Realty Income Stock: Bullish View Vs. Bearish View (NYSE:O)

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Company Snapshot

Realty Income Corporation (NYSE:O), structured as a REIT, is involved in the business of acquiring and managing freestanding, single-client commercial properties that generate rental revenue under long-term net lease arrangements; typically, these leases have a duration of over 10 years. O is currently considered to be one of the largest global REITs in the world, according to the FTSE EPRA Nareit Global Index.

I will attempt to segregate the major bullish and bearish narratives for prospective investors to consider.

What Is O’s Bullish View?

Principally, there’s something comforting about the end market exposure of Realty Income, and that’s not something one can say about a lot of other REITs that could remain vulnerable in this environment; the focus for O is primarily (94% of total rent) towards non-discretionary and low-ticket price retail entities who remain relatively insulated from recessionary pressures.

CBRE’s H1 cap rate survey also reiterated how supply conditions in the retail space looked quite healthy. For most of H1, retail cap rates were either flat or trending lower, and even though this has trended up recently, the movement could be capped as institutional buyers are likely to step in. With the exception of regional malls, which O is not overly exposed to, most of the other retail sub-sectors look poised to deliver attractive relative investment performance next year.

Survey

CBRE

I don’t believe anyone should expect any fireworks by way of ample AFFO growth, but in this current environment, Realty Income looks finely poised to exploit the weakness of the competition, and indulge in some nifty inorganic acquisitions. The pace at which interest rates have moved up has priced out a lot of highly leveraged competitors and brought pricing multiples to more palatable levels. You’re also seeing a lot of foreclosures and the auction market is brimming with enticing opportunities. Consider something like the Texas region, which is incidentally where O is most exposed (11% exposure). Recent reports have shown that institutional owners of even Walmart-occupied stores are defaulting on their loans. You could see these dynamics playing out with a lag in the European markets, where rates still have ample scope to trend higher.

Do consider that Realty Income’s acquisition spend per quarter has been quietly picking up over time; in Q1, they spent $1.5bn, in Q2 $1.7bn, and most recently in Q3 they did about $1.8bn. I wouldn’t be surprised if they overshoot their FY target of $6bn. Realty Income also has the balance sheet to comfortably back its inorganic plans. Currently, it is only one of seven S&P500 REITs with 2 A3/A- ratings and only 7% of its long-term debt profile is variable rate based. Even its fixed interest rate debt is not overly prohibitive and is comfortably managed as exemplified by a fixed charge coverage ratio of 5.5x.

From a technical perspective, after a difficult few weeks, I also believe there’s potential for things to change in favor of O’s stock. After six successive weeks of lower-lows and lower-highs on the weekly chart, the stock looks oversold and appears to have reached a zone that had previously served as a congestion zone from Q2-20 to Q1-21. There’s a good chance you see some buying come on board at these levels.

Technical chart

Investing

What Is O’s Bearish View?

There are categories of REITs that are well placed to offer protection during high inflationary eras, but given the elongated lease duration (10-20 years) of net lease REITs such as O, investors are better served by looking elsewhere.

The prospects of O’s AFFO per share growth also doesn’t look too bright. Just for some context, growth has been on a declining trend since the start of the year; AFFO per share growth in Q1 came in at 14%, followed by 10% growth in Q2. If one considers Realty Income’s FY AFFO per share guidance of $3.84-3.97 per share, you’re looking at FY growth of roughly 9%; that would imply a drastic slowdown towards the 6% levels in H2. A 6% AFFO per share growth rate does not reflect well on Realty Income, particularly as this is one of the REITs that faces very little pressure from recurring CAPEX (< 1% of O’s net operating income is taken up by recurring CAPEX).

Also consider that O’s provision for impairments has been relatively subdued, but this is not sustainable given the worsening environment. In Q2 this came in at only -7.7m vs -17.2m a year ago, as the company, also benefited from paybacks from some deferral agreements. This could put further pressure on the AFFO. Nonetheless, the slowing AFFO trajectory could prompt further readjustment in the valuation multiples that investors are prepared to shell out.

The unappealing AFFO outlook means that despite a ~21% correction in the stock price since mid-August, Realty income’s forward valuations don’t look too enticing, particularly when you compare it to the five largest net lease peers. On a forward Price to AFFO basis, O currently trades at a 10% premium to its large peer set average.

P/AFFO

Seeking Alpha

Realty Income could also be indirectly affected by the cost-of-living crisis in regions such as the UK which is its second largest geographic exposure after Texas. The DIY Home improvement market (the likes of B&Q are clients of O contributing 20% of its annualized contract rent from the European region) in the UK had benefitted from a post-pandemic boom. Still, recent reports from B&Q’s DIY rival- Wickes show that this market has slowed and will likely face challenges ahead.

Then there’s also the dividend yield angle, which is a vital component of this story, and I don’t believe it is enormously compelling, all things considered. Currently, Realty Income’s yield is a little less than 5%; the last time it was this high was back in Jan 2021, but those days the differential with the risk-free 10-year treasury rate was around a healthy 400bps; these days that differential is just 80 bps.

Yield

YCharts

Besides, when you compare the yield to O’s five major net lease peers, note that it is one of the lowest (only ADC offers a lower yield), and is over 40bps lower than the peer set average.

Yield vs peers

YCharts

Finally, investors may also consider how Realty Income’s stock is positioned relative to its peers from the real estate sector, as represented by the Vanguard Real Estate ETF (VNQ). Based on the long-term range, we can see that this ratio still looks quite overextended to the upside (~27% higher than the mid-point). Based on this ratio, if investors were looking for attractive rotational opportunities within the real estate space, O’s stock wouldn’t be a preferred bet.

O:VNQ

Stockcharts

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