VNQ - Realty Income: A Smart Investment Choice For 'Young' Investors?

2023-11-19 00:06:04 ET

Summary

• As an investor with time horizon for wealth generation over next 20-30 years, I'm assessing if Realty Income suits total return investors or it should be only income vehicle.
• Realty Income is a well-diversified REIT with experienced management, known for its business resilience.
• Given its historically depressed valuation attributed to elevated rates, Realty Income presents a compelling investment opportunity for achieving total returns.
• Realty Income offers a safe, gradually increasing dividend that appeals to both income-focused investors and those seeking total returns.
• Realty Income currently trades at a P/FFO ratio of 13.5x. Considering my anticipation for the company to realign closer to its historical averages, I foresee a total annualized return of 12.8% over the next four years.

Realty Income Corporation ( O ) is among the companies that receive substantial coverage here on Seeking Alpha. Unsurprisingly, the company stands out as a great income vehicle, offering a monthly dividend yielding at 5.81% and maintaining a stable and growing dividend record since 1994.

While it's undeniable that Realty Income is a dream stock for individuals seeking dividend growth or income, particularly those retired or nearing retirement, I'm frequently asked whether it's a sound investment for younger investors, who might have another 20-30 years before relying on their portfolio's passive income.

My response to this inquiry is, "It depends." The investment's value hinges greatly on the price paid for Realty Income, similar as for other REITs.

The rationale behind this is that investors with decades left before relying on passive income should prioritize the total return on their investment rather than merely focusing on a high dividend yield.

Capital appreciation tends to be more tax-efficient than paying taxes on dividends, especially if the appreciated stock isn't sold. Additionally, different life stages come with varying priorities; needing to utilize passive income alongside a full-time job salary in one's 30s or 40s is more of an exception than a rule.

However, as widely known, REITs, including Realty Income, have faced challenges in 2023 due to the FED combating inflation by increasing rates to 5.25% - 5.50% as of November. Naturally, when interest rates rise, real estate values tend to decline, and vice versa. Moreover, REITs often dilute their shareholders by issuing new shares to acquire properties and carry significant debt. Concerns about companies refinancing debt at higher rates, resulting in diminished investment returns, have impacted the market sentiment.

Indeed, Realty Income, Vanguard Real Estate ETF ( VNQ ), and another my favorite REIT, Prologis ( PLD ), have all notably underperformed the S&P 500 Index ( SPY ) this year.

This brings me to a crucial point: Realty Income is currently trading at what I consider a depressed valuation. I believe this is precisely the time when the company becomes a promising investment, even for younger investors with a long runway ahead seeking total return. We can anticipate a normalization of valuation while collecting a safe and high dividend for reinvestment.

Let me show you whether Realty Income meets all the criteria I consider essential for an investor. Quality business, safe and growing dividend, and expectation of strong performance in the foreseeable future.

Well-Diversified, High Quality Business

Realty Income operates as a REIT , specializing in single-tenant properties utilizing an unconventional leasing model known as the triple-net lease . While most leases involve tenants paying rent with landlords covering additional operating costs, the triple-net lease places responsibility on the tenant for taxes, insurance, and maintenance. These long-term leases, lasting over a decade and often containing built-in escalators, offer stability to the REIT due to their high costs to terminate.

The success of this leasing structure heavily relies on vetting potential tenants, as it represents a substantial financial commitment. Retailers in discretionary markets, like fashion retail, generally don't fit the bill. Instead, ideal tenants operate in defensive industries, displaying resilience to economic cycles—such as drugstores, dollar stores, or convenience stores. Realty Income boasts a well-diversified portfolio , with no single tenant exceeding 5% and its top 10 clients accounting for 27.1% of the portfolio, with key tenants like Walgreens ( WBA ) at 3.8%, Dollar General ( DG ) at 3.8%, and Dollar Tree ( DLTR ) at 3.2%.

Moreover, some 41% of its tenants are investment-grade credit companies, which should imply a low risk of default.

In a strategic move to bolster its portfolio, Realty Income recently announced the acquisition of Spirit Realty Capital ( SRC ) for $9.3 billion in an all-stock transaction back in October. This acquisition aims to further diversify Realty Income's portfolio, reducing the top 10 clients' impact to less than 24.3% of the total portfolio upon finalization.

Ensuring tenant diversification is crucial for stability in any REIT, yet concentrating too heavily on a single geographical area or industry brings additional challenges. Realty Income's portfolio predominantly comprises 82.6% of what I'd term as defensive retail, alongside 13.1% in Industrial properties and 2.6% in Gaming.

In 2019, Realty Income strategically expanded into Europe, which now contributes roughly 14% of its annualized contractual rent. Within this European expansion, 12.3% of earnings are generated in the UK, while the substantial majority, 86%, continues to be derived from operations within the U.S.

Realty Income, despite its significant scale, maintains promising growth opportunities on the horizon through ventures into new countries and industries. Strategic move, like divesting its office segment in 2021 and entering European markets, have positioned the company for stronger long-term growth.

At the same its, its venture into Ireland and the acquisition of a stake in Bellagio within the leisure and gaming industry demonstrate Realty Income's commitment to diversifying its asset portfolio and expanding into new verticals.

What's truly commendable is Realty Income's consistent occupancy rate, averaging 98.2% over the last two decades, significantly higher than the REIT median of around 94.2%. This steadfast figure signifies the business's stability, remaining resilient even through turbulent times like the Great Financial Crisis and the COVID-19 Pandemic. The defensive nature of its tenants has shielded Realty Income's portfolio from significant setbacks. Presently, the occupancy ratio stands near its historical highs at 98.8%.

Dividend Growth & Historical Returns

Realty Income, functioning as a REIT, is obligated to distribute a minimum of 90% of its net earnings to shareholders in the form of dividends. This requirement allows them to receive special tax treatment—unlike standard corporations, they're exempt from corporate taxes on the earnings allocated for dividends. This unique tax advantage enables them to sustainably offer high dividends while also facilitating capital appreciation for investors.

Indeed, the company boasts a robust dividend track record, achieving a 4.3% CAGR from its inaugural dividend payment in 1994 to the present day. This accomplishment solidifies the company's status as a dividend aristocrat, having consistently increased dividends for more than 25 consecutive years.

Currently, Realty Income's dividend yield stands at 5.81%. However, consider this: if you had invested in Realty Income back in 2013, your yield on cost would now be 8.17%. While this growth isn't the fastest, especially for investors with another 20-30 years of compounding ahead, let's project forward. Assuming Realty Income can achieve a 3.0% CAGR on its dividend over the next decade, the yield on cost in 10 years could potentially reach 7.6%.

Comparatively, imagine investing in a stock with just a 3.16% dividend yield today but with a projected 10% CAGR over the next 10 years; that would result in a yield on cost of 7.5% alongside stronger capital appreciation, a more enticing prospect in my opinion. Personally, I prefer lower yield and high growth instead, good example of such company would be Prologis ( PLD ).

Despite this, Realty Income's dividend remains secure due to the nature of its triple-net-lease structure and the stability of its defensive tenants, 41% of which hold an investment-grade rating.

Returning to the core question—whether Realty Income fits the bill for a young investor—past performance isn't a guarantee of future performance. However, historically, Realty Income has managed to perform in-line with the market with overall less volatility.

The years 2022 and 2023 posed challenges for the company, primarily due to its sensitivity to interest rates, resulting in significant underperformance of its stock compared to the market. However, I foresee a change on the horizon. Current interest rates appear restrictive, coinciding with signs of an economic slowdown. This trend might pave the way for the first interest rate cuts, possibly occurring in either Q2 or Q3 of 2024. Despite already experiencing an 18.76% rally from its bottom at $45, an impending rate cut could trigger a substantial rally for Realty Income. This has the potential to bring its 10-year performance more in-line with that of the broader market.

Discount to its Historical Valuation Presents Total Return Opportunity

Now, the most appetizing part of this investment thesis is the valuation and this bring me to the point where I want to highlight that Realty Income today is a good buy also for investors with total return goals, who have decades before using the passive income to finance their lifestyle and instead opt to reinvest the dividends.

I think this is the perfect time to use the saying of Warren Buffet, that we should buy when there is fear and sell when there is greed. If you bought Realty Income in August 2022 at its Price to Fund from Operations or "P/FFO" of 19.69x, you would we sitting today on a loss of around 40% not accounting for the dividend.

Realty Income's 15-year historical P/FFO is around 18.52x and while you could argue that most of this time the interest rates were rather lower than historical norms, today the stock is trading at depressed P/FFO of 13.5x. I think with the expectation of rates falling in the next couple of years, perhaps not to the lows we have seen during 2010 - 2021, it would be reasonable to expect Realty Income to trade around P/FFO of 17x and I expect the FFO growth to be around 3% annually driven both by rent increases and further acquisitions.

With that projection, if the stock trades at a normalized valuation of P/FFO 17x by 2027, the estimated stock price would hover around $79. This increase would represent a capital appreciation of 7.3% annually. Considering the dividend yield of approximately 5.5%, an overall anticipated annualized rate of return of 12.5% to 13.0% seems reasonable. I am confident that this performance will outperform the market during the same period.

Given Realty Income's currently depressed valuation, I hold a strong conviction that it offers a substantial margin of safety. Over the next four years, I anticipate its total return to surpass that of the market, making it an appealing investment opportunity for both income-focused investors and especially for those with long-term horizons seeking to capitalize on this undervaluation.

However, were the stock not trading at a discount to its historical valuation, I wouldn't recommend it as an investment vehicle for investors aiming to compound their wealth over the next 20-30 years rather than relying solely on passive income. This is because if, instead of the expected 7.3% annual capital appreciation, we were to see around 2%—a reasonable expectation for Realty Income when trading at its fair value—the total return wouldn't prove satisfactory in relation to the market and would result in a significant underperformance using decades long time horizon.

Conclusion

Realty Income, often referred to as "the monthly dividend company," checks all the boxes for me as an investor aiming to compound wealth over a 20-30 year horizon.

It boasts a well-diversified business led by experienced management, ensuring stability. The consistent and growing dividend reflects a strong track record of reliability. Trading presently at a considerable discount compared to its historical norms adds to its allure.

Despite its common perception as an income vehicle for retirees or those near retirement, at its current valuation, I foresee the potential for around 7.3% annual capital appreciation as Realty Income gradually reverts to its historical valuation. Moreover, with an average 5.5% dividend yield, I believe it's an attractive investment opportunity for individuals with long investment horizons. Over the coming years, it should outperform the market as interest rates stabilize at lower levels, albeit not as low as we've been accustomed to.

However, were the stock not trading below its historical valuation, I wouldn't recommend it for wealth compounding over extended periods, as the overall return might not match the market, resulting in significant underperformance.

Personally, I currently hold a substantial stake in Realty Income. Nevertheless, if the stock returns to its historical valuation, I plan to pivot to more appealing investments to pursue overall total returns. Meanwhile, I'm taking advantage of its monthly dividend distribution.

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