Realty Income REIT Dividend Income Investors 'Don't Need No Stinkin' Capital Gains' And Would Be Foolish To Chase Them

| About: Realty Income (O)

Summary

Realty Income REIT (O) has been a premier dividend income stock for decades.

The basics of O and of Triple Net (NNN) REITs.

Why O income dividend investors should ignore arguments to cash-in or "take some money off the table."

My real life example of O and the futility of trying to time the buying points and the selling points.

While the future as always is uncertain, dividend income investors should consider O as a "forever" basic holding.

Lately there have been a multitude of articles on Seeking Alpha that argue that the price of Realty Income REIT (NYSE:O) has risen far beyond fair value and that dividend income investors should sell to capture their capital gains, or at least sell part of their positions to "take some money (capital gains) off the table." These arguments then say dividend income investors can buy back O "later" at a lower price to re-establish their income positions.

Because O is a premier income REIT, with a dividend that has been rising for almost two decades, its price metrics have soared to unusual heights. This article will outline the reasons I believe recent, sell or sell part, articles are wrong in their advice and I will use my ownership of O shares to demonstrate the point.

The classic adventure movie "Treasure Of The Sierra Madre" has an oft quoted line that I paraphrased in the title of this article. The quote is from a tense scene in which three American gold prospectors are confronted by a group of heavily armed Mexicans. The leader of the Mexicans, tells the prospectors: "We are Federales. You know, the mounted police." One of the Americans replies skeptically: "If you're the police, where are your badges?" The sneering reply is: "Badges? We ain't got no badges! We don't need no badges! I don't have to show you any stinkin' badges!" O shareholders don't need no stinkin' capital gains either and would be foolish to chase them.

AN O POST MORTEM

First, for those who are not familiar with O, the company, or the REIT sector in general, I will quickly outline the playing field. O is an equity REIT, that is a company that buys physical property & then rents it as a landlord for income for its shareholders. This is different from the other type of REIT, the mREIT, which as the title suggests, finances the paper (property mortgages) and makes its shareholders income from the interest rate spread between short term rates and long term rates. Both types of REIT are pass through entities that by IRS rules must pay 90% of their net income to their shareholders in dividends to remain untaxed as a REIT. As a result, REITs usually pay a much higher yield than a C-corp., hence the outsized buying in their shares in the low interest environment of the past few years.

O has been a particular dividend income investor favorite because O has a "secret sauce" as an equity REIT. The secret sauce is that O is a Triple Net Lease REIT or NNN. NNNs lease their property for long periods, usually 10-30 years, with stated rent escalators in the lease and the tenant is responsible for all the ongoing costs of the property, such as taxes, maintenance, utilities, etc.

Why would a tenant agree to this seemingly one-sided lease? For three main reasons: 1) The square-foot cost of triple net rate leases is a bargain relative to a conventional REIT lease. 2) The long term gives the lessee the stability for long term business planning. 3) The alternative to leasing a building is the buy or construct one. Owning the building, where in addition to the mortgage cost, the company will still need to pay all building expenses and use vital business capital, is often not as cost effective as leasing.

These long NNN leases give the management of O a clear and stable, long-term view of REIT income so that dividend payments can be maintained or increased with relative safety. This dividend stability, along with the incomparable experienced 1st class management of O comprises the O "secret Sauce." An extensive detailed outline of the operations, balance sheet and metrics of O is outside of the thesis of this article. Instead, I direct the interested dividend income investor to these two articles on O by REIT guru Brad Thomas which can be found here and here.

So what can go wrong at O in the long or short term? In the long term the major potential catastrophes are: 1) Lease counter-party default. If a lessee of an O property can't pay due to business or balance sheet weakness, O will have a vacant non-income earning building that it will have to re-lease and possibly renovate as well. If a lessee's credit default problems become widespread, O might not have the cash to raise or maintain the dividend. 2) Major economic calamity like the 1930s. Even the most credit worthy companies could have cash flow problems if the economic downturn was severe enough. In the event the economic downturn was widespread enough throughout the economy, O might not even be able to fund the dividend and have to suspend it.

The O company's answer to either of these potential problems is the aforementioned incomparable 1st class management team. During the public company existence of O, its management has been through several real estate business cycles, and their real estate business decisions have allowed O not just to survive but to continue to thrive with a dividend that has increases yearly.

The O dividend continued to increase during the Chapter 11 troubles of Buffet's Inc. in 2007-08. Buffet's Inc. had several O properties under lease at the time it filed Chapter 11 but the filing had no effect on the O dividend. O even managed to keep increasing its payout, one of only two REITs to do so, during the "Great Recession" of 2008-10. See more about that in the next article section below. Any investor in any company must have trust that a management team that has been successful in meeting business challenges in the past, will continue to be successful in meeting future challenges, or they shouldn't be buyers of those shares.

In the short term the question of what can go wrong with the business of O, has and is, already going wrong. Low rates forced by the Federal Reserve since 2009 have left income investors few stock groups to invest money in for a decent return. This has pushed the value of O shares higher than normal and compressed the yield. Recent higher interest rates, fear that they will jump higher still, and the uncertainty surrounding Donald Trump's election has caused sharp up and down price gyrations in O stock. Since O and the REIT group generally will react, both positively and negatively, to changes in future interest rates the question becomes; what's the outlook for future interest rates? Nobody can know with certainty. Take your pick, maybe cloudy with a chance of completely clear sailing, or perhaps a category 5 interest rate "storm-of-the-century!"

SO WHAT'S IS ALL ABOUT ALFIE?

So what is a dividend income investor who holds O or a dividend income investor who is thinking of investing in O shares to do? My answer in this article to those who already have shares in O is to hold on to them & resist the siren call of the capital gains article crowd.

What about those dividend income investors who are considering opening a position in O? In these cases, I think age is the determining factor. First these prospective O buyers should decide the minimum YOC (yield on cost) they can accept in their dividend income share holdings. The younger you are the lower YOC rate you can begin with and still have dividend growth provide a great income stream at retirement and beyond. I'm 71 years old and I do not buy a REIT dividend income stock at less than a 5% YOC. This parameter is solely my minimum YOC position, other investors YOC may differ.

The point is, for the individual investor to decide for themselves their minimum acceptable YOC. O has raised its dividend over the years at 4-5% compounded for many years. I use the "Rule of 84" in gauging how long it will take a dividend YOC to double from the beginning rate.

The "Rule of 84" says that 84 divided by the annual average dividend increase rate gives the number of years it will take to double the YOC. This calculation should be used as a rule of thumb only because as the annual average dividend increase rate increases beyond 7%, the doubling occurs faster than the Rule of 84 actually calculates.

Using the "Rule of 84" as a guide, if O averages a 4% compounded yearly increase in the dividend which is the lower end of its recent past yearly increases, the YOC would double every 21 years. O is trading as I write this at $53.36 with a monthly dividend of $.202 or $2.42 year for a yield of 4.53%. Thus, in 21 years the present 4.53% YOC would double to 9.06% and in 42 years to 18.12% and so on. (Note: Since O dividends are paid monthly the present yield would take less than the 21 years the investor would find in a quarterly dividend payer, using the "Rule of 84.")

Another factor to consider is if you are in a position to set up automatic re-investment of O dividends in more shares or are you going to need the dividend stream as immediate income. This too, is usually an age related decision, since younger investors of say 50 years old or less, will still be working and can often set up automatic re-invest of dividends until a later time. I would urge younger investors to consider this route as the discipline of automatic re-investment is a useful tool towards reaching your goal of a retirement income level that would satisfy you for a secure retirement.

WHY O INVESTORS SOULD REMAIN "STEADY AS SHE GOES."

My basic thesis is that present long dividend income investors in O should stay invested and avoid the chimera of capital gains and/or the deceptive idea that they can successfully sell a portion of O shares, and will be able to buy them back at a lower price.

I also believe that a perspective dividend income investor in O should buy a portion at a YOC share price they have determined they will be comfortable with and then "dollar average" into the rest of their "full" position.

If the perspective O share buyer can afford to enroll in their broker's automatic re-invest the dividend plan until they are nearer or at retirement they would be well served to attain their income stream at retirement goal. Along these same lines the younger investor might buy, one-third to one-half of their proposed full position. This would allow the O dividend stream to provide the remaining shares necessary to attain the complete position. This in effect has O the company financing a portion of your final position.

To illustrate these points, I will relate my own O ownership. My SA articles usually are on stocks that I own under the dictum that I "eat my own cooking." I do not believe that SA authors who write on stocks they don't own are somehow derelict in their duty to SA readers. All financial knowledge and information is useful, it is the job of the reader to decide which information is pertinent for them. In my view that is the mission of SA, to provide a huge smörgåsbord of financial information for their readers to pick and choose whatever is useful to them.

MY STORY OF O; THE "G" RATED VERSION.

I bought my shares of O on 3/7/2007. I paid $23 a share including commission. At that time the O dividend was $.127 monthly or $1.524 yearly for a YOC of 6.62%. Uh Oh, I hear the reader groaning, just in time for the big meltdown! And yes that's right the price subsequently fell to a low of $17.53 on 2/1/2009.

I clearly remember the fear and panic in February & March of 2009. The market would never rise again, the Dow was going back to 1,000 or maybe less! All companies paying dividends would suspend the dividend forever-maybe longer! All investors were doomed, doomed "they" wailed. Of course with hindsight, that was the time to buy O-and about a thousand other stocks--but most of the shell shocked investors in the market then were acting like deer caught in headlights. Total paralysis would not be an exaggeration.

Thing is, the O dividend was not cut or suspended but instead continued to rise throughout the "Great Recession" period and has continued to rise to the present day! The O dividend has continued to rise to the present $.202 or $2.42 per year for a YOC of 10.52%.

Where along the way should I have sold and then bought back at a lower price? And when should I have repurchased shares if I had sold? When O had declined 10%, 15% or 20% from my sell price? There was been only a short two year window during which I could have then re-bought O at a price at or below $23, but only with 20/20 hindsight! In addition, any profitable sale of O, would have caused a me a taxable event and could have caused me to miss a pot-load of monthly dividend payments.

CONCLUSIONS.

For the dividend income investor, O is one of the very few REIT stocks that can truly be considered, as legendary investor Warren Buffett stated when asked what the perfect holding period was: "the perfect holding period is forever."

For those dividend income investors who already have a full O position, based on their individual investing parameters, selling all or part of their O shares with the goal of buying it back at a lower price than their sale price, they are playing a self defeating game of "woulda, shoulda, coulda." Adding insult to injury they are probably creating a taxable event unless they hold O in a tax sheltered account.

For those dividend income investors who are considering buying O for future retirement income, there is no blanket "perfect price." Those investors should decide what their minimum acceptable YOC is, then buy at that price. If possible, use your broker's automatic re-investment of dividends plan to dollar cost average your O share price.

For those investors young enough to do so, buy one-third to one-half of the O shares you decide you would like to be the number of shares in your full O position and let your broker's automatic re-investment of dividends plan provide the rest. Read SA articles on O, like the Brad Thomas articles linked above, for both due diligence and for further O company specific information, but don't fall into the take-some-money-off-the-table trap. Down the road you'll be glad you didn't.

Disclaimer: The information I have provided is not meant to be investment advice, nor is it guaranteed in any way to assure success in O or any other stock. Individual investors need to make their own choices based on further due diligence & their particular investment needs.

Disclosure: I am/we are long O.

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.

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