Real estate income: the market fears a catastrophe that will not happen

Arpana Singh

(Note: This article originally appeared in the October 7, 2022 newsletter.)

Real estate income (NYSE: O) navigated through the challenges of the coronavirus. But sometimes there’s just no fun in Mr. Market. This “throw them all out” reflex is in full swing at the FPI sector. This makes it a great time to reap excellent dividend income from industry leaders that rarely go up for sale.

There has long been an expression that the stock market can be best represented as a store where no one is interested in the commodity until it is marked up by 50% to 200%. Individual investors can take full advantage of this market attitude.

Often, institutional investors are unable to take advantage of falling stock prices of market leaders like Realty Income because they have benchmarks to meet. These goals are often too short term for them to buy bargains and then wait for those bargains to appreciate. Underperformance on Wall Street is often quickly dealt with. Despite this prompt treatment, the over-focus on short-term performance often allows long-term underperformance to persist. Individual investors are often free from the professional constraints that cause underperformance to persist.

Thus, the current attitude that certain types of retail businesses (if not all retail businesses) puts a group of REIT stocks on the “never own stock list” for now. But the good news for individual investors is that well-managed companies with strong balance sheets will come back into favor at some point.

Good performance

Realty Income has a yield that is heading into the “danger zone” where the market has serious concerns about the sustainability of that yield. This is true even if this company has maintained and increased this dividend for a very long time.

Real Estate Revenue Growth Summary

Real Estate Revenue Growth Summary (Q2 2022 Real Estate Revenue, Earnings Conference Call Slides)

The company obviously has a strategy that has proven to be relatively recession-proof in the past. There is absolutely no reason to believe that has changed. Yet you wouldn’t know that from the market’s reaction to the stock price. Right now, the consistency shown above is relatively less valuable compared to worrying about the winning streak coming to an end.

This rate of dividend growth will be accompanied by some appreciation in share prices. Sooner or later (usually sooner), quality will matter. This company is in the process of benefiting from a return to quality that is about to occur. In addition to the upside potential, the combined (long-term) ongoing return approaches 10% for a company with a very high debt rating and earnings consistency rarely matched across the stock market. The performance here is on par with much safer investments like utilities than with other REITs.

Avoid losses

This steady progress noted above comes from avoiding losses. I believe that management identifies business risks and then minimizes them. This is in addition to the reduced financial risk associated with the company’s very high debt financial strength ratings. There is an old saying that losses count twice as much as profits. This management makes losses matter a lot more, in my opinion.

Real estate income loss avoidance strategy

Real Estate Revenue Loss Avoidance Strategy (Q2 2022 Real Estate Revenue, Earnings Conference Call Slides)

This management has a detailed list of what to avoid. This indicates in an important way what to earn money on. Non-discretionary is the key to avoiding the effects of any cyclical slowdown in activity. Another key element is low price points. If the business is a “must have” like food, and it’s also cheap, that retailer will outperform.

But the other thing is that this company is in the business of leasing. There is a world of difference between customers who have a bad year and customers who go bankrupt and liquidate. The company is clearly focused on avoiding “not being able to pay” type situations.

As a business entity, this company wants customers who survive bad times. Second, a slowdown doesn’t matter to the company’s outlook, as the record shows. But Mr. Market often confuses a downturn with a fatal event. That clearly seems to be the case here despite a long track record that points to a much better performance in successfully avoiding customers with financial problems.

Quality matters

Since I’ve been investing, the market has gone through cycles where nothing in an industry is considered an asset for institutional investors. If it’s out of fashion, they don’t want that company in the portfolio under any circumstances.

Sooner or later, rational behavior returns as quality returns to grace. That should be especially true here given the company’s history of dividends and performance in fiscal years 2020 and 2021. Those were by far the toughest years for much of the market in a very long time. If management can perform well during this period, it should ride out any threat of a recession that may not come.

Real Estate Income Client Financial Strength Profile

Financial Strength Profile of Realty Income Clients (Realty Income Q2 2022, Earnings Conference Call Slides)

The qualitative advantage is evident in the average financial strength. These are companies that will pay the bills during a recession. Any serious downturn that “hits hard” would likely lead to a lower credit score long before there were serious problems.

The well-diversified customer base shown above helps keep credit surprises to a minimum. When this is combined with things like non-discretionary spending (if possible) and low prices, it’s easy to see how this company has increased its dividends throughout recessions. The fact that occupancy levels remain high throughout the business cycle is a given.

The future

Right now, the market is “throwing the baby out with the bathwater”. Institutional groupthink is a phenomenon documented by those wishing to combine economics and psychology for as long as I can remember. This combination has also been strongly opposed by economists since I also studied economics for my master’s degree. The best that can be done is to take advantage of the market psychological event by doing your due diligence and deciding whether or not you want the market panic to subside first or if you are ready to lower the average (or just the average over time).

Real Estate Income Common Share Price History and Key Valuation Metrics

Real estate income Common shares Price history and key valuation metrics (Seeking Alpha website, October 7, 2022)

That five percent dividend shown above is more than half the average annual return that most investors earn over the long term. The chart above indicates considerable recovery potential to return to the old high prices reached previously.

Assess

This is where the value argument comes in. As shown above, the P/FFO is 14.55. It has rarely been so low in the company’s history. This company has a consistency in financial results and dividend increases that have traditionally resulted in a considerable premium for the industry. This premium should resume with a P/FFO ratio in the 17-20 range. This implies minimal potential for a stock price rally of at least 25% on top of earnings growth and dividend increases. This recovery will likely be much more than that.

Similarly, the dividend yield is generally around 3%. It’s now gone to 5% on all sorts of market worries. With share price appreciation, the dividend yield should return to a normal range.

I always get asked at times like these “why should the stock rally?”. The reason is that this management continually finds ways to grow the business. This business continues to grow despite contractions in key metrics such as the P/FFO metric to historically favorable levels. It’s a business that does well in good times and bad. This means that the stock is likely to reach the $76 shown above and likely higher until the company stops growing. A return to normal valuations is very likely when a cyclical recovery begins. This company is in a position to be valued at a premium over the next economic cycle.

Risks

A business like this took a lot of risk. Very few companies in any industry consistently publish results similar to what is seen here.

Nevertheless, if this consistency were to be materially lacking, I would probably reanalyze my conclusion. This would most likely be caused by a failure to minimize all the risks presented in a previous slide earlier.

Similarly, a significant reduction in financial strength ratings or a significant change in dividend coverage would be another time I might change my belief.

To finish

Very few companies have the financial strength rating of this company in really any industry. Finances are extremely safe for risk averse investors. The ever-increasing dividend also removes a lot of downside risk from investing.

One of the things about a quality company like this is that when the institutions panic to get out, the only thing that happens is they come back at a higher price to drive the stock price higher. stock. This has been documented by David Dreman in several of his books from studies that spanned decades.

Interestingly, when they come back, they often come back at a higher price and push the stock price even higher.

As a contrarian, you want to be before these institutions invariably come back, and you probably want to get out if too many of them come in because you now see what happens in the action when they all want out.

Ironically, the long-term investment risk is likely lower than usual for this safe stock at a time when Mr. Market is in full panic mode. A further long-term decline from the current price is much less likely (and less meaningful) than a future cyclical recovery. Instead, unusually large salvage results are available in addition to a generous dividend. This kind of combination rarely occurs. It is rare that additional risk, at least temporarily, does not provide sufficiently superior risk-adjusted returns (on average). Right now it is. Again, this is often the case during market downturns.

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