peshkov
Realty Income Corporation’s (NYSE:O) three biggest tenants are:
Walgreens (WBA) Dollar General (DG) Dollar Tree (DLTR) / Family Dollar.
And what do all three of these companies have in common?
They have all three suffered some terrible news lately, and it is not a good look for Realty Income.
Walgreens recently announced that it was going to shut down up to a quarter of its stores as part of a “company-wide strategic review” and this caused its share price to crash to a multi-year low. Some analysts now claim that the company could face bankruptcy in the future, just like its peer, Rite Aid, which filed for Chapter 11 last October. This reminds me that VICI Properties’ (VICI) CEO told me this back in 2021 in an exclusive interview:
“If you look at drugstores, you have to ask the question: once Amazon gets truly serious about being an online pharmacy, what’s the impact on Walgreens or CVS (CVS)?”
Net Lease Advisor
Data by YCharts
Similarly, Dollar Tree / Family Dollar plans to close 1,000 stores in the near term. More specifically, they plan to shut 600 Family Dollar stores this year and an additional 400 under both banners in the coming years as their leases gradually expire. We recently interviewed Agree Realty’s (ADC) CEO, and we asked him what he thought about Dollar Tree’s plan to sell Family Dollar. His response was simply, “Hah. Good luck,” and this really embodies the struggles that the company is facing. Many of those stores are losing money, they are often stuck under long-term leases, they have been underinvested, and the competition is only growing bigger from Amazon (AMZN) and other offline discount stores. Their rival, 99 Cents Only, filed for bankruptcy earlier this year, citing shifting consumer demand, inflation, and theft as some main reasons for its demise:
Net Lease Advisor
Data by YCharts
Dollar General is today doing a lot better than its rival, but there are also growing concerns right now, and its share price has crashed by 50%+ over the past two years. Its profitability has been crashing because of the high inflation weighing down on the consumer. But the bigger long-term concern for me is that Walmart (WMT) could be going after Dollar General’s business. Historically, Dollar General has done well because it would open small shops in less competitive areas. In our interview with Agree Realty’s CEO, he explains that:
“Dollar General is the food supplier to rural America. It’s literally the sole general store in areas with zero competition from other retail. They build at least 15–20 miles from the nearest Walmart and are an essentials provider to rural Americans.”
But this could change in the future. Walmart and others are working hard on grocery delivery, and they are also developing smaller store concepts to bring the fight to Dollar General. My fear is that Walmart would win this battle because they have a much larger scale, more power with suppliers, and this allows them to offer even lower prices.
To be clear, I still expect Dollar General to do fine over time. However, it would not surprise me if it experiences growing struggles that force it to close some stores down the line, and from a real estate perspective, there is little to like about these properties. They are located in rural markets with often declining populations, and the build quality is poor as well.
Here’s what VICI’s CEO said to me in a previous interview when comparing the quality of their casinos to those of Dollar General net lease properties:
“Caesars Palace (CZR) in Las Vegas was built in 1966 and it is as vital a building as ever. The Venetian was built like the freakin pyramids of Egypt. I mean that asset will be there forever. You know, the Chinese use the term 1,000-year assets. Who knows if it’s truly here in a thousand years, but this is what the Chinese mean by 1,000 years.
Not to disparage the Dollar Generals, but those are built to last maybe 15 or 20 years. And then, you know what? Knock it down and start over. It was cheap to begin with.”
Put simply, Dollar Generals are poorly located, and cheaply built, and so their value relies heavily on the lease with Dollar General. If you lose this lease, the value of your property crashes, and this makes these properties very risky net lease investments. That explains why they typically also trade at relatively high cap rates:
Realty Income
Data by YCharts
All of this is a bad look for Realty Income.
Historically, it has been perceived as a “high quality” net lease REIT, but today, its top 3 tenants are facing issues and its biggest investments are in pharmacies and dollar stores, which most people would consider as “low quality” net lease investments.
But is this on its own enough of a reason to sell Realty Income?
The answer is no.
Realty Income is well diversified, it enjoys long leases, and it generally owns better than average properties, which are less likely to be shut down.
But it is not something to ignore either. Combined, these three tenants make up ~10% of the company’s rental income. Moreover, Realty Income also has other struggling companies like AMC Entertainment (AMC), Red Lobster, and CVS (CVS) in its top 20 tenants.
I believe that it reaffirms my previous point that Realty Income’s portfolio quality has degraded over the years following their many M&A deals, acquiring lower-quality net lease peers like Vereit and Spirit Realty Capital. This is also evident if you compare Realty Income’s occupancy rate to that of its close peers. It is today among the lowest in the net lease peer group and could drop lower in the coming years if it faces more tenant difficulties:
Occupancy Rate Realty Income (O) 98.6% VICI Properties (VICI) 100% Agree Realty (ADC) 99.8% NNN REIT (NNN) 99.5% Essential Properties Realty Trust (EPRT) 99.9% Click to enlarge
Therefore, Realty Income should not be compared to Agree Realty and other high-quality net lease REITs anymore, and it deserves to trade at a discounted valuation relative to them.
This is the case today, as Realty Income is trading at a 2-turn lower valuation than Agree Realty.
But am I buying shares of Realty Income?
I am not.
I have owned it in the past and would be willing to own it again, but the discount relative to Agree Realty would need to be larger than that.
Agree Realty enjoys many advantages that warrant an even larger premium in my opinion and therefore, I would rather buy more shares of Agree Realty instead:
FFO Multiple Realty Income (O) 13.6x Agree Realty (ADC) 15.8x Click to enlarge
These advantages have resulted in significant outperformance over the past decade and I expect this outperformance to continue because these advantages still aren’t properly factored into the company’s valuation:
Data by YCharts
But it is fair to say Realty Income is not particularly expensive right now either, and I expect it to do relatively well over time.
I just think that some of its peers will do even better.
I give Realty Income a Buy rating and Agree Realty a Strong Buy.
GIPHY App Key not set. Please check settings