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1 Reason I Haven't Bought Realty Income Stock

By Reuben Gregg Brewer – Aug 13, 2020 at 9:18AM

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There are a lot of reasons to like Realty Income, but there's one big reason to wait on the sidelines. Here's a deep dive on this iconic REIT.

Realty Income (O 0.51%) is a bellwether name in the net-lease real estate investment trust (REIT) space. It has this stature not just because it is a giant in the industry, but also because it is extremely well-run.

However, a great company isn't always a great investment. That gets to the heart of the problem with Realty Income. Here's a deeper look at the positives, and the one huge negative that might keep you from buying the stock.

A lot to like

As far as real estate investment trusts go, Realty Income is pretty big. To put some numbers on that, it has a $21.5 billion market cap, and owns over 6,500 properties across the United States. It also owns a few in the United Kingdom (which account for less than 2% of rents). Although the net-lease structure means that the company's lessees are responsible for most of the operating costs of the properties they occupy, being large still affords Realty Income some important benefits. For example, it has easy access to capital markets, and it can spread the cost of the home office over more properties. 

A person pushing a shopping cart through a store

Image source: Getty Images.

Realty Income also packs some diversification into its portfolio. At roughly 84% of rents, retail assets are the clear heavyweight in the mix -- but the REIT also generates around 11% of rents from industrial assets, and 4% from office (it also gets a tiny bit of rent from an opportunistic investment in vineyards). That's not as diversified as peer W.P. Carey, but way more diversified than National Retail Properties, which is focused exclusively on retail properties. The diversification here is part of Realty Income's long history of operating in a conservative manner. 

And then, of course, there's the dividend. For dividend investors looking to replace their paychecks, the REIT's monthly payment schedule should be greatly appreciated, along with the REIT's 27-year streak of annual dividend increases. With an average annual increase over the past decade of 4.7%, meanwhile, the dividend has more than kept up with inflation, growing investors' buying power over time. 

Not exactly a screaming buy

With all of those positives, it would be hard to suggest that investors who buy Realty Income are investing in a bad company. But as investment legend Benjamin Graham, the man who helped train Warren Buffett, has said, even a great company can be a bad investment if you pay too much for it. That's the problem here: Investors are well aware of how great Realty Income is, and the stock is almost always expensive. 

For example, using the second quarter's adjusted funds from operations (AFFO), which is like earnings for an industrial concern, as a run rate, Realty Income's full-year AFFO would be around $3.45 per share. That leads to a price to AFFO ratio of around 18 times, which is pretty high for an income investment. To be fair, that's relatively cheap for Realty Income, which has seen its price to AFFO ratio rise above 20 at times. But that doesn't make it a bargain, just a touch cheaper than usual. 

O Dividend Yield Chart

O Dividend Yield data by YCharts

You can also look at the REIT's yield, which is roughly 4.5% today, as a valuation indicator. The yield is higher right now than it was at times over the last few years, but still toward the low end of Realty Income's historical yield range. Note, too, that the spread between Realty Income's yield and that of the average REIT has narrowed dramatically, suggesting that, relatively speaking, the stock has become less and less of a bargain -- even in light of the COVID-19 pandemic. 

Watch and wait

Valuation is the No. 1 reason why investors should stay on the sidelines here. If you can hold off, in fact, opportunities to buy-in usually come along, like during the early 2020 bear market when Realty Income's yield spiked above 6%. That was probably a reasonable entry point, but at current prices, this REIT looks a little pricey again. In the end, there are a lot of things to like about Realty Income, but valuation definitely isn't one of them.

Reuben Gregg Brewer owns shares of W. P. Carey. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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