Realty Income: Forget All That You Know About REITs

| About: Realty Income (O)


Realty Income has surpassed $60 a share with an expanding valuation multiple minus an expanding growth rate.

Why higher-quality REITs tend to be viewed possessing "bond-like" attributes.

An examination of Realty Income's relationship to the 10-year Treasury over the past 5 years.

It has been interesting to watch the flood of cautionary articles surface as Realty Income's (NYSE:O) stock price approached and eclipsed the $60 mark. I've seen the chart illustrating O's dividend history more times than I would have considered imaginable, so I won't show it to you again. But despite the stock's impressive performance, most analysts have been urging caution, and a few have said you should sell.

For those that read me frequently, you'll know I've never been particularly bullish, having recommended purchase only one time over the past many years I've been writing about the company. That was when the stock dropped below $40 with a 6% yield point at the end of 2013.

Two-plus years later and 50% higher, that was certainly a good time to buy. Too bad I didn't take my own advice!

How Should You View O?

For some, Realty Income represents the epitome of a sleep-well-at-night dividend growth stock. The company markets itself as a solution for investors interested in durable monthly income. Although its dividend growth over the past few years hasn't exactly been robust, investors sleep soundly knowing that management is not taking stupid risks or fudging numbers to attain aggressive growth targets.

Unquestionably there are REITs out there that are growing faster with higher yields and lower valuations than O, but none of them seems to possess the bulletproof reputation that The Monthly Dividend Company has gained.

A typical evaluation of a REIT would incorporate at least minimal discussion of funds from operations and comparative valuation multiples. However, in this article, I won't be discussing Realty Income's equity valuation. Because to understand the company and where its stock price and yield head from here, you need to better understand what's going on in the bond market.

Why The Bond Market?

Realty Income is clearly not a bond. However, REITs, telcos, and utility-like companies that see dependable recurring income streams from customers can be considered "bond-like" by the investment community.

Typically, equity prices trade higher because investors see earnings upside relative to current expectations. Slow growth, bond-like equity instruments, like O, may react more in line with what is going on in the bond market as opposed to the equity market.

If we look at the 5-year chart below, it is evidence of Realty Income's inverse movement relative to the yield on the 10-year Treasury bond, which sits at about 1.9%. The red line is Realty Income's stock price % change, and the blue line represents the 10-year Treasury yield. Five years ago the Treasury yield was about 3.5%, so on a percentage basis, we are about 50% lower now as compared to then.

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Source: Yahoo Finance

The taper tantrum of 2013, the beginning of which I circled, lasted about six months, a time when the Treasury yield went from 1.5% to 3%. During the same time, Realty Income traded down from $55 a share to $36.60 a share. Over the past 2+ years, Treasury yield has been in a downtrend, while O's price has been in an uptrend.

The are other shorter-term inverse moves that can be plainly seen in the graph.

Also of note is that Realty Income's yield over the past many years has tended to gravitate to about twice that of the 10-year Treasury. When the bond yield was about 3% at the onset of 2014, Realty Income's was at 6%. Today, with the Treasury yield at about 1.9%, Realty Income sits at about 3.8%.

It seems, all things considered, investors require double the Treasury yield to compensate themselves for the equity risk that a bond-like REIT like Realty Income exposes one to.

Cap Rates: Is Realty Income Really Behaving Like A Real Estate Investment?

During its latest earnings call, executives pointed to a roughly 7% aggregate capitalization rate (net operating income divided by purchase price) on recent additions to the portfolio. Realty Income yields only 3.8% at latest trades, so investors are receiving only 54% of current cap.

Taking into consideration that 83% of current AFFO (REIT equivalent of FCF), leaving room for growth reinvestment, is being paid out, there's still 200 basis points of yield you may be leaving on the table. The convenience of a REIT justifies some of that dilution, but you'll have to decide for yourself whether that is simply too much. For many, ZIRP provides the justification.

Familiarity Does Not Breed Contempt

Further enhancing Realty Income's relative allure is that its underlying portfolio is highly composed of investment grade, familiar tenants. Here's a brief overview of where the company's rent is coming from.

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Source: Realty Income Presentation

These 20 tenants alone, most of which I would assume a majority of you are familiar with, represent more than half of the company's ABR. The market tends to look favorably on this kind of tenant base. It is why National Retail Properties (NYSE:NNN), a REIT with a similar tenant base, trades with a similar yield to O.

High Quality Balance Sheet

Adding more to the allure is O's investment grade balance sheet with reasonable leverage, low cost of debt and asset/liability matching. While there is always risk to leverage utilization, Realty Income does it in a comparatively low-risk manner.

More Odds and Ends

The Realty Income portfolio includes a 10-year average remaining lease term. This can be viewed as both a good and bad thing. Good from the point that lease rates are locked in, usually with a 1%-2% annual rate bump-up. Bad from the perspective that the company will not be able to reset leases frequently if there is a secular trend toward robust rent rises over the next decade.

This is another reason that REIT income, especially that derived from triple nets with longer lease duration, is sometimes considered bond-like.

Where Is The Bond Market Headed?

How you decide to handle a Realty Income portfolio position should be somewhat predicated on a rate-inspired view. If you see rates trending flat to down over many years, the stock should continue to perform well and is conceivably a buy right now in that scenario. If you see an upside breakout in Treasuries near term, capital will be better allocated elsewhere. Whether this constitutes a reason to sell or not is questionable and may vary from investor to investor.

If the 10-year were to hit 4%, which is double where it sits now, O could conceivably drop to $30 a share, representing an 8% yield point. I don't consider that at all likely.

While the recent bounce in stocks seems to have increased the likelihood of another Fed tightening next month, I still feel it could be a very long wait until we see 3% again on the 10-year. I'm not personally convinced, and neither is the bond market, that the domestic economy is strong enough to justify the Fed's tightening bias.

Although it may seem odd to follow the bond market for cues on what will happen with a real estate investment, the unique structure of a REIT and the quality asset base behind Realty Income makes the relationship more comprehensible. The tangible, quantitative value of Realty Income's underlying assets certainly has not appreciated 50% over the past two years. However, its intangible value to income investors as a quality equity-income holding certainly has.

Another case where perception is stronger than reality?

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.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions