Realty Income's Biggest Tenant Could Go Bankrupt
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Realty Income's Biggest Tenant Could Go Bankrupt
Just recently, I posted an article explaining that Trump's victory was bad news for Realty Income (O).
That's because his tariff proposals could have a particularly negative impact on its three biggest tenants:
Dollar stores and pharmacies would be some of the worst impacted retail categories because they import a lot of goods from China, face growing competition from larger players, and serve a lot of low-income consumers who cannot afford significant price hikes. Moreover, these tenants have been facing growing difficulties already prior to any potential tariffs, which would worsen their pain.
Unfortunately for Realty Income, these retail categories are its biggest investments and it is likely weight down on its market sentiment as we get more and more headlines about tariffs over the coming months.
Today, I have further bad news.
We just had the privilege of interviewing Agree Realty (ADC)'s CEO, Joey Agree, for High Yield Landlord and he explained to us that Realty Income's biggest tenant, Walgreens, is in even bigger trouble than the market understands.
Here is the relevant section from our interview:
High Yield Landlord: Walgreens is still about 1% of your total revenue. What do you think are the prospects of a successful turnaround for them?
Joey: Negligible.
High Yield Landlord: Negligible. Good to know. What are the odds of bankruptcy, do you think?
Joey: Probable. Highly probable.
Keep in mind that Agree Realty used to earn 25% of its rental income from Walgreens back in 2012 so few people understand the company better than Joey Agree. It used to be their biggest tenant by far, but they saw the problems coming and aggressively reduced their exposure, which is today just 1%.
He thinks that Walgreen will go bankrupt, just like its close peer Rite Aid, which filed for bankruptcy earlier this year. He then added that:
"We're over-pharmacied in this country just like we're overscreened for movie theaters... They just have to be rightsized. The next big step in that rightsizing process will be a Walgreens bankruptcy in the medium term. "
He is confident in this prediction because the majority of Walgreen's stores are losing money. Today, they have 8,000+ stores, but according to Joey Agree, only about 2,500 of them are making money. This is unsustainable and to get rid of their unprofitable locations, they will likely to need go through bankruptcy.
If he is correct, this will without a doubt have a big negative impact on Realty Income's market sentiment given that it is its biggest tenant.
Just recently, NNN REIT (NNN), which is a close peer of Realty Income, dropped by 13% in a few days after it announced that two of its small tenants were facing issues, causing it to miss 1.5% of its rental income. These are not even Top 20 tenants and its stock dropped so much anyway because it will hurt its growth in the near term. Walgreen is a far bigger tenant for Realty Income and therefore, the impact on its market sentiment could be even greater:
And the bad news doesn't end there.
Joey Agree also holds a negative view of dollar stores. When asked if they would be interested in buying out any of their peers, he explains that they aren't interested because of their high exposure to dollar stores:
HYL: Are there any publicly traded REITs that ADC would be interested in buying at the right price?
Joey: Maybe as a donation. What we saw was a number of publicly traded REITs go up the risk curve, deviate from their core competencies, add material exposures to tenants and sectors -- pharmacies and dollar stores, most notably -- that don't conform to our underwriting standards. We don't want to buy anybody else's problems.
That's Realty Income's story.
Their massive size made it increasingly difficult for them to grow and this forced them to go up the risk curve, deviate from their core competencies, and added exposure to riskier sectors. While he did not specifically mention Realty Income, he sure seems to be describing them.
Buy, Hold, or Sell?
It is a tough question to answer because it really depends on who you are asking.
If you are an income investor and only care about the dividend, then now could be a decent time to be accumulating Realty Income. It is priced at a historically low valuation and high dividend yield, especially relative to its close peers like Agree Realty:
Historically, Realty Income has commonly traded at a premium relative to its peers, but today, it is the opposite. That's because the market has corrected priced the growing risks that Realty Income is facing.
But even if Walgreens was to file for bankruptcy, I still think that Realty Income's dividend would be sustainable. It would slow down its growth and hurt its market sentiment, likely leading to a declining share price in the near term, but the dividend wouldn't go anywhere.
Often, the best time to buy blue-chip dividend stocks is when they are facing temporary issues that are causing them to trade at lower valuations and higher dividend yields.
But if you are a total return oriented investor, then I continue to think that there are better options in the REIT sector today. This is the main reason why we don't own Realty Income at High Yield Landlord.
Closing Note
It will be interesting to follow how Realty Income will deal with this problem and how the market will respond to it.
I would expect them to seek to gradually lower their exposure to both, pharmacies and dollar stores, over the coming years by divesting some properties all while aggressively investing in other net lease categories.
Realty Income's management is very good and I am sure that they will be proactive about this.
However, it could weigh down on their market sentiment, increase their cost of capital, and slow down their growth prospects in the coming years.
This could then lead to further underperformance relative to its close peers like Agree Realty:
We continue to avoid Realty Income and favor some of its peers instead for our Portfolio at High Yield Landlord.
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Analyst's Disclosure: I/we have a beneficial long position in the shares of all companies held in the CORE PORTFOLIO, RETIREMENT PORTFOLIO, and INTERNATIONAL PORTFOLIO either through stock ownership, options, or other derivatives. High Yield Landlord® ('HYL') is managed by Leonberg Research, a subsidiary of Leonberg Capital. All rights are reserved. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. The newsletter is impersonal and subscribers/readers should not make any investment decision without conducting their own due diligence, and consulting their financial advisor about their specific situation. The information is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The opinions expressed are those of the publisher and are subject to change without notice. We are a team of five analysts, each contributing distinct perspectives. Nonetheless, Jussi Askola, the leader of the service, is responsible for making the final investment decisions and overseeing the portfolio. We do not always agree with each other and an investment by Jussi should not be taken as an endorsement by other authors. Past performance is no guarantee of future results. Our portfolio performance data is provided by Interactive Brokers and believed to be accurate but its accuracy has not been audited and cannot be guaranteed. Our portfolio may not be perfectly comparable to the relevant index. It is more concentrated and may at times use margin and/or invest in companies that are not typically included in REIT indexes. Finally, High Yield Landlord is not a licensed securities dealer, broker, US investment adviser, or investment bank. We simply share research on the REIT sector.
