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Is Realty Income Running Out of Steam, or Taking a Breather?

By Matthew Frankel, CFP® - Jan 31, 2018 at 6:52AM

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The popular REIT just hit a new 52-week low. What's going on?

Leading net-lease REIT Realty Income (O 1.25%) just hit a new 52-week low and has dropped by 8% in January. In all, Realty Income stock has dropped by more than 25% since its mid-2016 peak. Should investors be concerned, or is this a buying opportunity?

Why is Realty Income falling?

To be fair, it isn't just Realty Income that's falling. Most of the real estate sector has been getting clobbered lately. The Vanguard REIT ETF is down by 6% for the year, and many retail-oriented REITs are down much more than Realty Income. Shopping Center REIT Kimco Realty is already down 13% for the year, and fellow net-lease REIT National Retail Properties is down by 10%.

Downward arrow over array of stock prices.

Image Source: Getty Images.

The main culprit is interest rates, or more specifically, the expectation of rising interest rates. The economy has improved rapidly in the past couple of years, and the Federal Reserve has begun hiking rates at a rapid pace and expects to continue doing so. The real reason for the decline in REITs is that longer-term bond yields are starting to respond. The 10-year Treasury yield, which is a good indicator for REIT investors to watch, just surpassed 2.7% for the first time in about four years.

Here's a simplified explanation of why this is bad for REITs. Rising-market interest rates tend to cause bond prices to fall, which translates into higher yields, like we're starting to see in 10-year Treasuries. This causes upward pressure on income-based investments like REITs, as investors expect a "risk premium" over Treasury yields, which are generally considered risk-free.

For example, if a 10-year Treasury is yielding about 1.5%, as it was in mid-2016 when Realty Income peaked, investors may be perfectly content with receiving a 3.5% dividend yield from the stock, which is roughly what the stock's yield was at the peak. However, now that the 10-year Treasury yields about 2.7%, investors expect a dividend yield of closer to 5%, so Realty Income's stock price comes down to provide that level of income.

Realty Income's business is doing just fine

The most important point is that the stock-price drop has little to do with Realty Income's business itself. Sure, it could get a little more expensive for the company to borrow money, but Realty Income isn't a particularly heavily leveraged REIT.

Businesswise, Realty Income is doing quite well. The company's portfolio is more than 98% occupied and releasing activity has been rather impressive. And the company is seeing a steady stream of attractive opportunities in the market: For 2017, the company expected to acquire $1.5 billion worth of properties. (We won't find out for sure until Realty Income reports year-end earnings.)

In addition, the balance sheet is as strong as ever. Realty Income's fixed-charge coverage ratio is the highest it's ever been, and recent acquisitions have been largely funded with equity, not debt.

Rock-solid dividends that look much sweeter now

It's tough to find a better dividend stock than Realty Income. Not only does the company pay a relatively high yield in monthly installments, but the dividend increases with more frequency than most other stocks.

In fact, Realty Income's recently announced February 2018 dividend increase is the 95th time the company has boosted its payout in its 24-year history as a NYSE-listed stock. The dividend has historically risen at a 4.7% annualized rate and hasn't been cut, even during the financial crisis. In all, the company will have paid 571 consecutive monthly dividends since its inception 49 years ago.

With the new, lower stock price, Realty Income's rock-solid dividend translates to a 5% yield, so the stock looks quite appealing from an income investor's standpoint.

You'll be happy, but in 10-plus years

To be perfectly clear, I'm not saying that Realty Income will perform well over the next month, year, or even over the next couple of years. In fact, if long-term bond interest rates were to unexpectedly spike, I can almost guarantee you that the stock will fall further.

However, I'm confident that if you approach your Realty Income investment in terms of decades, you'll be very happy with your performance. Just take a look at the company's track record. In addition to the frequent dividend increases, Realty Income has done a great job of creating value for its investors through a variety of interest-rate environments, economic conditions, and political situations. In fact, since its 1994 NYSE listing, Realty Income has generated annualized returns of more than 16% -- a remarkable level of performance to sustain for more than two decades.

While past performance isn't a guarantee of future results, there's no reason to think that Realty Income's long-term future is anything but bright. While there will be bumps in the road, it's important not to let price drops like this one -- that have little to do with the business itself -- scare you away. Just be patient and enjoy the 5% dividend yield along the way.

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