Shares of Realty Income (O -0.86%) have fallen a painful 15% so far in 2023. That compares to a decline of roughly 4% for the average real estate investment trust (REIT), using Vanguard Real Estate ETF as a proxy.
But don't judge a company like Realty Income on just nine months or so of stock performance. The big picture is so much brighter and suggests that long-term investors should probably be looking closely at the stock today.
A short-term laggard and a long-term leader
Realty Income's weak year-to-date stock performance is troubling. The stock is now lagging the REIT average over the trailing one- and three-year periods. But it's still beating the group over the trailing five- and 10-year periods.
For example, over the past decade, the stock's total return, which assumes dividend reinvestment, is 40 percentage points higher than that of the average REIT.
O Total Return Level data by YCharts.
Adding to this story is Realty Income's incredibly reliable dividend. The company has increased the payout for 29 consecutive years at a compound annual rate of 4.4%.
The yield is roughly 5.9% today, which is near its highest levels of the past decade. The last time the dividend yield was this high was during the early days of the coronavirus pandemic.
Also notable is that Realty Income is one of the largest net-lease REITs you can buy. A net lease requires the tenant to pay most property-level operating costs. As a result, Realty Income can take on deals that its peers couldn't even consider.
Given its strong financial position (it has an investment-grade-rated balance sheet), it also tends to have advantaged access to capital. That makes it easier for the REIT to find profitable deals, as well.
What's wrong with Realty Income?
Given the list of positives just laid out, income investors should be wondering why Realty Income is underperforming so badly. First, there's nothing wrong with its business model. It's executing the same plan that has successfully supported decades of annual dividend increases. The problem is a combination of the environment in which Realty Income is operating today and investor expectations.
To put it simply, Realty Income's long history of success has resulted in investors pricing the stock at a premium to its direct peers. But investors are an emotional bunch, and as the economic situation has become more difficult, Wall Street has decided to take a more dour view of the REIT's future.
The stock went up more and is now coming down more. If history is any guide, mercurial investors will eventually change their minds and again afford this net-lease bellwether a more attractive valuation.
But it's important to understand that the economic landscape is getting more difficult. That's largely the result of fast-rising interest rates. Realty Income's borrowing costs go up as rates move higher, and higher costs crimp profits. The stock decline, meanwhile, increases the cost of issuing stock -- a further hit to profits.
Adding insult to injury, property markets often adjust to higher rates in a slow fashion. Basically, higher financing costs generally lead to lower prices for properties (thus allowing a reasonable return for buyers). However, many sellers cling to old prices until they have to change, for example, due to needing cash to deal with debt coming due.
Not only are Realty Income's costs high right now, but attractive acquisitions aren't, perhaps, as plentiful as they once were. That bolsters the negative view over the short term.
This, too, shall pass
While interest rates may not fall back to the historically low rates of the past few years, the property market will eventually adjust to higher rates. That suggests that Realty Income's long, successful approach will eventually return to more historical performance levels.
If you think in decades, now could be a good time to add this dividend stock to your passive-income portfolio while the yield is toward the high end of its recent range.
