2 Great Ways To Overcome Realty Income's Overvaluation: Improve Your Yield, And Improve Your Returns

| About: Realty Income (O)

Summary

Realty Income has been one of the most popular and best-performing REITs over the past 20 years, and for good reason.

However, now it, and the entire retail REIT sector are trading at historically overvalued levels, causing yields to fall to pitiful levels.

These two strategies will allow you to generate additional income and yield which could greatly benefit your returns.

BUT, as always, nothing comes without a cost, and there are some risks you need to consider.


Source: Realty Income

Realty Income (NYSE:O), thanks to its historically generous monthly payout, and 75 straight quarters of rising dividends, has understandably been one of the most popular dividend growth stocks for decades. What's more, over the past 20 years, Realty Income has not only rewarded investors with sensational total returns that have crushed the S&P 500, but it's also beaten all of its major rivals such as: W.P. Carey (NYSE:WPC), National Retail Properties (NYSE:NNN), and EPR Properties (NYSE:EPR).

O Total Return Price Chart O Total Return Price data by YCharts

However, thanks to this stunning performance, Realty Income has become extremely overvalued, potentially threatening to result in far worse returns going forward. Read on to find out just how bad the situation has gotten, but more importantly, two potentially great strategies investors can use to mitigate that threat to boost their yield over the next few years.

Just How Overvalued is Realty Income?

Sources: Yahoo Finance, Ycharts, Fastgraphs
REIT Yield 5 Yr Avg Yield P/AFFO Historic P/AFFO P/NAV Historic P/NAV Average Overvaluation
Realty Income 3.7% 4.7% 23.0 18.3 3.20 2.49 27.3%
W.P. Carey 5.7% 5.3% 13.3 13.6 5.13 2.66 28.0%
National Retail Properties 3.7% 4.8% 20.2 16.7 2.37 1.5 36.3%
EPR Properties 5.1% 6.3% 16.5 13.1 2.19 1.51 31.7%
Click to enlarge

There are three kinds of metrics I consider the best ways of judging a REIT's valuation: yield, price/AFFO, and price/NAV. As you can see, when we compare these current metrics against their historical norms, it becomes obvious the entire triple net lease retail REIT sector is significantly overvalued.

In fact, things have gotten so out of hand that Realty Income is trading close to its lowest yield... ever.

O Dividend Yield (<a href= O Dividend Yield (TTM) data by YCharts

Why does this matter? Because when stocks become this overvalued, it greatly increases the risk that future returns will be far lower than what investors have enjoyed recently.

Sources: Yahoo Finance, Fastgraphs, FactSet.com
REIT Yield 10 Year Dividend Growth Projection 10 Year Total Return Projection
Realty Income 3.7% 3.6% 7.3%
W.P. Carey 5.7% 3.1% 8.8%
National Retail Properties 3.7% 4.4% 8.1%
EPR Properties 5.1% 5.8% 10.9%
S&P 500 2.1% 5.8% 9.1%
Click to enlarge

So with Realty Income, and the entire retail REIT sector, trading at nosebleed valuations, and only EPR Properties expected to beat the market's historic rate of return, what is an investor to do? The answer depends on whether or not you already own shares, your financial situation, and individual risk profile.

Strategy 1: Supplement dividends by selling in the money puts

Puts are a form of option contract that gives someone the right to sell you their shares at a guaranteed price called a strike price, by a certain date. Basically, think of it as a form of insurance that you are selling to someone who already owns shares and is worried they might fall in value.

Source: Yahoo Finance
Put Option Premium/Share Implied Share Price Decline Implied Purchase Price Implied O Yield Option Yield Annualized Option Yield
$60 Sep 2016 $1.35 7.8% $58.65 4.1% 2.25% 9.3%
$55 Sep 2016 $0.57 14.5% $54.43 4.4% 1.04% 4.2%
$50 Sep 2016 $0.37 22.3% $49.63 4.8% 0.74% 3.0%
$60 Dec 2016 $2.30 7.8% $57.70 4.1% 3.8% 7.7%
$55 Dec 2016 $1.30 14.5% $53.7 4.5% 2.36% 4.8%
$50 Dec 2016 $0.75 22.3% $49.25 4.9% 1.5% 3.0%
$60 Jan 2017 $2.73 7.8% $57.27 4.1% 4.55% 7.9%
$55 Jan 2017 $1.30 14.5% $53.7 4.5% 3.10% 5.4%
$50 Jan 2017 $0.85 22.3% $49.15 4.9% 1.70% 2.9%
Click to enlarge

For example, say you sell (write) one September's $60 contract, which expires September 16, and is trading at $1.35 per share. Because each option contract represents 100 shares of stock, this means that as the seller of this put, you would receive $135 in option premium.

From the perspective of the option buyer, he/she is now guaranteed to sell you his/her shares at $60 a share as long as the share price is at $60 or below by the expiration date. Conversely, you now have the obligation to buy those shares for a cost of $6,000.

Why would you want to take on this obligation? Because you get a guaranteed $135 in exchange for tying up $6,000 of your capital, (the money required to buy those 100 shares), for three months which comes to a 2.25% yield before commission. If the share price is above $60 at the end of September 16, then the contract expires and you keep the premium without having to buy the shares.

Put writing is a good way for investors who want to buy shares of Realty Income but think the share price is overvalued and the current bullish trend likely to continue. Deciding what put to write is where your individual characteristics come into play.

For example, say you absolutely love Realty Income and think that $58.65, ($60-$1.35 per share of premium received), a share, at which the REIT would yield 4.1%, is appealing. Most importantly, you have $6,000 available to buy the 100 shares at the contracted price. Then, by writing a $60 September 2016 put, you are able to earn that 2.25% yield ($135/$6,000), which represents a 9.3% annualized return.

BUT let's say that, like me you think even $58.65 a share for Realty Income is still greatly overvalued, AND believe the market may remain irrational for several more months. You still want to earn a higher return from the REIT but are only willing to buy 100 shares at a lower price. In that case, you can sell $55 or $50 puts that would only require you to buy the shares after a 14.5%, or 22.3% price drop, respectively.

Because the risk to you, in terms of having to buy the shares, is lower, your premium, and thus annualized return from these contracts is lower. On the other hand, if you write a $50 Sep 2016 put, then the maximum risk you are taking on is having to buy the 100 shares of Realty Income at $49.63, at which price your yield on cost is a much higher 4.8%.

Which brings me to the risks involved with this strategy. First, if you choose to write a put, you have to remember you are committing yourself to buy 100 shares per contract. Thus, investors without relatively large amounts of discretionary capital shouldn't use this strategy.

Second, only write a put option if you think the implied buy price (strike price-premium/share) is attractive. Third, there is always the chance that by the end of the expiration date the share price will have fallen far below the strike price. The longer the contract duration, the greater the risk of this occurring, which is why the option premium is higher for longer duration puts.

For example, say you are considering selling a January $60 put. Should the Federal Reserve increase interest rates in July and December then not only could the stock market react violently downward, as it did in January of 2016 after the December 2015 rate hike, but REITs could be especially hard hit. That's because their business model is based on paying out a minimum of 90% of taxable income as dividends. This is a legal requirement to maintain REIT status and avoid paying income taxes. So in order to grow their property portfolios REITs need to raise large amounts of external capital, either by raising debt, or selling additional shares.

This large reliance on both debt markets, AND fickle investor sentiment means that one or two rate hikes might pop the REIT bubble and make raising cheap growth capital harder. That in turn would likely slow their future growth rates and make their shares even less attractive, (as would higher interest rates for safe alternatives such as bonds, savings accounts, money market funds, or CDs).

In our hypothetical 2 rate hike scenario in which you wrote one $60 January 2017 put, Realty Income could end up falling to $45 per share. In that case, you'd end up buying those 100 shares at an effective price of $57.63, for a yield on cost of 4.1%. BUT as soon as you got those shares, you would be facing a 22% unrealized loss. What's worse, you could be kicking yourself because at $45, Realty Income is selling for a 5.3% yield, which is far above its historic norm. In other words, because you wrote that put, you've now bought Realty Income at a still overvalued level instead of a very undervalued one.

Finally, ALWAYS keep commission costs in mind. Optionshouse is the cheapest options broker I know of, and they charge a $4.95 + $0.50 per contact. Because Realty Income is a very low volatility stock (beta of 0.22), option buyers aren't willing to pay very much in terms of premium. So, unless you write several puts, thus decreasing your commission per contract, you might find that it's simply not worth the risk to use this strategy because too much of your premium is consumed by broker fees.

Strategy 2: covered calls, the less risky yield boosting method

Source: Yahoo Finance
Call Option Premium/Share Implied Share Price Rise Implied Sell Price O Yield At Strike Price Option Yield Annualized Option Yield
$70 Sep 2016 $0.37 8.8% $70.37 3.4% 0.57% 2.3%
$75 Sep 2016 $0.13 16.6% $75.13 3.2% 0.20% 0.8%
$70 Dec 2016 $0.88 8.8% $70.88 3.4% 1.37% 2.8%
$75 Dec 2016 $0.53 16.6% $75.53 3.2% 0.82% 1.6%
$70 Jan 2017 $0.95 8.8% $70.95 3.4% 1.48% 2.5%
$80 Jan 2016 $0.10 24.3% $80.1 3.0% 0.16% 0.3%
Click to enlarge

In an overheated market such as this, and especially with Realty Income trading at a ridiculously overvalued price, covered call writing is probably the best option strategy for investors who already own at least 100 shares of the REIT.

Calls are the direct opposite of puts, meaning that they let the buyer of the contract purchase your shares at a guaranteed price. Whereas the buyer of the put option is afraid that Realty Income's share price was about to fall, the buyer of the call option is worried it's going to keep rising.

Now, as you can imagine, because Realty Income has run up so much, most investors think it's expensive and due for a pullback, which explains why the premiums offered for calls are much lower than those for puts.

However, luckily for you, there are still some Realty Income bulls who are willing to buy these contracts. Why do I say potential option writers are lucky if Realty Income's call options are offering such pitiful premiums? Because covered call writing represents the least risky option strategy you can use, especially with Realty Income at these prices.

For example, take the best yielding call contract, $70 December 2016, which expires on the 16th of that month and pays a premium of $37 per contract. While that 2.8% annualized yield might seem small, consider this. If Realty Income closes below $70 at the end of December 16, then that contract expires worthless and you get to keep the premium, minus any commission fees, (NEVER ignore trading costs). That means that even if you bought shares at today's price, your effective yield is 3.7% + 2.8% or 6.5%.

The worst-case scenario is that Realty Income rises above $70 by December 16 and you are forced to sell your shares at $70.88. However, given that Realty Income's yield at that price is just 3.4%, that's probably not a great loss. After all, you can always take that capital and reinvest it into higher yielding quality REITs, such as W.P. Carey.

However, while covered call writing on highly overvalued shares is the less risky strategy, (compared to put writing), there are still two risks to consider.

First, if your cost basis on Realty Income is very low, because you bought shares many years ago, (or during the depths of the financial crisis), then should your shares be called away, you will have to pay capital gains taxes. Depending on your income tax bracket, this could cost you as much as 20% of your profits under current long-term capital gains taxes.

More importantly, it could also force you to lose an incredible opportunity to own shares that are generating sensational annual total returns and will do so forever. Specifically, I'm referring to the concept of yield on cost.

For example, say you were lucky enough to buy shares of Realty Income at the absolute lowest point of the financial crisis, $14.25 per share on March 6, 2009. Not only are you up 379% (including dividends), BUT more importantly from a dividend investing perspective, your yield on cost is now $2.39 (current annual dividend)/$14.25 or 16.8%.

That means, that, even adjusted for inflation, those shares are earning you 14.8% annual returns from dividends alone. What's more, because Realty Income is expected to keep raising its dividend far into the future, your real return will only increase with time. For instance, analysts expect Realty Income's 2025 dividend to be $3.33 per share. That would mean an unadjusted (for inflation) yield on cost of 23.4%.

Assuming 2% inflation over the next decade, that means that your inflation adjusted annual returns from dividends alone in 2025 could be 15.1%. Add in the likely share price appreciation over that time and those shares you so fearlessly bought back in 2009 will almost certainly beat the S&P 500's historic 9.1% return, and continue doing so as long as you own them.

So when deciding on whether or not you'd be willing to part with your Realty Income shares, you always need to consider your yield on cost and whether or not your post tax capital can be put to work into an investment that is likely to offer better returns. That's especially true given that Realty Income represents such a high quality, low-risk business.

Bottom line: Conservative option writing can boost your yield on Realty Income at these historically overvalued levels

While many investors are leery of using options because they think of them as highly speculative and dangerous financial instruments, in fact, this isn't necessarily true. Conservative option strategies, such as in the money put and covered call writing, can be an excellent way to boost your income and yield from Realty Income, despite its massively overvalued share price.

Just remember the risks that options represent and make sure that, if you choose to write a put or call, that you take into consideration your own individual financial situation, risk tolerance, time horizon, and yield on cost. That way, you can benefit from the increased income and yield without regret or losing sleep at night. Which is appropriate given that Realty Income is famous for being a SWAN or "Sleep Well at Night" stock.

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.