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A Riff On Rates And Realty

|Includes:Realty Income Corporation (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.

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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.

Stocks: O