Realty Income Defers Its Pain; 2Q20 Results Worse Than Headline Numbers Suggest (NYSE:O)

Financial executives when deciding on accounting treatments often say do we take our pain now or later. What they mean is how much bad news do we want to put in our earnings this quarter versus a future quarter. In the case of NNN REITs in the current environment that means letting investors know the full extent of the contractually owed rents that may never be collected. Many NNN REITs have taken a fair bit of pain in the last two quarters through write-offs and reserves. O has gone the route of deferring their pain. By doing so they caused their stock to surge when they announced earnings which included less reserves/write-offs than were expected. Given that they still have not collected 13.5% of the rent they were owed for the second quarter, the low level of reserves merely shows management’s optimism about the business not improved collections. The chart below highlights some of the actions taken by its NNN peers during the last two quarters.

REIT

Ticker

Quarter

Write-Off/Impairment (% annual of quarterly rental revenue)

EPR Properties

EPR

Q1

In 1Q20 wrote off $12.5 million (8%) of straight-line rent receivables, increased its expected credit loss by $1.2 million, (1%), provided $1.5 million in rent abatements (1%)

Agree Realty Corp.

ADC

Q2

In 2Q20 wrote off $500,000 (1%) in bad debts

National Retail Properties Trust

NNN

Q2

In 2Q20 reserved $8.2 million (5%) for account receivable and straight-line receivable write-offs

Spirit Realty Trust

SRC

Q2

In 2Q20 reserved $7.2 million (6%) for account receivable and straight-line write-offs and provided $2.4 million (2%) in rent abatements

Realty Income

0

Q2

In 2Q20 reserved $8.5 million (2%) for uncollectable accounts and straight-line rents

Source: Company 10-Q’s

O’s accounting indicates to investors that in theory they believe there is only a very small likelihood that they will not receive almost all of the contractual rent they are owed. To date they have only taken reserves of $8.5 million for both accrued rents and straight-line rent receivables which amounts to 2% of their quarterly revenue. Based on their decline in same store sales, which they attribute to quick serve restaurants, it looks like these reserves are likely for quick serve restaurants. As O explained on their earnings call, they had a tenant in the category declare bankruptcy. This should trouble investors as O’s most challenged tenants are theaters, casual restaurants, childcare and gyms. If most of the reserves are for quick serve restaurants that means, there is a very little in the way of reserves being taken for O’s other categories which have not been paying their rent. Every other NNN REIT with the exception of ADC has had reserves/write-offs that are much more significant as a percentage of revenues than O. ADC has a higher share of investment grade tenants than O and only 1.6% of its revenue comes from the theater category. As readers of my earlier piece (Realty Income Is Likely To Have Write-offs In 2nd Quarter Earnings ) know O has substantial exposure to the theater industry generally (6.3% of revenue) and AMC (2.9% of revenue) in particular. EPR Properties (EPR :NYSE) took a large write-off related to AMC in the first quarter. On O’s call we learned a little bit about the arrangement they have come to with AMC. AMC is scheduled to pay O all its contractual rent, including back rent, within the next 2.7 years. It is hard to see how O can have such confidence that it will be paid in full after having received just 3% of rents due from theater tenants in the 2nd quarter. (Investor Presentation page 8) AMC just completed a painful debt restructuring. On their last earnings call AMC highlighted that many of its landlords had agreed to accept percentage rents. Furthermore, the operational challenges for AMC continue to mount as Disney has announced it will release Mulan via Disney Plus bypassing theaters. It is also interesting to note in O’s Institutional Investor Presentation they show an illustrative example of theater rent coverage sensitivity. (Investor Presentation p. 62) It shows pre-COVID and post-COVID EBITDAR Coverage. In their own example it has 1.0x coverage in the post-COVID world. Given that math, it is hard to imagine how AMC with all their other troubles will be able not only pay the rent, but also their interest expense plus the back rent owned to landlords in the next 2.7 years.

One thing that may be driving O’s low reserves/write-off to date is its accounting policy that prohibits partial reserving. The following is description of their Accounting Treatment of Rent Deferrals from their Quarterly Supplement (Realty Income 2Q20 Investor Supplement p. 28):

The majority of the concessions granted to our tenants as a result of the COVID-19 pandemic have been rent deferrals with the original lease term unchanged. In these cases, we have currently determined that the collection of substantially all rent payments is probable. Our accounting policy establishes that rent collection must be probable for lease revenue recognition and does not provide for partial reserving.

The lack of partial reserving probably means a tenant is either considered likely to pay or not perhaps at the 75% probability threshold that was mentioned on the earnings call. This means that as long as they think there is a 75% chance that a tenant will eventually pay all its rent, they will take no reserves. For investors evaluating the stability of O’s earnings, taking no reserve on a tenant like AMC may seem surprisingly risky for a REIT with O’s reputation. A number of O investors could be in for a nasty surprise if in future quarters deferred rents continue to grow only to eventually be written-off. It is also important to remember write-offs will not only include base rent, but also reimbursement which can easily approach 20% of base rents. Just as an example, if O eventually needed to write-off two quarters of rent for all its theaters which currently make up 6.3% of base rent plus reimbursements this would equate to over 15% of the quarter’s revenue.

Clearly, the timing on my call for write-offs was off as I expected them to be announced with earnings. The catalyst for O to give up some of its recent price gains is not perfectly clear at this point. Nonetheless, I suspect as bad news continues to percolate about theaters, casual dining, gyms and childcare or specific O tenants it will trade off. It is also possible its investor may hold O until it is forced to take a write-off which could be in a quarter or two. However, if O is not collecting rent and is just deferring the size of the write-off will just grow.

What O’s quarter represents is optimism from management. The amount of deferred rent at this time, shows O still has its work cut out for them. Time will tell whether this optimism is warranted. In light of what we have seen from some of the other net lease REITs as well as the continued trouble in the theater industry, O’s 4.5% dividend yield seems out of line with the risks its business is facing.

Disclosure: I am/we are short O. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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