Article Thesis
Realty Income (NYSE:O) is a well-known triple-net real estate player that has generated highly attractive returns in the past. Due to a couple of advantages over peers and other factors, I believe that the stock could deliver sizeable returns for investors going forward as well, which makes it a solid investment pick at current prices.
Source: Imgflip
1. Great Management And A Strong Track Record
When it comes to choosing the right investments, looking at management and its past track record is not a bad idea at all. After all, if executives guided a company very well in the past, it is reasonable to assume that the skillset will allow the same people to do the same in the future, too. Another factor that plays a major role here as well is management alignment - do executives have proper incentives to maximize returns for shareholders?
When it comes to Realty Income, insiders are indeed well-aligned with common shareholders:
Data by YCharts
Insiders own a total of 1.3 million shares, a number that has been increasing over the past decade. Those shares are valued at ~$80 million, thus the stakes for insiders are high - when they do well, they will profit a lot, whereas they could lose vast amounts of wealth if they do not guide the company successfully. For common shareholders, this is a good situation to be in, as well-aligned management is less prone to make large mistakes in terms of capital allocation, M&A, etc.
Realty Income's management also scores well when it comes to the historical returns the company has generated:
Source: Realty Income presentation
In the above graphic, we see that Realty Income's historical return has been excellent. At 15%+ per year, it easily outperformed all relative indices over its 26-year history as a public company. Someone who invested $10,000 when Realty Income went public would have an investment valued at more than $400,000 today, seeing the initial investment grow more than forty-fold with dividends reinvested. At the same time, the company's beta versus the S&P 500 index is just 0.4. Not only did Realty Income thus easily outperform the broad market, but it also did so while being a less risky/less volatile investment at the same time. Being able to benefit from market-beating returns while being exposed to sub-average levels of risk was a great position to be in for shareholders in the past, and unless everything somehow changes going forward, the same could hold true going forward.
Realty Income's past returns were not only strong versus the broad market, but also versus peers from the triple-net industry:
Source: Stock Rover
Realty Income has delivered total returns of close to 300% since 2007, in a time frame when the broad market delivered total returns of 230%, while its peers also did not manage to perform on par with the company.
Regarding past management success, alignment between executives and shareholders, and management's apparent ability to deliver attractive returns through beneficial capital allocation and operating a lean business, Realty Income thus easily gets good grades.
2. Monthly Dividends That Continue To Grow Like Clockwork
Realty Income is famously known as the Monthly Dividend Company, a nickname its management embraces and cultivates. The very reliable dividend payments made monthly, combined with regular dividend increases, are why many retail investors, especially retirees, own shares of the company.
Source: Seeking Alpha
Realty Income has grown its dividend annually for more than two decades, and its dividend growth rate has not been bad at all. For the last 3, 5, and 10 years, its dividend growth rate has been in the 4-5% range. Over the last 12 months, the dividend growth rate has been a little lower, but I believe one should not read too much into that, as this can be explained by the fact that management wanted to remain on the cautious side during the current crisis. Once the coronavirus crisis has ended, I fully expect that Realty Income will get back to dividend growth rates in the 4-5% range. Something similar happened during the Great Recession: the dividend grew at a below-average pace during the crisis (2008-2012), but after the crisis had ended, management decided to hike the dividend in 2013 and increased the growth rate once again.
At current prices, investors get a dividend yield of 4.5% on new money. This is not the highest yield Realty Income has ever traded at, but it is in line with the 10-year average. A combination of a solid starting yield, 4.5% in this case, and long-term dividend growth at a meaningful rate can lead to quite attractive income growth over a longer period of time, especially when dividends are being reinvested.
Source: Author's calculation; assumptions: $10,000 initial investment, 4.5% annual dividend growth, dividends are reinvested
In the above chart, we see that an investment of $10,000 being made today could deliver annual dividend proceeds of more than $6,000 by 2050 if Realty Income manages to raise its dividend growth rate to 4.5% once again. The fact that an initial, rather small annual dividend receipt of $450 can turn into an income stream of almost 15 times that size over three decades is a great example of the power of compound interest, or, in this case, the power of dividend growth investing.
Realty Income's dividend payout ratio is not especially low, at 84% based on this year's forecasted FFO per share, but I nevertheless believe that the risk of a dividend cut is not overly likely. First, Realty Income's business model is not prone to volatility. Thanks to long-term (9 years remaining average), triple-net leases with tenants from many different industries (grocers, dollar stores, pharmacies, fitness studios...), its revenue stream is both diversified and relatively secure. The great resilience is also showcased by the fact that Realty Income managed to grow its FFO in 23 out of the last 24 years, which is, in my opinion, a great feat.
Second, its A3-rated balance sheet and its available liquidity of $2.7 billion would allow the company to finance dividends easily with cash on hand in any type of downturn. Last but not least, the fact that Realty Income has grown its dividend so steadily, and takes pride in the fact that it did, will make management relatively prone to keep the dividend growth record intact. After all, that is a key reason to own shares for many of its retail shareholders.
3. Taking A Closer Look, Shares Could Actually Be Historically Cheap
Based on forecasted FFO of $3.35 per share in 2020, shares are trading for 18.5 times this year's FFO. This is not an especially low valuation in absolute terms, and it is not an absolute bargain relative to how shares were valued in the past, either. In the following graph, we see Realty Income's price-to-FFO multiple from 2010 to early 2020:
Data by YCharts
We see that an 18.5 times FFO multiple is right about the average shares have traded at in the past. This does, however, not account for two other factors: markets at all-time highs and interest rates at record lows.
When we back out everything else, a more expensive market would warrant an increase in Realty Income's valuation, too. Even more important, record-low interest rates should lead to more buying in the stock, as yield-starved investors start to buy up dividend stocks. Looking at the spread between treasuries and Realty Income's dividend yield, we get the following picture:
The spread is at the highest level of the last decade, and apart from the bear market following the bursting of the dot.com bubble and the Great Financial Crisis, the spread between treasuries and Realty Income's dividend yield hasn't been this high.
What happened the last time the company traded at such a low valuation relative to US government bonds? Those that bought 11 years ago, in 2009, benefited from total returns of more than 330% since. Those that bought at a similar valuation in 2001, i.e., 19 years ago, bagged a total return of 1,200% since then.
Realty Income's management has chosen a valuation approach that is a little different. Calculating the AFFO yield spread over 10-year treasuries, they concluded that shares would be fairly valued at $87 if the spread would normalize to the historical long-term average. This would equate to a share price upside of ~40% from the current level.
Despite the fact that the price-to-FFO multiple is thus in a historically "normal" range, shares could thus be substantially undervalued still, once we factor in that interest rates are at all-time lows, which more or less forces income investors into equities.
Takeaway
There is no risk-less investment, but Realty Income may come close to it. The company sports a combination of very reliable growth and long-term, low-risk, triple-net leases, while its rent collection has already recovered to easily more than 90% during the current crisis. On top of that, its balance sheet is very strong, the stock is substantially less volatile than the broad market, and the company's high-quality management is well-aligned with common shareholders.
Shares may not look especially cheap at first sight, but factoring in the macro situation and record-low interest rates, shares could actually be quite undervalued. Even using a more conservative approach, they are at least fairly valued, in line with the historical norm.
For long-term-oriented investors looking for a sleep-well-at-night income stock, Realty Income is worthy of a closer look at the current price.
One Last Word
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