Realty Income: Don't Fall For The Short Thesis

| About: Realty Income (O)

Summary

This article is a rebuttal to the latest published short thesis on Realty Income.

While valuation concerns exist, the short thesis fails to list a convincing catalyst for a decline in Realty Income's common stock price.

I think the reward-to-risk ratio of a Realty Income short is not very attractive at this point.

Click to enlarge

SA contributor Dane Bowler recently published a piece on Realty Income (NYSE:O), titled "Short Realty Income", in which the case was made for selling one of the most popular real estate investment trusts on the Street. The short case listed the potential for an estimated ~30 percent valuation drop for Realty Income's shares. The reasons cited for supporting the short thesis were slowing growth, including funds from operations and dividend growth, bullish sentiment, and Realty Income's high valuation.

As I have said myself in my articles on the REIT, I also believe that Realty Income is overvalued today based on traditional metrics like P/FFO and P/AFFO. In fact, the surging market price for its common stock has resulted in Realty Income's dividend yield to drop below a relatively low 4 percent, which is another indicator for overvaluation. Further, I suggested that investors don't buy Realty Income because of its high price tag, but that's fundamentally different from actually going out and shorting a dividend-paying stock.

While I do believe that Realty Income's common stock is too expensive at this point, shorting a very popular income vehicle based on the notion that the REIT's growth might slow in the future is a potentially dangerous investment strategy.

The point that Realty Income is overvalued is not going to be contested by anybody, really. Realty Income estimated that it will pull in $2.82-$2.89/share in funds from operations, and $2.85-$2.90/share in adjusted funds from operations in 2016. Hence, Realty Income's market valuation implies a ~22x P/FFO and P/AFFO ratio. Expensive, but is this overvaluation reason enough to short the stock?

In fairness, I have recently said in an article that I wouldn't want to be a buyer of Realty Income's stock at present market prices, and rather wait for a pullback into the low $50s. So, in this particular regard, I agree with Bowler about Realty Income's downside potential.

What concerns me, though, is the fact that his article didn't mention a specific, negative catalyst for the potential decline in Realty Income's shares, for instance a negative expected earnings announcement, a collapsing property transaction or refinancing etc.

Sentiment can always shift, and it can do so quickly, but in the absence of a clearly defined, negative catalyst, it is difficult to accept the very high risk of shorting a popular dividend stock purely because Mr. Market likes a stock a little too much right now. That being said, even if Realty Income's FFO and dividend growth is going to slow down the road, a big, accretive real estate portfolio transaction could quickly change that trajectory. Realty Income has earned a reputation for pulling off accretive property transactions over time, a credit that the REIT was not really given in the latest short thesis.

Another problem with the short thesis as presented is that it suggests that shorting a dividend-paying stock is a good idea, when in fact that might not be so at all. Short sellers have to pay the dividend out of their own pockets to the original shareholders from which they borrowed the shares, putting their investment return into negative territory almost from the get-go. As far as I am concerned, the reward-to-risk ratio of a Realty Income short is not very appealing.

Your Takeaway

There are, in fact, two better ways of getting around the high valuation of Realty Income's common stock. You can either leave the common stock aside, and buy the preferred stock for a 6%+ dividend yield, or you just buy regular put options to protect common stock profits. In light of an absence of a clearly defined catalyst, shorting a dividend stock based on sentiment or valuation considerations alone is a highly risky investment strategy.

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.