SRC - Realty Income: Time To Chill As Bond Yields Stage A Resurgence (Rating Downgrade)

2024-01-20 08:45:05 ET

Summary

• Realty Income Corporation investors have enjoyed a significant recovery since its bottom in November 2023. However, it faced a stumbling block as bond yields bottomed out.
• Investors should pay attention to the market action in the 10Y Treasury yield, as it could impact O's recovery and dividend yield appeal.
• While Realty Income remains well-positioned for AFFO per share growth, I don't expect much further near-term upside from the current levels, given the recovery in the 10Y.
• I also explain why bottom-fishers in November are expected to cut exposure to protect their gains, as the pain from further potential gains in the 10Y could hurt.

My mean-reversion bullish thesis on Realty Income Corporation (O) has played out accordingly since my previous pre-earnings update in early November 2023. Investors should recall that O bottomed out in early November, as I anticipated, before staging a surging run of more than 35% (adjusted for dividends) through its recent January 2024 highs.

Compared to O's total return of -10.4% over the past year, dip-buyers who pounced on its peak pessimism have performed remarkably well. As a result, I assessed it's timely for me to provide an update on whether investors should consider moving back to the sidelines from the current levels. Accordingly, O has dipped this week as the worries from the recovery in the 10Y ( US10Y ) struck interest-rate sensitive REITs such as Realty Income. Notably, the 10Y has risen to 4.16% after bottoming out at the 3.78% level in late December 2023.

Therefore, based on my price action analysis, investors must continue paying attention to the market action in the 10Y, which seems ready for a resurgence. Some investors could point out, isn't the Fed primed to cut rates three times this year since its December 2023 FOMC conference?

However, my point to these investors is to consider at which level did the 10Y top out in late October 2023? Recall that it surged above the 5% zone before topping out, aligning with the bottom assessed in the S&P 500 ( SPX ) ( SPY ). Given where the 10Y last traded, as highlighted above, I assessed the market has astutely reflected the Fed's potential rate cuts even before Powell executes them. Therefore, what could drive O's recovery moving forward will likely be whether the market is confident about the appeal of its dividend yield at the current levels.

With O's forward dividend yield at 5.5%, it still offers a reasonable spread to the 10Y's at 4.16%. However, if the 10Y continues to rise (my current thesis), Realty Income investors must anticipate more pain as recent dip buyers take profit. Because O posted a 10Y total return CAGR of 9.34%, it does make sense for these bottom-fishers to lighten up their exposure out of caution.

Notwithstanding my caution, I believe Realty Income investors can still look forward to a more constructive 2024, suggesting they should buy steep pullbacks presented from time to time. Recall from Realty Income's third-quarter conference call that management upgraded its investment volume guidance from $7B to $9B. Therefore, the company remains well-positioned to leverage its market-leading REIT scale to power its acquisitive growth strategy. Given Realty Income's long-term leases (weighted average lease term of about 10 years), it's challenging to depend on internal growth metrics to drive the 4% to 5% AFFO per share growth sustainably over time (even with annualized rent escalators).

As a result, management clarified that the closure of the Spirit Realty Capital (SRC) acquisition is pivotal to its forward guidance, given its earnings accretive potential. Also, Realty Income is expected to deal with $1.8B of debt due for refinancing at potentially higher rates this year. As a result, I believe the market initially placed O under further scrutiny, coupled with the SRC acquisition, leading to O's peak pessimism in early November.

Wall Street estimates suggest Realty Income is on track to deliver an AFFO per share growth of 4.1% in 2024, up from FY23's 2%. As a result, FY23 is somewhat of a reset year, given the interest rate challenges affecting cap rates downstream and the lagging effect of adjustments. Therefore, Realty Income is still expected to deliver a notable improvement from FY24, suggesting a further re-rating could still be in store.

O last traded at a forward AFFO per share multiple of 13.6x, well below its 10Y average of 18.2x. However, we must also consider its forward dividend yield of 5.5% relative to its 10Y average of 4.5%. Given where we are with the 10Y yield, I assessed that the near-term upside on O has likely been captured with the recent surge from its November lows. I don't think it's realistic to expect O's forward dividend yield to re-rate further to the 4.5% level over the next year, considering my current thesis on the 10Y yield. Hence, it does make sense for us to allow the current pullback to take its course, letting the bottom fishers cut exposure before O consolidates at a more constructive level.

With my mean-reversion thesis playing out, I consider it timely to return to the sidelines from here as we await another more attractive buying opportunity.

Rating: Downgraded to Hold.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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