Interest rates are a big deal for real estate investment trusts (REITs) because these property owners make extensive use of debt to fund deals. The current volatile interest-rate environment has crushed the REIT sector, which is down around 10% over the past three months as the market’s interest-rate expectations have notably shifted.
Realty Income (NYSE: O) is down even more, having lost about 15% of its value over the same span. Here are three reasons this could be a great opportunity for long-term income investors to buy.
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Part of the reason investors are extra negative on Realty Income today is because it’s a net lease REIT. A net lease requires tenants to pay for most property-level operating costs, which reduces the risk for the landlord if it has a large enough portfolio. Realty Income’s portfolio contains over 15,400 properties, making it the largest net lease REIT in its relevant peer group.
Image source: Getty Images.
That’s good in other ways, too (more on that in a second), but the net lease model is really based on the spread between Realty Income’s cost of capital and the rates it earns on its investments. Often, it buys directly from a company, like a retailer, in a transaction called a sale/leaseback. The net lease is a way for the seller to retain effective control of the asset while also raising cash from the sale of the property.
The volatile interest-rate environment is narrowing the profit that Realty Income makes on new deals. Add in some concerns about weak retail tenants (more on this below, too), and you can see why investors have soured on Realty Income’s stock.
However, being the 800-pound net lease gorilla has its positives. For example, Realty Income likely gets to see all of the big deals in the market, giving it additional investment options over its smaller peers. It can also take on deals that would be too large for others to handle, and its size gives it access to capital markets that smaller peers would lack.
All in, the very real negatives today are transient, but the long-term benefit of being large easily outweighs the negatives. That remains true even if Realty Income’s size means it will take a more obvious hit from the near-term negatives since investors pay extra attention to the REIT’s results.
Being large is the first step here, but size alone isn’t enough. Realty Income is also financially strong, sporting an investment-grade-rated balance sheet. Its size allows it to access capital markets more easily, while its financial strength allows it to get advantaged rates on the debt it sells to fund growth investments. Size and financial strength also make it easier to sell stock on Wall Street at advantaged prices.
Don’t underestimate the importance of this for a REIT. In order to avoid corporate level taxes, REITs must distribute at least 90% of their taxable income as dividends. (Shareholders have to treat the dividends as regular income.) In practice, REITs often pay out much more, leaving very little internal cash for investing in new properties.
REITs are frequent issuers of debt and sellers of stock — it’s how they pay for growth. Therefore, having advantaged access to the capital markets is a distinct advantage for the company.
It’s important to note, too, that dividends are a key factor here, as well, since most investors buy REITs for their dividends. So it also helps that Realty Income has increased its dividend annually for 30 consecutive years. That’s another sign of the company’s financial strength and provides a solid backing for its lofty 6% dividend yield. (For reference, the average REIT’s yield is roughly 3.7%.)
That said, think about the last 30 years. Realty Income has handily survived the dot.com crash, the Great Recession, and the coronavirus pandemic, all while continuing to increase its dividend. Even during the worst year of the Great Recession, occupancy rates didn’t dip below 96.6%. (For reference, occupancy is currently up around 98.7%.) Simply put, Realty Income’s business is doing fine today, and the REIT has proven that even during truly frightening financial periods, it can still operate successfully.
O Dividend Yield data by YCharts.
That should help reduce the fear around any troubled tenants the REIT may have. In fact, with so many properties it will always have some troubled tenants.
While interest rates are a problem, too, Realty Income’s long-term success navigating changing property markets suggests it should be able to do so this time around as the rate environment again tries to find an equilibrium. And once that happens, property markets will likely adjust so that Realty Income can be more aggressive with the deals it inks, boosting its profits and returns for investors.
Realty Income’s 6% dividend yield is back near the highest levels of the past decade. Given the REIT’s size, financial strength, and proven ability to weather adverse market conditions, long-term dividend investors can consider adding this reliable income stock to their portfolios if they don’t already own it. And if you do own it, you may want to add to your position.
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Reuben Gregg Brewer has positions in Realty Income. The Motley Fool has positions in and recommends Realty Income. The Motley Fool has a disclosure policy.
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