If Realty Income Is Too Expensive, Have You Looked At The Preferred Shares?

| About: Realty Income (O)

Summary

The preferred shares on Realty Income Corp. have a fairly nice current yield and call protection for about one year.

The yield to call has fluctuated, but recent pricing offered investors a yield to call around 3%.

The preferred shares overall have been fairly steady in price over the last year, with a trend lower since the call date is approaching.

I find these shares interesting at prices below $26, and on Friday, February 12th, they closed at $25.76.

Realty Income (NYSE:O) is one of the highest quality triple net lease REITs available. Unfortunately, the market is well aware and shares trade at significant premiums to most other equity REIT investments. The substantial climb in share prices so far in 2016 has corresponded with rising prices on treasuries. The result is that many investors interested in owning O may find themselves unable to stomach the high cost to buy shares at the present time.

Preferred Shares

Realty Income Corporation has more than common equity available. Investors unwilling to stomach the high prices may want to consider the option of using the preferred shares as a way to park some capital. It is worth noting that the preferred shares were recently (end of Friday, February 12th) trading at $25.76 which is a $.76 premium to liquidation value. While liquidation is unlikely, it is also a premium to call value. The shares will first be callable on February 15th, 2017.

Many investors object to paying a premium to par value to purchase preferred shares and I believe there are several cases where that makes a great deal of sense. It is particularly problematic if the issue is already callable. The annual dividend on the preferred shares is roughly $1.65 so investors would still expect to receive more in dividends than the premium paid to the par value.

I expect shares to go ex-dividend on February 26th, 2016. The payment is expected to be made on March 15th, 2016. Because the call date aligns perfectly with a payment date, I wouldn't be surprised if O planned to utilize the option immediately. In that case, investors would expect to receive precisely 12 dividends with the final one occurring in February 2017.

I'm estimating about $.07 of accrued dividends for the call in the month so that the final holders of the shares would receive about $25.07 on the call.

Ticker Troubles

One of the challenges for investors in preferred stocks is the different symbols that will be used. In referencing the Series F for Realty Income Corporation, I have seen the following tickers used:

O.PRF (as seen as on Preferred Stock Channel)

O-F (as seen on Google Finance)

O.PD (as used here)

Shares may also occasionally be referred to as O-PF or OprF.

Stability

Despite interest rates fluctuating substantially over the last year, the price on the O preferred has been fairly stable as demonstrated in the following chart, from PreferredStockChannel, comparing O.PF to common shares of O.

Share prices on the O.ORF have declined slightly over the last year, but that could be heavily attributed to the call date approaching. If the preferred shares are not called, the current yield would be 6.43%. Investors who choose the common stock, as I would do if it were cheaper, may point out that the dividends on the common stock grow consistently. The company has raised them over 80 times. It is a logical argument to make, but the high multiple of price to FFO (funds from operations) is enough to concern some investors who don't want to buy into shares and watch them sink if bond yields turn higher.

Coverage

Preferred stock dividends in 2015 ran just over $27 million. In the same year, the company's FFO was $652.4 million. I'm quite comfortable with the coverage ratios and the quality of management. The data is all readily available in their latest 10-K.

My Expectations for O.PD

I think "lower for longer" will become a strong theme in bond interest rates over the next year, though there also may be a few substantial interest rate scares that send rates higher temporarily. Those scares may lead to more attractive buying opportunities for the common shares. In the meantime, I expect the preferred shares to be fairly steady since I believe long-term rates would have to move substantially higher to justify the preferred shares falling significantly.

I wouldn't be surprised if these shares are called some time within the next few years. As a result, I expect the yield to maturity to land somewhere between 3% or so and 6%. I don't expect the full current yield to be realized because I doubt these will stay outstanding indefinitely. The logic for O calling the preferred shares at some point has nothing to do with liquidation or a failure to find attractive properties. It is simply a situation where it would become worthwhile for O to call the issue and issue new preferred shares.

It should be worth noting that Realty Income does call their preferred shares. The most recent example was the E series of preferred shares. In September of 2014 the call for the E series was announced with a planned redemption date for October 24th, 2014.

Risk Assessment

There is always a material amount of risk involved in buying securities. Even treasuries carry interest rate risk. While the risk on preferred shares of O is substantially higher, I have enough faith in the common that I would be happy to buy it if prices were lower. Since the common shares easily fit within my risk tolerance at a lower entry price, it should be fairly reasonable to expect that the preferred shares would also be within my risk tolerance since the yield to call remains both positive and reasonable for a one-year investment. If I was to buy the shares and they weren't called for two years, it would give me a fairly reasonable return.

It is worth noting that the preferred shares over the last three days have traded as low as $25.756 and as high as around $26.24. At $26.24, the yield to call becomes fairly dreadful. I'm contemplating buying some of these preferred shares but my maximum price would be around $26.00. Anything above that simply does not provide a high enough yield to call for me to consider it.

Pricing and Yields

I put together the follow estimates of the yield available on shares at different price points. The annualized returns are very similar to the holding period returns because I'm assuming no reinvestment of dividend and the call date is only a couple days off from being precisely a year from now.

Over the last few days, I've seen prices range from $25.75 to $26.17. The difference in the expected holding period return ranges from 2.12% to 3.79%. It is worth noting that investors buying into these preferred shares get a substantially better deal if Realty Income Corp. takes a few months to use their call option. Unless there is a huge change in the environment over the next year, I would expect these to get called quickly once the option is available.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in O.PF over 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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.