When it comes to real estate investment trusts, Realty Income Corp (NYSE:O) has certainly been a standout performer. During the past 15 years, the total return for O stock has come to about 11%. Realty Income owns and manages free-standing, single-tenant properties — and about 80% of the portfolio is in retailers.
It definitely helps that Realty Income has maintained a strong dividend yield, which is currently at 4.5%. Keep in mind that the company’s tag line is “The Monthly Dividend Company.”
To this end, the company has made 563 consecutive dividend payments and there have been 79 quarterly increases since the company came public in 1994.
But lately, the O stock price has come under pressure. Since late February, the shares have sustained a 10% loss. It is also important to note that the REIT sector has lagged as well.
So is this just a temporary thing? Or perhaps Realty Income is a bargain?
Well, I actually think investors should be wary. And here are three factors to consider:
O Stock Risk No.1: Interest Rates
Higher interest rates will likely have an adverse impact on O stock. One reason is that the company is heavily dependent on debt financing for its properties. So future expansion plans could be more costly. But there are also the problems with existing debt. Keep in mind the O’s credit facility, term loans and some of our mortgages have variable rates.
Another issue is that higher interest rates make the yields on REITs less attractive — that is, in comparison to safer U.S. Treasury securities and other highly secure debt instruments.
In light of all this, it should not be encouraging that it appears that the Federal Reserve is in the early stages of tightening monetary policy. Last week, there was a 0.25% increase in the federal funds rate. And while this may seem minor, this is only part of the policy. Note that the Fed is also taking steps to reduce its balance sheet of $4.5 trillion.
For the most part, interest rates have been kept fairly low since the financial crisis of 2009. In other words, Fed policy appears to be in the midst of a major shift — to get to a more normal footing. But unfortunately, for O stock, there is likely to be continued pressures.
O Stock Risk No.2: Retail Woes
Amazon.com, Inc.’s (NASDAQ:AMZN) $13.7 billion proposed acquisition of Whole Foods Market, Inc. (NASDAQ:WFM) is a stark reminder of the wrenching disruption in the retail space. On the news, companies like Kroger Co (NYSE:KR), Wal-Mart Stores Inc (NYSE:WMT) and Target Corporation (NYSE:TGT) took hits to their stock prices.
Of course, before all this, there has been a spate of bankruptcies in the retail sector. Just some of the examples include Payless, ShoeSource, RadioShack, Wet Seal, Gymboree and rue 21.
Now, as for Realty Income, the company has a massive retail footprint, with 4,980 properties. Although, it is diversified across various industries and 49 states (including Puerto Rico). The occupancy rate is also at an impressive 98.3% and the average lease term is 9.7 years.
Yet despite all this, there are still risks in the portfolio: Roughly 5.8% of revenues come from Kroger, WMT and BJ’s Wholesale Club, which are companies that may ultimately get more aggressive with their negotiations to lower costs.
There is also heavy concentration in the drugstore industry, with tenants like Walgreens Boots Alliance Inc (NASDAQ:WBA) and CVS Health Corp (NYSE:CVS). This is also an industry that is poised for major changes as AMZN appears to have plans to make a play for the market.
Granted, this is not to imply that the portfolio of Realty Income is going to implode. Again, the company has a solid track record of disciplined execution. But going forward, it could get more difficult to find growth as the retail industry appears to be facing secular challenges.
O Stock Risk No.3: Valuation
Even with the recent drubbing of O stock, the valuation is still far from cheap. Consider that the forward price-to-earnings multiple is 49X. By comparison, Kimco Realty Corp (NYSE:KIM) trades at 29X and Simon Property Group Inc (NYSE:SPG) sports a multiple of 27X.
Wall Street analysts are not too enthused with O stock either, with the price target at about $59.50. So this implies only a 5% upside for the next year.
Tom Taulli runs the InvestorPlace blog IPO Playbook and is the author of various books, including All About Commodities, All About Short Selling and High-Profit IPO Strategies. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.