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I prefer to research before buying and to monitor while holding. I have a background in tax/finance/accounting with a career focus in the real estate industry. My username has a personal meaning and has nothing to do with the metal.
  • A Riff On Rates And Realty 16 comments
    Nov 29, 2013 3:05 PM | about stocks: O

    In a recent well-written article by Tim McAleenan Jr. seekingalpha.com/article/1865481-should-you-buy-realty-income-at-current-prices, Tim wrote: "When you look at Realty Income's December 31st dividend yield every year since 1994, we see a dividend yield between 4.5% and 11.3%, with most of those figures hovering around the 6%, 7%, and 8% range, once you subtract the extraordinarily low interest rates that have propped up Realty Income's valuation in recent years. Just by taking a cursory look of the company's historical dividend valuation, we can see that the current 5.70% is on the lower end of what can reasonably be called the fair value dividend range."

    For today's blog I wanted to share some thoughts I have on using the dividend yield to determine the value of the stock.

    The following chart reflects the same Current dividend yield of Realty Income (NYSE:O) cited by Tim, and then I've added two columns to reflect the 10-year nominal Treasury yield in each of these periods and the implied "Risk Premium" of O (i.e. the difference between the risk-free 10-year treasury yield and the current dividend yield of O). 10-year treasury data comes from bonds.about.com/gi/o.htm .

    What this tells us is that O trades at an average 2.74% "risk premium" to the 10-year Treasury yield. If we add the 2.74% historical "risk premium" to the 11/26/13 10-year treasury yield of 2.71%, O should theoretically be yielding 5.4%, or $40/share based on 2.182 in forward annualized dividends. In other words, today's price ~$38 is trading below Realty Income's price implied by the historical Risk Premium.

    However, there is another very important point to consider about this data: Both O's current dividend yield and the 10-year treasury are trading about 200 basis points below their historical average. Let us consider for a moment what would happen to O if the 10-year treasury yield were to suddenly spike up 200 basis points to it's historical 4.81% average (during the 1994-2013 time period)? If the risk premium relationship were maintained, investors would require O to yield about 7.55%. Since the dividend yield could be computed by dividing forward 12-month dividends by the current price, if O's current $2.182 of annualized dividends/share remain constant, O's price would need to fall to $28.92 to maintain the risk premium parity. On the other hand, if a $38.33 price per share wanted to stay constant, dividends would need to suddenly rise to $2.892 annualized dividends/share, or rise by $0.71/share. At 206M shares (after the 9.775M issuance in October - see my first blog post for background), $0.71/share represents an additional $146M in distributable cash. At a 1.5% spread (difference between O's borrowing cost and return on new assets), $146M in additional distributable cash represents around $9.75Bn in new asset acquisitions.

    I believe it would be highly improbable that O could suddenly acquire $9.75Bn in new assets overnight given their underwriting/due diligence process, so the most likely scenario in a sudden 10-year yield spike would be a collapse in O's share price to around $28-29/share to maintain the historic risk-premium. That would most certainly be a price with a significant margin of safety, but is definitely not what I'd call a "fair" price as it should only occur in the worst possible scenario (i.e. a reversion to the mean in 10-year treasury rates in a very short time-frame).

    Let's stop here for a second and consider what would happen to the economy in a broader sense if yields on the 10-year spiked 200 basis points to their historical average in a short period of time. I provide the following discussion with the caveat that I am not a macro-economic expert by any means, so please bear with me.

    The following is a chart I've compiled from the same data source bonds.about.com/gi/o.htm. It reflects the 30-year conventional home loan rate compared to the 10-year treasury yield (the 10-year is used instead of the 30-year for comparison purposes with the prior O data), with the difference being the "risk premium" for 30-year conventional mortgages above the "risk-free" 10-year treasury.

    This data shows the historic risk premium for a 30-year mortgage has been on average 1.8% (180 basis points) above the average 10-year treasury yield (based on the 1994-2013 period). If we consider what would happen to the 30-year mortgage rate if the 10-year treasury yield reverted to the mean in a very short timeframe, we should expect mortgage rates to spike up 240 basis points to around 6.6%, or approximately 150% above the current 4.22% 30-year conventional mortgage rate.

    If we take a trip back to the May timeframe you may recall that when Mr. Bernanke mentioned that the Fed may begin to taper QE3, 10-year treasury yields moved up over 100 basis points in a 2-month timeframe from 1.66% in early May to 2.73% in early July. Similarly, 30-year mortgage rates rose 100 basis points in the same timeframe from about 3.5% (early May) to about 4.5% (mid July). We then started seeing plenty of evidence that the housing market was stalling and the banks were laying-off folks in their mortgage lending operations in droves. Accordingly, a "no-Taper" announcement was made at the September meeting.

    From my perspective, I have a hard time reconciling a policy objective of supporting the housing market recovery, lowering the unemployment rate, increasing the labor participation rate, and fighting deflation by suddenly raising 30-year mortgage rates by 240 basis points. A lot of ink has been spilled on this subject, but one article you may want to consider is this one: www.forbes.com/sites/sharding/2013/11/01/its-still-too-early-to-worry-about-the-fed-tapering/; or this one by the same author: seekingalpha.com/article/1858771-the-fed-is-backed-into-a-corner

    While I believe the Fed would like QE to end, I believe they realize that ending the program overnight would also collapse the economic recovery overnight. We certainly may see a QE taper in the future, but I believe it will be combined with any number of policy tools to allow for an orderly scaling-down of the program without spiking treasury yields.

    Thus, I see two likely outcomes for Realty Income (and the REIT sector in general) moving forward: 1) interest rates remain low for a long period of time (i.e. the dreaded QE infinity); or 2) interest rates rise gradually normalizing to their historic mean over time (i.e. a managed end to QE implying a gradual increase in treasury yields to their historic 4.81%).

    Coming back to Realty Income, what this all means to me is that in order for Realty income to maintain its fair price of $40/share (based on the historic risk premium), it will need to pick up its pace of asset purchases and increase its dividend growth rate going forward. Whereas they may have acquired ~$500M in deals annually in the past (at a 1.5% spread to their cost of capital), they will begin doing around $1.5Bn or more in deals every year going forward.

    Consider that in 2013 alone, O acquired $1.24Bn in property acquisitions. seekingalpha.com/news-article/7910642-realty-income-completes-503-million-in-third-quarter-acquisitions; and seekingalpha.com/news-article/7012282-realty-income-completes-735-million-in-second-quarter-acquisitions

    Consider that John Case, their new CEO, has a transaction management pedigree from Wall Street. seekingalpha.com/news-article/7479902-realty-income-names-john-p-case-to-succeed-tom-a-lewis-as-chief-executive-officer

    Consider that on October 30th, the company exercised their $500M accordion option on their credit facility (while keeping all material terms constant) to give themselves $1.5Bn in "dry powder" to facilitate future acquisition activity and their EVP, Chief Financial Officer & Treasurer, Paul M. Meurer stated "This facility will provide us with the funds to continue to increase the size of our real estate portfolio, which is fundamental to our goal of regularly increasing the amount of the monthly dividend we pay to our shareholders." seekingalpha.com/news-article/7995922-realty-income-expands-credit-facility-to-1-5-billion

    Consider still that Management has an additional incentive to maintain a fair or high share price because it decreases O's cost of equity capital.

    In summary, today's price at ~$38 is at the lower-end of fair valuation based on the historic risk premium afforded to O. Similarly, based on a DCF valuation on the dividend stream, using a 9% discount rate and 6% dividend growth rate, O is at the lower end of fair valuation (see my prior blog post on this); alternatively using an 8% discount rate and 4.5% dividend growth rate, O is also at the lower end of fair valuation. However, these prices should not imply a margin of safety, as that would be any price at ~$28-$29 or below if the worst-case scenario occurred and treasury yields rapidly spiked up 200 basis points. It is up to the investor to determine which interest rate scenario is the most likely and proceed accordingly with their portfolio allocations and entry prices.

    For me, I like O as an income investment and have had a small position in my portfolio for the past few months as a hedge against low interest rates. However, based on my current analysis I am looking to make a larger investment at this time.

    ------------------------------------------

    As always, I take no responsibility for your investment decisions and you must perform your own due diligence. This data and any analysis are for informational purposes only and are intended to promote financial literacy.

    Best of luck to everyone on their investments.

    Palladium31

    Disclosure: I am long O.

    Additional disclosure: I have no other affiliation with the company and I wrote this post myself.

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Comments (16)
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  • Larry Harnar
    , contributor
    Comments (324) | Send Message
     
    Thanks. Very well thought out explanation of Realty Income and where the stock price may head next based on potential changes in future interest rates. I feel that O is a sound long term holding for those interested in increasing dividend income. I'm looking to establish a position as funds become available for investment.

     

    Larry
    29 Nov 2013, 03:42 PM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » Thanks Larry. Best of luck to both of us on our investment.

     

    P
    29 Nov 2013, 04:49 PM Reply Like
  • Dividend Sleuth
    , contributor
    Comments (2296) | Send Message
     
    Thanks, Palladium. That is about as thorough an analysis as I've seen around these parts! I was ready to buy a few more shares today at $37.97, but it didn't get quite that low.
    29 Nov 2013, 07:19 PM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » Thanks DS!

     

    Best of luck to you,
    P
    30 Nov 2013, 04:13 AM Reply Like
  • Brad Thomas
    , contributor
    Comments (10447) | Send Message
     
    Excellent!!! This is absolutely "spot on"...Happy Holidays, Brad
    29 Nov 2013, 08:41 PM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » Thanks Brad, and likewise, Happy Holidays to you too.

     

    Best,
    P
    30 Nov 2013, 04:13 AM Reply Like
  • Rudester
    , contributor
    Comments (2592) | Send Message
     
    Excellent article Palladium. This is the kind of in-depth analysis that I would expect to see from other authors on the genre.
    29 Nov 2013, 11:15 PM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » Thanks you very much Rudester!

     

    Best Regards,
    P
    30 Nov 2013, 04:15 AM Reply Like
  • montlakeal
    , contributor
    Comments (121) | Send Message
     
    I always appreciate your thorough analysis. Another well written article. Thanks.
    29 Nov 2013, 11:18 PM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » Thank you very much mont. Hope you are having a very happy Thanksgiving.

     

    All the best,
    P
    30 Nov 2013, 04:16 AM Reply Like
  • alg
    , contributor
    Comments (306) | Send Message
     
    Excellent article. IMO rates will rise very slowly so waiting for a bottom is forgoing current income. In ten years buying O in the high $30's now will look like a great move. Predicting that rates will rise is quite safe. Predicting how fast and how high is a fools errand.
    30 Nov 2013, 11:01 AM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » Thanks alg.

     

    Best Regards and Happy Holidays,
    P
    1 Dec 2013, 02:03 PM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » For those interested, check out http://seekingalpha.co... . The author is someone I'd consider to be an expert on the bond market. Based on his forecast from today's article (12/1/13), the 10-year is expected to reach ~4.75% yield in 10 years. By this time next year, he is forecasting the 10-year to be at 3.168%.

     

    Best of luck to everyone,
    P
    2 Dec 2013, 01:09 AM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » O just announced a dividend increase to 2.186 annualized from 2.182. Additionally, today's 10-year yield ended 2.84%. If I use the risk premium model (+2.74%), O should be yielding 5.58%. With 2.186 annualized dividends, the implied price is $39.17, and today's close was $39.02. It seems we are back at fair value.

     

    Also of note, O announced another $503M in upcoming acquisitions, bringing the total YTD acquistion activity to $1.741BN. I expect this trend to continue which will allow the annualized dividends to be raised in pace with the rising 10-year. The other thing to note about today's acquisition announcement is the company is moving forward with their plan to dip into industrial triple nets as discussed on the Q3 call. Diversifying into industrial is a good move IMO, but we will see a slightly reduced AFFO payout as a result (as there are slightly higher capex requirements for industrial properties even though they are triple net leases).

     

    We may also see some volatility tomorrow depending on the fed announcement, but the bond market seems to have already priced in a minor taper or immaterial change in policy with a minor taper in January.

     

    All in all, things look good, and congrats to those who were able to take advantage of the recent price distortions.
    17 Dec 2013, 09:39 PM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » One last observation that I'll leave everyone with for 2013:

     

    1.741BN in acquisitions at an average 1.5% capital spread implies $26.1M in new annual cash flow available for distribution. However, after ARCT and 2012 acquisitions, 2013 dividends have only been raised from 2.171 to 2.186, or 0.015/share so far this year. With the latest 206M of common shares outstanding, 0.015/share only represents about $3.1M in cash usage. So where is the other $23M in annual excess cash flow that these 2013 transactions represent (i.e. another $0.11/share of potential annualized dividends)?

     

    In my opinion, this represents future dividend "dry powder" which management can deploy at opportune times next year to fight a 10-year yield spike to maintain the historic risk premium. Quite a smart move ahead of the upcoming Dec/Jan/Mar fed meetings especially now that the stock price has reached parity with the historic risk premium. Just my 2-cents.

     

    Signing off,
    Palladium 31
    18 Dec 2013, 12:47 AM Reply Like
  • Palladium31
    , contributor
    Comments (489) | Send Message
     
    Author’s reply » Latest update to test the model's validity:

     

    $2.268 new dividend rate / share.

     

    Current 10-year yield 1.82% - add 2.74 historic risk premium = 4.56%.

     

    Implied fair price = $49.74.

     

    Current price $52.74 which about a 6% margin of error.

     

    Model seems to be working pretty well, and shares appear to be slightly overvalued (an argument could be made that the market is pulling forward future dividend growth or expecting lower 10-year yields - or there's a problem with the model).

     

    Best,
    P
    20 Jan, 08:48 PM Reply Like
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