NOT AN ANALYST

The Catalyst About a month ago we talked about Realty Income Corp as a good candidate for a short play, but since then the stock hasn’t really move in any direction. Let’s take a closer look at what can be the catalyst for a significant drop in value. The latest 10K reports that there are no maturities due until March 2013; therefore the company doesn’t need to refinance its debt anytime soon. But if the company wants to sustain or raise the common dividend, it would need to issue equity or new notes as the cash on hands and the operating income generated is not sufficient. I seriously doubt the company could raise funds early next year, so the only option would be to cut the dividend dramatically, which would cause a significant drop in price.

Tough Short It’s inevitable that the company will cut the common dividend, the problem is when. Keeping a short position open on Reality Income Corp it’s very expensive. You have to pay the big dividend to the long and it is an expensive stock to borrow because the amount of shares short as a percentage of the float is pretty high, around 22%.

NOI and Price There is no misprice at the moment between the intrinsic value and the market value. If NOI for next year is projected to drop 20%-25% from 2009 levels, the company should be valued around 19 dollars per share, but accounting for 303 mm in NOI for 2009, which seems accurate based on the latest 10Q, the company it’s correctly priced at 26 dollars per share. We calculate the Market Value as NOI/Cap Rate and the share price as the MV/shares outstanding. The cap rate is r (required rate of return) – g (growth rate). The required rate of return is simply the WACC = wd*D (1-T) + we*E. The capital structure consists of 47% debt and 53% equity. The yield on the latest bond issued, which is the 6.75% note issued on September 2007, is 6.50%. The tax rate is minimal as REITs are exempt from federal income tax, so I am going to ignore it. The yield on the common shares is now 6.54%. This gives us a WACC of 6.52%. The growth rate is calculated as the retention rate (b)*ROE. Net Income available to common shareholders for 2009 will be around 105 mm with cash dividends for the year amounting to 178 mm, which give us a retention rate (b) of -69%. ROE for 2009 is going to be around 6.7% and we arrive at a negative growth rate of 4.6%. Therefore the cap rate, calculated as r-g, it is 11.12%. Now we have all the data, with 104 mm shares outstanding and assuming NOI for 2009 remains at 303 mm, the Company is valued at 2,725 mm and the price per share is 26.2, which is around what it’s currently trading. However, if NOI drops 20% or 25%, which is a possible scenario accounting for the poor quality of lessees and their questionable capacity to pay, then the share price should be at least 6-7 dollars lower.