Real Estate Income Stock: Determining a Fair Market Value (NYSE:O)

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In this article, we will assess the valuation of real estate income (O) and discount future cash flows to determine a fair market value after the merger with VEREIT.

The weighted average cost of capital (WACC) is the primary metric for business valuation and the primary driver for generating more business. The WACC defines the hurdle rate for the acquisition of properties. The capitalization rate for new properties must be higher than the WACC. Cap rate and WACC are correlated, but the best RETIs manage to capture the biggest gap between the two.

The first element of the WACC calculation is the cost of debt. Recent inflation rates have dramatically raised expectations for upcoming Fed and ECB rate hikes. The market is fully discounting higher rates for this year and beyond.

O has done an outstanding job of maintaining a healthy spread through interest rate cycles so far.

Real Estate Income Assessment Considerations

Investor Presentation Feb 2022

The cost of equity is the second component of the WACC calculation. Recent geopolitics have significantly increased market volatility, as indicated by the VIX.

VIX chart
Data by YCharts

O has also done an outstanding job of keeping the volatility of its stocks low throughout economic cycles. This is very important for the company because most funds for acquisitions are generated by issuing new shares.

Realty Income stable earnings and low dividend volatility

Investor Presentation Feb 2022

Funding sources are strongly correlated to the share price and the market environment. Despite O’s excellent track record of managing these funding sources, no company is immune to risk and market disruptions. We’ll take a look at how this would affect O’s share price.

DCF analysis

Three main scenarios are modeled to capture different WACC and growth assumptions.

Label Negative+ Negative Based
Revenue increase 7% 8% ten%
WACC 7.0% 6.5% 5.7%
TGR 1.0% 1.5% 1.5%

Base scenario (most likely) – The revenue growth assumption is based on historical (conservative) growth extrapolated into the future. The WACC is given by the Investor Brief as the long-term sustainable assumption. The perpetuity growth rate beyond our detailed forecast is set at +2%.

Key assumptions on property income

Investor Presentation Feb 2022

Negative scenarios – Growth slows after the merger in the first negative scenario and WACC increases to account for additional equity price volatility and interest rate increases. The most negative scenario assumes that the company’s growth slows significantly, further increasing the WACC.

Financial projection

The strategic merger with VEREIT has boosted revenue in 2021 and the company is expected to increase revenue from this high level. Share dilution will be factored into the per share calculations.

Real estate income trend

SEC 10-K Annual Report

Total expenses increase in proportion to income. High costs in 2021 are attributed to one-time merger costs.

Total expenditure of property income

SEC 10-K Annual Report

The revenue and cost projections translate into the following evolution of the net result. Two years stand out, 2020 and 2021. At first glance, this seems to break the long-term trend, but this was pulled by one-off elements. Provision for impairment in 2020 (150 million) and debt extinguishment loss in 2021 (100 million). The historical trend remained unchanged excluding these elements.

Real estate income net income

SEC 10-K Annual Report

The development of FFO was impacted by merger and integration costs of €167 million. On a normalized basis, FFO available to common shareholders was 1,407 million in 2021. FFO for 2022 and beyond is higher due to the larger real estate portfolio and limited associated acquisition costs.

FFO trend in property income

SEC 10-K Annual Report

The same goes for the development of the AFFO since taking into account the one-time merger costs would bring the 2021 AFFO to 1,500 million.

AFFO trend in property income

SEC 10-K Annual Report

To fund the merger, O issued +20% additional shares, which impacted 2021 earnings per share (Excluding merger cost adjustments). Despite stock dilution, O is expected to maintain its AFFO growth per share in the base case. However, if revenue growth slows, the company will not be able to offset the impact of this stock dilution despite higher earnings. This is a wake-up call for investors.

AFFO real estate income per share

SEC 10-K Annual Report

Good time to invest?

By discounting the company’s future cash flows with the three model assumptions, we get the following stock price per scenario.

Label Negative+ Negative Based
DCF valuation $39 $58 $88

The stock is currently trading at $67.4 and our base case indicates a potential upside for the stock price of +31%. We see limited risk of more negative scenarios at this stage. We have also been cautious in our growth outlook in the base scenario.

Our recommendation is to buy O incrementally to capitalize on post-merger performance uncertainty and closely monitor WACC and growth rates in subsequent quarters on a per share basis.

The company must prove to investors over the next few quarters that the historic growth rate is sustainable (post-merger) to be valued at $88 per share by the market.

Recommendation: Buy at $67.4 and watch the WACC and growth rates per share in subsequent quarters. We will keep our readers informed.

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