Realty Income (O -0.26%) is a bellwether net lease real estate investment trust (REIT). Basically, with more than 10,000 properties, it is the 800-pound gorilla in the sector. With an impressive history behind it, investors tend to afford it a premium price. And this is where my mistaken thinking led me to sell it when I shouldn't have. This is what I, and many others, got wrong about Realty Income.
Bigger is better
Net lease REITs own single-tenant properties for which the lessees are responsible for most of the operating costs of the properties they occupy. Any single property has a material amount of risk, given that there's just one tenant. However, over a large portfolio that risk is diminished and, in fact, the overall risk is quite low. As noted, Realty Income today owns over 10,000 properties. It is huge.
But it wasn't always this big. I bought it way back at the turn of the century when it was still relatively tiny. And, at that point, REITs were an under-followed asset class that few investors were interested in owning. I bought it with an over 10% dividend yield. The yield today is around 4.2% and has been as low as 3.4% or so at points in the last decade. I don't remember exactly when I sold it, but the yield was in the 4% space and I reasoned that it was too expensive. I took my profits.
That was a big mistake. I wasn't thinking enough about the company's business and was, instead, focusing too much on the price.
Valuation matters, but...
As investment legend Benjamin Graham explained, value is what you get and price is what you pay. To put that into plainer English, paying too much for even a great company can turn it into a bad investment. That's why I sold Realty Income; I figured that investors were paying too much for it. I was stuck thinking about it with a 10% yield.
However, by the time I sold, REITs had become more mainstream and yields had fallen across the board. So my view was inherently outdated. Meanwhile, Realty Income, which is now a Dividend Aristocrat, has proven itself to be a reliable dividend stock. The yield indicated that it was being rewarded for its success with a premium price. But there's another incredibly important benefit that comes along with the premium price this REIT has earned.
Net lease transactions are more similar to financing deals than property deals. Essentially, a net lease REIT buys a property from a company in a sale/leaseback transaction so that the company selling the asset can raise cash for other things, like investing in its business. A net lease REIT makes the difference between its cost of capital and the rents it charges. It's pretty close to a win/win deal for everyone involved. The key here for Realty Income is the cost of capital.
Realty Income's debt costs are fairly low because it has an investment- grade-rated balance sheet. Its cost of equity, meanwhile, is related to what it can issue stock for in the market. In this case, a higher valuation (and thus a lower dividend yield) means that equity costs are low. What I got wrong was thinking that a premium price was a sign to sell. It's really a sign that Realty Income can more easily raise cash that it can put to work growing its portfolio.
Portfolio growth, meanwhile, is what will determine the worth of Realty Income over the long term. So, as it uses its size and low cost of capital to expand, it becomes more and more valuable. I missed out on a lot of portfolio and dividend growth by selling when I did. In fact, having a premium valuation actually helps this REIT maintain its industry-leading position. And given its massive size, it will be hard for peers to catch up at this point.
The big upshot here is that I shouldn't have sold Realty Income when I did because it was just getting to a point where it could use its stock more effectively. Still, the benefits the REIT gets from a rich valuation does not mean that investors should buy it at any price. It is, however, a name worth putting on your wish list for the next broad market sell off, like what happened in 2020 when the yield spiked over 6%. I didn't buy at that point -- I own Realty Income today because it bought another REIT I owned. But, with my changed view of the valuation here, I'm not about to make the mistake of selling it again just because the shares are pricey. A rich price, in my thinking today, just makes Realty Income's business model more attractive. Something fundamental at the company will need to shift before I would consider unloading this industry leader again.