The 27% Bank Account

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The 27% Bank Account

by Tom Dyson, editor,
The 12% letterfor DailyWealth January 2008

In his professional life, Thomas Lewis has one goal... producing dividends every single month.
Some companies produce shoes. Some companies produce golf balls. Some companies build houses. Lewis' company produces monthly dividends. It operates under the trademark "The Monthly Dividend Company." No joke. Every breath, flinch, twitch, or blink management makes is geared toward paying bigger dividends to shareholders.

And Lewis' single-minded obsession is paying off: Since the company listed on the New York Stock Exchange in 1994, shareholders have made an average total return of 27% a year.

There isn't another stock in America – or even the world – like this. As I'll show you, this investment is safer than a bank account, a CD, or a Treasury bond, yet it pays out magnificent returns. This is the best risk-reward income play I have ever found…

Some companies pay dividends because they have to. Others pay dividends when they can. There are high dividends, low dividends, special dividends, dividends that fluctuate, and dividends that grow...

But no company has ever approached its dividend payments the way Thomas Lewis' company does.

Take its annual reports, for example. The company releases the most investor-friendly reports around. The CEO writes his letters to shareholders in plain English. The reports present statistics with simple graphics. And the business? It's so easy to understand, analyzing this company felt like an afternoon with the Sunday paper.

The theme of the 2006 report is "Monthly Dividend Land." Each section takes you through an imaginary world where you "accumulate shares at every twist and turn on the road that leads to monthly dividends for life."

In his summary of 2006 results, Lewis writes: "Our most important accomplishment is that we were able to pay 12 monthly dividends and increase the dividend five times during 2006."

This company's corporate quest is to provide dividend income for its owners. "This philosophy colors every decision the company makes, dollar it spends, management discussions, and all of the employees' activities undertaken each day," says the COO.

I've never seen a company with such total dedication to its dividend. But do these guys walk the walk? You bet they do...

The Monthly Dividend Company is in its 38th year of business. As of January 1, 2008, the Monthly Dividend Company had paid 448 consecutive monthly dividends and 40 consecutive quarterly dividend increases. The annual dividend has grown from $0.90 in 1994 to $1.64 last month.

Here's what some current shareholders had to say about their company:
"I'm retired and I live off SS. It is my largest holding... and has been for years now. It makes up 30% of my portfolio. This is one stock I will never sell."
"I have been reinvesting my divvies for the last 3 years. It's amazing how fast my monthly payments have grown... I just wish I'd bought more."
"I've owned this stock since 1998. I can't imagine selling it. My original shares pay a 15% dividend and have risen 175%. That's better than 20% per year."

The Monthly Dividend Company's official name is Realty Income Corp. (NYSE: O). From here on, I'll refer to it as "the MDC."Why Retail Businesses Want a Landlord

In December 2006, 12% Letter readers bought McDonald's Corporation. Most people think McDonald's is a burger-flipping company. The reality is, the franchisees flip the burgers and manage the restaurants. McDonald's owns the properties and collects 9% royalties. In other words, McDonald's is just a glorified landlord.

The MDC uses a similar model. It buys property from convenience stores, gas stations, and fast-food restaurants. It then leases it back to store operators through long-term contracts. The retail chains get a cash-injection to grow their businesses. The MDC gets the property and a 9% rental yield.

That's it. It's a very simple model. In the industry, this arrangement is called a "sale-leaseback."

But you and I can think of the MDC as a retail landlord.

Unlike McDonald's, the MDC is set up as a REIT, so it pays no corporate tax as long as it distributes all of its profits back to shareholders each year in dividends.

Sale-leasebacks release valuable capital from unproductive, volatile assets, like property, and allow business owners to focus capital on their core business. The stock market rewards companies that grow earnings with much higher multiples than asset-rich companies, so sale-leasebacks push up share prices.

And private-equity groups and corporate raiders use sale-leasebacks to raise money for their takeovers. Conversely, asset-rich companies use sale-leasebacks to make themselves less attractive to the raiders.

Right now, the sale-leaseback business is hot. The financial world has figured out that retail companies have hidden treasure in their balance sheets.

Over the last 10 years, the MDC has averaged $220 million per year in new property acquisitions. In 2006, using exactly the same strategies and underwriting standards it has always used, it acquired $770 million... that's 3.5 times its regular volume. The Highest Occupancy Rates in the Business

This business is simple. Generating 27% annual returns for shareholders year after year is NOT. It's extraordinary. Let me show you how the MDC works:

The company opened for business in 1970. It currently owns 1,929 properties in 48 different states. Convenience stores and fast-food restaurants combined make its largest holding. But it also leases property to theaters, day-care centers, gasoline stations, and auto shops. Here's the breakdown:

Auto-related 18.9% Restaurants 17.8% Misc. Retailers 17.3% Convenience Stores 14.1%
Theaters 9.4% Child Care 8.9% Other 13.6%



Occupancy is the single-greatest concern for a landlord. An empty building is like a dairy cow that doesn't produce milk. A few vacant buildings will rip holes in your monthly dividend payouts.

The MDC achieves long-term occupancy rates of 98.5%. Through inflation, including the hyperinflation of the 1970s, recessions, wars, long bond rates from 18% to 4%… the MDC has never had more than 2.5% of its property vacant. Right now, 98.7% of its properties are occupied. These rates are the best in the industry – by far – and the chief reason the MDC is such a successful company.

So what's the secret to high occupancy?

This isn't the Cape Cod vacation-rental business. The MDC seeks retailers to occupy its properties and pay rent for 15 to 20 years at a clip. Selecting the right retail chain is the first step... and definitely the most important.

The MDC invests primarily in retailers that provide basic human needs... like cheap food, gas, or auto repairs. These businesses are the last to suffer in a recession. The MDC does not put more than 20% of its portfolio in any one industry or more than 10% of its portfolio in a single retail chain.

The industry divides retailers into three classes: venture, middle, and upper market. Venture-market retailers are the smallest chains, with fewer than 50 outlets. Typically, they sell a new retail concept. They don't have geographic diversity or experience in softer markets.

Middle-market retailers have between 50 and 500 locations in more than one geographic area. They have a proven, reliable concept and experience trading in different economic conditions. Credit ratings may border on junk. Middle-market retailers tend to be more recognizable.

Depending on where you live, you've probably heard of National Tire & Battery (car parts and service), Children's World (day-care), Wawa (convenience stores), and Zaxby's (restaurants).
The upper market is made of national chains with mature products and more than 500 outlets. They have investment-grade credit ratings and long trading histories.

The MDC likes middle-market retailers. Here's why:

Middle-market retailers need cash to fund growth. But unlike the national chains, poor credit ratings make other financing options expensive.

They have experience overcoming the managerial and operational obstacles that often trip up the venture retailers.

They can spread corporate expenses across a large number of stores.

They have the critical mass to survive even if some locations close.

Middle-market retailers grow stronger financially as their businesses mature. That means, given the risks, middle-market retailers offer the best investment returns of any market class, the MDC believes.

Even if the worst happens and a retail chain falls on hard times, the MDC still has little to worry about. It hasn't loaned any money to its tenants... just leased land. Worst-case scenario, the tenant is unable to pay the rent. Even this is unlikely. The company only invests in the best locations. These will be the last properties a retail chain shuts down in a reorganization or downsizing. The banks and bondholders may not be so lucky.Ivy League Appraisal Standards
The MDC's investment process makes MIT admissions look slapdash.

The company provides fantastic service to cash-strapped retailers. Retailers know it closes big, complex deals in a hurry. No one else can handle these deals.

Everyday, the MDC receives dozens of offers from retailers looking to enter sale-leaseback transactions. Like MIT applications, most of them get turned away.

The MDC has a fully staffed research team. It trawls the country looking for properties that meet the company's strict investment criteria. When it makes a match, it will grill the management team, tear apart the audited financial statements, and study its competitors. Then it studies the industry's history and outlook. Finally, the team will visit every location in the chain, shooting film clips of the property and preparing the key statistics to take back to the MDC's investment committee in California.

The MDC's CEO, president, CFO, and general council sit on the investment committee. These four executives spend every Friday watching hundreds and hundreds and hundreds of videos of the properties under consideration.

During 2006, the committee reviewed more than $5 billion worth of potential transactions, but acquired only $770 million in new properties. In other words, it bought about 15% of the properties presented by the research team. (MIT accepted 16% of its 2007 applications.)More Competitive Advantage

Let's pretend you have $200 million to invest in property and two weeks to close a deal. You could buy an office building. You could buy a warehouse. You could buy a stadium. You could buy a hospital. Or you could buy a portfolio of 100 small retail locations.

I don't know which one you would choose, but I'm pretty sure you wouldn't choose the retail portfolio. For one thing, you'd need to deal with 100 different tenants and administer 100 different properties. The deal would be more complicated. Your investment appraisal would be more costly, and your return would be less certain. That's why big institutional property investors steer clear of this niche. It's a hassle.

But they're the reasons this space offers higher rental yields than most other sectors. You could say that the MDC's ability to manage a large portfolio of small companies is its true competitive advantage.

So how does it pull off this tricky business so well?

Firstly, the MDC can close large deals quickly. It has the staff to analyze opportunities, advanced IT systems to deal with the sudden influx of new properties, and immediate access to a large pool of capital.

Second, the MDC has strong control over its portfolio. Sometimes an attractive deal contains a few undesirable properties, or the MDC portfolio may become overly concentrated on one industry. The company owns a specialist resale business that sells the properties the MDC doesn't want, using tax-deferred (IRS form 1031) exchanges.

Third, the MDC uses triple-net leases. Under a triple-net lease, the tenant pays the utility bills, insurance costs, maintenance, and property taxes. The MDC owns 1,929 properties in 48 states. That's a lot to manage. Triple-net leases make it easier to be a landlord. The majority, 98.4%, of the company's leases are triple net.Own 1,929 Properties with no Mortgage Debt

In 2006, the MDC added 378 new properties, 100% leased, with an average lease length of 16.7 years and an average lease yield of 8.6%.

The company uses a $300 million revolving credit facility to purchase properties. Once the properties are secure, it issues new stock or bonds to finance the investment over the long term. As a REIT, it can't retain earnings, so it has to finance new properties this way. In 2006, it issued five common stock, preferred stock, and unsecured-bond offerings.

The MDC has an excellent credit rating... as you'd expect from a company with a 37-year history of raising dividends with minimal debt on its balance sheet. This allows it to borrow money at virtually the same rates available to banks, local governments, and the largest American corporations.

Here's another way of thinking about the MDC's business: The sale-leaseback is a loan. The MDC borrows money at investment-grade rates near 6% and lends it at 9% junk rates to its middle-market retailers.

As an aside, the MDC never uses mortgages to finance its property investments. It never has. Nor does it use secured debt. In other words, it uses its excellent credit rating to borrow money, not its property portfolio. This means no one else has a claim on its property. And it frees up more rental revenue to pay monthly dividends. It also allows the MDC to keep a super-conservative, unleveraged balance sheet.

15% Returns with Less Risk than a Bank Account

I said this investment was safer than a bank account or a CD. That's a big claim.

But first consider, your principal is safe. The MDC has a $2.4 billion market cap.

And your money is invested in debt-free property. The company doesn't hold Miami condos or Manhattan lofts... we're buying properties that provide basic human needs. Through wars, inflation, recessions, and weak property markets, your principal stays intact.

Inflation is the reason this investment is much safer than bank accounts, CDs, and Treasury bonds. With these fixed-income investments, your return does not adjust, so over time, inflation undermines your annual receipts.

On the other hand, dividend payouts from the MDC rise about 4.5% a year.

Besides, a bank account may pay interest once a year. A bond pays out twice a year. But the MDC mails you a check every month... a check that got bigger four times in 2007.

Over the last 14 years, shareholders have made almost 30% a year in this stock. I think it's fair to expect total returns around 15% a year going forward.

For one thing, inflation makes property prices rise. That's good for 2% a year.

Second, consumers of basic products, such as cheeseburgers and cigarettes, are not price-sensitive... They don't care if prices rise by a nickel here and a dime there. In other words, the MDC's tenants have pricing power. So, the MDC can bump its rents 1%-2% every year.

Finally, the company's gradual expansion – buying properties that yield 9% with money that costs 6% – should be good for 11% a year.

Property Inflation 2% Rent Increases 2% Reinvesting Earnings 2%
Property Acquisitions 9% Annual Returns 15%

The MDC produces dividends. So we have only one sensible way to value this company: its dividend yield. The dividend yield is a barometer that tells you if a company is expensive or cheap. When the dividend yield is low, you're paying more money per dollar of dividend. When the yield is high, you get more dividend for your money.

The MDC is a transparent company and it never changes its strategy, so frankly, its valuation remains pretty constant. You could have bought the MDC with a 9% yield in 2000, but since 2003, its yield has traded in a narrow band between 4.5% and 6%. Right now, it's about 6.7%. That's cheap.

Action to take: Buy Realty Income Trust (NYSE: O) as long as you can earn a 4.5% yield or higher.

Good investing,

Tom Dyson

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