Realty Income: An Overpriced SWAN Stock

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About: Realty Income Corporation (O)
by: Big Ticket Fund Managers
Summary

Realty Income is one of the great SWAN stocks of our time, but at current levels, it does not look enticing.

The stock is trading with a yield of 3.79%, which is the lowest level since 2016.

Though Realty Income is the clear leader in the space, and a top holding of ours, we prefer others in the space.

It sounds like an oxymoron, "An Overpriced SWAN Stock", but that is exactly how far ahead of itself Realty Income's (NYSE:O) stock has gotten today. Do not get me wrong, Realty Income is one of the safest places to invest your money, but at current prices, we prefer others in the triple-net lease REIT space. From purely a valuation perspective, Realty Income is too pricey.

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Photo Credit

The Making Of The Ultimate SWAN Stock

Realty Income has long been one of the safest investments for all types of investors. The name has long been a saving grace during difficult times for investors as they can look forward to their growing monthly dividend checks over the years. In addition, the S&P 500 limped to the finish line in 2018 with a total return of -6%, while Realty Income plowed ahead for a return of 16% as seen in the chart below.

After a flat 2017, in which Realty Income returned only 4% compared to the S&P 500 returning 19%, REITs began to pick up steam into 2018 and saw strong momentum for much of the year in 2018. As confidence in the US economy turned dire at the end of 2018, investors were selling EVERYTHING under the sun, but eventually turned to REITs for safety.

REITs in general have continued to have a solid run into the new year, as the Fed has seemed to have paused on its rate hikes for the foreseeable future. Be sure you hear me out completely, as we are big proponents of the company as a whole, but what this piece will do is explain why we do not recommend buying shares at current prices. Without taking valuation into consideration, this company is rock-solid and deserves a position in every portfolio, at the right price. Before we get into valuation, let's take a look at what makes this company a SWAN stock for many investors.

Realty Income was founded in 1969 and began trading on the NYSE in 1994. The company is a member of the S&P 500 as well as the S&P High Yield Dividend Aristocrats index for having increased dividends every year for over 20 years. As of September 30, 2018 (Q3-18), the company's portfolio consisted of 5,494 properties located in 49 states and Puerto Rico, leased to 260 tenants. Realty Income has an average remaining lease term spanning 9.3 years. Also, during the most recent quarter, the portfolio maintained an occupancy rate of 98.8%, which, if the level remained through Q4, would be the highest end-of-year occupancy level since 2006.

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As you can see in the chart above, occupancy levels have been on a steady uptrend since hitting the low during the peak of the Great Recession in 2009/2010. This is a major sticking point for investors as to why this company is so great. As you can see, even in the depth of the "Great Recession" due to the company's high-quality portfolio of assets, it was able to maintain strong occupancy levels above 90%. One area investors focus on lately when investing in triple-net lease REITs, or really any stock for that matter, is how the company will be impacted when the economic backdrop changes. Looking at the chart above, Realty Income's occupancy levels started retreating at the peak of the market in 2007, and dropped 210 basis points from the '06 high of 98.7% to the 2010 low of 96.6%.

We believe what makes Realty Income so special is the quality of its portfolio. The management team has assembled such a strong, well-diversified portfolio that does not have the company relying too much on any one sector.

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Source: Q3 Investor Presentation

As we see in the charts above, the company's top-notch management team has assembled a diverse portfolio filled with high-quality tenants. The tenant selection is made up primarily of defensive tenants that perform during any economic backdrop. This company has long been a SWAN stock due to its quality management, diversified portfolio, and dependable dividends, but that does not mean it's trading at a price worthy of our investment. Let's take a look at valuation.

Now Is Not The Time to Buy Realty Income

As we have mentioned in numerous articles, Realty Income has long been a staple in my portfolio and continues to be one of the highest-quality stocks we own. However, being a value investor, I do not buy stocks merely because they are strong companies. To earn my dollar, stocks must be a sound investment based on quality and valuation. At this time, we are not adding to our position and may even trim some due to the high valuation.

Since writing our article on Jan. 10, 2019, detailing our "2 Favorite Triple Net Lease REITs For 2019 And Beyond", the stock has gained 11%. REITs have been on a tear to start the year, and Realty Income has been leading the charge as investors run for yield and some defensive positions after the debacle we saw in Q4 '18.

In terms of FFO, Realty Income has traded at an average P/FFO of 19.5x over the course of the last five years. The stock currently trades at a P/FFO of 23.3x, indicating the stock is overvalued. Over that same five-year period, the highest P/FFO the stock traded at was 25.9x.

Chart created by author

Realty Income tends to always trade at a premium when compared to other REITs within the triple-net lease sector, and rightfully so as the stock has been a consistent gainer with a low cost of capital and positive dividend increases over the years.

Another angle I like to look at when valuing a stock is known as the dividend yield theory, or DYT. This method is helpful for dividend payers that consistently increase their dividends, as it looks at current yield compared to historical. Over the course of the last five years, the stock has traded with an average dividend yield of 4.46%. As of today, the stock is trading with a dividend yield of 3.78%, which is the lowest level we have seen since 2016.

The lowest yield investors have seen over the last five years has been 3.25%. These indications tell us the stock appears overvalued.

As you can see, the couple of metrics we looked at are all flashing the "OVERBOUGHT" light, based on the company's prior historic norms. Now it is important to not only look at the past but also to look ahead as well. Sometimes a company could be trading at a premium to recent norms, but that is due to a change in the business. While FFO growth remained strong year over year, revenue growth saw its slowest growth over the past five years, based on TTM.

Investor Takeaway

Realty Income is one of the true, great, blue-chip stocks we have today, and we cannot say enough about the company's performance, which is led by a highly competent management team. The company has an amazing dividend history as well. This piece is not at all intended as a "Sell Realty Income" report, but rather a "Wait for greener pastures" article. We like to scoop up shares when the yield is closer to or over a 5% yield, so we will have to be patient on this name for the time being.

In closing, though the stock is a SWAN stock, we rate it a HOLD currently. Others in this space worth taking a look at instead include: Spirit Realty (SRC), W.P. Carey (WPC), and VEREIT (VER). We will provide write-ups on these REITs soon.

Note: We hope you all enjoyed the article and found it informative. As always, we look forward to reading and responding to your comments below and feel free to leave any feedback. Happy Investing!

Author's Disclaimer: This article is intended to provide information to interested parties. We have no knowledge of your individual goals as an investor, and we ask that you complete your own due diligence before purchasing any stocks mentioned or recommended.

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.