By The Valuentum Team
Realty Income's Investment Considerations
• Realty Income (NYSE:O) is a REIT that has 4,300+ properties across the US and Puerto Rico. It is an integrated real estate company with in-house finance/accounting, tenant research, portfolio management, and capital markets expertise. Its property portfolio amounts to over 70 million square feet. Occupancy rates are north of 98%.
• Realty Income's stated goals are simple: generate dependable monthly cash dividends from a consistent and predictable level of cash flow from operations. We think management is laser-focused on achieving these goals.
• We like Realty Income's geographic diversification. The REIT generates rental revenue in 49 states, and California and Texas account for the most (at only about 10% each). Realty Income is also diversified across industry, with exposure to nearly 50 different business segments.
• Realty Income's dividend track record is fantastic. The REIT has had more than 80 dividend increases since 1994, more than 70 consecutive quarterly increases, and more than 500 consecutive monthly dividends declared. It seems as though it increases its dividend every few months or so, albeit modestly.
• Realty Income's 2015 was a solid example of the attractiveness of an investment in the company. Favorable pricing and terms on capital raising activities and a health portfolio occupancy helped drive a 6.6% increase in adjusted funds from operations (AFFO) in 2015 from the year ago. The company grew its annualized payout 5% from February 2015 to February 2016 as a result of the steady performance.
• Realty Income's FFO per share for 2016 is targeted in the range from $2.82-$2.89 per share, an increase of about 2%-4% over 2015 FFO per share of $2.77. We're expecting upside to that measure, however.
Funds From Operations Analysis
Realty Income Corp's FFO expansion has been greater than that of both its peer group and industry group during the past three years. We expect the firm's FFO expansion to outpace its peer group and industry group during the next five years. Federal Realty (NYSE:FRT) sports the highest expected FFO growth rate among peers.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
Our discounted cash flow model indicates that Realty Income Corp's shares are worth between $47-$71 each. The midpoint of the fair value range is our estimated value for shares, or $59. The REIT's equity is currently trading at ~$63, in the upper half of our fair value range, and above our fair value estimate. This indicates that we feel there is more downside risk than upside potential associated with shares at this time. Income investors may find the steady payout attractive enough to keep holding shares, however.
Our model reflects a compound annual revenue growth rate of 8.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 31.3%. Our model reflects a 5-year projected average operating margin of 49.8%, which is below Realty Income Corp's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 5.1% for the next 15 years and 3% in perpetuity. For Realty Income Corp, we use a 7.3% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $59 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Realty Income Corp. We think the firm is attractive below $47 per share (the green line), but quite expensive above $71 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Realty Income Corp's fair value at this point in time to be about $59 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Realty Income Corp's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $66 per share in Year 3 represents our existing fair value per share of $59 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
In fiscal 2015, Realty Income had its third most active year in terms of acquisition spending, as it invested $1.26 billion in 286 different properties. In addition to the growth via acquisitions, same-store rents on 3,636 properties under lease advanced 1.3% from 2014. Favorable pricing and terms on capital raising activities and a healthy portfolio occupancy of 98.4% also helped drive a solid increase of 6.6% increase in adjusted funds from operations per share in 2015 from the year-ago period to $2.74.
Looking ahead to 2016, the firm is guiding AFFO per share to be in a range of $2.85-$2.90, good for growth of 4%-5.8% from 2015, which will continue to supply ample room for growth in the monthly payout. Realty Income is a holding in our Dividend Growth Newsletter portfolio and currently registers a 5 on the Valuentum Buying Index. We continue to be impressed with the REIT's performance.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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: Realty Income is a holding in the Dividend Growth Newsletter portfolio.