Dividend investors love big yields. Who wouldn't want to get back 4% or 5% (or more) each year for every dollar you invest? But those high-yield stocks can also be traps if the companies paying them can't afford them.
Realty Income (O +1.27%) is a dividend stock that yields more than 5% at its current share price. The company even pays a monthly dividend, which is uncommon for most U.S. companies.
So the ultimate question is, can you trust Realty Income to keep the checks coming? Let's break down its fundamentals and see why the dividend is so high and whether dividend investors can own Realty Income and sleep well at night.
A primer on real estate investment trusts
Realty Income is a real estate investment trust (REIT). It's a publicly traded company that specializes in real estate. The REIT business model was established by congressional action back in the early 1960s to give the investing public opportunities to own real estate without needing the wealth to purchase buildings outright.
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Key Data Points
The tax codes around REITs require that the business pays out at least 90% of its taxable income to shareholders as dividends, so REITs are often popular with dividend investors and retirees. Most REITs focus on one type of real estate, and for Realty Income, that's single-tenant retail properties.
Realty Income owns and operates approximately 12,000 properties, renting to tenants like Dollar General, Walgreens, CVS, 7-Eleven, Dollar Tree, and more. The company uses net leases, meaning the tenant is responsible for overhead like insurance, taxes, and maintenance. A net lease fetches smaller rent, but it makes rental income much more predictable. On top of its net leases, Realty Income emphasizes tenants with recession-resistant businesses. The company's earnings have only fallen once in the past 27 years.
Why is Realty Income's dividend yield so high today?
So, if Realty Income is such a reliable business, why is the dividend yield so high? A stock's share price can reflect investor demand for shares, like a popularity contest. Investors spent much of the past decade in a situation where interest rates were meager, and bank accounts and Treasury bonds offered minimal yield. To generate investment income, many turned to dividend stocks like Realty Income.
But the landscape has shifted since the Federal Open Market Committee (FOMC) began rapidly raising the Federal Funds Rate to tame inflation. Today, you can get better yields from lower-risk assets, which can decrease demand for dividend stocks like Realty Income. The stock averaged a 4.3% dividend yield over the past decade, but that's at 5% today, 16% higher.
In other words, Mr. Market isn't willing to pay as much for a stock like Realty Income when you can generate comparable income from assets with less potential volatility (risk). The lower share price drives the dividend yield higher.
Can you depend on the payout?
REITs commonly use funds from operations (FFO) to speak to their business performance. That's because real estate has a lot of non-cash factors that could impact reported profits. You can think of FFO as being similar to free cash flow. Dividends are paid in cash, so using Realty Income's FFO can give investors a clear picture of how it's affording its payout.
Realty Income has paid and raised its dividend for 30 consecutive years. You can see below that based on its $4.23 FFO-per-share over the past year, the company's dividend payout ratio is just 70%.
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Investors can expect slow and steady dividend growth. Since its IPO in 1994, the average annual increase has been 4.1%, which tracks the company's 5% average FFO growth rate over that time. Analysts estimate Realty Income's FFO will grow by 4% over each of the next two years, so it should be more of the same given its healthy payout ratio.
But is Realty Income a buy today?
Despite coming close at times, Realty Income stock hasn't yet revisited its pre-pandemic highs. However, the company's FFO has grown considerably at the same time. Today, the stock trades at a price-to-FFO ratio of 14.
Given the company's underlying profits are growing at a low-to-mid single-digit rate, I don't think the stock's valuation is a bargain. However, it may finally be reasonable after years of low rates made stocks like Realty Income the only place to find decent investment income.
A common phrase you'll hear in the investing community is that it's OK to buy a wonderful company at a fair price. While Realty Income might not be a jaw-dropping bargain, it's (at least) reasonable for investors who want to sit on shares and collect the dividends while Realty Income's profits slowly march higher over the coming years.
