The drastic and quick rise in interest rates has pushed investors away from income-focused investments like real estate investment trusts (REITs). A certificate of deposit yielding 5% is too big a draw for some, given there's no need to take on the risk of owning stocks involved. But that's a problem for REITs, which depend on the capital markets for funding. Realty Income (O -0.17%) thinks it will be able to grow adjusted funds from operations (FFO) between 4% and 5% next year just the same. Here's what's going on.
REITs are designed to pay dividends
As a way to give individual investors access to institutional-level income properties, REITs are allowed to avoid corporate-level taxes. The catch is that they must pay out at least 90% of taxable earnings as dividends, though most REITs pay out much more than that. Essentially, most of the cash a REIT generates goes toward dividends. That leaves these companies highly reliant on the capital markets when it comes to raising money to pay for buying new properties.
That's a big problem right now because interest rates have risen dramatically over the past year or so. Thus, issuing debt has become much more expensive. And with the broader REIT sector falling, thanks partly to investors shifting to other income options (like high-yield CDs), selling stock isn't all that attractive, either. It's a problem for the entire sector that will take time to even out, with property prices likely to adjust so that acquisitions are attractive even with higher rates. That probably won't happen until there's more pain among property sellers, which normally comes from debt issues (like the rollover of lower-cost debt to current interest rates).
Realty Income is a good example. While off from its low, the stock price is still down more than 25% from its 2022 highs. The dividend yield, which was around 4% at one point, now hovers around 5.7%. That's a small change on an absolute basis but a huge 40% increase in the yield on a percentage basis. Using the yield as a rough gauge of equity capital costs, selling stock has clearly become much less desirable for Realty Income.
Realty Income is on track for a solid year
One positive thing here is that Realty Income isn't known for its rapid growth. Slow and steady is the norm. So, the hurdle that Realty Income has to jump for Wall Street is modest. And, as noted, the company is already telling investors that 4% to 5% growth in adjusted funds from operations is in the cards in 2024. Normally, a company wouldn't provide that kind of guidance until early in 2024, when they report full-year 2023 earnings.
But there's a slightly different dynamic at Realty Income as it enters 2024. It is set to buy peer Spirit Realty (SRC) in an all-stock transaction. This is a $9.3 billion acquisition, so it will go a long way toward the growth plans that Realty Income is working on for next year. The company expects it to be immediately accretive to adjusted FFO. This is why Realty Income CEO Sumit Roy was happy to (repeatedly) highlight the adjusted FFO growth he expects next year during Realty Income's third-quarter earnings call:
I think, if you look at where we are today and you look a year ahead in 2024, we believe that without having to rely on the equity capital markets, we'll be able to deliver approximately 4% to 5% AFFO per share growth. And that is a pretty powerful statement to make, and that obviously assumes that the Spirit transaction closes either in the first month, either in January or in February. And with just the free cash flow that we are going to generate pro forma, which is going to be right around $800 million, some of the headwinds that we are going to experience in the refinancing, absorbing all of that to be able to sit here today and say that we could deliver that growth without having to raise $1 of equity, I think it's a very good place to be.
It is a very good place to be since selling stock today is far more expensive than it was just a year or so ago. More importantly, the REIT is buying time for the property markets to adjust and for Wall Street's view of REITs to improve. That's already starting to happen with Realty Income, as its stock has begun to inch higher after hitting a low point in late October. But there's still a lot more room for recovery.
Realty Income isn't exciting, but it is reliable
Realty Income has increased its dividend annually for 29 consecutive years. The rate of dividend growth was a modest 4.3% or so per year over that span. This isn't the type of stock you brag about to friends, but it is one you can count on to keep paying you through good times and bad ones. Right now is a bad time in the REIT sector, but Realty Income is openly telling investors that it can handle the headwinds. If you are looking to create a reliable income stream, you might want to jump aboard this well-positioned REIT while the shares are still depressed.
