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Realty Income – Capture Yield Without Buying the Common Stock

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realty-incomeDuring the recent rise in interest rates, the negative price performance of bonds and the common stocks of mortgage REITs and equity REITs has received a lot of attention. What’s received less attention, however, is the selloff that’s occurred in many preferred stocks. In recent weeks, I’ve found myself purchasing a number of preferred stocks, one of which I would like to introduce in this article.

Realty Income is a REIT that, through Q2 2013, owns 3,681 properties in 49 U.S. states (not in Hawaii) and Puerto Rico. The properties are typically freestanding buildings and are leased to nearly 200 companies. The leases are usually triple-net leases with 15 to 20 year terms, and the current weighted average remaining lease length is approximately 11 years. A triple-net lease puts the onus of paying for taxes, insurance, and maintenance on the tenant. Through the second quarter of 2013, the portfolio’s occupancy rate was 98.19%, and its top 15 tenants by rental revenue were as follows:

Realty Income - Tenant Diversification

The approximate leasable square feet in Realty Income’s portfolio is 58,346,000, with Texas, Ohio, and California occupying the top three positions. In terms of rental revenue, California and Texas hold the top two positions by a long shot at 10.6% and 9.6% of revenue respectively. Florida is in third at 5.6% of rental revenue. Additionally, in terms of industry diversification, retail industries comprised 77.7% of the portfolio’s rental revenue as of June 30, 2013. While 77.7% is quite high, it should be noted that the number is down from 86.7% at the end of 2012 and down from 98.3% at the end of 2009. Finally, in addition to a large and relatively well diversified portfolio of properties and tenants, Realty Income’s revenue, net income, and Funds from Operations (FFO) are growing strongly. For the six months ending June 30, 2013, revenue growth was 58.07% (to $355.46 million), net income growth was 53.09%, and FFO increased 67.99%.

At this time, Realty Income has two Classes of preferred stock available for purchase. The Class E shares were issued in 2006 and are already callable at the discretion of Realty Income at $25 per share. It is the Class F shares, however, that I recently purchased. Those shares are cumulative preferreds paying cash dividends at the rate of 6.625% of the $25 per share liquidation preference. That amounts to $1.65625 per share per year. Also of interest is that Realty Income’s preferred shares, like its common shares, pay dividends monthly. The Class F preferred is callable after February 15, 2017 at a price of $25 per share and is callable prior to February 15, 2017 only under two conditions: (1) to preserve the company’s status as a REIT and (2) upon a Change of Control, as defined in the prospectus supplement. Additionally, there is no stated maturity date, and the dividends are not eligible for preferential dividend tax rates. On May 8, 2013, as the spike in interest rates was just getting started, Realty Income’s Class F preferred shares (symbol O/PF, O-PF, O prF, etc.) hit a 52-week high of $27.85. On August 20, shares touched a 52-week low of $24.00, down 13.82% from the May high. At $24.00 per share, the Class F preferred yielded 6.90%. If you are the type of preferred stock investor who only likes to purchase shares trading under their liquidation preference, that opportunity now presents itself in Realty Income’s Class F preferred.

Before concluding, for those income-focused investors who like to remain further up the capital structure than the preferreds, I’d also like to make you aware of Realty Income’s July 2013 issuance of 10-year notes. The August 1, 2023 maturing senior unsecured notes, CUSIP 756109AP9, have a 4.65% coupon, pay interest semiannually, and are rated Baa1/BBB+ by Moody’s and S&P respectively. Moreover, the notes have a make whole call at the Treasury Rate plus 30 basis points. Despite being senior unsecured notes, it is important to be aware that because the notes are not guaranteed by any of Realty Income’s subsidiaries, they are structurally subordinated to the liabilities of Realty Income’s subsidiaries. Finally, there is no change of control provision attached to these notes. For additional details, including, but not limited to, “Key Financial Covenants” and “Risk Factors,” refer to the prospectus supplement.

If you are searching for securities that have the potential to provide significant capital appreciation, Realty Income’s preferred stock (and senior unsecured notes for that matter) is likely not for you. But if you are looking for reliable fixed income at a respectable yield and credit risk, meant to serve as one piece of a diversified income portfolio, then Realty Income’s Class F preferred shares are worth considering.

Please keep in mind that this article is for informational purposes only and not a recommendation to buy or sell any securities. Only you can decide if taking the counterparty risk of investing in individual securities is right for you.

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