Realty Income: Outrageous Valuation, But Blowout Earnings May Justify A Buy

| About: Realty Income (O)


Realty Income's epic performance over the past year has left its competitors, as well as the S&P 500, in the dust.

This has left shares trading at seemingly insane levels, even pricing in 10+ years of growth.

But its latest earnings results were nothing less than spectacular, indicating that management may be able to beat long-term market expectations.

Which means that, in today's ultra-low rate environment, Realty Income might still be worth buying.

And investors who've owned shares shouldn't necessarily feel the need to sell, given their high and rising yield on costs.

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Source: Realty Income

REITs have been on fire over the past year, but few have done as well as Realty Income (NYSE:O) whose investors have enjoyed a meteoric rise that has far surpassed the average REIT or S&P 500.

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

Then again, some of this price appreciation is warranted by the fact that Realty Income is led by one of the best management teams in the industry, with an unbeatable track record of shareholder wealth creation.

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

Let's take a look at Realty Income's latest impressive earnings results to see how management plans to continue its strong track record of dividend growth going forward. More importantly, however, learn what these latest earnings mean for Realty Income's valuation, and why it may still be worth buying shares, even at today's outlandish valuations.

Q2 earnings were spectacular

Source: Earnings releases
Metric Q2 2016 Q2 2015 YoY Change First Half 2016 First Half 2015 YoY Change
Revenue $260.1 Million $241.4 Million 7.7% $516.9 Million $476.6 Million 8.5%
FFO $176.7 Million $159.5 Million 10.8% $347.3 Million $312.4 Million 11.2%
AFFO $180.9 Million $159.1 Million 13.7% $356.8 Million $311.2 Million 14.7%
AFFO/Share $0.71 $0.68 4.4% $1.42 $1.36 4.4%
Forward Monthly Dividend $0.2015 $0.19 6.1% $0.2015 $0.19 6.1%
AFFO Payout Ratio 85.1% 83.8% 1.6% 85.1% 83.8% 1.6%
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While from an absolute perspective Realty Income's latest earnings may not be as impressive as those of, say Facebook (NASDAQ:FB), compared to that of other large triple-net lease retail REITs, they were nothing less than a blowout.

For example, three-month and six-month AFFO growth was monstrous, at 13.7%, and 14.7%, respectively. And while AFFO/share growth of 4.4% was far smaller, that's because Realty Income funded the majority of this year's $663 million acquisitions to date with over $500 million in equity.

With shares trading at near record highs all year long, that actually makes sense. That's because, as Realty Income's cash flow grows, its balance sheet gets stronger. For example, both S&P (NYSE:SPGI), and Moody's (NYSE:MCO), upgraded Realty Income's credit rating from BBB+, and Baa1 to BBB+ positive, and Baa1 positive, respectively. This means that Realty Income is very close to achieving a grade "A" credit rating, which would be the highest in the REIT industry, and potentially lower its borrowing costs even more.

Why does that matter? Because this quarter's acquisitions were at cap rates of 6.5%.

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Source: Realty Income earnings presentation

While that is at the lower end of Realty Income's historic norm, because of falling equity costs (due to high share prices), Realty Income's acquisitions to date have been "at record-high investment spreads relative to our weighted average cost of capital" according to CEO John Chase.

In other words, despite rising property prices, Realty Income is able to grow its quality property portfolio at the most accretive rates even. Better yet, management still has a lot of deals in the pipeline and raised its guidance for 2016 acquisitions from $900 million last quarter to $1.25 billion. Even more impressive, management started the year expecting $750 million in acquisitions, and has now raised acquisition guidance two quarters in a row.

Which means that full 2016 AFFO/share growth may come in at the top end of management's full-year guidance of 4% to 5.8%. In fact, if management can keep finding attractively priced properties to buy, and borrow at ever falling interest rates, than Realty Income may end up growing AFFO/share at 6+% this year. Which would mean that, despite 2016 dividend growth of 6.1%, far higher than what analysts were expecting, its payout ratio may come in at 83%; lower than last year's.

How realistic is it to expect Realty Income to be able to keep up this fast pace of acquisitions? While it's impossible to know the company's precise potential acquisition pipeline, the fact that Realty Income has $1.35 billion in remaining borrowing power under its low cost credit revolver means that management will have plenty of liquidity with which to keep the REIT's portfolio growth humming along. Better yet, once management taps into the debt, it will be able to grow the REIT's property portfolio, and AFFO, without diluting existing investors.

Which could send AFFO/share soaring and mean continued, better than expected dividend growth in the years to come.

Valuation still not justified...on any time frame…

Sources: Yahoo Finance, FAST Graphs, GuruFocus
Yield Average Five-Year Yield P/AFFO 20-Year Average P/AFFO P/NAV 13-Year Median P/NAV Average Historical Premium
3.5% 4.7% 24.7 18.3 3.46 2.19 39.5%
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Whether on a yield, price/AFFO, or price/net asset value, is massively overvalued. While the epic rally over the past year means that's not surprising what may be surprising is that Realty Income also appears very overvalued, even accounting for long-term growth potential.

Source: Morningstar
Morningstar Fair Value Estimate Current Share Price Premium to Fair Value
$51 $69.59 36.5%
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Don't get me wrong, no analyst's valuation should be taken as gospel since they are all based on various assumptions about the future. That being said, Morningstar analysts use long-term, four- or five-year time horizons, and utilize conservative, and realistic growth assumptions that makes their intrinsic value estimates far more valuable than the average sell-side analyst's one-year price target.

In this case, that five-year fair value estimate comes from analyst Edward Mui, who is assuming a long-term cost of equity of 7.5%, total cost of capital of 6.9%, and $700 million, and $50 million in annual acquisitions, and development investments at cap rates of 7.5%, and 7.0%, respectively.

While I view most of those assumptions as reasonable based on Realty Income's historic results, investors need to remember one thing. Realty Income's top-notch management team has an excellent track record of beating analyst estimates by actually accelerating its growth as it gets larger, and gains larger access to cheaper capital.

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Source: Realty Income earnings presentation

For example, despite its already massive size Realty Income continues to find attractively priced investment opportunities, usually far more than $700 million per year.

Then, there are the potential for acquisitions of competing REITs, such as 2013's American Realty Capital Trust, or 2014's purchase of Inland Diversified Real Estate Trust.

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Source: Realty Income investor presentation

As you can see, these large REIT acquisitions proved to be well chosen, and expertly executed on by Realty Income's world-class management team. And with shares now near all-time high, Realty Income may have another opportunity to acquire another quality REIT, one that happens to be undervalued, and capable of resulting in a dividend boost of 25% to 35%.

Sources: FAST Graphs, GuruFocus
TTM AFFO/Share Projected 10-Year Growth Rate DCF Fair Value Estimate Reverse DCF Implied Growth Rate Margin of Safety
$2.77 4.1% $55.16 9.2% -26%
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Which is why Realty Income's 10+ year valuation, as represented by this discounted cash flow analysis, may not prove nearly as crazy as it seems. Because the combination of expensive shares can actually be used as currency to fuel numerous potential deals that could result in Realty Income's growth rate beating market expectations. That's especially true if Realty Income can grow its dividend at a rate of 5.7+% over the next decade. This is because under the rule of thumb that total returns equal yield + dividend growth, given the company's current yield of 3.5%, that pace of dividend growth should be enough to beat the market's historical 9.1% CAGR since 1871.

...But here's why buying shares today may still make sense for some investors

Don't get me wrong, I'm not arguing that Realty Income isn't overvalued because no matter what time horizon, one year, five years, or even 10+ years, it is. However, that doesn't necessarily mean that it's crazy to open an initial position or hold onto shares even if management can't continue deliver on its historically strong dividend growth.

That's because different investors have different portfolio goals, goals that Realty Income might still be exceptionally well qualified to fulfill.

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Source: Realty Income earnings presentation

For example, no REIT can match Realty Income's track record for growing dividends through any and all economic cycles, including the worst financial crisis since the Great Depression. So for income investors needing dependable cash flow, Realty Income's rock-solid dividends make still make an appealing alternative to bonds trading at record low interest rates.

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Source: Realty Income earnings presentation

Then there are long-time investors, who have owned shares for years, and purchased shares at much lower prices, and thus have much higher yield on costs. For example, if you bought shares at Realty Income's IPO, then your yield on cost is a staggering 30, meaning the dividends alone are more than triple the S&P 500's historic return.

Sources: Realty Income, Bureau of Labor Statistics
Time of Purchase Yield On Cost Inflation Adjusted Yield On Cost
IPO 29.9% 18.3%
1994 28.0% 17.2%
1995 21.3% 13.5%
1996 20.1% 13.1%
1997 18.8% 12.5%
1998 19.2% 13.0%
1999 23.2% 16.0%
2000 19.2% 13.7%
2001 16.3% 12.0%
2002 13.7% 10.2%
2003 12.0% 9.2%
2004 9.5%


2005 11.1% 9.0%
2006 8.6% 7.2%
2007 8.9% 7.7%
2008 10.3% 9.2%
2009 9.2% 8.2%
2010 7.0% 6.3%
2011 6.8% 6.4%
2012 6.0% 5.7%
2013 6.4% 6.2%
2014 5.0% 4.9%
2015 4.6% 4.5%
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Even adjusted for inflation, those shares are still returning double the market's historical total return. Which is why selling shares now and taking a potentially large tax hit might not make sense for most investors. After all, as long as Realty Income can continue growing its dividend faster than inflation, on a constant purchasing power basis, your money will be earning higher, and safer, returns than pretty much anything you can find in the market today.

Bottom line: Realty Income is priced for perfection but for good reason

Don't get me wrong, despite reporting quarter after quarter of excellent results, I'm not saying that Realty Income's valuation is necessarily justified. Then again, depending on your investing goals, time horizon, and risk tolerance, buying at today's sky-high prices may still make sense for you.

For example, investors looking for generous, highly secure, and moderately fast growing dividends in an era of record low rates could certainly do far worse than owning shares of this "Sleep Well at Night" or SWAN blue-chip.

Meanwhile, investors who bought Realty Income years ago, and at much better yields, are still benefiting from dependable income. Income whose growth rate is likely to remain far above inflation for at least the next five to 10 years. Which is why I don't necessarily recommend selling Realty Income unless your goal is to increase your current income stream by diversifying into higher-yielding, quality alternatives such as W.P. Carey (NYSE:WPC), or EPR Properties (NYSE:EPR).

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.