Preparing For A Drop In Realty Income

| About: Realty Income (O)

Summary

As Seeking Alpha contributor Brad Thomas pointed out recently, although it's been a great performer, Realty Income is richly valued.

Wall Street seems to agree regarding Realty Income's valuation, with the median price target for the REIT being below its most recent market price.

Given Realty Income's rich valuation, we present two ways to add a margin of safety by hedging it, one of which may be of interest to Realty Income longs. .

Realty Income: Pricey But Passes The Test

In his recent article ("No Margin Of Safety But A Strong Hold For Realty Income"), Seeking Alpha contributor Brad Thomas highlighted the strong performance and attractive dividend yield of Realty Income (NYSE:O), but acknowledged that its current, high valuation meant the stock had no margin of safety. In this article, we'll show a way for Realty Income shareholders to add some margin of safety to it (actually, we'll show two ways, but we suspect Realty Income shareholders won't be interested in the first one). Before that, though, a quick follow up regarding this REIT.

In a previous article of ours ("Buying REITs When There's Blood In The Streets"), we mentioned that Realty Income was one of the REITs that passed our 2 screens to avoid bad investments. As of Friday's close, it still passes those two tests. Still, stocks that pass those two tests aren't immune to the possibility of steep drops, so it may make sense to consider adding a margin of safety by hedging. Since not all REIT investors hedge, let's take a moment to review a few hedging terms before presenting the O hedges.

Refresher On Hedging Terms

Recall that puts (short for put options) are contracts that give an investor the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). And calls (short for call options) are contracts that give an investor the right to buy a security for a specified price before a specified date.

A collar is a type of hedge in which you buy a put option for protection, and at the same time, sell a call option, which gives another investor the right to buy the security from you at a higher strike price by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest cost, while not capping your possible upside by more than you specify. In a nutshell, with a collar, you may be able to reduce the cost of hedging in return for giving up some possible upside.

Hedging O With Optimal Puts

We're going to use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge O below, but you don't need the app to do this. You can find optimal puts and collars yourself by using the process we outlined in this article if you're willing to take the time and do the work. Whether you run the calculations yourself using the process we outlined or use the app, one additional piece of information you'll need to supply (along with the number of shares you're looking to hedge) when scanning for an optimal put is your "threshold", which refers to the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purpose of the examples below, we've used a threshold of 17%. If you are more risk-averse, you could use a smaller threshold. And if you are less risk-averse, you could use a larger one. All else equal, though, the higher the threshold, the cheaper it will be to hedge.

Here are the optimal puts, as of Friday's close, to hedge 500 shares of O against a greater-than-17% drop by mid-September. This is the hedge we alluded to above that we suspect most Realty Income shareholders would eschew, but we're including it here for illustration purposes.

As you can see at the bottom of the screen capture above, the cost of this protection was $1,375, or 4.57% of position value. The cost there is why we suspect most O shareholders wouldn't be interested in this hedge: on an annualized basis, it's significantly higher than the REIT's yield, and the yield is part of what attracted you to the "monthly dividend company", as the image from Realty Income's website below describes it.

Nevertheless, let's note a couple of points about the cost:

  1. To be conservative, the cost was based on the ask price of the put. In practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 17% threshold includes this cost, i.e., in the worst-case scenario, your O position would be down 12.43%, not including the hedging cost.

Hedging O With An Optimal Collar

When looking for an optimal collar, you'll need one more nuber in addition to your threshold, your "cap", which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. A logical starting point for the cap is your estimate of how the security will perform over the time period of the hedge. For example, if you're hedging over a seven-month period, and you think a security won't appreciate more than 5% over that time frame, then it might make sense to use 5% as a cap; you don't think the security is going to do better than that anyway, so you're willing to sell someone else the right to call it away if it does better than that.

Realty Income differs from two recent stocks we've presented optimal collars for, Apple (NASDAQ:AAPL) and IBM (NYSE:IBM), in a couple of interesting ways. The first is that, unlike Realty Income, Apple and IBM both failed the two screens we mentioned above, so Portfolio Armor's website didn't calculate potential returns for them. The site did calculate a potential return for O: 16%. But bear in mind that, historically, the average actual return has been 0.3x the potential return the site estimates, so its potential returns are high-end, bullish estimates.

The second way Realty Income differs from IBM and Apple is that, unlike those two stocks, the median Wall Street price target for O is below the stock's most recent closing price ($60.22 as of Friday), as the screen capture from Yahoo Finance shows. This supports Brad Thomas's point about O's current valuation.

Ordinarily, we'd start with our site's potential return estimate as a cap, but given that O is already trading above its median price target, we decided to be more conservative and start with a cap of 4.8, or 0.3x the potential return. Then, since we were able to increase that to 7% without raising the hedging cost, we used 7% as our cap.

As of Friday's close, this was the optimal collar to hedge 500 shares of O against a greater-than-17% drop by mid-September, while not capping an investor's upside by less than 7%.

As you can see in the first part of the optimal collar above, the cost of the put leg was $825, or 2.74%, as a percentage of position value. But if you look at the second part of the collar below, you'll see the income generated by selling the call leg was exactly the same.

So, the net cost of this optimal collar was $0.

One note on this collar hedge: Similar to the situation with the optimal put, to be conservative, the cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask), so in reality, an investor would likely have paid less than $0 when opening this collar, i.e., he would have likely collected more income for selling the calls than he paid to buy the puts.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.