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– John Bogle, May 2017.
Life and investing are long ballgames.”
Over seven years ago, I authored an article on Seeking Alpha titled, “Realty Income Corporation: Even More Extravagantly Overpriced“, and since that time frame, Realty Income (NYSE:O) shares have declined 17.3% on a price change basis, they have returned 12.4% in total returns, due to the accumulated dividends, and they have significantly underperformed the S&P 500 Index (SP500), which has returned 104.3% over this time frame.
As a follow-up to this article, I wrote the article titled, “Realty Income Shares Have Gone Nowhere For 4 Years“, on August 14th, 2020, and since that article was published, Realty Income shares have continued to underperform. On a price return basis, since the August 14th, 2020 article was published, Realty Income shares are down 5.2%, they have returned 8.4% on a total return basis, including dividends, and the S&P 500 Index is up 30.6% over this time frame. So once again, Realty Income shares significantly underperformed.
Following up that article, I authored the article titled, “Realty Income Shares Have Gone Nowhere For 6 Plus Years“, on September 28th, 2022. Since that article was published, on a price return basis, Realty Income shares are down 7.2%, on a total return basis, including dividends, Realty Income shares are down 3.0%, and the S&P 500 Index has gained 18.5%.
Since each of these articles were published, Realty Income shares have significantly underperformed, practically running in place on a total return basis.
Adding to the narrative, despite being bullish on Realty Income as young, green stock broker at Charles Schwab (SCHW) circa 2000, and getting criticized because REITs had underperformed for so long, I have received an almost equal amount of criticism being caution on Realty Income shares over the last seven years.
Clearly, with the benefit of hindsight, that has been mostly the correct call, especially on a relative basis. The key question, now, is it time to buy Realty Income shares today?
My short answer is that while Realty Income shares have been running in place for roughly seven years now, and the relative valuation is getting more attractive, we have not reached the panic stages of capitulation yet.
In my roughly 30-year history of personal experience with the stock market now, from my accumulated years of tuition, sometimes we never get there, to the capitulation stage, especially with blue-chip quality companies, however, more often than not, we do get to the panic capitulation stage, even with blue-chip companies, as the behavior psychology of investors is largely the same. This means that investors as a whole chase performance after it has happened, chasing poor valuations, then investors as a whole give up when valuations are much better, which creates the panic bottoms in stocks and sectors.
Overvaluation Was The Culprit Behind Realty Income’s Relative Underperformance
Simply put, Realty Income shares had a fantastic run, from those 1999 and 2000 levels where many investors did not want to buy shares, because REITs were out-of-favor for much of the 1990s to their 2016, 2020, and 2022 peak levels.
The chart above is adjusted for dividends, meaning it incorporates the dividends into the total return. The following chart below is the same long-term chart, except that it is unadjusted for dividends, which will help me make a point below.
Looking back, in August of 2016, the annualized monthly dividend yield of Realty Income was roughly 3.4% at Realty Income’s August 2016 peak price. The monthly dividend of $0.205426 back then has grown to $0.256 monthly dividend today, which is a total growth of 24.6% in Realty Income’s dividend over this time frame, however, the yield today on an annualized basis is 5.5% going forward.
So clearly, on an absolute basis, the dividend yield indicates that Realty Income shares are a much better value proposition today. However, on a relative basis, there is still a headwind. Let me explain.
Going back in time, in August of 2016, the 10-Year U.S. Treasury Yield near Realty Income’s peak share price was roughly 1.6%, where today the 10-Year Treasury Yield closed at 4.2% on Friday, August 25th, 2023. So back in August of 2016, Realty Income shares yielded roughly 3.4%, trading at a 1.8% premium to the 10-Year U.S. Treasury Yield, while today, Realty Income shares only trade at a 1.3% premium to the 10-Year U.S. Treasury Yield.
Ultimately, Realty Income shares, for all the wonderful attributes of their management team, and the quality of their properties, really Realty Income is just an alternative to government bond yields, and that is the biggest driver of where Realty Income shares will go, meaning the risk-free yield, as Realty Income shares are going to be driven by long-term interest rates.
A Secular Bond Bear Market Is Still A Worry For Interest Rate Sensitive Investments
For over 40 years, we had been in a secular bond bull market, from the early 1980s until 2022, when the bond bull market ended with a thud, as evidenced by the 31.2% decline in the iShares 20+Year Treasury ETF (TLT) in calendar 2022.
The bond bear market has continued in 2023, after an initial retrace to start the year, that gave renewed life to the buy-the-dip crowd in technology stocks.
One primary risk to yield-oriented investors, who have been chasing yields the last two decades, in part forced by the Fed and central banks out the risk curve, is that interest rates stay higher for longer.
If the 10-Year U.S. Treasury Yield traded in a higher range, or even stayed in the current range for a long time, this would force a continued reset of yield-oriented assets to compensate for the increased risk-free yield.
Inflation Is A Risk Too Because Of How Rent Escalators Are Built In
Since we have been in a disinflationary environment with lower interest rates for much of the past four decades until the last couple of years, the way contracts have been written, the risk of CPI increases, has been understated, or largely marginalized.
What do I mean by this?
I found this quote interesting from the article.
The existing Bellagio triple net lease structure with MGM includes 2.0% annual rent escalators for the next six years, the greater of 2.0% or CPI (capped at 3.0%) in years 7-16, and the greater of 2.0% or CPI (capped at 4.0%) in years 17-26.
For Realty Income, who paid a premium valuation to the valuation Blackstone acquired their interest in The Bellagio from MGM in 2019 ($5.1 billion for this transaction versus $4.25 billion in 2019), they are taking on inflation risk here in addition to interest rate risk.
More specifically, if CPI inflation is over 2.0% in the next six years, which could amplify longer-term interest rates higher, then the rent adjustment will be capped.
Looking at the most current Moore Inflation Predictor, it looks like CPI headline inflation has a chance of a renewed upturn here.
If the most likely headline CPI inflation path plays out, and we do not return to the disinflationary environment that most investors have been accustomed to the past 40 years or so, then there could be a further downward adjustment to yield-oriented assets, which of course, is already underway. Said another way, a bet on Realty Income here is at least partially an interest rate bet, and a bet on the direction of inflation, and there is still risk with both of these variables.
Financial Review & Valuation
Realty Income has a strong balance sheet compared to peers, and with over 12,000 properties, as the largest triple-net lease REIT, there is certainly a size and scale advantage.
However, Realty income is venturing farther out on the risk profile, both with new types of acquisitions, as described in the Bellagio transaction above, and with the quality of tenants. On this note, Morningstar noted in their recent analysis that, “the total number of leases to investment-grade tenants fell to 39.7% in the second quarter (of 2023) compared with 40.8% in the first quarter of 2023 and 43.2% in the second quarter of 2022.”
While Realty Income focuses on defensive tenants, and the underlying tenant quality is very good with high coverage ratios in their leases and an increasing element of diversification, the downside of this focus is that the average annual rent increases of around 1% make Realty Income over-reliant on acquisitions to fund future growth.
Given the low levels of built-in rent growth, which was the problem I highlighted in the Bellagio acquisition, with Realty Income’s overall Portfolio showing an even slower level of rent growth, Realty Income’s biggest risk is rising interest rates, which can be spurred by inflationary pressures. Effectively, Realty Income is a bond-like instrument, so higher rates have a high correlation to share price underperformance.
Morningstar has a $76 fair value target on Realty Income shares, however, that is assuming a 5% cap rate. Their fair value drops to $60 assuming a 6% cap rate. If the 10-Year Treasury Yield rises to the 5% range or higher, which is possible as the yield curve steepens, then the estimated cap rate is going to keep increasing, holding back the share price performance of Realty Income. In practicality, this is what has happened to Realty Income shares over the last seven years.
Said another way, Realty Income is as close to high-quality real estate bond as an investment can get, their extraordinary property diversification and sheer size give them a scale that few can match, however, the price paid for this safety is future income growth, which is capped organically, and which must be funded via acquisitions.
As described in the Bellagio acquisition section, Realty Income paid Blackstone a higher price than Blackstone previously paid in 2019 for their stake in the Bellagio. Personally, I think they are letting Blackstone off the hook a little bit, and could have gotten a better deal just by waiting, however, there is a need to deploy capital, and the acquisition actually improves Realty Income’s overall Portfolio of rent increases, albeit at the margin.
Closing out this section, for longer-term investors, the recent decline in Realty Income’s shares is offering a semi-compelling entry point, with a dividend now near 5.5%, however, keep in mind that interest rate risk is the primary risk, and the spread of Realty Income’s dividend is less today than when I started writing about the stock over seven years ago on Seeking Alpha. Thus, the $56 price range is arguably fair value, however, if cap rates keep increasing, there could be capitulation selling that see’s Realty Income shares trading into the low $50’s, or even into the $40’s.
Closing Thoughts – A Paradigm Shift Is Underway In Yield-Oriented Investments
When I started writing this series of articles on Realty Income, I drew on my experience personally recommending this stock in 2000 as a young, advice registered broker at Charles Schwab. As a preeminent yield-oriented investment with a treasured monthly dividend, I knew Realty Income was in-favor by investors, and likely overpriced seven years ago, because there had already been a structural bull market in Realty Income shares that existed for a long time.
The series of articles I have written over the years have shown how this overvaluation identified in 2016 has led to relative, and absolute underperformance in Realty Income shares. Eventually, there will be a good time to buy Realty Income shares again for the buy-and-hold investor, and after seven years plus of running in place, we are getting closer to that point in time, though we are not there yet, in my opinion.
With the risk-free 10-Year U.S. Treasury Yield where it is at right now, one could argue that the dividend yield on Realty Income shares should be even higher. Adding to the narrative, if the 10-Year U.S. Treasury Yield rises further, or even maintains itself in this range, the higher risk-free yields will put downward pressure on dividend-oriented investments as interest rate spreads adjust.
Since Realty Income borrows money to invest, the cost of their capital will rise too, shrinking margins as well, so there are multiple sources of pressure from rising interest rates.
In summary, without realizing it at the time, the end of the structural bond bull market in 2022, has had profound implications, especially if we have entered a structural bond bear market, which I suspect is indeed the case. Oftentimes when you get these phase changes, these paradigm shifts, there is a lot of volatility, confusing many investors. Thus, by the time the new secular trends become evident, momentum money jumps on board, and the new secular trends accelerate.
Ultimately, as a long period of outperformance gives way to a long period of underperformance, investors lose patience with an investment or asset class, then give up in a capitulation. Given how beloved Realty Income is from investors, that panic capitulation seems unlikely to happen, as there will always be a core shareholder base celebrating the monthly dividend yield. However, seven years ago, it seemed unlikely that Realty Income would underperform the S&P 500 Index by roughly 90% points over this time frame, so before you say a capitulation will never happen here, we need to look at the rear-view mirror in order to move forward.
Personally, I would be a buyer of Realty Income shares in the low $50s into the $40s as an income instrument, acknowledging the reality that if a true panic by investors takes hold as a structural bond bear market emerges, shares of this dividend stalwart could trade into the $30s to offer comparable yields to other viable yield alternatives.
Hopefully this exercise in looking back to look forward has been helpful for investors to consider different possibilities and probabilities as they construct their investment portfolios.