When it comes to the business world, being bigger is very often better. A clear example of this today is real estate investment trust (REIT) Realty Income(NYSE: O), which stands head and shoulders above its closest peers. However, it is important for investors to step back and look at the full picture. Being big is good, but it also has a downside.
Big is good
Realty Income performed very well for investors over the years. That's highlighted by 28 consecutive years of annual dividend increases. A record like that is created via a purposeful and diligent approach to managing a business. That's backed up by the fact that this REIT's balance sheet is investment-grade rated, giving it the financial strength to survive through bad times. Earning an investment-grade rating is not an accident, it is a conscious managerial decision.
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On top of these facts, Realty Income is also the 800-lb. gorilla of the net-lease REIT subsector. (Net leases require tenants to pay most property-level operating costs.) Its portfolio of over 12,200 properties and its over-$41 billion market cap easily outdistance its closest peers. The company's history and massive scale provide it with material benefits.
For example, it generally has easier access to low-cost capital in both the equity and debt markets. It can also take on larger acquisitions than its peers. And when spending money on things like property redevelopment, it generally has more negotiating power. All of these things give it a leg up on the competition. These are the types of benefits that often accrue to industry giants, be they in the REIT space, consumer staples, industrials, etc.
Big can be a problem
So there are very good reasons for investors to favor the largest names in a given industry, and Realty Income fits that bill in the net-lease REIT niche. But you need to go in with your eyes open because being large can also be a business headwind.
For example, Realty Income's guidance for property acquisitions in 2023 calls for over $5 billion in spending. Its next-closest peers, National Retail Properties(NYSE: NNN) and W.P. Carey(NYSE: WPC), are projecting acquisition spending of around $550 million and $2 billion (at the midpoints), respectively. Basically, in order for Realty Income to move the needle on the top and bottom lines it needs to spend more than twice as much as smaller peers. That requires materially more effort.
Complicating this growth goal is the fact that Realty Income, thanks to its scale, can't be as nimble as its peers. Buying small one-off properties, even if they are great investments, just isn't worth the effort. A more modestly-sized net-lease REIT can adjust quickly to the market environment and pick off such opportunities to the benefit of its shareholders. Realty Income has to find big deals, and often big deals require buying portfolios of properties that include both desirable and less desirable assets.
Also, as noted above, Realty Income can more easily tap capital markets. That's partly because being a large and successful company has led investors to afford it a premium stock price. However, with that premium comes extra scrutiny and high expectations. Realty Income cannot simply operate behind the scenes, and any misstep is amplified -- and every company makes mistakes. That's extra pressure that might not exist at a smaller peer. Although this is a hard issue to quantify, it is very clear that Realty Income tends to operate in a conservative manner. And being too conservative can stifle long-term growth.
A great company, if you understand what you own
The benefits of Realty Income's size likely outweigh the negatives. You can probably say the same about industry giants from other sectors as well, like Procter & Gamble or Johnson & Johnson. But investors need to go in with a clear understanding of the problems that size can impose.
Realty Income's premium price means it offers a more modest dividend yield (4.8%) and is, at best, a slow-growing REIT. For conservative dividend investors that might be completely acceptable, but others might prefer to step down to a smaller, less followed peer that can be more nimble and grow at a faster clip.
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Reuben Gregg Brewer has positions in Procter & Gamble, Realty Income, and W. P. Carey. The Motley Fool recommends Johnson & Johnson, Realty Income, and W. P. Carey. The Motley Fool has a disclosure policy.
