On May 24th I wrote an article (Realty Income Is Simply A Great REIT And Nowhere Close To A Bubble) explaining that one of my favorite blue-chip REITs, Realty Income (O), had become "costly and perhaps even speculative based upon the definition of a true "Grahamian-based" investor." Although I have been preaching Realty Income's stalwart dividend performance for years, I decided that it was time to toss out the yellow flag and acknowledge that "The Monthly Dividend Company" was seeing signs of narrowing dividend yields. As I wrote:
For investors considering purchasing Realty Income shares today, I would wait patiently for a pullback (it's coming, I promise)…
Since May 22nd, when Uncle Ben (Bernanke) mentioned that the Federal Reserve might soon cut back its stimulus efforts, Realty Income shares have declined by over 16% and investors have lost around $1.63 billion in value. Comparatively speaking, the global stock markets lost over $3 trillion in value in the same period.
Pundits have mixed theories as to what Uncle Ben was thinking about over three weeks ago, but it's clear that Realty Income was not a bubble stock and that the fixed income markets likely overreacted due to the fear of rising interests rates. Regardless of the cause of the sell-off, the facts remain that rates have increased (and subsequently leveled off). The yield on the 10-year is 2.17% and was as high as 2.29 percent, a level not seen since April 2012.
Now when comparing Realty Income's current dividend yield of 4.93% to the 10-Year Treasury yield of 2.17%, we can see that there is still a wide margin of difference between the two securities. In fact, Realty Income's dividend yield increased by 18.8% since May 22nd while the 10 Year increased by 16.4% during the same period.
How Does Realty Income's Dividend Yield Compare
First off, let's compare Realty Income's dividend yield to direct real estate. For example, one could purchase a free-standing Dollar General (DG) store with a 15 year lease for around 6.9% (cap rate or yield on cost). Dollar General is investment grade rated and the buildings are double-net, meaning that the landlord must pay to maintain roof, structure, and parking lot repairs. Essentially, Dollar General pays for taxes, insurance, and interior items (such as HVAC, lights, plumbing, etc.).
An average Dollar General store sells for around $1 million, so assuming an all cash deal, an investor could expect to receive a cash-on-cash yield (cap rate) of 6.5% (after building reserves and management).
Now in today's low interest rate environment 6.5% is not bad; however, let's assume that in 10 years Dollar General's business model slows down or better yet, assume that Dollar General leverages its balance sheet up and loses its investment grade rating. Then assume that Dollar General has to close stores and the rent check becomes worthless.
You know where I'm headed now. It's like Sir John Templeton said:
The only investors who shouldn't diversify are those who are right 100% of the time.
Without proper diversification, a 6.5% yield could turn into a 0% yield and the odds of that are much greater without ample diversification. Now compare the risk-adjusted return of owning one Dollar General store to owning over 3,525 single tenant properties owned by Realty Income. Also remember first that Realty Income's occupancy ratio has NEVER dropped below 97% and the company has 195 individual tenants of which Dollar General is one.
In addition to diversification, Realty Income has something even much more essential and perhaps the most critical element when comparing risk-adjusted returns: LIQUIDITY.
Owning direct real estate can be a good way to balance your overall investment portfolio; however, it's critical to compare the risk-adjusted premium of owning an illiquid asset with a fully liquid security. In the example of Dollar General, some stores are easier to sell than others. For example, many Dollar General stores are located in smaller, tertiary markets and that presents risk and a reduced prospective buyer pool. In addition, since Dollar General's leases are structured such that the landlord maintains roof and structure, there is another element of risk that limits investor liquidity,
Also, real estate transactions are not done overnight as it generally takes between 30-60 days to close a deal. Whereas stocks can be liquidated within 24 hours and that alone represents a significant premium for average investors.
By owning Realty Income today an investor is sacrificing a 6.5% yield that could be earned in a private deal for extraordinary diversification (3,525 properties) and full liquidity. That premium of 1.57% (6.5% - 4.93%) is the risk-adjusted "margin of safety" that I call "sleeping well at night."
Now let's move over to the peer group analysis…
I have summarized below several direct and indirect peers of Realty Income. As you can see, Realty Income is not paying as high of a dividend yield as some of the others; however, as I discussed in a previous article, Realty Income has a much lower risk profile that is driven by the company's sustainable cash flow (and dividend) track record.
Also, as illustrated above, WP Carey (WPC), National Retail Properties (NNN), and Realty Income are the three lowest paying REITs (mentioned); however, all three REITs maintained a stellar track record of paying and increasing dividends during the Great Recession. The ability to manage risk in a turbulent market is what I call "insurance" for the future. In other words, I am satisfied with a 4.93% dividend yield and I am simply not willing to accept the risk of a 6.18% dividend yield (as in ARCP) unless there are other conditions that allow me to accept the risk. For my SWAN portfolio, I am not willing to accept the risk (of owning ARCP); however, for my growth portfolio (called SALSA), I am willing to accept more risk.
Looking at the valuation trends (directly correlated with dividend yields), Realty Income is trading at the higher-end of the spectrum. Perhaps not as "moderately expensive" as three weeks ago, The Monthly Dividend Company is now trading closer to fair value.
The FAST Graph below indicates that Realty Income share price (the black line) is beginning to trend along with the (orange) earnings line or Funds from Operations. It is my opinion that Realty Income will continue to trade in line with the two other "dividend champions" (WPC and NNN) and I don't suspect Realty Income's shares to decrease to a range that would produce a 5.5% dividend yield or higher (or shares that would drop below $38).
Based on info from Realty Income's 13-Fs (source: SNL Financial), 38% of the company's stock is owned by institutional investors. However, a significant portion of that is held by index funds which would only sell if they experienced redemptions. As you can see below, trading volume has fluctuated a bit since the beginning of the year, with periods of higher volume in late January and especially over the last 30 days or so.
One theory that I have researched regarding Realty Income's more dramatic share price sell-off is the likelihood that there are considerable number of foreign money redemptions associated with Japanese markets. It seems that the fund flows into US held REITs from Japanese investors could have triggered redemptions of ETF fund flows that led to a higher than normal volatility.
According to a June 13th Research Report from Citi:
Flows from Japan were negative for the first time in 18 weeks with gross outflows of $124m. Prior to this week, net inflows to Japan over the last 18 weeks totaled approximately $4.3bn.
The report went on to read:
Assuming income received from the funds is flat, the Japanese funds still would have to sell ~$1.25bn of securities a quarter - or about $20m a day - to fund the excess between the income received from its holdings and their set monthly dividend.
A Little More Skin in the Game
This week I increased my exposure in Realty Income. I purchased shares at $44.10 and I intend to increase more if the price drops below $42.00. I don't expect the 10-Year to increase much more this summer and I believe that the overreaction in Realty Income shares have created a window of "fair valuation." Should Mr. Market opt to set Realty Income's price at lower levels, I expect to increase my position based on weighted portfolio allocations.
Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return. I find it interesting that the behavior of institutional investors (including ETFs), dictated by constraints on their behavior, often cause stock process to depart from underlying value. Perhaps that's the case with The Monthly Dividend Company.
O is a Buy, Not a Bargain
In Margin of Safety, Seth A. Klarman explains:
Risk is a perception in each investor's mind that results from analysis of the probability and amount of potential loss from an investment. If an exploratory oil well proves to be a dry hole, it is called risky. If a bond defaults or a stock plunges in price, they are called risky. But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren't risky when the investment was made? Not at all. The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made.
Klarman went on to say:
There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount, The bargain element helps to provide a cushion for when things go wrong.
Source: SNL Financial