Realty Income: 8 Year Return Drought (NYSE:O)

JamesBrey While we were not raging bulls with regard to Realty Income Corporation (NYSE:O) back in March, we did think that it made for a better buy than NNN REIT Inc (NNN) at the time. David had outperformed Goliath over the last three years, but the odds were in the O’s favor for the next round. Both the businesses were projected to grow FFO through 2026, but O was in the lead in terms of pace. That it was trading at a lower FFO multiple and yielding slightly higher made choosing it a no-brainer. Both Realty Income and NNN REIT have solid balance sheets. Realty Income has A- rated credit and 5.5X debt to EBITDA ratio. NNN REIT is one notch lower at BBB+ and carries the same debt to EBITDA ratio. But that (one notch higher) does give Realty Income an edge should financial conditions deteriorate. NNN’s smaller size has also not really boosted growth on a relative basis, despite multiple assertions for the opposite. In fact, Realty Income has been able to use its size to make large acquisitions and move the gauge on its FFO per share. Source: Realty Income Vs. NNN REIT: How The Turntables Have Turned While the outperformance has not been earth-shattering, O has come out ahead over the last three months. Data by YCharts It should be noted that O has increased its monthly payouts a few times since that piece. Seeking Alpha – O Whereas, we typically see NNN announcing its annual increase in July. Today, we will focus solely on the Q1 results of O and provide our verdict based on its current metrics. PICS Realty Income Investor Presentation_Q1 2024 Q1-2024 Realty Income found ways to invest assertively in Q1-2024, with an initial weighted average cash yield of 7.8%. Its breakdown showed that it was able to find European assets at an even higher yield. Q1-2024 Presentation These numbers are important in the context of a non-ZIRP (zero interest rate policy) regime. REITs have been battered on the valuation front and that has caused their cost of capital to rise. But this rise is being made up in the cap rate they pay for new properties. By comparison, have a look at the yields on new investments in 2019. 2019 Presentation You can see this capital rate-cap rate spread in the next chart below. Q1-2024 Presentation That is the key reason that Realty Income continues to generate income and income growth, in all interest rate environments. The REIT reaffirmed its guidance for the year at $4.13-$4.21 per share, and we think it will come in at the high end of those numbers. The Macro Interest rates and the timing of a recession are the top tow things on investor minds. The gun slingers came into 2024 expecting 6 rate cuts, and now it appears their best case is just one. Even that might not happen right on the cusp of an election. On the recession front, one must remember that this has been an extremely unusual cycle and one that has played out longer and slower than most (including us) expected. But that yield curve is still inverted, and there will likely be some hell to pay eventually. In the face of that, we have an unusual bifurcation. Growth stocks have become extremely expensive, and they form the bulk of the S&P 500 (SPY) holdings by weight. On the other hand, value stocks have never been this cheap, at least relative to growth. We discussed this previously, and we can see it in a different way in the chart below as well. Bank Of America As time passes, Realty Income’s growth is slowly making the company more and more valuable at the same price. In the chart below, you can see the yahoos who were so enamored with Realty Income’s reputation that they ponied up 25X funds from operations (FFO) multiples on 3 occasions. TIKR If you bought at the 2016 peak, you have negative price returns over a period of 8 years. Your total returns including dividends badly lag Treasury bills, not to mention SPY. Data by YCharts But that pain has a silver lining. Today, we are down to 12X on 2024 numbers. Realty Income has also got here while keeping its balance sheet in phenomenal shape. As one of few REITs with an A rating, one has to usually pay a premium multiple (16X-18X) of FFO for this most of the time. Q1-2024 Presentation But not today. It is hard to envision a scenario where you really regret taking a position here. Outside the global financial crisis, the dividend yield is near the ultra-high end of its range for the past two decades. Data by YCharts The chart below is using the trailing 12 months yield, whereas the actual yield is now a shade above 6.0% based on the most recent dividend. If you extrapolate out 10 years, you should make at least 6.5% annual yield on your current cost. This happens even if Realty Income slows monthly increases to a crawl. If you assume then that Realty Income meets its 2024 guidance and then increases FFO by just 2% a year for the next decade and then trades at a 10X FFO multiple, you still make a 6.5% annualized return as your price is about the same. Author’s Calculations So even under rather draconian earnings and valuation scenarios, you land up beating the 10-year investment grade corporate bond yields. Data by YCharts On the upside, it is probable that you see 3% annual FFO growth and a 15X ending multiple. Author’s Calculations This would create a fantastic return profile with dividends reinvested. We think this is a good investment for long term holders, as long as they keep their time horizons long and their expectations modest. We are upgrading this to a Buy here. Realty Income Corporation 6% PFD SER A (NYSE:O.PR) Realty Income inherited the Spirit Capital preferreds. History has shown that they (Realty Income management) do not adore preferred shares hanging around. This one has a 6% coupon and REIT will tolerate it for now as its common equity cost of capital is even higher than that. With the preferred shares trading slightly below par, they yield about 6.2%. Investors looking for a longer duration play might find these interesting. But they will only not be called if rates stay permanently high. In almost any kind of rate cutting cycle, these are likely to be called by Realty Income. If that happens over the next 12 months, the preferreds could return about 10% total as they are redeemed at $25.00. We stayed out of this one and instead bought the Rexford Industrial Realty, Inc. 5.875% PFD SER B (REXR.PR.B). Those had about a 7% stripped yield at the time, and that made them more appealing. We see the credit quality of Rexford Industrial Realty Inc. (REXR) as identical to Realty Income. Also, since those are far below par, we have a very large upside to an unlikely redemption. Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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