Realty Income Corporation: This Income Remains Too Expensive

| About: Realty Income (O)

Summary

Realty Income Corporation can be measured on the yield spread relative to treasuries.

While Realty Income and treasuries were both rallying, the increase in O substantially outpaced the growth in treasuries.

The weakness in the market in the first quarter seemed like an optimal time for a big deal.

If O does acquire cheaper competitors, it may have to remove several properties from the portfolio.

I’ll keep an eye on O and look to enter if the yield spread widens materially.

Realty Income Corporation (NYSE:O) is a great triple-net-lease REIT. Its excellent track record of increasing dividends combined with paying those dividends on a monthly basis has made it a favorite for many income investors. I agree with those investors that O is an excellent security and I doubt it will spend much time at dramatically cheaper levels, but I'm still holding off on entering an order. As an analyst dealing with interest rates a great deal, it makes sense for me to put an emphasis on yields when assessing the different equity REITs. However, assessing yields in a vacuum is significantly less useful than assessing relative yields. Therefore, I put together a good chunk of data for assessing the spreads.

The Yield Spread

The objective here was to make a system that is fairly simple but remains actionable. A system that is too complex won't be updated frequently enough unless the updates can be automated. Therefore, the technique needs to be simple to update.

I gathered data on the last 12 dividends for Realty Income Corporation and used them as a guideline for establishing yields at any point over the last 16 months. This clearly creates a system that isn't quite perfect since it ignores some of the prior dividends and investors didn't know precisely what the dividends would be. However, they do know Realty Income Corporation has never cut the dividend and increases are both common and quite small. The objective here is to establish a rough estimate of the dividend yield at any given point in time. The following chart shows the yield on O using the most recent 12 dividends and the yields on treasuries:

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It should be pretty clear that the yield on O is coming down materially relative to the treasuries. However, it would be more useful if we could highlight the most relevant treasuries and simply compare the yield spread from O to those securities.

Essentially this strategy will standardize everything saying how much yield that security offers relative to an investment in O.

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When we are assessing Realty Income by comparing it to each treasury, we are getting a better feel for whether shares of O are cheap or expensive when considered simply as an income investment. The trend over the last few months would suggest that O was becoming materially more expensive.

To reinforce that image, I want to point out the change since the start of 2015:

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This is the change in the yield available. A slight disconnect wouldn't be too much trouble, but this is a fairly significant change. While the values will fluctuate some over time, the fairly weak yield relative to treasuries should cause investors to question how much upside remains.

Loving O, Just Not the Price

O is an easy security for both investors and analysts to appreciate. Management seeks to offer a great deal of transparency on its financial results and its business strategy. Shareholders have demonstrated appreciation by trading the company at a higher multiple than most peers. Management leveraged that higher multiple to issue shares and grow the company by acquiring high-quality properties in excellent locations with attractive capitalization rates. This emphasis on desirable properties in the right location leads to consistent growth in its revenues because when a property does come off of a lease, O is still desirable for tenants to sign new deals. Of course, Realty Income Corporation also emphasizes leases with a long life span and the opportunity to grow rental revenues over the life of the lease. These traits provide further stability to its performance.

Hoping for Issuance

Since shares are trading at fairly high multiples right now, it would make sense for Realty Income Corporation to be issuing new shares if it has a viable use for the funds. Its exceptionally low WACC (weighted average cost of capital) would be a great tool to leverage. There is some speculation about whether O should be acquiring smaller REITs that trade at much lower multiples. Such an option could be fairly attractive, but O still has a reputation to maintain. In most acquisitions, it could be forced to trim the portfolio of the properties it acquired to remove properties that do not fit its investment standards.

Properties with weak locations or with an emphasis on less sustainable industries will tend to have much lower prices and consequently higher capitalization rates. Buying those properties would increase FFO in the immediate future, but the speculative properties would expose O to declining FFO in the future if the properties could not be released at rates that would be attractive to O. That would be a substantial blow to the company because its excellent reputation is driving the low WACC and allowing it to finance properties by issuing new common shares. I was hoping for big announcements about a large issuance to come out during the first quarter when the rest of the market was weak and O was strong. Just like I want to buy stocks when there is blood in the streets, I would love to see O making acquisitions when there is blood in the streets.

Continuing to Wait

The recent declines in price brought me back to review O and consider if I should step into a position. While O remains very attractive, the declines in price have not been enough to bring the yield spread back to the level that would make me feel ready to part with my cash. If it declines significantly again, I may step into the market to acquire some shares.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in O over 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: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.