Realty Income (O) is exactly the kind of high-quality asset that I intend to go through life collecting. Business-quality wise, while I may not put it on quite the same pedestal with Coca-Cola (KO) and Johnson & Johnson (JNJ) because realty investments don't have quite the same brand strength to fall back upon if the underlying business gets mismanaged, the company nevertheless has an excellent record that includes maintaining a streak of dividend increases through The Great Recession of 2008-2010 when many real estate companies had to slash payouts to deal with deteriorating income.
And to be sure, Realty Income's payout history and policy most likely constitutes a great amount of the company's appeal. Unlike most dividend companies that pay shareholders dividends every three months (quarterly), The Realty Income company sends you a check every thirty days. This can be a welcome policy for investors that do not have a diversified portfolio that shoots off monthly income in aggregate, and the monthly dividend policy can encourage investors to maintain an "ownership mentality" that focuses on the dividends and profits instead of the share price, thus protecting investors from the dreaded outcome of "selling low."
In terms of track record, Realty Income is hard to beat. In its forty-three years of operations, the company has declared 509 monthly dividends. And since going public in 1994, the company has increased its dividend 68 times, a number that is impressive yet perhaps unduly eye-popping because some of the increases have been to the tune of a fraction of a penny per month.
During every year from 2001 to 2011, you could buy shares of Realty Income at some price point that falls between $13 and $30. It would have been very doable to spend the start of the millennium collecting 100 shares of Realty Income per year by only making annual investments of $2000-$3000. So what would be the situation of an investor who dutifully added 100 shares of Realty Income every year from 2001 to 2011 without reinvesting the dividends? Well, this investor would own 1100 shares of Realty Income (at a cost of somewhere around $27,500 assuming a purchase of 100 shares for $25 every year for 11 years). This would generate about $166 of income every month.
I get excited at the thought of planting a dozen or two financial money trees like this over the course of my life. This is when income investing gets fun-you can take that $166 check and use it as fun money in your life-you could get a couple of "free" dinners per month, good tickets to the football, or ironically enough, use real estate dividends to pay a chunk of the mortgage/rent. Or you could plow the money back into more shares of Realty Income. Or you could set-up an account at Computershare.com and have $50 invested into Becton Dickinson (BDX), $50 into Exxon Mobil (XOM), and $50 in Dr. Pepper (DPS) every month free of charge. You've basically got a real estate dividend machine that could create entirely sustain further investments in a health care, oil, and soft drink company each month as long as the underlying business strength of Realty Income remains strong. And those companies will be paying their own dividends that grow with time! While I can't write an article that will be doable for everyone reading it, I do like the fact that these results could have been attained by investing about $200 per month for eleven years.
Despite my very high opinion of Realty Income as a potential investment, I can't bring myself to buy it today. My general view of real estate investment trusts is that most are either fully valued or overvalued because they offer reasonably safe high yields in a low-yield market environment. And when I evaluate the fundamentals of Realty Income in relation to the company's current valuation, I can't help but conclude that the company is fully valued or overvalued based on the following three reasons:
- The company's current yield is 4.61%. This current yield is below the average annual dividend yield for Realty Income going back every year to 2001. There was no year between 2002 and 2010 in which you couldn't buy shares of Realty Income with at least a 6.0% yield at some time in the year. And considering that Realty Income pays out around 90% of its funds from operations as dividends, I find a focus on the current dividend yield warranted. For a company that dubs itself "The Monthly Dividend Company", I don't want to be buying shares at a time when the shares are offering the lowest current yield relative to its dividend levels in the past decade.
- The historical valuation seems expensive. For the past decade, Realty Income traded at a P/FFO ratio of between 12.3 and 15.0.That has changed in the past two years, as the P/FFO ratio has crept above 17. The current Value Line estimate (if and when) the American Realty Capital Trust (ARCT) vests and becomes fully accretive is that Realty Income will be earning FFO of $2.45 per share. At the current price of $39.39 per share, that is a forward P/FFO of 16.07. Considering that the trailing P/FFO for Realty Income was no higher than 15.0 for most of the 2001-2009 stretch, I would not be comfortable paying a forward P/FFO ratio that is above its historical average. It strikes me as reasonably likely that the valuation of Realty Income will fall more in line with historical norms when interest rates rise.
- The dividend growth has slowed down. Not only is the current Realty Income yield below its historical norm, but the dividend growth rate has been quite unimpressive the past couple years (this is, of course, relative, since plenty of real estate investment trusts lowered payouts during the Great Recession, so the fact that the dividend has grown over the time period can be viewed favorably). Nevertheless, the company has only grown the dividend 10.8% in total since 2008. While the ARCT acquisition could give Realty Income the legroom to give better annual dividend boosts, this is still a case of counting chickens before hatching. I'm not comfortable paying a historical premium for a company that currently offers a lower than historical average yield coupled with a slow growth rate.
A useful tactic that I learned from Charlie Munger, the Vice-Chairman of Berkshire Hathaway (BRK.B), is that we owe it to ourselves to regularly try and tear down our best ideas. Coca-Cola, Johnson & Johnson, and Berkshire Hathaway are my favorite companies, and that's why I make a point of reading something negative written about any of them. Likewise, Realty Income is an excellent firm that I'd like to own. That's why I feel the obligation to be extra-thoughtful in trying to come up with reasons not to own it. And personally, I can't get past the current valuation. While I think it's possible Realty Income deserves a premium because its percentage of investment-grade tenants will shoot up following the ARCT merger, I don't go around looking for reasons to pay a historical premium for a company. If you're considering purchasing shares of Realty Income, I think it could be useful to ask the following before making a purchase order: Do I want to buy at a time when the dividend yield is near a twelve-year low? When the P/FFO is around a twelve-year high? When the dividend growth rate has been slowing? When rock-bottom interest rates could have driven the valuation upward? When I consider these questions, I conclude that now is not the time to buy one of my favorite companies. But as the ancient Roman orator Cicero once said, "Suum cuique."