Boy, it seems that the word "bubble" has been used in Seeking Alpha titles quite a bit. Just a few days ago, Felix Salmon wrote a terrific article (Don't Fear the Bubble) where he explained the varied definitions of the "bubble" term. One of his versions was centered on the way investors pursue risky investments or speculation; Salmon explains:
People buying an asset which is going up in price, just because they think they're going to be able to sell it to a greater fool at a substantial profit.
In this instance, Salmon's definition of the word "bubble" has implications that the less speculative investments would have a greater "margin of safety" and the larger the bubble, the greater the opportunity for profit.
Salmon added another definition of the word bubble by implying that some investments are not rooted in speculation but more so by rapid price appreciation - products that increase in value so quickly that the economics become blurred simply due to value misalignment, not speculation.
Regardless of the two "bubble" definitions, I thought that Salmon wrote a brilliant summary that explained the use (or overuse) of the word "bubble":
The reason to be worried about bubbles has nothing to do with fear of what happens when everybody is happily making money. Rather, the problem with bubbles is that they burst; bursting bubbles are dangerous, unpredictable things which we should rightly be afraid of. Or, to put it another way: if asset prices simply decline without causing substantial collateral damage, then you weren't in a bubble to begin with; you were simply in a bull market which then became a bear market.
Salmon hit the nail on the head when he wrote:
That's not a bursting bubble: it's just a common-or-garden bear market, of the type that all investors should be able to withstand.
Then there was another Seeking Alpha article (Are We in a REIT Bubble?) earlier this week in which the author, Dividend Growth Investor, argued that REITs are in a bubble. The author explains:
If this madness continues, the possibility that many investors will get burned down the road increases exponentially.
The author was clever in the use of the word bubble to generate page views, but I thought one of the comments summed it up squarely:
It seems as if everyone is using 'bubble' to define anything they believe is overvalued. It seems 'bubble' has become the new term of the year and the use of 'bubble' is in a bubble as many authors are using it to acquire readers. That being said, for the most part REITs are NOT in a bubble, just fairly to moderately overvalued as is most of the market today. Are there some REITS that are extremely overvalued? Of course, but again that is no different than every other sector.
Is The Dividend Machine Beginning to Bubble Up?
Now we get to the "meat on the bone", or shall we say, the purpose for my article today. One of my favorite readers and friends Tim McAleenan wrote an article yesterday citing the use of the word "bubble". Like the other authors cited, McAleenan made use of the broad "bubble" verb in which he pointed out the "expensive" valuation range associated with Realty Income's (NYSE:O) share price. McAleenan's argument was centered on the following excerpt:
The dividend yield is at the lowest point it has been since 2003, and Realty Income is trading at ranges well above where it has been in this past decade. The P/FFO ratio of 23.60 is well above the 14.0 we saw during the 2003 to 2009 range. Wednesday, Realty Income fell almost 5% amidst a broad market decline in response to Ben Bernanke's comments that the Fed's bond-buying spree may eventually taper off.
McAleenan's conclusion was a question:
What do you think will happen to Realty Income's stock price when interest rates rise to 3-4%?
So McAleenan argues that "The Monthly Dividend Company" is "approaching bubble territory" and specifically his targeted use of the word "bubble" is centered around the notion that Realty Income could become a more speculative investment when interest rates begin to rise again (to 3% to 4%).
Before I commence with my targeted comments on Realty Income, I would like to provide a quote from Brad Case, Ph.D., CFA, CAIA, VP and Director of Research with NAREIT. I spoke with Dr. Case earlier as I intend to use his comments in another article; however, I decided to also use this quote (in this article) as it reflects my views of the overly cited use of the word "bubble".
I don't think REITs are in a bubble. Valuation metrics (such as Price/FFO) depend on the assumption that today's FFO is a good representation of FFO in the future. I think REITs are likely to see strong growth in FFO going forward, as operating fundamentals (rents and occupancy levels) improve. Investors are setting current stock price targets that take into account strong growth in FFO going forward.
Similarly, in the May 13 issue of Barron's, writer Andrew Barry asked Mike Kirby, co-founder and director of research at Green Street Advisors, whether REITs were overvalued. Kirby's reply:
Let me start with the least-favorable comparison -- stocks. REIT's trade for about 25 times 2013 earnings, and when I speak of earnings, I am using AFFO, or adjusted funds from operations, which is the industry's primary earnings benchmark. The S&P 500 trades at 15 times forward earnings. That suggests that REITs are awfully expensive. But I'll throw you a couple of mitigating points. One is that REIT earnings growth is going to be very impressive. We project 9% growth in AFFO over the course of each of the next two years, and there is no reason that is slows down much after that because we are in the sweet spot in the real estate cycle. Over the past eight years, REIT multiples have been higher than the S&P 500. We have to ask ourselves if this is a new normal situation.
In the Barron's article, Kirby went on to say that given the current environment, REITs are trading at fair valuation ranges:
Given the growth outlook, REITs look pretty attractive in a low-yield world. When we add it all up, we conclude that REITs are somewhere within a fair-value range, maybe at the pricey side of that fair-value range, but certainly not dramatically overpriced.
It's plain to see that REITs are trading cheap relative to bonds and where assets are trading in the private market, some REITs are at massive premiums and some are trading at discounts; however, I see no sign whatsoever that a REIT "bubble" is forming.
It's important to remember that all REITs traded down on the recent Bernanke news, and in my opinion Uncle Ben is watching to see how the market responds to the noise. Just based upon the number of times the word "bubble" has been cited on Seeking Alpha (and other websites), the fear of the "bubble bursting" (as Seeking Alpha's Salmon referenced) is a valid indicator that investors are preparing for rates to go up.
Although I have no crystal ball for REIT investors, I do believe that Bernanke is starting to telepath us all signals and conversely, he is also watching and listening. Maybe it's good that all of us continue to use the word "bubble" as that could help stall the eventual reality of what is not actually a "bubble" but "a bull market that becomes a bear market."
23 Charts To Help You Sleep Well at Night
Investors like REITs not just because they have strong current dividend yields relative to other income assets, but also because investors expect their operating earnings to grow strongly as the economy improves. Simply put, Realty Income is a perfect example of a sustainable fixed-income alternative that has become a mainstream dividend brand of excellence. The benefits of owning "The Monthly Dividend Company" can be summed up in 23 charts that I prepared below.
Note, all of these charts (below) reflect the five year time frames in which Realty Income initiated various strategic plan initiatives. In other words, these five periods are all critical hurdle dates in which Realty Income evolved and transformed into the brand we know today: "The Monthly Dividend Company".
Chart 1: Growing Property Diversification
Chart 2: Growing Geographic Diversification
Chart 3: Growing Tenant Diversification
Chart 4: Growing Industry Diversification
Chart 5: Reduced Tenant Concentration
Chart 6: Reduced Focus on Core Retail
Chart 7: Increased Investment Grade Credits
Chart 8: Stable Average Lease Term
Chart 9: Stable Occupancy (Realty Income Has Never Dropped Below 96%)
Chart 10: Growing Assets
Chart 11: Growing Market Cap
Chart 12: Conservative and Healthy Balance Sheet
Chart 13: Growing Revenues
Chart 14: 2013 FFO guidance is $232 million - $238 million (up 14.9% to 17.8%)
Chart 15: 2013 AFFO guidance is growth of 13.1% to 16%
Chart 16: AFFO Payout Ratio is 89.7% (as of 3/31/2013)
Chart 17: Growing Dividends per Share
Chart 18: Number of Dividends Paid Since 1970
Chart 19: Number of Dividend Increases Since 1994
Chart 20: Dividend Yield
Chart 21: Cumulative Dividend Effect
Chart 22: Compounded Average Annual Return
In closing, I am not arguing the fact that Realty Income is fairly valued. In fact, I agree with Tim McAleenan that the shares are rather costly and perhaps even "speculative" based upon the definition of a true "Grahamian-based" investor. But remember, one of the most important attributes of safety is dividend sustainability, and companies with a long history of dividend increases (and trading histories) generally show generally narrow dividend yields.
Realty Income is the largest Triple Net REIT in the nation and the growth in the overall sector is enormous. Remember that the "free-standing" sector that was once a small specialty sector is evolving into a dominating industry that will soon surpass many of the other major asset sectors. Realty Income has already closed in on around $128 million in 2013 as well as the $3.2 billion merger with American Realty Capital Trust (in Q1-13).
I see no indication that a REIT bubble is forming and I see no evidence that indicates REIT dividends are a poor consolidation to capital growth. Quite clearly, REITs are outperforming all other sectors and, in fact, undervalued when you compare historical relationships with investment-grade and high-yield bonds.
Current investors owning shares in Realty Income should sleep well at night knowing that the "blue chip" portfolio has a superior management team and any cushion for error (or margin of safety) is reflected in the premium pricing we see today. For investors considering purchasing Realty Income shares today, I would wait patiently for a pullback (it's coming, I promise) and I recommend a target entry price of $50.00. I summed up it all up in a recent article:
I agree that Realty Income is a moderately expensive REIT to own today; however, I also believe that if one is purchasing the shares today, he or she would not be foolish at all. In fact, I believe that an intelligent income investor could benefit by diversifying into a bond-replacement alternative (like Realty Income) that should provide very attractive risk-adjusted dividends. Simply said, the biggest question for an income investor is what do you do with your money right now? That's why I think O is still a Sleep Well at Night REIT.
By the way, here is my last chart. I promised you would get 23: