The S&P 500 (SNPINDEX: ^GSPC) nosedived in March 2020 as the coronavirus pandemic spooked investors, creating major uncertainty about the economy. But as the world learned to live with COVID-19, the index eventually recovered and went on to hit numerous new highs in the following years. But not all S&P 500 stocks fully recovered. Realty Income (O 0.49%), for example, still trades down around 25% from its pre-pandemic highs. That suggests an opportunity for income investors who buy stocks with a target holding period of forever.
What does Realty Income do?
Realty Income is a net lease real estate investment trust (REIT) with a heavy focus on single-tenant retail properties. A net lease requires the tenant to pay most of the property-level expenses for the asset they occupy. While any single property is high risk, given there's only one tenant, that risk falls if the net-lease REIT has a large portfolio to spread it across. Realty Income's portfolio includes more than 15,600 properties. It is the largest competitor in its space.
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Moreover, while Realty Income's focus is on retail assets (around 75% of rents), it also invests in industrial properties and a collection of "other" assets such as vineyards and casinos. So there is diversification in the mix, with a business that spans across North America and Europe.
Given the heavy exposure to retail, it is understandable that investors were worried about Realty Income during the pandemic. Social distancing and the government shutdown of non-essential businesses were scary and could have been devastating to Realty Income's tenants. Luckily, the uncertainty didn't last, and the REIT's occupancy levels didn't fall below 97.9% in 2020. That's a great number anytime, but occupancy has since improved from there. And investors don't seem to care because the stock remains well off its pre-pandemic highs.
The big problem is interest rates
The reason that investors are so downbeat on Realty Income's stock is likely interest rates. The Federal Reserve increased interest rates coming out of the pandemic to tamp down on a burst of inflation. The problem with this is that REITs grow by making acquisitions. Because REITs have to pay out 90% of their taxable earnings as dividends to remain REITs, they have little internal capital to use for growth. Therefore, they need to tap the capital markets for cash. Higher interest rates make that more difficult.
It isn't an unreasonable fear to think that Realty Income's growth will be slow. But Realty Income is so large that slow and steady growth is actually the norm here, anyway. Moreover, its size and financial strength (it has an investment-grade rated balance sheet) actually give it advantageous access to capital markets. So, compared to competitors, it still has attractive access to growth capital. In other words, the fears are legit, but likely overblown.
But the big story is actually the dividend, which has been increased annually for 30 years. Simply put, the company has lived through different rate environments before and survived just fine. There's no reason to believe it won't muddle through today's higher rates (though historically speaking, the rates aren't outlandishly high) without skipping a beat on the dividend.
Buy now to collect an attractive yield
Sure, dividend growth is likely to slow somewhat in the near term, as Realty Income's interest costs rise. But eventually, property markets will adjust to make acquisitions more profitable, or rates will fall. And then Realty Income's financial performance will improve. In the meantime, investors can collect a fat 5.6% dividend yield backed by a still-growing dividend. In other words, for income lovers, Realty Income's laggard stock price is an S&P 500 index investment opportunity.
