Net-lease real estate investment trust Realty Income (O 1.94%) pays a 4.5% dividend yield in monthly installments, making it a favorite of many income-seeking investors. However, while the market has been hitting record highs recently, Realty Income is down by more than 6% over the past few weeks and by about 20% since its peak in mid-2016. Is the stock a bargain, or could there be more downside ahead?
A bit of background
Realty Income focuses on freestanding retail properties, but also has smaller holdings in office, industrial, and agricultural real estate. As of the second quarter of 2017, Realty Income owns just over 5,000 properties located in 49 states.
Interest rate fluctuations and retail headwinds have put pressure on Realty Income's stock price. Image source: Getty Images.
The company is a "net lease" REIT, so its properties are leased to tenants on a triple-net basis, which transfers the responsibility of paying property taxes, building insurance, and certain maintenance expenses to the tenants. Net-lease tenants typically sign long-term leases (15-year-plus initial terms) with annual rent increases built in. This type of lease creates a consistent, growing income stream and minimizes turnover and vacancy risk.
Why is the stock down recently?
Realty Income is certainly down for a reason, but the good news is that there's nothing wrong with the company (or its business model).
The biggest reason for the recent performance is interest rates -- more specifically, the anticipation of rising interest rates. Rising interest rates tend to put negative pressure on REITs, as well as other types of income-generating investments, as investors need to be compensated for the risk they're taking.
As a simplified example, if Realty Income yields 4% while 10-Year Treasuries yield 2%, it may seem worth it to take on the additional risk and volatility of owning the stock. However, if the 10-year Treasury yield rises to 4%, it might not seem like such a good idea to own a stock like Realty Income when you can get the same yield without the risk. So, REIT prices tend to drop, which makes their yields rise.
And as you can see, the recent price action in the stock is almost the exact opposite of the rise in the 10-Year Treasury yield.
Another potential reason for Realty Income's underperformance is general weakness in the retail sector. To be clear, none of the recent high-profile retail bankruptcies have affected Realty Income's portfolio, and as I've written before, the company specifically looks for tenants that are recession- and e-commerce-resistant. In fact, Realty Income's portfolio is currently 98.5% occupied. However, that doesn't mean that sector headwinds can't push the stock price down.
Valuation
Based on the midpoint of Realty Income's 2017 adjusted funds from operations (FFO) guidance, the stock trades at a price-to-FFO ratio of 18.4. While I wouldn't exactly call this cheap, it's on the lower end for Realty Income, and it is certainly the expensive than the S&P 500's average P/E of 25.4.
(It's important to use FFO when valuing REITs, as it's a better measurement of a REIT's earnings than the traditional method.)
The Foolish bottom line
I think Realty Income is an attractive buy at this price. It remains one of the largest holdings in my own portfolio, and I don't expect this to change anytime soon.
Having said that, I'm not calling a bottom here by any means. Retail headwinds, rising interest rates, and general market weakness could certainly cause the stock to fall from its current level. I think Realty Income is attractive from a long-term perspective, but there could still be a few bumps in the road ahead, so be prepared to ride them out.
