Realty Income Comes Back To Earth For A Moment

| About: Realty Income (O)
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Summary

Treasury yields moved up over the last two days.

A delayed reaction in Realty Income Corporation resulted in an exaggerated effect with a decline of 4.11%.

The Treasury to O spread was never larger in April than it was on Wednesday.

It was never smaller than it was on Thursday.

If Realty Income Corporation continues to struggle, it finally provides another solid entry point.

Realty Income Corporation (NYSE:O) is one of the great dividend champions every investor wants in their portfolio. Whether the investor is seeking income or retirement or simply better returns from having a well-managed triple net lease REIT in a tax advantaged account, there are few people who can say anything truly negative about Realty Income Corporation. The one complaint that does come up, and rightfully so, is that Realty Income Corporation has been fairly expensive over the last couple of months. As of Thursday, share prices came back to a much more attractive level. They still aren't cheap, but they are trading at much more attractive yields than at any point this month.

The Yield Spread

Realty Income Corporation is seen as such a safe income source that the stock is often trading in a spread relative to Treasuries. Over long periods of time, the connection starts to break down, but over shorter periods such as a couple of months, the connection can be extremely strong. The following table shows the yields on Treasuries across four maturities along with the trailing dividend yield for Realty Income Corporation based on the closing price each day:

7 yr

10 yr

20 yr

30 yr

Div. Yield

Ending Share Price

4/1/2016

1.56

1.79

2.2

2.62

3.75

$61.56

4/4/2016

1.53

1.78

2.19

2.6

3.65

$63.29

4/5/2016

1.49

1.73

2.13

2.54

3.65

$63.15

4/6/2016

1.52

1.76

2.17

2.58

3.66

$63.01

4/7/2016

1.46

1.7

2.1

2.52

3.68

$62.67

4/8/2016

1.47

1.72

2.13

2.55

3.66

$63.08

4/11/2016

1.48

1.73

2.14

2.56

3.62

$63.74

4/12/2016

1.54

1.79

2.18

2.61

3.66

$63.00

4/13/2016

1.53

1.77

2.16

2.58

3.66

$63.00

4/14/2016

1.57

1.8

2.18

2.61

3.68

$62.65

4/15/2016

1.52

1.76

2.14

2.56

3.66

$62.97

4/18/2016

1.54

1.78

2.17

2.58

3.67

$62.86

4/19/2016

1.57

1.79

2.19

2.6

3.71

$62.16

4/20/2016

1.63

1.85

2.25

2.66

3.71

$62.25

4/21/2016

1.65

1.88

2.29

2.69

3.91

$59.03

It appears that the dividend yield moves somewhat in line with the Treasury rates, but some disconnections can certainly occur. The following chart compares the yield spread at the end of each day:

It should be fairly clear that these rates all remained tied quite nicely, but spreads compressed on Wednesday. That is demonstrated by the dip in the line just before the end. On Thursday, shares of Realty Income snapped back with fierce selling and ended the day at the widest dividend to Treasury yields that have been seen so far this month. I highlighted the smallest spreads in red and the largest spreads in green.

The Selling Started Wednesday for Bonds

As you can tell from reading the first table, the yields on bonds started rising on Wednesday. The following chart breaks down the timing of the rate increases much closer:

The rates were soaring slightly before the middle of the day. Realty Income Corporation had a decent day on share price though and didn't take the fall. When the pressure continued on Thursday, the top quality triple net lease REITs all took a harsh fall.

Weakness in Quality

There are three triple net lease REITs that I put at the top of the list for quality. These companies all trade at fairly high multiples, but they have excellent management and a clear strategy for delivering value to both shareholders and customers. The other two are National Retail Properties (NYSE:NNN) and STORE Capital (NYSE:STOR). NNN was down by 2.98% and STOR was down by 3.78%. I'm long both NNN and STOR, and managed to catch them each before they took off early in the winter. Unfortunately, I missed out on the opportunity to acquire Realty Income Corporation at the prices I was willing to pay. If it comes back down towards earth, I may get a chance to rectify that mistake by acquiring some O.

Expectation on Rates

As an analyst that primarily covers mortgage REITs and triple net lease REITs, interest rates are a major area of emphasis. I'm expecting domestic interest rates to be "lower for longer," but I'm also expecting the Federal Reserve to create some rumblings regarding the rates. I expect we'll see at least one rate increase this year, though two is possible.

By lower for longer, I'm talking about the longer end of the yield curve. I don't think we'll see the 10-year yields break over 2.5%. There is simply too much pressure for international central banks. When several other developed countries have 10-year yields that are near 0%, or in some cases negative, it seems unlikely that the U.S. would not be influenced. For those negative rates, take a look at the yields on Japanese bonds:

The 10 year is trading at -.11% in Japan. Those exceptionally low rates are also common throughout Europe. The biggest threat to send shares of Realty Income Corporation crashing down would be a significant increase in interest rates. I think a few scares will occur, but I don't believe rates are going to move higher and stay there.

Conclusion

The market dropped shares of Realty Income Corporation quickly as they prepared for a reversal in interest rates. While this year has seen rates falling significantly since the start of the year, the decline is unlikely to last over the longer term. Short-term interest rates scares will send bond yields higher and put pressure on Realty Income Corporation, but the lack of a clear path to sustainable high rates in the United States amidst international pressure on rates suggests that Realty Income Corporation is likely to spend more time north of $55 over the next 8 months than it would spend below it.

I'm keeping an eye on O and cash in my portfolio. If rates send shares lower, I'll be looking for an entry point.

Disclosure: I am/we are long NNN, STOR.

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.