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Realty Income May Be 30%+ Overvalued


REITs are being bid up through low-yield savings and sovereign debt markets, as well as the tailwind low rates provide for real estate through lowered borrowing and property acquisition costs.

At sub-2% organic growth and a 3.7% expected forward dividend yield, O provides little attraction above a basket of bonds of the same credit rating as the company itself.

At a more normalized FFO multiple (14x-18x), O should trade at $40-$52 per share.

In terms of the macroeconomic perspective on the REIT industry, my current conviction is that because of the low or non-existent yields in the savings and sovereign debt markets, bond-like equity assets, such as REITs, are being bid up to very full valuations. The market is also adjusting to the expectations that rates may be lower for longer, which is a direct macro tailwind for REITs (though somewhat sector dependent), as it directly lowers borrowing costs and increases the possibility of effectuating accretive property acquisitions. I believe Realty Income (NYSE:O) is no different on the valuation front, with a sub-4% dividend yield and sub-2% organic growth rate.

Business Overview

The company is a triple-net REIT, owning 81.7% of their properties in the retail space. As of June 30, 2016, the company owned 4,646 properties, geographically distributed among all U.S. states aside from Hawaii. Reality Income rents to 246 commercial clients among 47 different industries. Occupancy rate stands at 98.0% (industry average is 93.5%) and hasn't fallen below 96% since 1970.

The company's top clients include Walgreens (6.6% of revenue), FedEx (5.7%), Dollar General (4.5%), LA Fitness (4.1%), and Dollar Tree / Family Dollar (4.0%). Drug stores have increasingly become a part of the firm's portfolio, now representing 11.0% of rental revenue, up from 3.5% as of year-end 2012. Dollar stores comprise 8.7% of rental revenue, up from 2.2% since year-end 2012, and provide attraction to the company due to their lesser susceptibility to e-commerce competition. Convenience stores have fallen from 16.5% of the portfolio to 8.8% over the same time period.

Realty Income has significantly outperformed the market since its 1994 listing on the NYSE, generating compounded annualized returns of 18.2% versus 9.2% for the S&P 500 as a whole. The company has had 75 consecutive quarterly dividend raises and made 553 consecutive monthly dividend payments (46+ years), making it one of the most reliable dividend stocks on the market.

Company Strategy

The company targets properties that are freestanding structures, commercially zoned, and contain a single tenant (99.5% of properties are single-tenant). The weighted average remaining lease term currently...