How To Beat The Realty Income 'Problem"

| About: Realty Income (O)

Summary

Realty Income has a good problem - it went up too far too fast from my point of purchase.

My premise for buying Realty Income has not changed; the only change is current valuation.

My solution was to write September 55-strike calls for 3.23 premium, only a little more than the June 55 strike but providing 1.33 for seven months of distributions.

A close above 55 gives me 58.23, a very high valuation; a close below 55 reduces my cost by 3.23 and renders a break-even of 51.77, an acceptable valuation.

This action is still available on essentially the same terms.

A stock that goes up too much too fast creates a problem - a good problem to have, maybe, but still a problem. That's what has happened to my August 31, 2015, buy of Realty Income (NYSE:O).

Until last July I had never owned a REIT or REIT fund. I knew what they were and how they worked, had taken a look a couple of times, and was aware that a number of very successful permanent portfolios have REIT fund positions as high 20%. I thought REITs were fine investments (unlike MLPs, which have always seemed to me more dangerous than advertised). But why did I take the plunge and buy REITs last summer? Here's why:

(1) REITs seemed to fit a personal need. Doing some estate planning, I decided that one of my children was a good candidate to inherit my IRAs. While I expect to live to see the principle degraded by RMDs, I thought it would be nice to produce a steady rate of cash return that held the principle amount reasonably steady for at least the next five or ten years. REIT distributions seemed to fill the bill. Putting about half in REITs might even allow for a couple of growthier investments.

(2) REITs had seemed pricey at the beginning of 2015, but had endured a major sell-off in the first half of the year. The best explanation seemed to be the market's fear that an imminent cycle of rate increases by the Fed would inflict very specific harm on REITs particularly, both by reducing the value of their distributions relative to other income opportunities and by increasing their cost of debt capital and thus reducing their future growth in funds from operations (FFO).

I suspected that the attractiveness of REITs would not be damaged to the extent the market anticipated. I had my doubts that the Fed's pace of rate increases would equal market expectations. The global undertone was deflationary. The economy looked a bit punk, and seemed likely to remain so. Rates were unlikely to zoom higher.

So I bought a few REITs, including several health care REITs, Realty Income, and W.P Carey (NYSE:WPC). In making my choices I relied to a significant extent on SA and Forbes pieces by Brad Thomas, to whom I have to give a shout out. His work seems to me very solid and well grounded and particularly helpful advice in the case of REITs, where it would be hard for even a sophisticated investor to get up to speed on the whole investing context.

The decisions I made for myself were to focus on health care but include Realty Income and W.P. Carey among REITs more focused on the larger economy. My thinking then was that health care REITs should be less vulnerable to further weakening in the economy while REITs with malls and industrial properties, even triple nets, might suffer in unanticipated ways much like MLP infrastructure plays which were supposed to be immune to oil prices. So far this thinking has proved wrong. It's the healthcare REITs that have dragged, and I can't find any good explanation involving new information so I'm OK to sit with what I own.

That being said, my single biggest position is Realty Income. I bought it on August 31 at $44.87. It has gone more or less straight up since then and at yesterday's (Thursday) close was north of $57.50. Too much, too soon. I had thought it was cheap when I bought it, so I expected it to chug gradually upward, but I can't find a reason for it to have gone up so fast except that the world of REIT purchasers has temporarily gone a little bonkers.

REITs are mainly an income vehicle. They are great in tax advantaged accounts. They are somewhat more conservative than many stocks bought for income. They are to some degree a separate asset class, with risks and market cycles different from those of ordinary stocks. And they grow a little bit if well managed. Realty Income fits this description.

What REITs are not is rapid growth vehicles. There is no expectation of sudden bursts of growth, new products, or new markets, and not generally much likelihood of being bought out at a higher price, certainly not for a REIT the size of Realty Income. So what's up? Again, for the life of me: people just went a little bonkers!

The trouble is, I still like Realty Income as a business, just maybe not so much at the current price. Here's how I thought about that and what I did about it.

A Perfect Moment For A Call Write

On January 27 I wrote the September 55 calls, which were more or less at the money, against my entire Realty Income position. I was paid a premium of 3.23. Here was my thinking: if Realty Income closed above 55, I would pocket 58.23 per share, an amount at which I would consider it quite a bit overpriced. I would also have received a little over 1.33 per share in distributions over the 7 months. None of it would be taxable.

On the other hand, if Realty Income closed below 55, I would keep my shares, pocket the 1.33 in distributions, and reduce my cost by 3.23. Put another way, it would have a break-even point before distributions of 51.67 per share.

The price of 51.67 per share was about what I had originally thought Realty Income might be worth if it merely chugged along upward at a reasonable rate from being very underpriced. At the point at which I bought my position (44.87), its yield exceeded 5%. At 55 the yield had fallen to 4.2%, not enough, in my view. Writing the call would get my prospective return back on track.

The call write, in effect, enabled me to be indifferent to future price movement of the stock. Note: I might have chosen the June 55s, for which the premium was not so far from what the Septembers afforded, but after factoring in the distributions I chose September.

This strategy still works as of the moment of my writing this. At yesterday's (Thursday) close, I had thought that I would need to write a little coda about what to do now that Realty Income had jumped ahead another couple of points to a bit over 57.50. It would require a bit more of an opinion as to the speed and direction of the next move to choose the best strike price and expiration date.

As it happened, Realty Income gave back most of its recent quick move up in a rush while I was out to breakfast with this article half done. The last quote I saw on O was 55.77; the last option price and spread suggested the current call write would be slightly more favorable that the terms I accepted.

The alternatives with O are to do nothing and sit or sell your position. I think this suggestion is better. Nobody really knows the next direction this or any other stock position will take. All you can do is assess the value, consider the options, and do nothing or take an action.

Disclosure: I am/we are long O, WPC.

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.