The Federal Reserve's recent announcement of a 50-basis-point rate cut is a big deal. It marks the long-awaited easing cycle after the Fed aggressively raised rates to combat inflation in 2022. Interest rates affect almost everything in the economy, dictating the cost of borrowing money for companies and consumers.
Realty Income (O -0.60%) has been a market laggard under high rates, but it could soon jump off the page now that rates are declining. With lower rates, Realty Income might especially appeal to yield-hungry investors.
Here's why Realty Income likely has brighter days ahead and why, with rate cuts in motion, the stock instantly becomes a table-pounding buy.
Why Realty Income is popping on lower rates
Realty Income stock didn't even wait until the Fed's formal rate cut announcement. It has been ripping since July, when lower-than-expected inflation data ignited market speculation that the Fed would soon consider rate cuts. Why did Realty Income take off at the mere thought of rate cuts?
It all comes down to the cost of borrowing money. Realty Income is a real estate investment trust (REIT), a company that acquires and leases real estate. REITs don't pay a corporate income tax, but they must distribute at least 90% of their income to shareholders. Since REITs have to return so much of their profits to shareholders, they generally use debt and stock to fund acquisitions and grow the company.
REITs increase their intrinsic value when they earn a higher return on their capital (debt or issued stock) than it costs.
Higher interest rates make debt more expensive, narrowing that spread and stunting the value Realty Income creates when it borrows and invests for growth. So, why did Realty Income jump at the first sign of rate cuts? Because Realty Income's business should perform far better in an environment with cheaper borrowing.
Hungry for income? Feast on this dividend
Following the recent cut, the federal funds rate is 4.75% to 5.00%, and financial vehicles like high-yield savings accounts will yield less. Retirees and other income-seeking investors will look to alternatives like dividend stocks for income. And when it comes to high-yield stocks, Realty Income is a genuine blue chip.
Realty Income boasts a portfolio of more than 15,000 commercial properties. It primarily rents to recession-proof single-tenant companies, such as grocery, convenience, and dollar stores, pharmacies, automotive service centers, and restaurants. The company has raised its dividend for 31 consecutive years, a streak that has endured the most severe economic crises in recent history, such as the Great Recession in 2008-2009 and COVID-19 in 2020.
The dividend remains mathematically rock-solid. Management is guiding for approximately $4.20 per share in funds from operations (FFO) this year, easily enough to cover the $3.16 it pays in total annual dividends. Realty Income yields approximately 5% despite the stock trading near 52-week highs, and that yield will only stand out more if the Fed keeps lowering rates.
Realty Income is still a buy
The stock's dividend could be enough reason for some investors to buy Realty Income, but the stock is still at a good value overall. I'm valuing Realty Income using its cash from operations as a substitute for FFO, a non-GAAP metric standard in the REIT industry.
Today, Realty Income trades at roughly 15 times its cash from operations, which is still at the low end of its range over the past decade. Below, you can see how the highest federal funds rate of the past decade pushed the stock to its lowest valuation.
O Price to CFO Per Share (TTM) data by YCharts.
Now, that's unwinding. It's hard to say how high Realty Income's valuation could go, because nobody knows how low rates will go now that the Fed has begun cutting. However, you can see that the stock could realistically trade at 20 times its cash from operations or higher if rates go low enough.
Investors looking for a margin of safety might play the middle and buy the stock while it trades under 18 times Realty Income's cash from operations. That makes the stock an excellent option for income-seeking investors today.
