Realty Income: When To Buy In A Rising Interest Rate Environment

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 |  About: Realty Income Corporation (O), Includes: HCN, OHI
by: Brian Ditchek

Summary

Realty Income Corporation, the Monthly Dividend Company, has a long record of delivering above market dividends and total return.

How will Realty Income perform in a rising interesting rate environment?

The price of Realty Income and its dividends will be reviewed over the past twenty years, a period of changing interest rates.

An investment that has yielded a consistent, above average dividend and has demonstrated S&P 500 beating returns over the past 20 years is usually considered attractive. Realty Income (NYSE:O) has achieved this distinction. Current dividend is about 5% and is paid monthly. On its website Realty Income points to its total return, with dividends reinvested, from 1994 through 2013, as 14.9 times initial investment, easily beating the S&P 500, with a record of 5.77 times initial investment. Anyone who bought it then and kept it through today with continuous dividend reinvestment must be pleased. The question this article will try to answer for new investors is, if you bought it today, could you expect a similar result over the next 20 years?

Value in a rising interest rate environment

Currently, the Price for O is about 17 times AFFO. AFFO is the company's adjusted funds from operations. Price/AFFO ratio for a REIT is like the Price/Earnings ratio for a non-REIT company. Since the Great Recession hit in 2008, the Fed has kept interest rates low, with the current 10-year treasury yield running about 2.5%. But current rates are at historical lows and most economists seem to believe that interest rates will rise back to their traditional levels in the future. My question is, if that happens, what will be the impact on O's price? An approach to answering that question and obtaining some guidance on future price points for buying Realty Income is to look back at O's performance and the 10-year Treasury interest rates since 1994.

The table below shows Realty Income's price at the end of each of the last 20 years and the yield on the 10-year Treasury on the same day. AFFO for that year and the Price/AFFO ratio is included.

Date

Price

Div Yield

AFFO

10-Year Treasury yield

Price/AFFO

12/31/2013

37.33

5.8

2.41

3.04

15.5

12/31/2012

40.20

4.5

2.06

1.78

19.5

12/31/2011

34.96

5.0

2.01

1.89

17.4

12/31/2010

34.2

5.1

1.86

3.3

18.4

12/31/2009

25.91

6.6

1.86

3.85

13.9

12/31/2008

23.15

7.3

1.90

2.25

12.2

12/31/2007

27.02

6.1

1.92

4.04

14.1

12/31/2006

27.70

5.5

1.77

4.71

15.6

12/31/2005

21.62

6.5

1.63

4.39

13.3

12/31/2004

25.29

5.2

1.61

4.24

15.7

12/31/2003

20.00

6.0

1.5

4.27

13.3

12/31/2002

17.50

6.7

1.41

3.83

12.4

12/31/2001

14.70

7.8

1.34

5.07

11.0

12/31/2000

12.44

8.9

1.27

5.12

9.8

12/31/1999

10.31

10.5

1.24

6.45

8.3

12/31/1998

12.44

8.3

1.17

4.65

10.6

12/31/1997

12.72

7.9

1.10

5.75

11.6

12/31/1996

11.94

7.5

1.03

6.43

11.6

12/31/1995

11.25

8.2

0.98

5.58

11.5

12/31/1994

8.56

10.5

0.98

7.84

8.7

Click to enlarge

There are several conclusions to derive from this table.

  • Since 1994, Realty Income has seen a steady increase in its AFFO, starting at $0.98/share and ending 2013 with $2.41/share.
  • Over this period, the dividend has never been less than 4.5% (2012) and in the first ten-year period, 1994-2003, the dividend yield averaged 8.2%, while in the most recent 10 years, (2004 to 2013) it has averaged a good, but lower 5.8%.
  • The 10-year treasury yields on December 31 of each year have ranged from a high of 7.84% in 1994 and appear to have decreased steadily until 2012, when it was 1.78%. It is up slightly since then.
  • Price/AFFO has ranged from a low of 8.3 in 1999 to a high of 19.5 in 2012. In general, it may also be said that in recent years Price/AFFO has been higher than in the earlier years, or stated differently, Price/AFFO has been higher during low treasury yield periods and lower in periods of high yields.

The accompanying graph shows the Price/AFFO on the last day of each of the last 20 years relative to the 10-year treasury rate on that date. Through the scatter, you can detect a clear trend of descending Price/AFFO as the yield increases.

Click to enlarge

The data in the table and the graph seems to indicate that when interest rates are higher, the market tends to value Realty Income at a lower Price/AFFO.

In addition, AFFO seems to march upward each year almost unaffected by the ten-year yield, but the market seems to have reacted by lowering the price/share relative to AFFO, when interest rates are higher. This is probably related to the increased opportunities for achieving a good yield on your money without much risk, as in CDs, when the US Treasury rates are higher.

Of course, no one knows where the yields will go. But it has been at all-time lows to spur the economy and it is likely to go up from here. If the market reacts as it has in the past, that means that the current Price/AFFO of 17 might be high.

Personally, I continue to like the dividends and will likely invest again in Realty Income soon because of its solid history of increasing its AFFO and raising dividends. However, due to a forecast of rising interest rates, a buying opportunity would be signaled by a Price/AFFO of about 15. In general, I still think Realty Income is a great investment for a retiree or anyone interested in a consistent, high dividend. However, if interest rates increase over the next 20 years, it is likely that Realty Income will provide good total returns, but will not repeat the extraordinary14.9 times initial investment it delivered over the last 20 years.

Predicting the next big dividend increase

There is one other point I would like to make. It does not concern the impacts of Treasury yield increases but rather might provide an indicator as to when to expect Realty Income to increase their dividend more than usual.

REITs, like Realty Income, are obligated to pay out 90% of their earnings in the form of dividends to shareholders. As stated by Realty Income in their last Annual Report:

"In order to maintain our tax status as a REIT for federal income tax purposes, we generally are required to distribute dividends to our stockholders aggregating annually to at least 90% of our taxable income (excluding net capital gains)…"

REIT investors normally compare the total value of dividends issued to common shareholders relative to AFFO. The following Table shows the dividend payout ratios for Realty Income relative to AFFO, and as expected it is usually less than 90%.

Year

AFFO

dividend

div % of AFFO

% div increase following year

2013

2.41

2.147

89.1%

2012

2.06

1.772

86.0%

21.2%

2011

2.01

1.737

86.4%

2.0%

2010

1.86

1.722

92.6%

0.9%

2009

1.86

1.707

91.8%

0.9%

2008

1.90

1.662

87.5%

2.7%

2007

1.92

1.560

81.3%

6.5%

2006

1.77

1.437

81.2%

8.6%

2005

1.63

1.346

82.6%

6.8%

2004

1.61

1.241

77.1%

8.5%

2003

1.5

1.181

78.7%

5.1%

2002

1.41

1.151

81.6%

2.6%

2001

1.34

1.121

83.7%

2.7%

2000

1.27

1.091

85.9%

2.7%

1999

1.24

1.043

84.1%

4.6%

1998

1.17

0.983

84.0%

6.1%

1997

1.10

0.946

86.0%

3.9%

1996

1.03

0.931

90.4%

1.6%

1995

0.98

0.913

93.2%

2.0%

1994

0.98

0.300

30.6%

204.3%

Click to enlarge

There are two years that should be excluded from this analysis, 1994 and 2012. For 1994, the table only shows the dividend for the last 3 months of that year, as given by the Realty Income Annual Report, and thus, doesn't warrant inclusion. In 2013, the dividend awarded was 21.2% larger than in 2012, but that was an unusual case, as the big increase was related to a large acquisition by Realty Income. In that year, Realty made a $3.2B acquisition of American Realty Trust (NASDAQ:ARCT), and the large dividend increase was mostly a direct result of the acquisition.

So, if you review the years 1995 through 2011, you will see that Realty Income increased their dividend the following year an average of 4.0% per year. The last column in the table shows the actual increase in the dividend in the following year. In other words, for example, after completing the year 2006, when the dividend to AFFO ratio was only 81.2%, the following year, 2007, Realty increased their dividend 8.5 % from $1.437 (in 2006) to $1.560 (in 2007).

To make it easier for you to read the chart, I have highlighted the years in which results prompted Realty Income to increase their dividend more than their average of 4.0%. You see that in each of those cases, Realty Income had a dividend payout to AFFO ratio that dipped to 84.1% or less. The suggestion is that in future years, if you see that Realty Income posts a dividend payout to AFFO below 84%, it is a signal that the following year is likely to result in a higher than average dividend increase and that might be a good time to buy. For me, at the beginning of 2015, I will look to see how Realty Income's dividend payout to AFFO ratio was in 2014 and if it is 84% or below, I will likely be a buyer.

I will soon perform and report a similar analysis on other REITs, like Health Care REIT Inc (NYSE:HCN) and Omega Health Care Investors (NYSE:OHI) to see how they compare to O in these respects. In the meantime, I would appreciate comments back from readers on the approach taken here for developing buy signals for Realty Income.

Disclaimer: The author is long O. The following is solely the opinion of the author. Past results may not be indicative of future performance. Please consider the information provided, but always make your own decisions when investing in securities.

Disclosure: The author is long O. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.