Realty Income Is Overvalued, So What? Buy The 6.37% Yielding Preferred Stock Instead

| About: Realty Income (O)

Summary

Realty Income's common stock is overvalued.

An alternative is Realty Income's Class F preferred stock.

I discuss the advantages and disadvantages of investing in Realty Income's preferred stock.

Realty Income's preferred stock yields 6.37 percent, substantially more than the common stock.

Click to enlarge

Real estate investment trusts have had a good run in 2016. Realty Income Corporation (NYSE:O) and National Retail Properties (NYSE:NNN) are two REITs that have done especially well this year, gaining ~21 percent and ~15 percent, and outperforming the S&P 500 stock market index by a wide margin.

In light of this outperformance, I have penned a piece lately about Realty Income, titled "Realty Income: Is This A Bubble?", in which I questioned the REITs high valuation on an adjusted funds from operations basis. In a nutshell, Realty Income sells for ~21x this year's adjusted funds from operations, which is above Realty Income's historical valuation range of ~17-19x AFFO. Further, Realty Income has climbed to a new 52-week high, making it ever more likely that new income investors are running a high risk of overpaying for Realty Income over the long haul.

While I concluded that I didn't think Realty Income was in a bubble, the REIT clearly has gotten too expensive, and is now priced for perfection.

So, if you like Realty Income and the steady dividend payments that come with it, but are turned off by the REIT's rich valuation, what are you going to do?

Taking a look at Realty Income's preferred stock would be a good start. That's right. Real estate investment trusts issue not only common stock, but also preferred stock, which are, as a rule of thumb, less risky than the common stock because the preferred stock ranks higher in the capital structure.

As a matter of fact, Realty Income Corp.'s 6.625% Monthly Income Class F Cumulative Redeemable Preferred Stock (O.PRF) is worth a serious look for income investors for three reasons:

1. Realty Income's preferred stock also pays a dividend on a monthly basis, which is good for shareholders desiring monthly dividend paychecks. Realty Income's Class F preferred stock throws off a monthly dividend of $0.138021.

2. Realty Income's preferred stock has a distinct yield advantage over the common stock.

At the time of writing, the preferred stock sells for ~$26. Based on an annualized dividend payout of $1.65625/share, the preferred stock yields 6.37 percent. Compare this to the 3.84 percent yield investors get their hands on when buying the common stock today. Put differently, the surge in Realty Income's common stock has driven down the common stock yield so low, that investors buying the preferred stock now have a 253 bps yield advantage vs. the common stock buyer.

3. Realty Income's Class F preferred stock is substantially less volatile than the common stock (as it should be).

Click to enlarge

Disadvantages

Realty Income's preferred stock, due to its seniority, is much less volatile than the common stock, this was just shown. On the flip-side: Realty Income's preferred stock has very limited potential for appreciation, whereas Realty Income's common stock, in theory, can edge much higher.

Further, Realty Income's preferred stock may have a higher yield than the common stock, but preferred stock dividends are 'no-growth' dividends, as opposed to Realty Income's common stock dividends. This means that preferred stock dividends will be held steady and not grow in the future.

Your Takeaway

If the goal is to achieve steady dividend income from Realty Income, buying the Class F preferred stock can make a lot of sense. Importantly, the preferred stock yields substantially more at this point in time than Realty Income's common stock: The yield advantage for the preferred stock has increased to 253 bps thanks to the surge in Realty Income's common stock price. I think given the high valuation of Realty Income, the preferred stock is an appealing alternative for income investors.

Disclosure: I am/we are long O.

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.