Introduction
I wasn't planning on covering Realty Income (NYSE:O) this year. After all, it's one of the most well-covered stocks on Seeking Alpha - or anywhere.
Also, as much as I love the company and its smart management, it was never a suitable investment for my dividend (growth) portfolio, as I prefer more aggressive growth.
However, here we are.
I decided to cover Realty Income for two reasons:
- This valuation has gotten a bit ridiculous. Either we get a new financial crisis, or we're dealing with one of the best buying opportunities since, well, the Great Financial Crisis of 2008.
- It's a great opportunity to incorporate my macro view in an article that covers a very macro-economic-driven stock.
While I will stick to dividend stocks that emphasize growth over yield, I am currently buying O-shares for some family accounts and will step up these investments if the valuation keeps dropping.
Now, let's get to the details!
The Macro Impact On Realty Income
On October 15, the Wall Street Journal wrote an article titled A Recession is No Longer The Consensus.
According to the article, economists are becoming increasingly optimistic about the U.S. economy. They have reduced the probability of a recession in the coming year from 54% to 48%, marking the first time it's below 50% in over a year!
Optimism is driven by several factors: declining inflation, the Federal Reserve's decision to halt interest rate increases, and strong labor market performance and economic growth exceeding expectations.
Economists predict a 2.2% increase in GDP for the fourth quarter of 2023, a significant upward revision from the previous 1% growth forecast.
Well, someone please tell the market, because this is not at all what the market expects.
Let's say the market expected inflation to normalize quickly and the Fed to turn dovish soon. Realty Income would trade much higher.
We aren't just dealing with a random sell-off but the worst stock price decline (excluding dividends) since the company went public. Only the Great Financial Crisis and the brief pandemic sell-off were worse.
Despite what one might be thinking, the market is telling us that it expects increased chances of stagflation. That's worse than a recession, as it means stagnation on top of elevated prices.
Especially for companies with limited pricing power, that's an issue.
Realty Income is one of these companies. The company, which has a triple-net lease model where tenants pay for insurance, taxes, and maintenance, could suffer from elevated inflation for two reasons:
- It tends to make debt more expensive (variable rates + new debt).
- Its contracts tend to rise with inflation, except when inflation rises above its rent cap. Generally speaking, these ceilings are close to 2.0%-2.5%.
Increased inflation or anticipated inflationary periods could have a more pronounced negative impact on any variable rate debt we incur in the future and on our results of operations. During times when inflation is greater than increases in rent, as provided for in our leases, rent increases may not keep up with the rate of inflation and other costs (including increases in employment and other fees and expenses). - Realty Income
Going back to market expectations, we're dealing with a bit of a run against the clock.
Prior to and during the pandemic, a lot of companies were able to get great deals on new debt. After all, rates were close to zero.
Now, we're slowly approaching a wall of debt maturities, which means that companies need to refinance. They usually take on new debt to pay the principal of the maturing debt.
U.S. retailers and supermarkets, for example, face a maturity wall starting next year.
The overview below shows what the maturities of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) look like.
Starting in about two years, the economy will be faced with a wave of refinancing requirements, in this case, in the Junk category.
In commercial real estate, the situation isn't much different. On September 24, Brad Thomas and I wrote an article highlighting some of these issues.
In total, the report found that $436 billion of multifamily debt is potentially troubled, while total CRE debt in the same condition totals $1.2 trillion!
To make things worse, banks are particularly exposed to the multifamily market, with a significant percentage of loans set to mature by 2025. The report indicates that 52% of such loans are held by banks, emphasizing their vulnerability to the dynamics of the multifamily sector.
To make things worse, the market isn't pricing in a very dovish Fed. Nope. It's pricing in elevated rates on a prolonged basis!
For example, the implied chances that the Federal Reserve funds rate is above 4.50% on November 7, 2024, has risen to more than 80%. In June, that number was close to zero.
As one can imagine, the renewed upswing in inflation has something to do with that.
For Federal Reserve policymakers, the stickiness of US inflation argues for the higher-for-longer scenario for interest rates. Futures prices continued to show a small chance of a further hike, but also somewhat diminished expectations for the scale of reductions in 2024. - Bloomberg
Also, I'm well aware the inflation upswing doesn't look that wild.
However, please know that the market expected inflation to come down in a straight line. Now, it's seeing heavy resistance, oil prices close to $90, and new disruptions that could keep inflation from hitting 2.0% anytime soon.
Hence, the race against the clock continues.
We're getting closer to a situation where the Fed may have to choose between protecting economic stability or fighting inflation.
This is what Deutsche Bank (DB) CEO Christian Sewing said earlier this month:
Deutsche Bank AG Chief Executive Officer Christian Sewing said commercial real estate is facing tough times in the years ahead after central banks raised interest rates more than expected to combat inflation.
[...] Commercial real estate has emerged as a key concern for banks and their regulators as the rapid surge in borrowing costs threatens to push developers into default. Many firms had piled into the asset class over the last decade to buoy revenue as negative interest rates eroded profitability.
[...] Central banks will probably keep interest rates elevated given “stubbornly high” inflation, according to the Deutsche Bank CEO. It’s also not “completely unthinkable” that rates will rise again, he added.
So, to go back to the start of this article, while most market participants believe that a recession is unlikely, we see that the market is preparing for a recession.
In other words, when bearing in mind that real estate stocks have lost a third of their value - including dividends! - there are two options:
- Either we're about to enter a new Great Financial Crisis, which could erase another 30% to 40% off the value of REITs.
- Or we're dealing with fantastic buying opportunities!
That's where Realty Income comes in.
Buying Quality At A Great Price
A market downturn doesn't bother us. It is an opportunity to increase our ownership of great companies with great management at good prices. - Warren Buffett
As a long-term investor, I know I won't always turn bullish at the very bottom. However, getting a great valuation is one of the best ways to build long-term wealth.
This also applies to Realty Income, a stock I've ignored for a long time, as I didn't like the subdued yield, at least in light of its somewhat low dividend growth.
For example, the five-year dividend CAGR is 3.7%. That's not a lot. Realty Income's dividend growth is inflation protection at best.
Having said that, O shares now yield 6.2%!
If a 6.2% yield keeps growing at 3% (even lower than the five-year CAGR), investors turn a 6.2% yield into an 8.3% yield-on-cost after ten years. That's not too bad.
It also helps that:
- Realty Income has a track record of 29 consecutive annual dividend hikes, obviously including the Great Financial Crisis, the pandemic, and every recession since the early 1990s.
- The dividend is protected by a 77% 2023E adjusted funds from operations payout ratio.
- The company is one of the few REITs with an A- rating (or better).
- More than 90% of its rent is resilient to economic downturns, meaning it includes non-discretionary tenants.
The company, which has 11% rent exposure in the U.K., has a lot of stock-listed companies in its top-ten holdings. It has more than 1,300 clients in 85 industries.
The largest tenant is Dollar General (DG), which accounts for close to 3.8% of its sales. Walgreens (WBA) comes in second with a similar exposure.
More than a quarter of its revenue comes from convenience stores, grocery stores, and dollar stores.
It has a 99% occupancy rate, the highest in 20 years!
Now, the company is moving into gambling/leisure.
In August, the company announced a $950 million investment in the Bellagio Las Vegas at a $5.1 billion valuation.
Upon closing, Realty Income will invest approximately $300 million of common equity in the joint venture, subject to certain adjustments, to acquire a 21.9% indirect interest in the property, BREIT will retain a 73.1% indirect interest, and MGM Resorts International ("MGM") will retain a 5.0% interest in the property. Realty Income will also invest $650 million to acquire a yield-bearing preferred equity interest in the joint venture.
Although I do like the Vegas gaming sector, I'm not necessarily a fan of this investment, which comes with a cap rate of just 5.2%. Especially considering higher financing costs down the road, 5.2% is a bit tight for my taste.
Having said that, Realty Income is also benefiting from higher rates.
Why?
Companies with unfavorable access to debt may use sale-leaseback deals to raise capital by selling their buildings to companies like Realty Income.
Realty Income's addressable market, which includes around 300 firms with $1.6 trillion of owned real estate, presents significant opportunities for sale-leaseback capital providers.
As the attractiveness of sale-leaseback financing continues to grow due to elevated debt costs and the elimination of maturity risk, Realty Income's growth opportunities are set to expand on a sustainable basis.
The company also has the balance sheet to do it.
Realty Income maintains a healthy financial position with net debt to annualized pro forma adjusted EBITDA of 5.3x and a solid fixed charge coverage ratio of 4.6x.
The company, with an A- credit rating, has actively issued equity capital via the ATM (at the market), raising around $2.2 billion in the second quarter.
Additionally, they successfully raised €1.1 billion through a debut public offering of euro-denominated unsecured bonds. The proceeds from this offering helped repay short-term borrowings, resulting in a well-capitalized balance sheet with significant liquidity heading into the third quarter.
96% of its debt is unsecured. 92% of its debt has a fixed rate.
With that said, on top of a top-tier balance sheet, SLB opportunities, and anti-cyclical tenants, the company has a very favorable valuation.
So Cheap!
Realty Income is yielding 6%, which investors also get when buying into high-yield bonds.
However, unlike bonds, Realty Income is consistently growing its payout. This is backed by consistent (adjusted) funds from operations growth.
- Realty Income's AFFO fell by just 2% in 2008 and 2% in 2009. That's a fantastic performance during one of the toughest periods for REITs ever.
- This year, AFFO is expected to increase by 2%.
- In the years ahead, AFFO is expected to grow by 3-4%. This secures low-single-digit annual dividend growth.
It also means that O shares are very cheap!
Realty Income is now trading at just 12.6x AFFO. This is the cheapest valuation since the Great Financial Crisis.
The normalized valuation multiple is 17.7x AFFO. If the company returns to this valuation, it could return 27% per year through 2025.
I'm not promising that the stock will return this much, but it shows that there's a realistic path to these returns if the market starts to give REITs a better valuation again.
After all, with valuations and stock price movements like the ones we've seen this year, we either enter a new massive recession or we get the best bargains in over a decade...
I'm mildly bearish on the economy, as I've often highlighted my belief that inflation will remain sticky and the implications this has on debt quality.
However, at these prices, I'm buying.
I've aggressively added to REITs like Extra Space Storage (EXR) for my own portfolio and bought Realty Income for accounts that I manage that are focused on income over growth.
If Realty Income continues to fall, I'll average down.
I've little doubt that this stock will remain a terrific tool for income for many decades to come.
Takeaway
In a market that seems to be preparing for a recession, Realty Income presents a compelling opportunity. With its recent yield surge to 6.2%, the stock offers significant potential for long-term wealth building.
Despite its somewhat modest dividend growth, Realty Income boasts a track record of 29 consecutive annual dividend hikes.
The company stands out with an A- credit rating, a strong balance sheet, and anti-cyclical tenants, making it a safe haven in uncertain times.
Furthermore, Realty Income's consistently growing payout, backed by steady funds from operations growth, positions it as an attractive investment.
Currently trading at just 12.6x AFFO, the stock is exceptionally cheap, possibly offering substantial returns if the market reevaluates REITs favorably.
While economic concerns persist, the compelling valuation and income potential of Realty Income make it an enticing option for investors willing to bet on a brighter future.
In my view, these market conditions offer a prime opportunity to buy into a resilient and income-generating stock for the long term.
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