Realty Income's (O -0.17%) market cap is $38 billion, making it more than twice the size of its next closest peer. There are benefits to being an industry giant in the net-lease real estate investment trust (REIT) industry. But there's one important negative that has investors worried right now: Realty Income needs a lot of deal flow to grow. Management doesn't share that concern.
Realty Income is out of favor on Wall Street
The share price of Realty Income has declined a huge 27% since hitting a peak in 2022. A very important part of that decline stems from the fact that interest rates have been rising as the Federal Reserve tries to fight inflation. The immediate impact is negative for the stock.
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REITs are income investments, as they are specifically designed to pay dividends. That means they compete with other income-producing assets, such as CDs and bonds. When interest rates were near zero, investors were willing to take on the extra risk of owning a stock. With rates materially higher today, lower-risk alternatives are much more attractive, and investors are switching. That's put downward pressure on income stocks across the board, including REITs like Realty Income.
But there's another factor here, too: REITs tap the capital markets to raise capital so they can buy the properties that live in their portfolios. As rates rise, the cost of debt capital rises, too. And as stock prices decline, the cost of equity capital also increases. That makes it more costly to invest and can reduce profits. Investors are worried that Realty Income's costs will put pressure on its profits.
Realty Income has huge needs and sees huge opportunities
This isn't unique to Realty Income, as all of its net-lease peers face the same problem. A net lease requires that the tenant pay most property-level operating costs. Transactions in this space often involve sale/leaseback deals, in which a company sells a property to raise cash for other purposes, such as debt reduction or capital spending. The requirement to pay for operating costs is actually a positive because it means the lessee can ensure that the property is maintained to its standards, not the standards of its landlord.
The added issue for Realty Income is that, given its vast size, it needs to make a lot of deals in order to grow. That's just simple math. In a tough market, investors are increasingly worried that Realty Income won't be able to find enough attractive deals, which isn't an unreasonable concern. But management doesn't share that fear.
In fact, while recognizing that rising interest rates are a headwind, Realty Income also sees them as an opportunity. That's because the REIT isn't the only company that's facing increasing interest costs. So, too, are its customers and, more to the point, potential customers. As more businesses have to refinance expiring debt at higher rates, Realty Income believes an increasing number will opt to do sale/leaseback deals in the net-lease space to keep debt levels and interest costs manageable.
The numbers are huge. In sectors where Realty Income operates, companies in the S&P 500 own $1.6 trillion worth of real estate that could be sold. And, within that group, there's $1.2 trillion worth of debt maturing between 2024 and 2027.
Clearly, all of that debt won't be paid off with sale/leaseback deals. And Realty Income won't get every sale/leaseback deal that's inked. But given its vast scale, it will be a competitor for any sizable deal that does come on the market. And it should get its fair share of the transaction volume that does occur. Thus, assuming that management's expectations play out, rising rates could actually be a benefit for the REIT, too.
There's no reason to worry just yet
Realty Income has survived through hard times before, including the Great Recession. It has increased its dividend annually for 29 consecutive years at this point. Yes, the business environment is getting tougher. But that's not unique to Realty Income, and in the next few years it could actually result in increased deal flow for the REIT. Now is not the time to bail on Realty Income if you own it, but you might want to buy it if you don't, noting that the dour mood on Wall Street has pushed the yield to 5.6%, near its highest levels of the decade.
