Should You Buy Realty Income Corp (O) Stock? 3 Pros, 3 Cons

Realty Income Corp (NYSE:O) is arguably the world’s most popular real-estate investment trust. The company cleverly branded itself as the “Monthly Dividend Company” well before monthly dividends became popular. And investors have flocked to O stock ever since. The combination of reliable monthly income and strong performance has won the company many fans.

Should You Buy Realty Income Corp (O) Stock? 3 Pros, 3 ConsHowever, O has become more controversial over the past year. With interest rates beginning to rise, REITs could take a hit. And Realty Income remains one of the most expensive REITs out there on a price-to-funds-from-operations “FFO” basis.

O stock has dropped as much as 25% from its 2016 peak as investors rethink the company’s future. Is this dip enough to make this REIT stalwart attractive, or will a better sub-$50 entry point be coming soon?

Let’s take a look.

O Stock Cons

Rising Interest Rates: Any discussion of REITs has to start with the big questions. How far will interest rates rise? And how badly will REITs be affected? Since 2009, U.S. short-term interest rates have held steady at zero, more or less. This has led to a boom in REIT prices. This is for three reasons.

First, the value of a real estate company’s properties increase when interest rates fall, since cap rates decline. Second, REITs can borrow money cheaper, reducing their interest costs, leading to more FFO, higher dividends and more deal-making ability. Third, investors will accept lower dividend yields (and thus higher stock prices) for REITs given the dearth of safer yield options.

All these favorable effects go into reverse as interest rates rise. Realty Income’s properties lose value as investors demand better cap rates. Realty Income’s substantial debtload will require higher interest rates to refinance. And the company’s dividend yield will rise. A mere 0.5% increase in interest rates would likely cause O stock to have to yield 5% (it yields 4.5%) now; such a move would cause the price of O stock to fall from $55 to $50.

Retail Woes: Realty Income is more diversified than many of its peers. We aren’t talking a low-end mall REIT here. Still, Realty Income has invested heavily in properties whose tenants are generally brick and mortar retailers. Yes, many of their leading tenants, such as Walgreens Boot Alliance Inc (NASDAQ:WBA), Dollar Tree, Inc. (NASDAQ:DLTR), Wal-Mart Stores Inc (NYSE:WMT), and CVS Health Corp (NYSE:CVS) are less exposed to, Inc. (NASDAQ:AMZN).

But less exposure doesn’t mean that they are entirely in the clear. As the recent news about a potential Amazon Pharmacy reminds us, very little is safe from e-commerce at this point. More broadly, the United States is already among the most overbuilt countries in the world for commercial retail space. Even if Realty Income’s tenants hold up well, the flood of failing retailers will cause overall rent rates to decline as vacancies pile up.

Still Expensive: No matter how you cut it, O stock still looks expensive both against peers and its own past history. You can get retail-orientated REITs with decent properties trading at far cheaper multiples today. Sure, Realty Income has earned a premium with its reliable performance over the years. But arguably the share price is still too lofty here.

Consider the dividend. Over the past 13 years, Realty Income’s historical median dividend yield has been 5.1%. The majority of that span fell during the zero-interest rate years. And yet now, with interest rates on the rise, O stock yields just 4.5%. This will easily move to 5%, or even, perhaps, 5.5% given a couple more Federal Reserve rate hikes. O stock could hit 50 or even the high 40s to account for that new interest rate reality.

O Stock Pros

Huge Historical Performance: There’s no denying it. Realty Income has been a star performer in the REITs category, returning almost 17%/year compounded (including dividend) since it listed on the New York Stock Exchange in 1994. The company has paid 562 consecutive monthly dividends without a hitch, and it has increased its dividend 78 quarters in a row.

That’s simply a phenomenal showing. 17% annualized returns are great from any company. It’s especially impressive coming from one with such a robust dividend and hard assets underlying the company’s value.

More Diversified Tenants: As mentioned above, American retail operators are in panic-mode. Many mall REITs are down 40% or more over the past 12 to 18 months. Amazon seems to be killing off apparel and department stores faster than ever now.

Realty Income is quite sheltered from this, at least in the short-run, due to its tenant base. The company has minimal exposure to the big box tenants such as Sears Holding Corp (NASDAQ:SHLD) that are endangering the mall operators. Realty Income, by contrast, has exposure to a variety of things such as dollar stores, movie theaters, logistics operations and convenience stores that are somewhat more Amazon-sheltered. Realty Income still has long-term issues due to digital competition, but they don’t face a short-term crisis.

Long Leases: Realty Income performed well through the financial crisis, with occupancy never falling below 95%. It outpaced most other retail-focused REITs. A good portion of this is because the company locks retailers into long-term contracts.

The average new lease the company signed in 2016 runs 14.7 years. This is great news, given the current troubles in the retail space. By locking in long-term contracts, Realty Income can protect itself from vacating tenants and/or falling rental prices in the short-run. This gives O much more flexibility as it maneuvers through the current reworking of the post-Amazon physical retail environment in coming years.

Verdict on Realty Income

Realty Income’s track record speaks for itself. If you can acquire O stock at a fair price, it’s a great buy and hold investment. However, that fair price probably isn’t $55. The 4.5% current dividend yield simply isn’t high enough, especially considering that Realty Income’s long-term median yield is 5.1%. Given the likely trajectory of interest rates, we’ll probably see O hit $50 later this year.

At the time of this writing, Ian Bezek owned WBA stock. He had no position in O stock. You can reach him on Twitter at @irbezek.

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