47 states (99% leased).

I'm Bullish on the Triple-Net Sector, Especially the Monthly Dividend Company

I'm bullish on the entire REIT sector, especially the triple-net-lease REITs: Realty Income ( O), American Realty Capital Properties, W.P. Carey, National Retail Properties ( NNN) and EPR Properties ( EPR). They offer the best value thanks to the high level of earnings-accretive acquisitions.

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.

Many companies today (REITs and non-REITs) are hoping to be like Realty Income; however, the well-balanced REIT has become the "gold standard" in the broader net-lease sector. Realty Income owns more than 3,500 stand-alone properties and due to its cost-based advantage, the company has been able to exploit all of the potential cost drivers that allow for greater efficiency in the company's overall value-add proposition.

This company benefits from its low cost of capital, it very experienced management team, its discipline, its history of 19 years of consistent and increased dividends, and its attractive valuation metrics.

With growing demand in REIT-dom, the marketplace is becoming littered with cheap REITs that are trying to be like "The Monthly Dividend Company." Some REITs have already crashed ( TriNet, US Restaurant Properties, CNL) because they had to compromise their balance sheets and underwriting to be competitive. Others are still trying to carve out a niche.

Realty Income has paid dividends every year since going public in 1994, and raised them for 19 years in a row. The company recently raised its monthly dividend by 19% to 18.09 cents a share following the completion of the acquisition on American Realty Capital Trust. This was the highest increase in distributions done by the monthly dividend company. The new annual dividend at the current rate is at $2.171 a share.

Realty Income has a current market cap of $8.90 billion, and the current common share price is $45.90. (The 52-week high was $46.65 on March 5). The company's year-over-year total return is 30.15%, and the current dividend yield is 4.73%.

Source: SNL Financial, FAST Graph.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Brad Thomas is the owner/editor of The Intelligent REIT Investor. Under no circumstances does this information represent a recommendation to buy, sell or hold any security. Thomas is also a licensed real estate agent with Bull Realty in Atlanta, GA. He is Managing Director where he advises individual and institutional investors on a variety of commercial real estate related acquisitions. dispositions, and capital markets transactions.

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