This 23% Undervalued Dividend Aristocrat Is a Buy as Interest Rates Fall

Realty Income O is a midsize real estate investment trust that owns more than 13,000 properties, most of which are retail-focused. This REIT offers one of the most stable dividends in its industry; its monthly dividend therefore should provide reliable income for those investors who seek it. This undervalued dividend aristocrat lands on our list of the best REITs to buy. It’s also among our analysts’ 33 undervalued stocks for the first quarter and one of Morningstar chief U.S. market strategist Dave Sekera’s six undervalued stocks to buy after the market rally.

Realty Income is the largest triple-net REIT in the United States. Even though more than 80% of its tenants are in retail, most are focused on defensive segments. Additionally, the triple-net lease structure places the burden of all operational risk and cost on the tenant and requires the tenant to make capital expenditures to maintain the property rather than the landlord. These leases are often long-term—frequently 15 years with additional extension options—which provides Realty Income with a steady stream of rental income. The stable stream of revenue has allowed Realty Income to be one of only two REITs in the S&P High Yield Dividend Aristocrats index and hold a credit rating of A- or better. This makes Realty Income one of the most dependable investments for income-oriented investors. Stability comes at the cost of economic profit, however. The lease terms include very low annual rent increases of around 1%, which helps keep the coverage ratio high but severely limits internal growth. Therefore, Realty Income must rely on acquisitions for growth.

Key Morningstar Metrics for Realty Income

• Fair Value Estimate: $76
• Star Rating: 5 Stars
• Economic Moat Rating: None
• Uncertainty Rating: Low

Economic Moat Rating

We don’t believe that Realty Income benefits from moat sources, such as efficient scale or network effect, that we attribute to some retail property owners. With annual rent escalators of only around 1%, the company sees very low internal growth. Instead, Realty Income must rely on acquiring new properties to increase cash flow. Given that it has generally acquired properties at mid- to high-6% cap rates, the combined returns from internal and external growth do not exceed our estimated 7.1% weighted average cost of capital, which leads us to conclude that the company does not possess an economic moat. Although the company has the ability to create value through a high volume of external growth at attractive pricing while increasing portfolio quality, we view this as part of the skill of management and not as evidence of a moat.

Read more about Realty Income’s moat rating.

Fair Value Estimate for Realty Income Stock

Our $76 fair value estimate implies a 5.2% cap rate on our forward four-quarter net operating income forecast, a 19 times multiple on our forward fourth-quarter funds from operations estimate, and a 4.0% dividend yield, based on a $3.05 annualized payout. We expect same-store NOI growth to average 1.5% across our 10-year forecast. We believe that Realty Income will continue to acquire new assets to drive growth, though the volume will decline from $8.2 billion in 2022 to $1.2 billion by the terminal year. The company will also selectively dispose of assets to partially fund its external growth, though that amount will be limited to just $100 million-$200 million a year. We estimate Realty Income’s net asset value to be approximately $63 per share based on a 6.0% cap rate assumption. We use NAV as an assessment of potential private market value, essentially viewing the company as a portfolio of assets.

Read more about Realty Income’s fair value estimate.

Risk and Uncertainty

About half of Realty Income’s tenants are not investment-grade. More than half of its net operating income is still concentrated in its top 20 tenants, and 6 tenants represent more than 3% of NOI. Barriers to entry for competitors are very low, given the small size of the properties and their relatively low cost to build. Realty Income’s dependence on acquisitions to drive growth makes it subject to changes in the private markets and capital markets. Additional competition from well-capitalized investors could drive up purchase prices. Realty Income depends on regular debt and equity issuances to fund acquisitions. A drop in the stock price or a rise in interest rates will increase the cost to acquire, which narrows the spread between the company’s weighted average cost of capital and its acquisition cap rate, reducing the value it can create from external growth.

Read more about Realty Income’s risk and uncertainty.

Realty Income Bulls Say

• Realty Income provides a reliable, albeit slow-growing, monthly dividend built on an underlying portfolio that performs steadily through various market conditions.
• With reasonable leverage and ample liquidity, Realty Income should have the financial flexibility to take advantage of any attractive investment opportunities that become available.
• Realty Income’s operating history, defined underwriting criteria, and expanded portfolio transparency should give shareholders comfort while also maintaining management accountability.

Realty Income Bears Say

• It will take an increasingly greater number of attractive risk-adjusted acquisitions to create meaningful shareholder value growth, possibly pushing Realty Income to take more risk as competition intensifies for its traditionally targeted assets.
• The value of Realty Income’s long-term leases, which altogether exhibit minimal built-in rent growth, is particularly susceptible to rising interest rates and inflation.
• Rising interest rates reduce the spread between acquisition cap rates and financing costs, sapping management of its ability to create value through continued external growth.

This article was compiled by Susan Dziubinski and Sylvia Hauser.