Realty Revenue: Dividend At Unreasonable Value (NYSE:O)

Again in June this 12 months, I wrote an article on Realty Revenue Company (NYSE:O) during which I laid out my considering on why investing in O comes with a significant alternative price.

Within the article Realty Income: Time To Reallocate To Better Risk-Adjusted Alternatives my argumentation revolved round O’s inventory worth and the way it has been overly proof against the looming recession dangers and better rate of interest prices. Since then, O’s whole returns have been unfavorable 7.8%, whereas the broader U.S. fairness REIT market has gained round 1%.

Now, with this text my purpose is to deal with O’s dividend story and actually reply whether or not it’s rational from a basic degree to allocate into O with an intent to seize nice and rising dividends.

These days, I’ve been additionally considering on including O to my dividend portfolio given O’s monitor report, considerably acceptable yield, M&An influence and, most significantly, upper-investment grade stability sheet, which is essential within the context of present macroeconomic dynamics. Granted, there are various different advantages related to O reminiscent of strongly diversified portfolio, well-laddered lease profile, embedded hire escalators and so forth.

But, there are a two main elements, which have maintain me again from deploying a part of my capital into O.

#1 – Comparatively unattractive dividend yield

Presently, O yields round 5.5%. This is kind of according to the place the dividend has been over the previous decade. There have been some durations during which the dividend yield has decreased to 4%, however within the grand scheme of issues I don’t think about this a fabric distinction.

If we examine the 10-year historic dividend yields of O and the Vanguard Actual Property Index Fund ETF Shares (VNQ), we are able to discover that the unfold has considerably narrowed, exceeding the historic norm.

Because of this as of now O doesn’t provide any notable premium for dividend-seeking traders relative to the general REIT market regardless of being positioned as a dividend-oriented funding.

One may argue that it’s like evaluating apples to oranges and that O’s is far more financially extra resilient and confirmed its capability to ship rising dividends.

Partially true.

I might agree that these are totally different investments (i.e., on the apple and orange comparability), however I might disagree with the thesis that O is far safer than VNQ.

There are at the least two arguments for this.

First, if zoom again 10 years and have a look at the examine the cumulative dividend development of O and VNQ, we are going to as soon as once more discover an fascinating dynamic.

The entire dividend development for VNQ has been rather more risky than for O, however on a cumulative foundation, the whole end result may be very comparable. So already right here we conclude that O has failed to offer traders with an irregular dividend although it’s generally considered because the “REIT dividend king”.

Second, VNQ consists of a diversified set of sectors and entities, which collectively mathematically cancel out idiosyncratic threat. That is clearly not the case with O, the place we’re speaking about clear singe safety threat.

Lastly, in the case of the attractiveness of O’s dividend (or fairly lack of it), there’s little motivation to spend money on O, whereas the mounted revenue markets are offering juicy yields.

The distinction between O’s yield and the U.S. 10-year Treasury notice is simply 150 foundation factors. In comparison with T-bills, the distinction comes right down to solely 10 or 20 foundation factors. And we’re not speaking about corporates credit score, the place there are some clear pockets of upper yield which can be backed with robust fundamentals.

A possible problem to this comparability could be that O is ready to develop the underlying dividend, whereas a pure-play publicity to mounted revenue doesn’t provide this luxurious.

Properly, I don’t suppose that O will have the ability to sponsor notable development going ahead as a result of its present AFFO payout profile, leverage and simply generally greater rate of interest atmosphere (see extra particulars beneath). On the identical time if rates of interest proceed to go up, O will seemingly fall. Mounted revenue positions can even drop, however if you happen to maintain them till maturity, you possibly can derive greater revenue by reinvesting in cheaper bond. If the rate of interest go up, the chance is excessive that there shall be higher returns for a hard and fast revenue holder because of the period impact and O’s wealthy valuations.

#2 – Increased for longer situation damaging O’s fairness story

The important thing precept how O is ready to create shareholder worth and develop its dividend is by capturing a optimistic unfold between the cap fee and its weighted common price of capital (i.e., WACC). This isn’t one thing O-specific, however a common precept for nearly all fairness REITs.

To take action, O has to search out and purchase sufficiently high-yielding properties, the place the corresponding cap charges cowl the underlying financing prices. In observe, O may also purchase properties at cap charges beneath the WACC after which redevelop or usher in new tenants to spice up the NOI.

These days, it has been very difficult to search out and signal new offers, which supply some significant unfold from the O’s WACC. The truth that the selectivity proportion of O has exceeded the 10-year excessive is a transparent testomony of that.

I might additionally argue that the current deal, the place O invested $950 million in Bellagio, Las Vegas additionally confirms this because it agreed for a yield-bearing most well-liked fairness curiosity construction, which may be very unusual for O.

With that being stated, let’s assume that O by some means manages to search out accretive offers, which supply a optimistic unfold from its WACC. Contemplating Bellagio’s transaction and O’s rising deal with the worldwide markets and totally different sectors of actual property, I believe that the Firm will handle to search out establish new inorganic development targets.

Nonetheless, right here is the issue.

In my humble opinion, O underestimates its WACC or at the least determines it in a really optimistic method.

O has calculated its long-term WACC at 6.6%, which is ~ 200 foundation factors above the U.S. 10-year Treasury and solely ~ 100 foundation factors above the U.S. T-bill. So, 6.6% is the yardstick for O when making a closing funding determination whether or not to purchase new property or not.

To make issues extra fascinating, O has decided its 1-year nominal WACC at 5.5%, which is used to measure preliminary earnings accretion. This WACC is used to unfold spend money on high-quality actual property alternatives.

Trying on the YTD investments, O has acquired properties at a weighted common cap fee of 6.9%, which supplies solely 30 foundation factors of unfold to accommodate additional worth creation for the present shareholders.

The YTD debt financings have been stipulated at an efficient semi-annual yield of ~5.15%. The price of financing for revolver is clearly a bit greater, albeit nonetheless partially offset by some favorable hedges.

Up till now, O has managed to register optimistic AFFO development and thus with the ability to maintain the dividend rising. The important thing causes for that is the present price of financing of three.79%, which is approach beneath the traditionally (and not too long ago) acquired property cap charges.

Nonetheless, already now we are able to see that the financings associated to the credit score facility, business paper and unsecured time period loans are round 5 – 5.5%. The primary component, which has saved the financing prices low is the senior unsecured notice and bond element. This financing supply yields 3.5% and has a comparatively lengthy maturity profile.

Steadily, O’s financing prices will converge to the market degree as the present unsecured financing expires, forcing O to draw contemporary and higher-yielding debt to refinance.

In consequence, O must endure from diminished spreads which can be related to traditionally acquired properties. Contemplating the tiny margin of security in the case of the unfold between WACC and cap charges, I don’t see how O will handle to extend dividends a lot additional.

The underside line

So my fear right here is that if the rates of interest stay elevated for an extended time period, O’s capability to accommodate significant development in its dividend with out sacrificing the AFFO payout or the capital construction appears restricted.

In a nutshell, whereas there is no such thing as a substantial foundation for shorting O, dividend-seeking traders ought to significantly think about higher yield alternate options as O’s case appears to not provide sufficiently enticing yield in opposition to the backdrop of high-yielding mounted revenue devices and main headwinds stemming from greater rate of interest atmosphere.