2. Shareholder Dilution
Dilution of existing shares is another lower growth signal by management and a risk to existing shareholders. For example, despite recent price decline, the following chart suggests Realty Income is still not cheap by historical standards.
And when a stock price is not cheap it incentivizes management to use the stock (instead of cash) as currency for transactions because theoretically they get more bang for their buck. Said differently, if management thinks they stock is “overvalued” then they should pay with stock instead of cash. And perhaps not coincidentally, that is exactly what Realty Income has been doing. They have issued a lot of new shares of common stock over the last year as the valuation has climbed. For example, on May 24, 2016, Realty Income closes a 6.5 million share common stock offering.
However, the company makes very clear the risks of diluting shareholders with the following two excerpts from the most recent annual report.
Future issuances of equity securities could dilute the interest of holders of our common stock. Our future growth will depend, in large part, upon our ability to raise additional capital. If we were to raise additional capital through the issuance of equity securities, we could dilute the interests of holders of our common stock. The interests of our common stockholders could also be diluted by the issuance of shares of common stock pursuant to stock incentive plans. Likewise, our Board of Directors is authorized to cause us to issue preferred stock of any class or series (with dividend, voting and other rights as determined by our Board of Directors). Accordingly, our Board of Directors may authorize the issuance of preferred stock with voting, dividend and other similar rights that could dilute, or otherwise adversely affect, the interest of holders of our common stock.
And this one…
We may acquire properties or portfolios of properties through tax deferred contribution transactions, which could result in stockholder dilution and limit our ability to sell or refinance such assets. We have in the past and may in the future acquire properties or portfolios of properties through tax deferred contribution transactions in exchange for partnership units in an operating partnership, which could result in stockholder dilution through the issuance of operating partnership units that, under certain circumstances, may be exchanged for shares of our common stock. This acquisition structure may have the effect of, among other things, reducing the amount of tax depreciation we could deduct over the tax life of the acquired properties, and may require that we agree to restrictions on our ability to dispose of, or refinance the debt on, the acquired properties in order to protect the contributors’ ability to defer recognition of taxable gain. Similarly, we may be required to incur or maintain debt we would otherwise not incur so we can allocate the debt to the contributors to maintain their tax bases. These restrictions could limit our ability to sell or refinance an asset at a time, or on terms, that would be favorable absent such restrictions.
And as we mentioned earlier, if the stock was undervalued, prudent management would be less likely to give it away so freely. For reference, here are some Realty Income valuation metrics versus a couple peers.