jaturonoofer
Elevator Pitch
I have a Hold rating assigned to Realty Income Corporation (NYSE:NYSE:O).
Realty Income Corporation’s price correction in September 2022 is justified, taking into account the negative effects of rising rates on its inorganic growth prospects. O’s stock price outlook isn’t favorable; Realty Income Corporation should trade sideways going forward until the Fed reverses course and the rate hiking cycle comes to an end. As such, I think that O deserves a Hold investment rating.
Why Did Realty Income Stock Drop?
Realty Income Corporation’s stock dropped by -15.3% in September 2022, and this was significantly worse than the S&P 500’s -8.2% decline in the prior month.
In my opinion, rising interest rates have hurt O’s performance in the previous month. Seeking Alpha News reported on September 21, 2022 that “the Federal Reserve has bolstered its key rate by 75 basis points.” Higher interest rates make it more challenging for Realty Income to secure low-cost financing to fund value-accretive acquisitions in the future.
In its Q2 2022 results presentation slides, Realty Income Corporation highlighted that “external acquisitions drive ~2/3 of total earnings growth”, which is a clear indication of the high degree of O’s dependence on inorganic growth (versus organic growth). This implies that a rising rate environment could have a significant impact on Realty Income Corporation’s growth outlook.
More importantly, Realty Income’s key metrics disclosed as part of its most recent Q2 2022 financial results announcement didn’t fully satisfy investors’ expectations. I will touch on this point in the next section of the article.
O Stock Key Metrics
Both O’s revenue and FFO (Funds From Operations) for the second quarter of 2022 came in above market expectations. But it was disappointing that Realty Income didn’t raise its fiscal 2022 AFFO (Adjusted Funds From Operations) guidance, which was the key metric that investors had their eyes on.
In its Q2 2022 financial results press release, O kept its FY 2022 AFFO per share guidance unchanged at $3.84-$3.97, which translates into a midpoint of $3.905. In other words, Realty Income expects its AFFO per share to rise by a decent +9% this year as compared to its FY 2021 AFFO of $3.59.
But the market was anticipating an increase in Realty Income’s FY 2022 AFFO guidance, given that O had guided for a higher volume of acquisitions for the current year. Specifically, Realty Income’s acquisition volume guidance for FY 2022 was raised from “over $5.0 billion” previously to “over $6.0 billion” now as indicated in its most recent second-quarter results release.
Realty Income acknowledged at its Q2 2022 results briefing in early-August that its “cost of capital overall has also increased”, and stressed that the key issue is to “generate the right spreads to move the needle on the overall AFFO per share growth.” O also noted at the recent quarterly investor call that its spreads in 2022 thus far are “slightly below our overall average” due to “the velocity at which these interest rates have moved.”
In summary, Realty Income has historically relied heavily on acquisitions to drive its growth. With interest rates on the rise, it will be increasingly difficult for O to create as much value with acquisitions going forward, as it did in the past when financing was much cheaper.
What Is O Stock’s Target Price?
The mean Wall Street analysts’ price target for O is $77.03, and this implies that Realty Income has a potential upside of +32% as compared to its last done price of $58.20 as of September 30, 2022.
But the sell-side’s consensus target price for O doesn’t seem to be aligned with Wall Street’s investment ratings for Realty Income Corporation.
Among the 21 analysts covering Realty Income’s shares, slightly over half of them, or 11 analysts to be specific, have assigned either a Strong Buy or Buy rating to O’s stock. The other 10 sell-side analysts deem Realty Income to be a Hold instead.
In the subsequent section, I share my thoughts on O’s current valuations.
Is Realty Income Fairly Valued?
In my view, Realty Income is at a fair valuation.
Realty Income’s consensus forward next twelve months’ dividend yield of 5.2% is roughly on par with its 15-year average forward dividend yield of 5.1%, according to S&P Capital IQ’s valuation data.
Separately, O trades at 14.7 times consensus forward next twelve months’ price-to-AFFO, and this represents a 15% discount to its 15-year mean forward price-to-AFFO valuation multiple. But I will argue that this 15% valuation discount for Realty Income relative to historical averages based on the price-to-AFFO metric is justified. One has to consider that the expectations of value accretion for O driven by acquisitions have been lowered with the increase in interest rates as discussed earlier in this article.
Moreover, Realty Income’s dividend yields and price-to-AFFO valuation multiples aren’t as attractive as most of its peers, as highlighted in the chart presented below.
Peer Valuation Comparison For Realty Income Corporation
| REIT | Consensus Forward Next Twelve Months’ Dividend Yield | Consensus Forward Next Twelve Months’ Price-to-AFFO Valuation Metric |
| Agree Realty Corporation (ADC) | 4.2% | 17.5 |
| Realty Income Corporation | 5.2% | 14.7 |
| National Retail Properties, Inc. (NNN) | 5.6% | 12.4 |
| Essential Properties Realty Trust, Inc. (EPRT) | 5.6% | 12.5 |
| Four Corners Property Trust, Inc. (FCPT) | 5.7% | 14.5 |
| W. P. Carey Inc. (WPC) | 6.1% | 13.2 |
| Getty Realty Corp. (GTY) | 6.3% | 12.4 |
| Spirit Realty Capital, Inc. (SRC) | 7.2% | 10.1 |
Source: S&P Capital IQ
Realty Income noted in its Q2 2022 results presentation that it was the only “1 of 8 Retail Net Lease REITs” and “1 of 15 S&P 500 REITs” to raise dividend payouts in 2020 during the worst of COVID-19. Yes, O is much more defensive and resilient than its peers, but this has largely been priced in as evidenced by its relatively lower dividend yield and comparatively higher price-to-AFFO multiple in the peer group.
In a nutshell, O is fairly valued based on historical and peer comparisons.
Is O Stock A Buy, Sell, or Hold?
O’s stock is a Hold. Realty Income’s current valuations are fair, and O’s shares are only likely to re-rate in a meaningful way when inflationary concerns ease and the Fed signals a pause in rate hikes.
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