I'm a huge fan of Realty Income (NYSE:O). I used to own it, having purchased shares in the real estate investment trust, or REIT, back when they yielded around 10%. However, I've since sold the shares because I just can't justify the current prices Mr. Market is affording this top-notch triple-net lease player. At some point, even a great company can be a bad investment.
A Great Business
There's no question that Realty Income is one of the best REITs around. It has a long history of successfully operating in the triple-net lease space, including in both good years and bad. It has an impressive record of returning value to shareholders via regular dividend hikes. It is large and financially stable. And management clearly has a commitment to shareholders, a fact that becomes very clear if you take the time to review the company's website and the other educational and financial material it creates.
There's no doubt that investors should like this REIT from a business perspective. In fact, it has few direct competitors when it comes to scale and operating history. For example, National Retail Properties (NYSE:NNN) has an equally impressive dividend and performance record, but is a much smaller company. While that means NNN has more opportunity for growth, it also means that Realty Income has the scale to do deals that NNN couldn't (In this case, it more likely wouldn't since NNN prefers to grow in small increments rather than through splashy purchases).
On the size front, O's only direct comparison would likely be VEREIT (NYSE:VER). But VER is a company trying to work itself back from an accounting scandal. So, sure, it's roughly the same size, but it certainly isn't the same quality. That, of course, helps explain why O yields around 4.3% and VER yields about 7.1%.
What's That Worth?
But here's the big question, "How much is a great company worth?" Realty Income is projecting adjusted funds from operations, or AFFO, for 2015 of around $2.73 a share (that's the midpoint of its guidance range). At recent prices above $56, that equates to a price-to-AFFO ratio of nearly 21. Price to AFFO is kind of like P/E, so a ratio in the 20 space suggests a rich valuation often associated with growth companies. But Realty Income is a REIT not a tech company, and has a history of slow and steady growth, not fast and furious expansion.
That's too rich for my taste, and I'd caution new investors from jumping on board right now at what I believe is a premium valuation.
To be fair, I've been worried about REIT valuations for a while. My fear is that low interest rates have pushed investors to bid up yield-based investments like REITs. At some point that love affair will end, if no other reason than everything eventually comes to an end. In fact, the 2015 REIT sell off was, in my eyes, a cannon across the bow.
While all REITs took a hit, the highest quality appear to have recovered better than lower quality. That suggests that investors are starting to focus more on safety. Not a bad call, but it pushes the valuation of the largest and best-run REITs even higher. They are the same companies they were before, but the risk of owning the stock goes up because of the premium pricing. In other words, you get Realty Income trading with a price-to-AFFO ratio in the low-20s.
You can easily dismiss my concerns based on the quality of Realty Income as a company. You could also argue that its valuation is justified because of low interest rates, which don't look to be headed materially higher anytime soon. And perhaps I am overly cautious.
But when you can buy industrial conglomerates with global businesses like Emerson Electric (NYSE:EMR) and Eaton Corp. (NYSE:ETN) and a tech giant like IBM (NYSE:IBM) with 4% or so yields, I find it hard to get excited about a REIT with a 4% yield and a premium valuation. Yes, Realty Income looks like it's hitting on all cylinders right now and EMR, ETN, and IBM are facing company-specific and industry-wide troubles. But that's where you find great companies at a discount. Fallen angles, if you will. The exact types of businesses that I believe Benjamin Graham suggests "defensive investors" should be searching for.
If you are looking at Realty Income for yield, I suggest broadening your search. If you own it, I wouldn't rush to sell, but I'd certainly think now about what you'll do if the price starts to head materially lower.
Disclosure: I am/we are long IBM, VER, ETN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.