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Realty Income: Watch Out Below

3oliver

A couple of weeks ago, I wrote a piece highlighting the overvalued nature of the REIT space in general. In that piece, I used Realty Income (O) as an example of a high-quality company that is trading at exceedingly high valuations right now. I’ve been writing about dividend growth stocks for years now, so it shouldn’t come to a surprise to me anymore, but I must admit that I’m still taken aback by the incredibly loyal bullish following that this stock has. Realty Income is a stock that has a bit of a cult following in the high dividend growth/retirement communities at Seeking Alpha and elsewhere. The reason for this is the company’s commitment towards its reliable monthly dividend and the incredible, long-term success that it (and its shareholders) has enjoyed over the years. The company calls itself “The Monthly Dividend Company” for goodness’ sake. And it’s not lying; O has paid a monthly dividend for 587 consecutive months. I’ll be the first to admit that Realty Income is a wonderful company to own and a blue chip in its space. Yet, I’m not willing to turn a blind eye on valuations because of a company’s illustrious past, and I worry sometimes that many retail investors are exposing themselves to unnecessary risks because of the rose colored glasses that they use when examining shares of Realty Income.

Although I’m sure many of you don’t need it, here’s a little history lesson with regard to O’s long-term performance (because it’s always nice when I can back up the “wonderful company” tag with some cold, hard data).

If someone put $1,000.00 to work in Realty Income back at the turn of the millennia, they would have bought approximately 94 shares at a split adjusted share price of ~$11 (O had a 2-for-1 stock split in 2005). At the time, those shares carried a very high ~10% yield. Although Realty Income was founded back in 1969, it didn’t go public until 1994, and therefore, in 2000, it was a relatively young company as far as the public markets were concerned. Two decades ago, shares didn’t carry the same cachet as they do today. Because of this, they traded with a much lower p/FFO premium at roughly 8.5x. This low premium played a large role in the company’s high yield back then. Little did investors know in 2000 that O would transform into the monthly dividend behemoth that it is today.

Over the years, assuming that the hypothetical investor in this scenario reinvested his or her dividends, those original 94 shares would have grown into quite the pile today. The original $1,000.00 invested would be worth nearly $20,600.00 after 19 years+ of compounding. That’s good for a total annualized rate of return of 16.7%, which is well above the S&P 500’s total annualized ROR of 5.8%. For comparison’s sake, a $1,000.00 investment made into SPY at the same time as the original O investment would only be worth a bit more than $3,000.00. Sure, tripling one’s month over a 19-year period isn’t bad. Yet, it pales in comparison to turning $1,000.00 into more than $20,000.00.

It’s also interesting to note that the original ~10% yield on cost in this scenario has increased to a YoC of ~75%. Because O continues to generate reliable dividend growth, it won’t be very long before that investors who bought shares at the start of the new millennia will be receiving a triple-digit yield on cost. In the DGI world, that’s living the absolute dream. It doesn’t get any better than a company paying you an annual dividend that is larger than your original investment. Success stories like this are exceedingly rare.

Realty Income is one of the few companies that you’ll see generating these types of returns over the last 20 years or so. With that in mind, it’s no wonder that investors love this company so much. But, now it’s time to snap back to reality in the present day and take a close look at the stock’s valuation and how it stacks up against its historical averages because this valuation will play a major role in the total returns that the stock generates for investors moving forward.

Source: F.A.S.T. Graphs

Right now, Realty Income shares are trading for roughly 22.5x TTM FFO. This is a valuation multiple that the company has reached only two other times during the last 20 years. O’s 20-year average p/FFO multiple is 15.7x. Its 10-year average p/FFO is 18.2x, and five-year average p/FFO multiple is 19.3x.

As you can see, as we shorten the time period examined, O’s average multiple rises. This is largely because we’ve been living in a uniquely low interest rate situation in recent years. REITs and other high-yielding names with reliable dividends do well during low yield environments like this. This is due to the market’s general thirst for yield and having no other alternative to get it than high-quality equities.

So, while I’m not surprised to see O shares trading near all-time highs (in terms of share price and valuation multiples) when the U.S. 10-year is making new lows below 2%, I think it’s very important to acknowledge that anyone buying O at these levels is chasing momentum. This is a dangerous practice, even when you’re doing so with a high-quality investment vehicle like Realty Income.

I mentioned before that O shares have only reached valuation heights like this twice during the last two decades. Well, after each of those previous two times, the stock sold off precipitously. I’m not a soothsayer, and I’m not here to attempt to predict the short-term price movements of O stock, yet when looking at the name from a value investor’s standpoint, it seems clear to me that this name carries a ton of valuation risk.

The first time at O reached a valuation this high was during April/May of 2013. The stock rallied hard from a ~16.5x multiple in the late summer of 2011 to roughly 24x multiples in the late spring of 2013. The stock topped out at $51 during this rally, but during the second half of 2013 O shares experienced a steep sell-off, trading down to $37 and a ~16x p/FFO multiple by the end of the year. This represents a ~27% sell-off in roughly seven months.

Up next, we see that O shares hit what appeared to be all-time high multiples of ~26x in the late summer of 2016. The stock’s price was roughly $71 at the top of that rally. But that multiple proved itself to be irrationally high as well and the stock sold off precipitously down to $49 and a p/FFO multiple of roughly 17x in February of 2018. This represents a ~31% sell-off.

Well, shares have a “V” shaped recovery off of those 2018 lows and now they’re trading at all-time highs. O’s FFO grew by an 11% in 2018 and is expected to grow by another 5% in 2019, so even though the stock’s price is at all-time highs, the multiple still hasn’t reached those 26x highs of 2016. Could the stock continue to rise to the $85 level where we’d see all-time high premiums associated with these shares as well? Sure they could. However, I think that history proves that O’s stock can support multiples this high for very long, and when they’re trading with such high premiums, the slightest whiff of a rising interest rate will send the stock crashing down.

Will rates rise in the short-term? Your best guess is as good as mine. Honestly, I don’t see any catalysts for such a rate rise to happen. I thought the Fed was in normalization mode six months ago, but then the trade war worsened and the world’s economy began to slow. We’re seeing governments loosen fiscal policy around the world and many speculate that the U.S. will join them. Could be in for another spell of quantitative easing? Maybe. If this is the case, REITs, including highly priced Realty Income, will likely do quite well. However, if recent history can show us anything, it’s that putting money to work in these interest rate sensitive stocks when their valuations have been driven up in a T.I.N.A. (there is no alternative) environment is a very risky bet.

Right now, I think Realty Income’s fair value lies somewhere in the mid-$50 range. If I’m right, the stock has 20%+ downside risk at the moment. I don’t know about you, but I don’t need a 3.75% yield so bad that I’m willing to put my capital at that sort of risk.

There are other names in the market that pay a high dividend with much lower valuations which point towards a higher margin of safety (relatively). That’s where I’d be putting my money to work if I absolutely had too, but with the major indexes hitting all-time highs, I don’t feel compelled to do much of anything but sit back and allow my dividend income stream to augment my cash position. I want to keep my powder dry for when we see a rainy day in the markets. Right now, it’s sunshine all around. However, I do see clouds on the horizon and I’m happy playing the waiting game.

If you’re a true buy-and-hold investor and you have confidence that you won’t be dismayed by a precipitous dip and sell the stock into weakness, then there is little reason to sell here. Over the long run, Realty Income shares have performed exceedingly well and while I don’t expect this company to generate the same results over the next 20 years as it has during the last 20 years, I would still be very surprised if the share price wasn’t much higher in 2040 than it is today.

Yet, I’ve seen the situation where someone buys a stock like Realty Income because they’re looking for reliable yield and then becomes scared and sells at a loss during a sell-off. By locking in losses one not only hurts their income stream, but also the size of their capital base and therefore, the strength of their purchasing power when making new investments to augment their income stream in the future.

When you’re reading this, the idea of buying high and then selling low (when yields are even higher than they were when one originally bought shares) probably seems silly. That’s not something that anyone would do right? Why wouldn’t they just buy more shares if passive income was truly their primary goal? That’s a good question. But at the end of the day, people chase momentum, they chase yield, they chase the next greatest thing, and they end up getting scared and selling at a loss when the market realizes its folly and begin to price stocks based upon their underlying fundamentals again instead of sentiment.

And the answer to why is simple: fear. Fear makes us do silly things that can be detrimental to our financial health. This is why I think it’s important to take stock of your risk tolerance and your intestinal fortitude and be honest with yourself. If you don’t think you have what it takes to hold during weakness (especially if history has proven this to you), then there is no shame in locking in profits when valuations are elevated and waiting for a better entry point with a higher margin of safety.

I know that most investors will say that a name like O is meant to be owned and not traded. For the most part, I think they’re right. However, I also think that O shares have posted gains of more than 45% over the last year or so and I wouldn’t argue with anyone who thinks it’s a good idea to take some of their chips off of the table. That’s an incredible run. And what’s more, the proceeds from such a sale would represent years’ worth of dividend payments, should you choose to look at it that way. No one ever went broke taking a profit. And I can promise you this: barring some sort of crazy scenario where the world ends, O shares will be around in three months, six months, a year, etc. for you to buy again. And while I can’t say this for certain, I’d be willing to bet that at some point during the next year or so O shares will be trading with a much lower multiple than they are today and investors will have a chance to add to their positions with a wider margin of safety.

This article was previously published for members of The Dividend Growth Club.

Disclosure: I am/we are long O. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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