Realty Income (NYSE: O) has done a fantastic job of growing shareholder value over the years. The real estate investment trust (REIT) has produced a 14.1% compound annual total return since its public market listing in 1994. It has delivered that robust return by growing its portfolio, cash flow, and dividend payment.
The REIT has grown by investing shareholder capital into income-generating net lease real estate. It plans to leverage that expertise by bringing in private capital in a brilliant move that could grow shareholder value significantly in the future. Here's a look at this smart strategy.
Tapping into the massive private capital market
Realty Income has grown into a behemoth in the REIT sector over the last half-century. It's currently the seventh largest REIT in the world, with $58 billion in real estate assets in eight countries.
Despite its enormous size, it holds a small fraction of the commercial real estate market. The U.S. commercial real estate market is worth about $20.7 trillion. Currently, publicly traded REITs like Realty Income only hold about $1.9 trillion in real estate. That means 90% of the market remains in private hands.
Realty Income plans to tap into this massive opportunity by launching a private investment fund targeting institutional investors (i.e., pension funds, sovereign wealth funds, and insurance companies). The fund will focus on U.S. net lease properties that the company will initially seed with some it currently owns. It aims to grow the fund over time by bringing in new investors and acquiring additional properties.
That third-party capital will provide Realty Income with additional funding to pursue more acquisitions. The REIT sources more deals than it can close, which leaves opportunities on the table. For example, it has sourced $34 billion of potential transactions this year, only closing on $2.1 billion, or 6% of its sourced volume. It's highly selective, due in part to capital limitations.
A potentially enriching strategy
Realty Income would earn recurring fee-based income to manage this third-party capital. That fee-related income would enable the REIT to grow its adjusted funds from operations (FFO) per share at a higher rate in the future, because it would earn much higher returns on new investments made in the fund.
For example, Realty Income currently buys net lease properties at a 7.5% real estate cap rate. It funds those deals with 35% debt and 65% equity (all from shareholders). However, if it made the same investment in a fund, it would only need to invest 20% of the equity, with fund investors covering the remaining equity requirement to keep the same leverage level. The REIT would earn a 1% annual fee from managing the third-party equity investment.
This structure significantly enhances the deal's returns for Realty Income and its shareholders. The investment would have an effective cap rate of 10.1%, while the REIT's return on equity would improve from 8.8% on a stand-alone basis to 12.8% in the fund. In other words, every dollar of capital invested in the fund would generate a higher return for shareholders.
In addition to the higher growth rate and returns, Realty Income should also see a valuation boost, because the market values asset managers much more highly than it does REITs. For example, Realty Income currently trades at about 15.3 times earnings, which is a slight discount to the REIT sector average of 16.3x. For comparison, asset managers currently trade at 24.3x because fee-related income is so stable and high-margin. As the company scales its asset management business and fee-based income, its valuation should rise.
A brilliant way to create additional shareholder value
Realty Income is only capturing a small slice of the commercial real estate market, due in part to the limitations of the public markets. That's leading the REIT to launch a fund to tap the massive private capital market. This strategy will enable it to grow faster, earn higher returns, and potentially secure a higher valuation. That should help make its investors richer in the future by increasing their dividend income and the REIT's share price. Because of that, it looks like a very smart move by a company that has already done a fantastic job growing the wealth of its investors over the years.
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Matt DiLallo has positions in Realty Income. The Motley Fool has positions in and recommends Realty Income. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
