SRC - Why Realty Income Stock Will Likely Crush Rental Properties

2023-12-13 07:35:00 ET

Summary

• Real estate investing is a proven path to compounding wealth over the long term.
• We compare investing in O stock vs. rental properties by discussing the pros and cons of each.
• We share seven compelling reasons why O is a much more attractive investment than rental properties.

Real estate has long been considered a highly attractive investment option and a proven path for building and preserving wealth over the long term thanks to its attractive combination of offering the potential for both income and capital appreciation. That being said, there are multiple methods for investing in real estate, including purchasing physical rental properties or investing in Real Estate Investment Trusts (VNQ). In this article, we will delve into why one REIT in particular - Realty Income (O) - is likely a much better investment choice than rental properties right now.

The Case for Realty Income Stock

1. Diversification and Professional Management

One of the primary advantages of investing in O is its vast diversification and professional management. When you purchase a rental property, you are essentially putting all your eggs in one basket or at the most, a few rental properties, given that it takes a lot of capital for a retail investor to build a portfolio of rental properties. As a result, your investment portfolio is tied to a single or a few physical assets that are generally not well diversified by tenant type or geographic location. As a result, your long-term investment returns are highly dependent on factors like the property's location, property condition, tenant quality, and the local real estate market.

In contrast, O is a diversified REIT that owns a vast portfolio of 13,282 income-generating properties with 1,324 different tenants in 85 different industries and located in all 50 states, Puerto Rico, Ireland, Italy, Spain, and the United Kingdom. This diversification helps spread out the risk, reducing your exposure to any single property, tenant, geography, or sector.

Moreover, the REIT is managed by a team of real estate professionals who make strategic decisions to optimize the portfolio's performance. Their track record of generating long-term outsized total returns for shareholders speaks for itself:

2. Passive Income Stream

Owning rental properties often ends up being a very hands-on endeavor, requiring you to find tenants, handle maintenance, collect rent, and manage various other aspects of property ownership. If you have bad tenants, it can quickly become a very costly, stress-inducing, and time-consuming endeavor. Even in the case of having good tenants, it is still very much like running a part-time business, and the more properties you own, the more of your time it consumes. As a result, many rental property investors who end up assembling a substantial portfolio of properties decide to hire a property manager. However, these managers typically charge 6-10% of the monthly rent check to manage the property, which eats quite significantly into the profitability of the investment, especially over the long term.

Realty Income, on the other hand, offers a truly passive income stream. As a shareholder, you receive a portion of the rental income generated by the REIT's properties without having to deal with the day-to-day management of the portfolio. The REIT handles property acquisition, leasing, and maintenance, allowing you to enjoy the benefits of real estate ownership without the headaches. Best of all, given the management's proven track record, you can sleep well at night knowing that your real estate empire is in good hands.

3. Divisibility & Liquidity

A third advantage of investing in O over rental properties is that the stock is highly liquid, can be purchased without having to invest much at all, and can be partially sold very easily. Today, you can purchase a share through a brokerage account for only ~$55 (and in many cases, brokerage accounts even allow you to purchase fractional shares), providing an opportunity for diversification even with a modest investment.

Additionally, the liquidity of the shares allows you to buy, add to, trim, or fully sell your position at any time, providing the flexibility that physical real estate investments lack. Investing in rental properties often involves significant upfront capital investment, including down payments, closing costs, and ongoing expenses, and - barring some special and often complicated partnership structuring of the asset - is very difficult to partially sell. In most cases, you must either buy a full property or sell the full property, and both sides of the transaction of such real estate can be very time-consuming and full of costly fees.

O stock, meanwhile, can be bought or sold in virtually any amount with no fees and with only a few clicks of a mouse to a ready buyer who will pay full market price at any time during market hours.

4. Dividend Consistency

Another big reason to like O stock is its reputation as a "Dividend Aristocrat" thanks to its 29 consecutive years of growing its dividend as a public company. Perhaps even more impressive is that O has declared 642 consecutive common stock monthly dividends over the course of its 54-year operating history and increased its dividend a whopping 123 times since its public listing in 1994. As such, it is known by many as The Monthly Dividend Company and is one of the most reliable sources of monthly passive income from real estate available today.

In contrast, investing in rental properties, while potentially very profitable, does not come with the same assurances of consistent and predictable monthly cash flow. Vacancies, delinquencies, and maintenance costs contribute to the unpredictability of rental property cash flow, making it a less desirable source of monthly cash flow relative to the steadily increasing monthly payouts from O stock.

5. Portfolio Quality

Another big reason to like O stock right now relative to rental properties is the sheer quality of its real estate portfolio. While rental properties are backed by the creditworthiness of the individuals living in them and the leases are often very short-term in nature, O leases its real estate out to quality companies.

In fact, nearly 40% of its rental income comes from investment-grade counterparties, over 90% of its rent is considered resistant to recessions and/or e-commerce headwinds, and it enjoys contractual rental increases each year on virtually all of its properties and its leases have a weighted average 10 years remaining on them. This means that O's real estate empire is inherently higher quality than the typical rental property investment or even retail investor's rental property portfolio.

6. Cost of Capital

O also enjoys a much more attractive cost of capital than the typical rental property investor. At a time when interest rates on investment property loans range from the high single digits to the mid-double-digits, O - with its stellar A- credit rating - recently raised nearly $1 billion in debt at a weighted average term to maturity of approximately 12.8 years and a weighted average coupon rate of 5.900%. This means that O can earn a much better spread on a similar property cap rate investment compared to the typical retail rental property investor, leading to much better risk-adjusted returns.

7. Valuation

Last, but not least, O stock offers investors a much more attractive valuation than the vast majority of rental properties today. Even if you are able to buy a rental property fully with cash right now, you are likely going to be massively overpaying for it.

According to S&P Global Ratings , the U.S. housing market is approximately 20% overvalued based on regional price-to-income ratios compared to historical norms. This overvaluation is partly due to high home prices and mortgage rates, which have led to fewer homes being put on the market and even fewer sales. Buyers are increasingly priced out of the market, particularly first-time homebuyers, as mortgage interest rates continue to climb. This problem is compounded further by a persistent housing shortage, as higher rates discourage potential sellers from entering the market, preferring to hold onto their low mortgage rates and contributing to a 15.2% drop in new listings in the first 11 months of 2023 compared to the same period in 2022.

In contrast, the properties that O typically invests in are not in nearly the same bloated market that housing is. Moreover, O stock is currently trading at a 5% discount to its private market value (as estimated by consensus NAV), meaning that investors are buying its high-quality and well-diversified portfolio of real estate on sale and are effectively getting its franchise value, A- credit rating, and professional management for free. This discount is particularly compelling when considering that O has historically traded at a 20% premium to the private market value of its properties.

As a result, shareholders who buy today will likely see significant total returns through a combination of a 3-4% cash flow per share CAGR, a ~25% expansion of the P/NAV multiple, and the current 5.7% NTM dividend yield. This all adds up to a likely mid-teens total return CAGR over the next half-decade. In contrast, rental properties in most cases are unlikely to appreciate by much more than a few percentage points per year and in fact may even see their values decline in the coming half-decade, while cap rates on rental properties rarely exceed 6-8% these days, and in some cases are even lower. As a result, rental property investors are unlikely to top 10% of total return CAGRs on property purchases right now. When combined with the greater risk and hassles of rental property investing relative to O stock, O appears to be a vastly superior investment opportunity.

Potential Downsides of Realty Income Stock

That being said, while investing in O stock offers many advantages, investors should still keep the following potential negatives in mind before investing:

1. O stock is publicly traded and therefore likely to have a much more volatile total return performance in the near term than you would generate when purchasing a rental property. For long-term investors, this is irrelevant and if anything is a pro rather than a con because it can give investors a chance to double down at an even greater discount if the stock tumbles and if the stock rises quickly to above fair value, investors can sell it quickly at a compelling bargain. However, for investors who lack the temperament and patience to navigate rocky markets and even stock market crashes, volatility in O's stock price may cause them a great deal of stress and even cause them to panic sell at an inopportune time.
2. The other big consideration to keep in mind is that O is a truly passive investment, thereby leaving the typical retail investor with basically zero control over how the underlying real estate assets are managed and how the REIT's cash flow is allocated. In contrast, rental property investing often gives the investor complete control over as much of the investment as he/she desires. For some, not being able to control their investment is a deal-breaker. For others, it is a wonderful blessing to have a completely passive investment.
3. O has gotten very large in size, making it harder and harder for them to sustain their per-share growth metrics. While we like some of their recent growth investments (such as acquiring Spirit Realty Capital ( SRC ) at a very attractive price), as we shared in a recent article, O has also gotten increasingly creative in its drive to continue fueling growth, including investing in data center development projects. This potentially increases the risks to the business model, as O is starting to invest in property sectors that are outside of its traditional circle of competence.

Conclusion

While there are many paths to building wealth through real estate, investing in O stock is currently one of the most attractive, especially when taking into account the risks and the hassles of actively managing properties. Moreover, O stock's attractive valuation and cost of capital compared to the currently overvalued housing market and the bloated interest rates facing retail real estate investors further enhances its appeal.

For investors who are fine with dealing with public market volatility and the passive nature of buying REITs rather than taking the hands-on approach to rental property investing, O stock looks like a highly opportunistic investment for long-term wealth and passive income compounding through real estate.

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