Realty Income Trades At Decade Low Valuations, Worth The Yield?

As the business cycle gets off its high peak, and interest rates continue to rise in an attempt to get rid of inflation's ugly head, markets and investors alike begin to favor high-quality predictable cash flows over projections and promises of growth. In the real estate side of markets, the glory days of high-growth residential and development stocks like Equity Residential NYSE: EQR and Essex Property Trust NYSE: ESS seem to fall behind.

Residential Real Estate Investment Trusts (REITs) rose to beat the benchmark Vanguard Real Estate ETF NYSEARCA: VNQ throughout 2020-2022, when interest rates were at rock bottom, making money cheap for would-be home buyers and builders. However, this time around, the commercial real estate branch is beginning to spark momentum, with players like Realty Income NYSE: O and Simon Property Group NYSE: SPG striking the right balance between high yields and decent appreciation upside.

When Logic Faulters, Opportunities Arise

Market sentiment fell to a disastrous low with regard to grocery stores, restaurants, gyms, and convenience drug stores. During 2020-2022 participants priced stocks in these industries as if the artificial intelligence and multi-verse revolution had already happened, taking everyday people away from needing these establishments. Yet, unsurprisingly, these businesses are still operating at healthy levels, and the need to lease real estate to keep it that way is only rising.

Luckily for Realty Income investors, the REIT holds a diversified portfolio of high-quality American conglomerates that are not going away soon. CVS Health NYSE: CVS and Lowe's Companies NYSE: LOW are among the top twenty largest customers who lease real estate from the trust. Realty Income analyst ratings see a double-digit upside to the stock, as management has successfully hit the right balance between non-discretionary customers and cyclically growing ones.

Now that the United States economy is slowing down and interest rates continue to rise, the so-called 'defensive' stocks will begin to be of interest to markets. When a non-discretionary company benefits from sustained financial support, even in a slowing economy, investors may also think of who else in the value chain benefits in these scenarios, such as the holder of real estate allowing these companies to operate in the first place.

Being the defensive of the defensives, Realty Income should not be trading at its lowest price-to-book ratio in over a decade.

Best of Both Worlds

During Realty Income's first quarter of 2023 earnings presentation, management points out key metrics that may kickstart a new rally in the stock soon. First, management has invested upwards of $1.7 billion via a sale-leaseback transaction valued at a 6% cap rate. A cap rate is a proxy for how much NOI (net operating income) the property is expected to produce based on its value.

According to REIT payout regulations, this transaction alone would account for an additional $102 million in income for the trust or a different dividend payout of $0.15 per share. 

More importantly, management shared its cap rate acquisition chart from 1996; the lowest rates in this period were present in 2021. Today, the trust can expect to continue to acquire and develop properties over 8% cap rates, which investors can use as a dividend yield proxy when these become fully operational. CEO Sumit Roy stated in the earnings press release that "... Given the active start to the year, we are increasing our 2023 acquisitions guidance to over $6 billion." which is corporate for 'everything is becoming cheap, and there is cash flow to be had.'

Speaking to cash flows, which ultimately feed down to investors, Realty Income dividend yields are at a five-year high (ex. 2020 COVID-19 effects on price) of nearly 5%. High dividend yields compared to previous historical levels may indicate some undervaluation; considering that the trust is looking to invest up to $6 billion at 7-8% cap rates in 2023, the case for value becomes stronger. Analysts see a 15% upside from today's prices; however, the top-side price target estimate of $78 per share may be more sensible considering these developments and yields.

Realty Income charts would show that the stock is reaching a decent support level of $58-$60, where volumes have historically increased to push the stock higher on the back of buying pressure. These prices would also coincide with a 14x to 16x price to AFFO multiple; AFFO (adjusted funds from operations) is a real estate proxy for a company's traditional earnings and is thus assigned a multiple such as a P/E would. CEO Sumit Roy stated, "... we are updating 2023 AFFO per share guidance range to $3.94 to $4.03, representing 1.7% annual growth at the midpoint." These assumptions would severely undervalue Realty Income's historical P/AFFO multiples of 20x to 25x.