Investors looking to build an income portfolio should spend some time looking at the real estate investment trust (REIT) sector. While the sector has had its ups and downs during the COVID-19 pandemic, several companies have been able to weather the storm without cutting their dividends.
One of the most reliable REITs out there is Realty Income (NYSE:O), which has over a 50-year track record of performance throughout the entire economic cycle. If I were looking to start an income portfolio, Realty Income would be the stock I would start with.
REITs are a special type of company that's exempt from paying corporate income taxes, provided they invest in real estate assets and distribute the vast majority of their earnings as dividends. This means they generally pay above-market dividend yields. The basic business model is simple: Invest in real estate (for example, shopping malls, office towers, apartments) and then rent out the units.
Triple net leases vs. gross leases
Realty Income invests in single-tenant buildings and is known for the type of lease it offers tenants: the triple net lease. Triple net leases are different from gross leases, which are the most common lease type. An example of a gross lease is an apartment contract; it's a short-term agreement in which the landlord is assigned responsibility for all the maintenance, taxes, and insurance in exchange for a monthly rent check.
Triple net leases, on the other hand, require the tenant to cover taxes, maintenance, and insurance. These leases have much longer terms -- often five to 10 years -- and contain automatic rent increases.
Realty Income serves tenants that have the financial wherewithal to accept that type of financial commitment, and those tenants are often in highly defensive industries. A drugstore is much more insulated against a changing economy than, say, an apparel store subject to fashion trends and discretionary spending.
Realty Income's tenants are less sensitive to the economy
Realty Income's biggest customers are dollar stores, drugstores, and delivery companies. During the COVID-19 pandemic, most Realty Income tenants have been considered essential businesses and permitted to stay open. While Realty Income did have some exposure to fitness centers and theaters, most of its tenants made rent during the pandemic.
Realty Income raised its dividend in 2020
Realty Income's resilience during the pandemic allowed the company to raise its dividend when most REITs were cutting theirs. In fact, Realty Income raised its dividend twice during 2020. The company's record of steadily increasing dividends makes it a Dividend Aristocrat -- a rare group of companies that have raised their dividends for 25 consecutive years.
Note that Realty Income pays a monthly dividend and has trademarked its moniker "The Monthly Dividend Company."
REITs generally don't trade based on their earnings per share (EPS) like most stocks. Since REITs are invested primarily in real estate, they have a lot of noncash depreciation and amortization charges, meaning EPS understates the company's true cash flows. REITs use a measure called funds from operations (FFO), which is the equivalent of EPS. Other REITs like Realty Income also use adjusted funds from operations (AFFO).
A core holding for an income portfolio
Last year, Realty Income earned $3.39 in AFFO per share, compared to $3.32 per share in 2019, and was one of the few REITs that reported increases in earnings during 2020. This gives the company a multiple of just under 21 times FFO per share, which is a reasonable multiple given where interest rates are. The dividend yield of 4% is not the highest in the REIT sector, but it is certainly one of the most stable.
Realty Income is one of those stocks that would make a solid core holding for an income portfolio. The company's business model is easy to understand, and it has a demonstrated track record of success throughout a variety of economic challenges.
It won't necessarily be a high flyer, but that isn't its purpose: Realty Income provides steady monthly dividends and has been raising its dividend annually for at least the past 25 years. That is something an income investor can depend on.