Realty Income is a dividend investor's dream. But isn't it already too expensive?
Realty Income $O announced in August its 674th consecutive monthly dividend, and at a price around $61.25 from the September 4 close, it offers an annual dividend of $3.252, a yield of roughly 5.3%. For a dividend investor, it looks like a simple choice: an aristocrat with more than 31 years of uninterrupted payout growth, portfolio occupancy of 98.8%, and income credited every month. But the ten-year U.S. Treasury yielded 4.78% as of September 4, and after strong August labor market data, the market began pricing in even the possibility of a Fed rate hike. The premium that Realty Income pays for equity, real estate, and interest rate risk on top of that has thus fallen below 0.6 percentage points relative to the risk-free rate. And a forward P/AFFO around 13.8 times is not significantly below the level at which the stock has typically traded in recent years.
Key points
A 5.3% dividend looks like a win, but a ten-year U.S. Treasury now yields 4.78% without equity risk. The premium for all that extra risk has shrunk to less than half a percentage point.
Realty Income has paid 674 consecutive monthly dividends and has raised them for over three decades. But its AFFO per share added only 2.1% last year, and rent in its buildings is growing around one percent.
The company wants to invest $10 billion this year, even though its organic rent is growing barely one percent. The rest of its growth must therefore be bought with money it borrows or raises through equity issuance every year.
Apollo invested one billion dollars, and the $6 billion data center partnership shifts Realty Income from American retail properties to completely different assets. Classic net-lease retail is no longer enough for a company of this size to achieve significant growth.
At 13.8 times AFFO, the stock trades slightly above its own three-year average, even though the dividend exceeds 5%. A high yield and a low price, however, are not necessarily the same thing.
The dividend beats the bond by only half a point; the rest must come from growth
A dividend yield of 5.31% and a ten-year U.S. Treasury yield of 4.78% are separated by only about half a percentage point. That is the entire reward the market currently offers for swapping a risk-free coupon for a stock. This bet faces three layers of risk that a bond does not have: stock price volatility, the value of the real estate itself, and the sensitivity of the entire model to interest rates.
Historically, Realty Income's stock offered a much thicker cushion over the risk-free rate. When the ten-year yield hovered around 1 to 2 percent, a 5% dividend meant a premium of three or more percentage points. Today it has shrunk to half a point, and that is due to rising rates, not because the payout weakened.
Reading this difference as a comparison of two identical things would be a mistake. A bond coupon is fixed; 4.78% today will be 4.78% ten years from now. Realty Income's dividend, on the other hand, grows. The company has raised it 133 times since its 1994 IPO, and its AFFO per share—operating profit adjusted for real estate depreciation and one-time items, from which the REIT pays its dividend—is expected by management to rise about 4% this year. That growth is the only thing that justifies today's thin premium.
The entire bet on Realty Income thus shrinks to one thing: the yield has barely any edge over the bond, but it grows a little each year, while the coupon stays put. For that growth, the investor bears additional equity and interest rate risk.
This ties the stock's valuation to rate movements more tightly than for a typical company. If long-term yields continue to rise, the thin premium will be erased, and the stock will be expected to compensate for its lost attractiveness versus the bond through faster AFFO growth. If rates fall, the opposite happens, and today's 5% suddenly looks generous. Rates are therefore not an external backdrop for this stock but one of the main forces that determine it.
Rent from 15,588 buildings is predictable, but on its own it grows only one percent
Realty Income is built on one type of contract, the so-called triple-net lease. The company owns the building, but the tenant pays property tax, insurance, maintenance, and operating costs. Realty Income thus collects rent from which most operating expenses do not detract, making its cash flow unusually predictable.
The scale of that collection is enormous. As of June 30, the company leased a portfolio to 1,798 clients in 92 industries, spanning all 50 U.S. states, the United Kingdom, and eight other European countries. The average remaining lease term is 8.6 years, and annual contractual rent reaches roughly $5.28 billion. Over 97 percent of the portfolio consists of single-tenant buildings, and no single client accounts for even 4 percent of rent. If one of them goes bankrupt, the loss is diluted among thousands of other contracts. The core remains retail, but with a growing share of industrial properties and Europe, which already accounts for about one-fifth of rent.
The last quarter confirmed this model. In the second quarter, AFFO per share rose 3.8% to $1.09, revenue reached about $1.54 billion, and occupancy held at 98.8%. On leases the company re-leased, new rent reached 102.7% of the original, and extensions alone ran at 104.6%, so expirations of old leases are not yet leading to income declines. The share of rent from investment-grade tenants also rose to 34.3% from 32% at the start of the year, so portfolio quality is improving. However, 98.8% occupancy also means the portfolio is practically full and can no longer serve as a growth lever; it cannot be raised by more than a few tenths of a point. No surprises up or down—exactly why dividend investors hold Realty Income.
But within that stability hides a ceiling. Same-store rent grew just 1.0% year over year. Most leases have built-in annual escalations of around one percent, so the existing buildings themselves cannot deliver much more. Management, however, targets AFFO per share growth of around 4%. The gap between one percent from the existing portfolio and the four percent the company promises must be filled each time by buying more properties. Without a steady influx of new investments, Realty Income's growth would fall to the pace of rent escalations, i.e., low single digits. The entire question of this stock's quality therefore shifts elsewhere: to how much the company can buy for and how it finances it.