Offering monthly dividend payments and an attractive 5.7% yield, Realty Income (O 1.36%) has long been a favorite of income-oriented investors.
However, the real estate investment trust (REIT) has not been a great performer in recent times. With its stock price down about 23% over the past five years, it has actually generated a slightly negative return for investors even after dividends over that stretch.
That's thanks, at least in part, to soaring interest rates which typically pose a challenge for the real estate business. But now with the Federal Reserve poised to start lowering rates later this year, could this stock be a good opportunity for investors?
A steady business
Realty Income has traditionally run a steady, predictable business. Its main focus is on the retail sector, where it primarily leases out its real estate properties to less economically sensitive retailers such as grocery stores, dollar stores, and pharmacies that are also isolated from e-commerce pressure.
This accounts for about 75% of its real estate portfolio, while 11% of its properties are leased to more economically sensitive retailers, and 14% of its properties are leased to non-retailers.
In addition to its steady tenant base, Realty Income also uses long-term triple net leases to help provide it with long-term visibility. With these leases, tenants are responsible for utilities, property taxes, and maintenance expenses.
The leases generally have 10- to 20-year initial terms with rent escalators. This gives Realty Income solid visibility into future growth while not having to worry about increased costs. The REIT's steady business has helped it increase its dividend for 29 straight years.
Finding growth in different areas
In recent years, Realty Income has started to look for growth in different geographies and industry verticals. It entered Europe several years ago, and now has over $10 billion invested there. The company has less competition in Europe compared to the U.S., and believes Europe is an $8.5 trillion addressable market opportunity.
Earlier this year, Realty Income acquired 82 properties located in France, Germany, Spain, Italy, and Portugal from sporting goods retailer Decathalon in a 527 million euro sale-leaseback transaction. Sale-leasebacks are when companies sell their real estate assets for cash, and then the new owner leases the properties back to the previous owner. This has been a common way for Realty Income to build up its real estate portfolio over time.
Realty Income has also started entering new verticals outside its core retail holdings. It added to its industrial real estate holdings when it acquired Spirit Realty this past January. It also started making inroads into the gaming industry through a $1.7 billion sale-leaseback transaction with Boston Harbor Casino in 2022 and through a $950 million investment in the property of The Bellagio Las Vegas, which is operated by MGM Resorts.
Realty Income also formed a joint venture with Digital Realty last fall to develop two new data centers in Northern Virginia. It invested approximately $200 million to acquire an 80% stake in the venture.
Image source: Getty Images.
Why Realty Income's stock has struggled
Despite a steady business and venturing into new areas to help drive growth, Realty Income's stock has struggled. The big reason behind this has been an increase in capitalization (cap) rates used to value commercial real estate properties. Cap rates are the net operating income a property generates, divided by its current value.
In many ways, cap rates are similar to bond yields. If cap rates go up and the net operating income of a property stays pretty steady, that means the value of the property will decrease. Not surprisingly, higher interest rates have impacted cap rates, which will often trade at a premium to 10-year Treasury yields. Other factors such as supply and demand and the economy can also play a role.
For its part, leading real estate investment service CBRE sees cap rates expanding another 25 to 50 basis points this year (which equals a 5% to 15% decline in property values) before stabilizing. Given the increase in cap rates over the past five years, it should not be surprising that Realty Income's stock has struggled as the value of its properties have declined.
Time to buy?
With cap rates set to stabilize and the Fed still likely to cut interest rates this year, now looks like a good time to buy Realty Income stock for income-oriented investors. The shares have struggled largely due to increasing cap rates which have lowered the value of its properties. However, the market should start to stabilize this year and then begin to improve over the next several years. This makes it a good time to buy this dividend stock ahead of this shift.
