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.
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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.
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.
