Income investors love Realty Income (NYSE:O). There's a lot to like about the bellwether net lease player, so the market's fondness for this real estate investment trust (REIT) is understandable. However, that doesn't mean you should jump in and buy it. Here's a critical look at Realty Income and its dividend.

Solid as rock

Realty Income operates a net lease portfolio with over 5,800 properties in it. These assets are largely in the retail space, which makes up roughly 82% of the company's rents. Within retail, the portfolio is fairly well diversified, largely made up of stand-alone buildings. Only one sector, convenience stores, represents more than 10% of rents. Meanwhile, most of its retail assets are focused on businesses that are non-discretionary (drugstores), low price point (dollar stores), and service oriented (gyms).   

A hand drawing a scale weighing value and price

Image source: Getty Images.

The remaining 18% of the portfolio is spread among industrial (roughly 12% of rents), offices (4%), and agriculture assets (vineyards, 2%). Although these are relatively small compared with the company's retail portfolio, they provide valuable diversification. On that front, Realty Income has recently ventured beyond North America for the first time, buying 12 stores from a large grocery player in the United Kingdom. That investment makes up just 2% of portfolio rents, but opens up an additional avenue for growth in Europe.

Domestically, the REIT's portfolio is fairly well diversified, with only one state (Texas) representing more than 10% of rents. So Realty Income's portfolio is fairly well structured, noting the heavy exposure to retail overall. 

The performance of the portfolio is pretty impressive as well. At the end of the first quarter, the company's occupancy rate was a strong 98.3%. It's worth noting that the worst levels of occupancy the company has experienced over the last 10 to 20 years occurred during the deep 2007 to 2009 recession period, when the figure dropped to a low of 96.6% -- still very good. Even during one of the worst periods in recent U.S. economic history, Realty Income's portfolio stood strong. 

O Chart

O data by YCharts.

That helps explain how the REIT has managed to increase its dividend annually for 27 consecutive years. Within that is a streak of 85 consecutive quarterly dividend increases. And the payout ratio is a modest 80% or so of funds from operations (FFO). There's no reason to expect a dividend cut or for the company's streak of regular dividend increases to stall. In fact, Realty Income calls itself the "monthly dividend company," which pretty much highlights its dedication to returning value to shareholders.   

That's a great backstory, but...

So far there's a lot to like about Realty Income. The fundamental story here is rock solid. However, Benjamin Graham, the man who trained Warren Buffett how to analyze a stock, was fond of pointing out that a great company can still be a bad investment if you pay too much for it. And that looks like the case today with Realty Income.

The first crucial issue here is dividend yield, which when compared with peers and history can provide a rough valuation guide. Realty Income's current yield is around 3.8%. That's better than what you would get from an investment in an S&P 500 Index fund but not exactly compelling for an asset class that is designed to pass income through to shareholders.

For example, the yield for the entire REIT sector, using the Vanguard Real Estate ETF (NYSEMKT:VNQ) as a proxy, is 3.9%. Some of the REIT's direct peers, meanwhile, offer yields of more than 5%. There are reasons for the yield difference, but that doesn't change the fact that Realty Income's yield is on the low side of the industry.

O Dividend Yield (TTM) Chart

O Dividend Yield (TTM) data by YCharts.

What's more troubling, however, is comparing Realty Income's yield to its own history. The current yield is near the lowest levels ever for the REIT. Note, too, that during the last recession, the yield spiked to more than 9% from the 6% range. So while the next recession may not see 9% from the current 4% range, something higher (perhaps 6% or so) would seem a reasonable expectation -- and a much better entry point for investors who don't already own Realty Income. Nobody likes to invest when the market and economy are struggling, but if you can hold out (recessions and bear markets are inevitable), you'll be much better off.

Fundamental Chart Chart

Data by YCharts.

Looking at valuation a different way, Realty Income's price-to-FFO ratio also hints at an expensive share price. Price to FFO is, effectively, P/E for REITs. Using the company's projected 2019 FFO of around $3.30 per share, Realty Income's price to FFO ratio is a huge 21 times today. That's a number you'd expect from a growth stock, not a dividend stock that's focused on slow and steady dividend growth. For reference, the dividend has increased at an annualized rate of around 4.5% over the past decade. That beats inflation, but not by enough to justify a price-to-FFO ratio over 20. This is not a cheap stock, even though it is a good company. Some of its close peers, meanwhile, have price-to-FFO ratios in the mid to low teens. 

Wait for a better entry point

It isn't that Realty Income is a bad company. In fact, it's a great company. The dividend is rock solid, too, backed by a widely diversified portfolio with high occupancy rates. But these facts don't mean investors buying at today's prices are getting a good deal. And that increases the risk that investors could end up losing money even with an investment that boasts the fundamental strengths of Realty Income.

If you are looking at this top-notch REIT, you should put it on your watchlist. The next recession and/or bear market (which will eventually come) is likely to offer a better buying opportunity than today, which will materially increase the chances of investment success for buyers of Realty Income.