Realty Income Looks Impaired

Summary

• O has been vastly underperforming its peer group.
• The market has revalued the stock much lower than pre-COVID.
• But this is not a buying opportunity.

Image source

Certain types of REITs have been decimated in this crisis, while others have held up fairly well. One area that has been sort of in the middle is retail REITs, although it does depend heavily on what type of retail. Malls are a disaster to a large extent and I wouldn’t go near them. Dividend legend Realty Income (NYSE:O) is making the best of its situation with its off-mall retail properties and high levels of diversification. However, that’s not good enough to make the stock a buy.

We can see the stock has been in a fairly narrow channel since the summer of last year, and given where the valuation is today, I don’t see a catalyst to the upside or downside that should change that anytime soon. If you’re just in it for the dividend, that might suit you just fine, and if it does, you can continue to collect your dividends.

I’m at the stage where I need capital appreciation potential and I just don’t see it here despite the fact that the stock is nowhere near its pre-COVID pricing. The bottom panel shows also that Realty has been pounded against its peer group in the past three months or so, ceding around 30% in a bout of enormous relative underperformance. As I said, I don’t see any reason for Realty to go higher, so unless the group suddenly weakens, you’re better off somewhere else for price appreciation.

No upside catalysts

Realty is probably the most famous retail REIT in the market because of its exemplary dividend history. That reputation has been well-earned, and the company deserves its due there.

Source: Investor presentation

It has size, scale, diversification, a smart management team, and a massive streak of paying increasing dividends to shareholders. However, the bottom line is that it is still a retail-focused REIT, and half of its tenants are below investment grade. In an environment where physical retail is rapidly becoming less relevant, I wonder long term how Realty will cope.

Source: Investor presentation

The company’s exposure to offices is negligible, so that’s a good thing as that model is breaking down with widespread working from home. Industrial properties is the sector I’m most bullish on for REITs, and Realty has a bit of exposure there. However, let us not lose sight of the fact that Realty is and presumably always will be focused on physical retail. That strategy has worked for decades, but there is no getting around the fact that the model for retail was already changing prior to COVID, and that change has simply been accelerated.

Source: Investor presentation

Realty points out its contractual rent collections have moved higher since the crisis began, and that’s great. Its highest exposures are to non-discretionary industries, but it has significant exposure to health and fitness and movie theaters, two industries I have serious concerns about moving forward.

I think the movie theater business model is permanently impaired and that it is only a matter of time before they go away completely. Health clubs are being rendered irrelevant by streaming fitness classes and world-class equipment you can put in your home. That industry isn’t as bad as movie theaters, and I don’t think they’re going away. I do see overcapacity, however, and Realty is exposed significantly to both theaters and health clubs.

Source: Investor presentation

One way the company has created value over time is by disposing of select properties and reinvesting the proceeds. However, given the concerns I have about physical retail in general, and in particular, some of the industries Realty is exposed to, I wonder how strong pricing will be for the properties it will try to dispose of. After all, the unstoppable trend in commercial real estate is more digital commerce and less physical, which means that over time, demand for these properties will decline. I don’t know when that will be, but I do think that will be the case, and that exposes Realty to holding properties that are declining in value. At the least, even if values remain stagnant, the company may lose the tailwind of selling for favorable prices.

But that dividend!

Of course, if you own Realty, you likely own it for the dividend and probably don’t care about any of the points I just said. And why not?

Source: Investor presentation

Dividend track records like this are extremely difficult to find and as I mentioned earlier, Realty deserves all the credit in terms of putting this together over the years, because countless REITs have failed to do anything like this.

The problem is that with the points I raised above, I’m not sure how long the company can continue to do this. Below, we have trailing-twelve-months FFO and cash common share dividends in millions of dollars for comparison’s sake.

Source: TIKR.com

FFO has been rising on a dollar basis over time, but so has the dividend. Realty has always paid most of its FFO in dividends, which is normal for a REIT, so I don’t give that a second thought. The problem is that as the company continues down the path that I see where its properties are in less demand over time, I wonder how long this can persist.

This is particularly true because habitual and substantial dilution of shareholders has been present for years.

Source: TIKR.com

Realty was at it again just last week as it issued a further 10.5M shares with an overallotment of 1.575M shares. While that helps the company raise capital to buy more properties, it also means there are now 10.5M shares (at least) that require dividends. In other words, Realty is playing a game where it is constantly issuing shares to fund growth, but those shares have a ~5% dividend on them, in addition the implied cost of spreading FFO out over an ever-rising number of shares. With the long-term demand case I laid out for retail space, my view is that this hurdle rate will become more and more difficult to clear over time.

This may be playing out already because Realty has significantly picked up its share issuances in recent quarters, while net debt has remained roughly stagnant.

Source: TIKR.com

Realty has clearly chosen dilution over leverage, but with interest rates so low, it should be the opposite. Realty has a significant amount of leverage already, but the growth-at-any-cost mindset of issuing billions of dollars of new shares almost constantly is doing more harm than good to my eye.

Why I’m not bearish

You might be wondering if I’m so pessimistic, why I’m not bearish on the stock. First, the factors I’ve laid out will play out over years, not months, so I’m not looking for an immediate decline in the share price. My point is simply that it doesn’t appear to me that Realty is adapting to a changing retail landscape.

Second, the stock isn’t expensive, but I do think it is fully priced. Price to forward AFFO gives us a good look at the valuation, and we’ve got a five-year picture below.

Source: TIKR.com

Shares go for ~17X forward FFO today, and that’s somewhat below its historical average, and well below its pre-COVID pricing. However, COVID has accelerated the move towards more digital commerce, so I think Realty should be cheaper than it was. This is not a buying opportunity in my view, but an entirely warranted revaluing of the stock.

Price to tangible book value shows roughly the same picture, as we can see below.

Source: TIKR.com

Shares are slightly below their historical average on this metric too. I won’t beat the proverbial dead horse, but my point is that I don’t think Realty is expensive, but I wouldn’t view these valuation declines as anything other than the market correctly assessing the situation.

Unfortunately, the same thing is true for the dividend, as we can see below with the stock’s yield for the past decade.

Source: Seeking Alpha

Shares are at 4.8% today, which is a nice yield, but certainly isn’t unprecedented for Realty. This chart again shows me that if we value the stock based on this metric, it looks okay, but nowhere near a buy.

The bottom line is that I think Realty’s model that has worked for the past few decades is at risk. It isn’t at great risk today, but it will be over time. I think the market has correctly revalued the stock, and I therefore see a very long time between now and the stock getting back to pre-COVID highs, if ever. With Realty vastly underperforming peers and all the headwinds I mentioned above, I don’t see any reason to own it. The stock is materially lower because the company’s model is impaired, and this is not a buying opportunity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.