Of all the investments I’ve covered — and I’ve covered quite a few — Realty Income Corp (NYSE:O) is one of the most difficult to analyze. In my opinion, O stock features well-balanced pros and cons. What it boils down to is this: do you trust the Realty Income fundamentals against a broadly declining industry?
Not surprisingly, my InvestorPlace colleagues are split roughly evenly between the bulls and the bears. Recent optimistic articles forwarded by contributors Aaron Levitt and Lawrence Meyers focus on the distinct characteristics of Realty Income. They both acknowledge the challenges awaiting O stock. Nevertheless, O performed strongly relative to the real estate investment trust (REIT) sector. Furthermore, their business is more immune to online threats like Amazon.com, Inc. (NASDAQ:AMZN).
They bring up excellent points. For example, direct REIT competitors Simon Property Group Inc (NYSE:SPG) and GGP Inc (NYSE:GGP) are down 8% and 13% year-to-date, respectively. In contrast, O stock is down just 1%.
And while Amazon has wreaked havoc on traditional retail, Realty Income is exposed to secular businesses.
Meyers writes, “O stock has a lot of industry diversification, and the top three are high-margin businesses, two of which are consumer staples. Drug stores (11.1%) and dollar stores (8%) are the staples and convenience stores (9.9%) offer high margins.”
Levitt succinctly sums up the sentiment by stating, “You’re getting a portfolio of real estate that is as online-proof as it comes.”
Again, they make compelling arguments about O stock. However, so do the bears.
Significant Headwinds hurts O stock Prospects
Because REITs must pay out at least 90% of their taxable earnings as dividends, they’re forced to issue both debt and equity. Otherwise, operations and capital growth are severely restricted. But that doesn’t sit well with InvestorPlace contributor Ryan Fuhrmann.
He writes: “The nature of a REIT’s existence has always worried me. In periods of severe market dislocations, like occurred in 2008, issuing both debt and stock can become an issue. Realty Income has thousands of valuable properties it could theoretically sell, but that is also tough in a downturn.”
Zero questions exist that brick-and-mortar businesses are taking a hammering. While Levitt and Meyers vouch for O stock in terms of Realty Income’s property diversification, that might not help. Secular grocery stocks like Kroger Co (NYSE:KR) and Smart & Final Stores Inc (NYSE:SFS) are feeling the pain in terms of severe volatility. When people are skimping on food, I think you have a big problem.
Additionally, Realty Income’s heavyweight players aren’t guaranteed to keep the cash flow flowing. Analyst Tom Taulli writes:
“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.”
No Bullish Argument to Break the Deadlock
As you can tell, Realty Income has its fair share of positive and negative arguments. Ultimately, the decision to buy or walk from O stock comes down to perceived risk. Is the REIT strong enough on its own to go against the industry’s grain?
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Investors should also consider commercial real estate prices, which has been in a downtrend since the beginning of 2011. Just based on simple economic theory, less demand equals greater supply of empty commercial lots. Clearly, this is not the dynamic which O stock investors were hoping for.
But what really gets me is the capital risk relative to the O dividend yield. Under any other circumstance, a 4.5% yield is remarkably enticing. But when you’re essentially flat for the year, whereas buying the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) gets you double digits, the argument is less convincing.
I respect Realty Income for weathering prior storms, and rising above the competition again this year. But this time around, O stock faces fundamental challenges that are only becoming more troublesome. Additionally, investors have viable alternatives. Realty Income may surprise us, but the risk-reward balance isn’t truly convincing.
As of this writing, Josh Enomoto did not hold a position in any of the aforementioned securities.
