If I Were Retired And Owned Realty Income, This Is What I'd Do

| About: Realty Income (O)

Summary

There is currently an ongoing debate on SA about what to do with O.

I want to both offer an alternative to what has been suggested so far, while also illustrating a point.

I explain what I would do if I were retired, income dependent, and, owned--or wanted to own--Realty Income, but didn't want to go to cash, short, or use options.

Click to enlarge

Introduction:

There is currently an ongoing debate about what investors should with Realty Income (NYSE:O). The article that first drew my attention to the discussion was David Van Knapp's article "Realty Income: What should I do?", asking what should be done with rather his large position in Realty Income now that it appeared overvalued.

I hadn't been watching Realty Income at all this year up until I read DVK's article because I don't own Reality Income and I've been busy looking for undervalued stocks, not overvalued ones. Needless to say I was surprised at how far Realty Income had run up since I last looked at it in 2015. So, it didn't surprise me when someone, in this case Dane Bowler, wrote a piece "Short Realty Income", suggesting that O should be shorted. It also didn't surprise me that Brad Thomas immediately responded with a piece "The Danger of Shorting Realty Income" that warned of the dangers of doing so. (You can find and read all of these articles, and several others, by clicking the blue "O" above.)

A few months ago, in October of 2015, I wrote an article suggesting STAG Industrial (NYSE:STAG) should be shorted. Brad Thomas immediately issued a rebuttal to my argument, just as he did with Dane's. Brad included similar points about STAG that he made regarding someone potentially shorting O. I ended up being correct about STAG, and STAG declined precisely as I had expected it to for the period of time in question (you can find those articles on my profile page). However, in the end, I thought Brad made a legitimate point about the risk involved with shorting STAG and I think his point about the risks involved shorting O are legitimate as well.

My goal, then, is to figure out a strategy that an average-- or below average--investor could use if they have come to the conclusion that Realty Income is a desirable stock to own, but is currently way overvalued. Context and individual circumstances are really important when designing such a strategy so I'm going to premise my suggested Realty Income strategy with some assumptions I'm making given what I've read in the comment streams of these articles and in the articles themselves.

Here is the investor I have in mind for this article:

1. An investor who needs income. I am envisioning an investor who is retired and who wants to hold companies that can provide a predictable income stream. I will assume that if they own Realty Income already, or that if they are looking to purchase it, that they will do so via a tax sheltered account.

2. I will assume that any alternative investment the investor makes will be with a high quality company with a long history of success. So, any alternative investment will at least have to be as high of quality as Realty Income.

3. I will assume that an investor desires inflation protection and that is a major reason they are looking to invest in equities. This will eliminate a strategy that advises to simply hold cash until O becomes available at a cheaper price.

4. I will assume that the investor prefers to do little work, and to do minimal monitoring of their investments. This means I won't suggest a strategy that requires constant monitoring of the news or markets.

5. I will assume that the investor either doesn't want to, or isn't able to use an options strategy, or to short.

6. I will assume that the investor wants to own Reality Income, but that they want to own it at a lower price.

Okay, that's a lot of assumptions, but I think that there is a vast, vast group of investors who fall into this category, and this strategy is written with them in mind.

Before we begin, it is important to ask the question: Why is Realty Income overvalued?

Brad Thomas suggested that what is happening is that we are having a flight to quality. While this may be a contributing cause, I don't think it is one of the primary causes. In my view their are two primary causes, the first is that people want dividends, the second, and often overlooked reason, is that people are chasing past performance.

Extrapolation errors are one of the most common errors made by investors, and my view is that is what is happening with Realty Income. Investors look at the dividend history and the historical performance of the stock and they think they'll be able to get similar performance over the course of the next 10 years or more. The investors who are chasing past performance are not value investors. If and when the price of Realty Income stock price declines, I predict they will panic and run for the exits and Realty Income will be available for purchase at a much lower price. Realty Income may be high quality but their are other high quality stocks which are at better valuations. It's the past performance and dividends that are driving the price up.

With all this in mind, and given the assumptions I've mentioned above, here is the strategy I recommend if one either wants to buy O, or one already owns it, but thinks it's overvalued and would like to sell it and buy it back at a lower price.

The strategy:

The basic strategy involves five steps: (1) sell Realty Income for 63.00 per share, (2) take the proceeds, or the amount one would like to invest in O, and set aside 12% of that money to pay yourself a 4% dividend over the next three years, (3) take the other 88% of your 'O' money, and buy Berkshire Hathaway (NYSE:BRK.B), (4) wait for O to hit $47.50, and when it does, sell BRK.B and buy O, (5) Each month, while you wait, pay yourself 0.34% of the cash you set aside for your monthly income.

Let's start with step one and assume your Realty Income stock is worth $10,000 after you sell it, or that you have $10,000 you would like to invest in Realty Income (this 10k number can be obviously be scaled up or down depending on the size of one's portfolio). Out of that 10k, you set aside $1,200 dollars in cash and will diligently pay yourself a dividend each month in the amount of $33.34. If my math is correct, this is about the equivalent of a 4% dividend yield. Realty Income only has a 3.81% dividend yield, so you are actually paying yourself more than you would get with O. This will help to offset any potential dividend increases Realty Income makes over the course of the next 36 months.

At this point, at the end of 36 month's time, you are guaranteed to both have income during that time period equal to, or greater than, that derived from Realty Income, and you would have $8,800 left to invest.

The only problem is that you have no inflation protection and no chance of price appreciation if you simply hold the cash. It is entirely possible that O will never see $47.50 in the next 36 months, and that inflation will increase. In this case, holding cash will cost you 4% a year, plus whatever inflation takes. My solution for this problem is to buy Berkshire Hathaway with the remaining 88% of the cash.

Why do this? And does it fit with our assumptions and potentially meet our goals?

It's important to remind ourselves the mistakes that other investors are probably making. The first mistake they are likely making is that they are equating dividends with income (or at least assuming that dividends are a superior form of income). This means that dividend paying companies are probably going to be more highly prized and priced higher than non-dividend paying companies, all other things being equal. Basically, Berkshire is being undervalued because it doesn't pay a dividend while Realty Income is being overvalued because it does, even though both are high quality companies. In my opinion, at some point in the next 3 years, this situation will correct itself.

If we go back to August of 2015 and look at the price change between O and Berkshire we can see the divergence.

O Chart

O data by YCharts

Why pick August?

O Chart

O data by YCharts

In truth, I could have picked a different time period, but the fall of 2015 was the last time the price of the two stocks converged at prices that approached their relative long-term average. What's missing from the chart above, though, are dividends, which is where Realty Income has outshined Berkshire on a total return basis. Here is O's total return for the same time period as the chart above:

O Total Return Price Chart

O Total Return Price data by YCharts

The stocks don't look so even now. This is an important consideration to make over the long term. The longer we wait to buy O, and instead hold BRK.B, the more dividends matter. But, in my opinion, they don't matter that much right now. Look at how O has performed since its price spike in 2013.

O Total Return Price Chart

O Total Return Price data by YCharts

For over two years, from June 2013 to about August of 2015, Berkshire was equal to or better than O on a total return basis. That includes dividends. My prediction is that we will probably see another period like this one going forward. One reason why I think that, is that Realty Income's yield is lower than it was even in June of 2013. The dividend simply isn't contributing that much to the O's total return.

O Dividend Yield (<a href=

O Dividend Yield (NYSE:TTM) data by YCharts

As late as early November O and BRK.B were at similar relative prices, then O exploded to the upside 30%. This is the range O was in last fall before it jumped higher.

O Chart

O data by YCharts

I think that at some point in the next 3 years it will trade back in this range again, and so I'm aiming for a buying price of $47.50. At that price Realty Income's expected dividend yield would be about 5%.

Here are four types of scenarios we might expect from this strategy:

Really Bad Case: We have a recession, the Fed launches more QE, the dollar weakens, and Warren Buffett dies. This is probably a worst case scenario, and one in which Berkshire may actually decline more than Reality Income. If this happened, however, one wouldn't be forced to sell their Berkshire shares for income for three years, so there is some protection due to the fact that one could wait out a temporary decline in Berkshire. In this scenario, I think an investor could potentially lose 40% of their investment. However, I think this scenario has a very low probability of happening.

Bad Case: A bad case would probably be a scenario where O never reaches the $47.50, Berkshire stays flat, and more investors pile into O, driving up the price even more. In this case there is an opportunity cost for the investor and perhaps some capital loss. However, given where O's price is right now, and given our rather long, three year time horizon, it is far more likely we'll see O come back down to Earth at some point.

Base Case: This is the base case that I think has the most likelihood of happening. I expect that sometime within the next year O's price will hit our target of $47.50. We've already seen how jittery this market has been over the past year. Some combination of interest rate hike expectation, external economic shock, or political panic, will likely send investors to the sidelines, and I think when that happens overvalued companies will suffer disproportionately. If this scenario happens I expect that Berkshire will trade somewhere in between $125 to $130 per share, for a loss of about 12.5%.

So, let's say if this happens in October 2016, and one has paid themselves 2% of their cash in dividends up to that point, they still have 10% in cash. In total, if they started with $10,000, they would have about $8,800 in cash available to buy O with their combined BRK.B sold @ $125.00 and cash. That amounts to about 185 shares of O @ $47.50 if my math is correct. If one were to buy O today, $10,000 would only buy 159 shares. Some variation of this scenario is probably the most likely outcome of the strategy, and we would achieve our goal of purchasing 15% more shares of Realty Income than we could today.

Optimistic Case: The optimistic case for this strategy would probably involve the Fed raising rates more rapidly than expected. This would likely be interpreted by the market as benefiting Berkshire's financial holdings while harming REITs in general. In this case, over the course of a year or two, Berkshire could go up, while O lingers, and goes down. In this case, one would be able to purchase up to 25% more shares of O than they could now, simply by being patient. I actually think there is a reasonably good chance of this happening.

There is also a really optimistic case where Berkshire goes way up while Reality Income tanks, but I don't think the odds of that happening are worth considering.

Conclusion:

Since I'm mildly obsessed with tracking the performance of my strategies, I'll give quarterly updates for those curious to see how this strategy turns out. There is a larger point I wanted to illustrate, though: dividends and income are not the same thing. You can get income without dividends and without being subject to market pricing. We have extremely low inflation right now. It doesn't cost much to hold cash for several months at a time and pay yourself a dividend while prices are really high. Just as important. It's not that hard to do. This isn't a complicated or a risky strategy.

From a valuation standpoint, it's similar to the strategy I tried to get potential buyers of Disney to make back in December when I explained Regal Entertainment was a better Star Wars bet over the medium-term. Here is how that is shaping up:

RGC Total Return Price Chart

RGC Total Return Price data by YCharts

Now one can buy a lot more Disney than they could just a few months ago simply by not buying it when it was at a really high valuation and buying an undervalued company instead.

Well, there you have it. My opinion on what to do if you want to own Realty Income, but think it's overvalued. I am going to track this strategy quarterly (or until O hits $47.50), and see how it performs. My expectation is that it will result in owning far more shares than if one went out and bought O today at $63.00.

Disclosure: I am/we are long BRK.B, RGC.

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.