I recently published an article titled “The Best Monthly Dividend Stocks” in which I evaluated 17 C-corporation stocks that pay dividends monthly.
In that article I covered the benefits of monthly dividends and provided the reader with a red/yellow/green recommendation on investment potential and a brief rationale for the recommendation on each of the 17 stocks.
To provide more granularity on those stocks ranked green in the previous article, I’m covering in more detail the four stocks I consider “The Best of the Best Monthly Dividend Stocks.” In the first, second and third articles of this series I covered:
- STAG Industrial (STAG, Financial).
- Chatham Lodging Trust (CLDT, Financial).
- LTC Properties (LTC, Financial).
This latest article covers the fourth and last stock in the series, Realty Income Inc. (O, Financial).
Introduction to Realty Income Inc.
In the spirit of providing actionable investment recommendations, I chose to cover the four “Best of the Best” monthly paying stocks in order of most undervalued to least undervalued.
Many investors view the REIT sector as a fairly uniform group of companies (trusts) that own property or make loans on property with the investor focusing on the highest yield in the sector. This approach to primarily looking at a REIT’s yield is a mistake. All REITs are not created equal and equity REITs and mortgage REITs are as different as apples and oranges.
When selecting a REIT for investment, it is important to interpret dividend yield through a qualitative (versus strictly quantitative) lens looking at the underlying risk-adjusted performance to ensure the overall metrics such as the balance sheet, diversification, earnings growth and payout ratios support continued growth of the REIT and its dividend. Consistent with this approach, the investment thesis for Realty Income is laid out in the following paragraphs and charts.
Realty Income is an internally managed REIT that invests primarily in retail and light industrial spaces with a small exposure in agricultural properties and office space. The majority of Realty Income’s properties are in the retail space with broad diversification within that sector. The chart below provides a snapshot of Realty Income’s top 20 tenants.
Source: Realty Income website
The largest tenant in Realty Income’s stable is Walgreens (WBA, Financial) with a 6.8% contribution to total revenue. This level of diversification effectively prevents Realty Income from suffering significant impact to revenue and earnings if one tenant has financial difficulties. The other point to note from this chart is that eight of the top 20 tenants maintain an investment grade credit rating.
In addition to tenant diversification, Realty Income also maintains effective industry diversification as shown in the chart below.
Source: Realty Income website
Realty Income’s portfolio is a little heavy on drug and convenience stores at 20% of the total, but these businesses are solidly entrenched in our economy so there is little risk posed by the 20% share.
Realty Income has properties located in 49 states and Puerto Rico. The only state absent from the list is Hawaii. The chart below shows the percentage of the total properties (4,615) Realty Income owns in each state and Puerto Rico.
Source: Realty Income website
So Realty Income is a well diversified retail and industrial REIT with properties located in 49 states. How has it performed up to this point?
How has Realty Income performed?
The short answer is:Â Realty Income’s performance to date is legendary.
The company is well known as the “Monthly Dividend Company” and for good reason.
The company has raised its dividend 85 times since its IPO in 1994 and paid 549 monthly dividends through April. While the dividend growth rate has been a modest 4.7%, it is measured over 22 years. The chart below shows Realty Income’s annual dividend payments since its IPO.
Source: Realty Income website
This is not a “get rich quick stock,” but it is definitely a “get rich slowly” stock. A number of people who invested in Realty Income near the time of its IPO have enjoyed returns that have beaten all the major market indices. The chart below shows the value today of $100 invested in Realty Income in 1994.
Source: Realty Income website
To put the graphical representation above into numbers, the table below shows Realty Income’s compound annual growth rate (CAGR) since the IPO versus the major market indices.
Source: Realty Income website
Both the graphical representation and the CAGR table above are based on returns with all dividends reinvested. Imagine what you would have today if you had gotten a 17.8% return for 22 years. It’s clear that Realty Income’s past performance has been stellar. But, before we conclude that Realty Income really is a great company, we should look at its capital structure.
Realty Income maintains a BBB+ investment grade credit rating. If you have looked at the REIT sector in detail, you know there are not many REITs with investment grade credit. Realty Income has a very solid and conservative balance sheet. The chart below shows the capital structure and the debt metrics for the company.
Source: Realty Income website
The debt metrics are very solid and the majority of Realty Income’s capital structure is in equity. This is the kind of company in which I want to be invested.
What about Realty Income’s current valuation?
Realty Income’s current valuation
I have owned Realty Income off and on for a number of years. The most recent period was September 2015 to the end of March. The short answer to the question of why I sold Realty Income is that I had a very nice gain in a short period of time and Realty Income had become overvalued.
I sold at $62.50 for a 38% gain in just over six months. Realty Income went even higher and hit $64.50 before falling back down to about $59 today. I’ve got Realty Income on my watch list, but it remains overvalued today. Let us look at some numbers.
Source: Author
The yield of Realty Income is a little low and the Price/FFO is a little high, maybe more than a little high. Realty Income’s yield is about 4% and its Price/FFO is about 21. Based on my past experience with this REIT, my recommended entry point would be a yield of about 5% and Price/FFO of 16. Will we get there?
An investor could decide to buy now and hope that Realty Income grows quickly and sufficiently to get to an improved yield on cost. I don’t recommend that approach. Realty Income’s first-quarter report indicates it is on track to meet or beat its full-year 2016 guidance. The chart below shows both the first quarter highlights and the full-year 2016 guidance.
Source: Realty Income website
For 2016, the company is expecting about 3% growth in FFO and 5% in Adjusted FFO (AFFO). Those numbers represent good solid growth and should allow for continued increases in the dividend in 2016. But, at that growth rate, it would take a couple of years to “grow into” the current valuation.
I’ve always managed in the past to buy Realty Income at a yield valuation of 5% or better and, with patience, I’ll have the opportunity again. I recently published another article on Sure Dividend that looked at different strategies for maximizing returns based on entry valuations. Part of that article discussed typical stock volatility and how to benefit from that volatility. Readers can view the complete article here. With Realty Income, I’ve frequently benefited from “buying the dips.”
What are the risks of an investment in Realty Income?
The primary risk is the potential for interest rates to rise significantly. Realty Income is primarily an income investment with medium growth and a significant dividend yield. It therefore falls into the category of bond surrogate and will likely see its share price fall if interest rates begin to rise.
Because Realty Income is able and expected to grow along with the economy, a fall in Realty Income’s valuation due to rising interest rates would likely be temporary.
The second impact of a rising rate environment would be an increase in borrowing costs to continue to grow its real estate footprint.
That said, I don’t expect the U.S. Federal Reserve will make any significant move to raise interest rates. It is an election year, the U.S. economy is soft, the employment metrics have turned down over the last couple of months, and the rest of the world is still trying to juice economies via loose monetary policy. If there is to be an increase in the federal funds rate in June, I expect it will be a small one.
Conclusion
Realty Income is a great company and has a tremendous following.
Based on its historical performance, conservative management and solid balance sheet, I expect it will continue to do well in the future.
I introduced this article as well as the prior three articles on the premise that I would list the “Best of the Best” monthly dividend paying stocks in the order of most undervalued to least. That I am listing Realty Income fourth out of four does not mean its potential is less than STAG Industrial, Chatham Lodging or LTC Properties.
It is simply that I consider Realty Income’s valuation to be high at this time and recommend waiting for a better opportunity to buy into the company.
(By Dirk S. Leach)
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