Realty Income (NYSE:O) rightfully has earned its place in the portfolios (and hearts) of income investors. Over the years, the real estate investment trust has earned their trust through consistent cash flow and dividend growth, independent of the health of the overall economy. But I think it is time to tread carefully now. Let me explain.
I do own Realty Income myself, and am pleasantly surprised by the REIT's year-to-date performance, as I am sure most of you are, too. Realty Income's shares have risen ~35 percent since January, which is a remarkable performance considering two worrying market sell-offs in 2016 related to crude oil price concerns at the beginning of the year, and the Brexit referendum at the end of June. Realty Income's shares, however, have been extremely resilient.
I am sure you know that Realty Income reported 2nd quarter results on Wednesday, which once again showed the company's progress toward growing cash flows from its real estate portfolio.
For instance, in the last quarter Realty Income's revenues gained 6.7 percent year-over-year to $271.0 million, supporting the REIT's basis for continued cash flow growth (which ultimately backs the dividend). In terms of funds from operations, or FFO, a key metric for real estate investment trusts, Realty Income also didn't disappoint: The company's FFO was up 10.7 percent to $176.6 millon, and its adjusted FFO gained 13.7 percent to $180.9 million. On a per-share basis, Realty Income's funds from operations hit $0.70 in the 2nd quarter (last year: $0.69), and its adjusted funds from operations reached $0.71 (last year: $0.68).
Realty Income's 2nd quarter financial results were again underpinned by a well-performing property portfolio. Realty Income's same store rents were up 1.4 percent to $224.4 million, and the REIT's occupancy rate was 98 percent, reflecting that its properties are almost fully let.
A REIT Bubble?
Though there is little to complain when it comes to Realty Income's financial results and portfolio performance, the REIT's valuation is a serious source of concern for me.
I have hit that drum many times, and I am going to double down on it in light of Realty Income's 2nd quarter results: The current market valuations and price appreciation rates of Realty Income, and other REITs, too, including National Retail Properties (NYSE:NNN), is not sustainable over the long haul.
Realty Income reaffirmed its FFO guidance for 2016, saying that its expects 1.8%-4.3% growth in 2016. Based on expectations for its FFO to clock in between $2.82-$2.89/share this year, Realty Income's shares effectively change hands for ~24.4x estimated 2016 FFO.
I am invested in Realty Income, love the company, and have by no means any short interest in it, but purely from a valuation point of view, we are approaching bubble territory. A correction is overdue, and will hit income investors at some point.
Though I like Realty Income just as much as the next income investor, when a commercial REIT sells for almost 25x (!) FFO, it is time to tread carefully. The REIT pulls in a great amount of cash flow, no doubt, but the current rate of price appreciation in Realty Income's shares is not sustainable, and will normalize eventually. As far as I am concerned, Realty Income, but other real estate investment trusts also, are at serious risk of a correction in light of their inflated market valuations.
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Disclosure: I am/we are long O.
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