Realty Income (NYSE: O) has long been an income-focused investor favorite given its monthly dividend payout that rises quite regularly. However, the stock’s price performance has been a bit of a dud over the past five years, falling more than 15% over that stretch.
More recently, though, Realty Income stock started to regain some momentum, and it is up more than 25% over the past year. With this momentum likely set to continue, let’s look at three reasons you should be choosing this name.
1. Realty Income offers a steady and rising dividend
When it comes to paying higher dividends each year, Realty Income is a star performer. The real estate investment trust (REIT) has raised its dividend for 29 straight years and seen 108 consecutive quarterly increases.
Over the past decade, its dividend has had a 4.3% compound annual growth rate, from $0.90 per share in 2014 to a $3.156 yearly run rate as of the end of July. Its current monthly dividend was just increased to $0.2635 per share in October, good for a forward yield of about 5.1%.
Its ability to consistently increase its dividend stems from its steady, predictable business model. How a REIT like Realty Income makes money is from the difference between the rental income it generates from the properties it owns and the interest expense to fund those properties. It uses what are known as triple net leases, whereby its tenants are responsible for utilities, property taxes, and maintenance (along with the rent).
The triple net leases help Realty Income avoid any unexpected expense increases, while it generally signs up tenants to long-term leases with 10- to 20-year initial terms and yearly rent escalators. This, along with acquiring new properties, creates a nicely steady and increasing rise in its adjusted funds from operations (AFFO), which it then uses to boost its dividend.
2. Realty Income’s portfolio increased its diversity
Traditionally, Realty Income has focused on the retail sector, preferring to lease to what it deems as less economically sensitive retailers such as grocery stores, dollar stores, and pharmacies, which are better insulated from e-commerce pressures. However, the REIT has diversified its business in recent years.
First, it expanded into Europe, where it now has an approximately $11 billion real estate portfolio. Recently, this has been the company’s biggest area of new investment, where it has been able to get higher capitalization rates (caps) than in the U.S. Cap rates are basically a lease’s yield, which is calculated using a property’s net operating income and dividing it by its purchase price.
Meanwhile, the company has increased its exposure to industrial properties through its acquisition of Spirit Realty earlier this year. These properties now account for about 14.5% of its annualized contractual rent.
Realty Income has also begun to make investments in other verticals, such as casinos and data centers. It entered the gambling industry in 2022 with a $1.7 billion sale-leaseback deal with the Encore Boston Harbor Casino, and later it bought a nearly 22% equity stake in the property of The Bellagio Las Vegas operated by MGM Resorts.
Last year, the company invested about $200 million to acquire an 80% equity interest in two data centers being built by Digital Realty, forming a joint venture with the data center REIT.
This diversification comes at a good time because the retail pharmacy and dollar store businesses have come under pressure, as have home furnishing and home decor stores. Walgreens is one of Realty Income’s largest tenants, and the pharmacy chain plans to close about 25% of its locations. However, the REIT said that only 26 basis points of its total portfolio annualized contractual rent expires over the next 2 1/2 years with Walgreens.
On its last earnings call, the REIT’s management said that it estimated the rent at risk associated with Rite Aid, Red Lobster, Walgreens, Dollar Tree, At Home, and Big Lots was only 2.3% of its total portfolio annualized contractual rent through year-end 2026.
Management said if it can achieve the 84% long-term average recapture rate it typically gets with bankruptcies, the potential risk to its AFFO is only $0.02 per share. Meanwhile, it said any advanced notice of store closures provides value since it typically gives the company years to plan for an optimal outcome.
3. Lower interest rates will help Realty Income
Realty Income’s lackluster stock performance over the past few years largely stemmed from higher interest rates. Commercial properties are generally valued based off the aforementioned cap rates, which are highly influenced by interest rates. As cap rates follow interest rates up, the value of properties purchased at lower cap rates declines to reflect the current higher cap rate.
For example, if a REIT buys a commercial property for $5 million at a cap rate of 4%, it would be generating $200,000 in net operating income a year at the start of its lease. If after five years, rent escalators pushed its net operating income up to $220,000, but cap rates increased to 6%, the REIT would be earning more income, but the present value of the property would now be closer to $3.7 million ($220,000 in operating income/6% cap rate = $3.67 million property value). With the Fed previously pushing up interest rates, this is why Realty Income’s stock struggled.
However, the Fed recently cut rates by 50 basis points in what is expected to be the start of a decline in interest rates over the next few years. Cap rates, meanwhile, have also begun to fall in the U.S. and Europe after what had been a steady climb since the start of 2022. If this is the start of a trend, Realty Income should see the value of its real estate portfolio rise, and with it, its stock.
Time to buy Realty Income stock?
While Realty Income does have some tenant headwinds, they appear very manageable, and the company has a long history of dealing with stressed tenants and rent recapture. More importantly, though, the REIT market appears to be at the beginning of a lower cap-rate cycle, which will help reverse some of the reduced value the company saw in the past few years. As such, I would be a buyer of the stock since it looks poised to be a big rate-cut winner.
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Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Digital Realty Trust and Realty Income. The Motley Fool has a disclosure policy.
3 Reasons to Buy Realty Income Stock Like There’s No Tomorrow was originally published by The Motley Fool
