Why You Should Love the Realty Income Deal As Much As Luxor Capital

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Luxor Capital Partners bumped its ownership of American Realty Capital Trust Inc (NASDAQ: ARCT) in early January, as shareholders of the REIT were still in debate over whether or not to accept Realty Income Corp (NYSE: O)’s acquisition offer. Luxor Capital and Christian Leone made American Realty one of its newest holdings during the third quarter, and with the early January purchase doubled its stake from 7.8 million shares to 16.5 million. Luxor now owns 10.5% of the REIT and was a big supporter of the buyout offer from Realty Income. Shareholders approved the deal, with the details being a $0.35 per share cash payment and 0.2874 shares of Realty Income for American Realty shareholders. Billionaire investor Ken Griffin, founder of Citadel Investment Group, also added American Realty to his portfolio in 3Q (check out Griffin's biggest bets).

Luxor has been finding other intriguing values in the REIT industry. Commonwealth REIT (NYSE: CWH) is Luxor’s newest REIT addition after adding the stock to its portfolio in late-2012. The office REIT pays one of the highest dividend yields in the industry at 6.3%. It is heavily weighted toward office space and as a result is down 35% since its mid-2010 IPO, due to the fact that the office property industry has been struggling on the back of a poor economy (see more on Luxor's Commonwealth pick).

American Realty has been focused on building up a portfolio of commercial real estate, primarily operating freestanding single tenant properties net leased to tenants on a long-term basis. Realty Income operates with similar principles; acquiring and owning freestanding retail and other properties that generate rental revenue under long-term lease agreements. American Realty had the following notes to shareholders about the American Realty/Realty Income deal, in an effort to convince shareholders that the Realty Income offer was more than fair:

- On Sept. 5, 2012, the offer value implied a weighted average capitalization rate for ARCT's assets of 5.9% based on current cash rents.  This is significantly below the weighted average capitalization rate of 8.2% paid by ARCT for its assets as well as the weighted average capitalization rates of similar transactions, which range from 7.1% - 8.25%. 

- The 15.7x forward EBITDA multiple represents the second highest amongst similar REIT transactions.

In reality there is no other REIT that could pull off such an acquisition based on its sheer size and integration. Given the business models are similar, the integration is expected to be fairly quick, with the earnings from American Realty properties contributing immediately to Realty Income’s bottom-line.  

Diversify, diversify and diversify…

Realty Income will grow its total portfolio of properties to 3,250 after adding American Realty’s 500. The deal appears to be quite intriguing, with the ability to decrease Realty Income’s reliance on its 10 industries for 73% of rental revenue to 64%. Other diversification measures include expanding the number of industries Realty covers by 8% to 48, increasing the number of tenants by 34% to 202, and having a pro forma rental revenue mix of 77% (retail), 11% (distribution facility), 6% (office), 3% (agriculture), 2% (manufacturing), and 1% (industrial). A couple of American Realty’s top tenants are FedEx and Walgreen, which could contribute about three-fourths of the rental revenue added to Realty via the deal.

How does the valuation stack up? Just when you thought Realty’s valuation was getting ahead of it – with the stock up 85% since the start of 2009 - they go and make an acquisition that will be immediately accretive to funds from operations and earnings. The American Realty addition to funds from operations will be $0.21 (midrange) annually. The new expected FFO for 2013 now comes in at $2.35 (midrange), and 19% above 2012. Based on the 2013 FFO estimates Realty Income now trades at 18.5x. This is above historical levels, but the expected performance irrespective of the American Realty acquisition is enough to drive Realty Income higher. For 4Q 2012, the REIT invested nearly $450 million in real estate by buying 189 new properties, and invested $1.1 billion for the entire year—purchasing 423 properties. These series of acquisitions for the year were the most in history year over year.

Dividend boosting

Following the close of the deal, Realty Income shareholders will see its annual dividend payment increased by $0.35 per share to come out to a $2.17 annual payment. The increase was scheduled to be $0.10 per share if the American Realty deal fell through. This new dividend payment is a pro forma dividend yield of 5%, up from its current 4.2% yield. Based on the projected $2.17 annual dividend, the pro forma FFO (2013) payout is only 92%.

Stacking up some of the competitors:

Retail Properties of America Inc (NYSE: RPAI) owns and operates shopping centers, as does Alexander's, Inc. (NYSE: ALX). Federal Realty Investment Trust is specialized in retail and mixed-use properties.

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>Dividend Yield </strong></p> </td> <td> <p><strong>Interest Coverage</strong></p> </td> <td> <p><strong>Debt-to</strong></p> <p><strong>-Capital </strong></p> </td> </tr> <tr> <td> <p><strong><em>Realty Income</em></strong></p> </td> <td> <p>4.3%</p> </td> <td> <p>2.4x</p> </td> <td> <p>50%</p> </td> </tr> <tr> <td> <p><strong><em>American Realty</em></strong></p> </td> <td> <p>5.6%</p> </td> <td> <p>1.3x</p> </td> <td> <p>49%</p> </td> </tr> <tr> <td> <p><strong><em>Retail Properties</em></strong></p> </td> <td> <p>5.2%</p> </td> <td> <p>0.5x</p> </td> <td> <p>56%</p> </td> </tr> <tr> <td> <p><strong><em>Federal Realty </em></strong></p> </td> <td> <p>2.7%</p> </td> <td> <p>2.2x</p> </td> <td> <p>61%</p> </td> </tr> <tr> <td> <p><strong><em>Alexander's</em></strong></p> </td> <td> <p>4.5%</p> </td> <td> <p>2.1x</p> </td> <td> <p>75%</p> </td> </tr> </tbody> </table>

Realty has one of the best-capitalized balance sheets, based on interest coverage and debt to capital, and will soon have a dividend yield that puts it in line with the top paying REITs. 

<table> <tbody> <tr> <td> <p>Realty Income</p> <p>($ in millions)</p> </td> <td> <p><strong><em>2013E</em></strong></p> </td> <td> <p><strong><em>2012E</em></strong></p> </td> <td> <p><strong><em>2011</em></strong></p> </td> <td> <p><strong><em>2010</em></strong></p> </td> <td> <p><strong><em>2009</em></strong></p> </td> <td> <p><strong><em>2008</em></strong></p> </td> <td> <p><strong><em>2007</em></strong></p> </td> </tr> <tr> <td> <p><strong>FFO Per Share</strong></p> </td> <td> <p>$2.35</p> </td> <td> <p>$1.90</p> </td> <td> <p>$2.05</p> </td> <td> <p>$1.80</p> </td> <td> <p>$2.04</p> </td> <td> <p>$2.00</p> </td> <td> <p>$2.00</p> </td> </tr> </tbody> </table>

It appears that Realty Income is one of the better performing REITs in the industry, not to mention one of the most consistent. The REIT continues to impress and is expected to grow FFO nicely in 2013. And keep in mind that this REIT started its monthly dividend paying tradition some forty-three years ago (check out all the hedge funds in love with Realty).

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