Realty Income Isn't Cheap Enough

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At first glance, a company that pays a high-yielding dividend on a monthly basis would seem like an investor’s dream.  Add in the fact that this company has a 43-year track record of dividend payments and raises the dividend on a yearly basis, and one would be hard-pressed to come up with a reason to not buy the stock.  This company is Realty Income (NYSE: O), and even though all of the above is true, the stock appears fully valued with risk than meets the eye.

Realty Income prides itself on having a consistent business model that pays reliable dividends to shareholders.  In fact, the company calls itself “The Monthly Dividend Company.”  As a REIT, Realty Income pays no federal income tax provided it distributes at least 90 percent of its taxable income to its shareholders.  The company is currently yielding roughly 4.5 percent, and by paying dividends monthly rather than quarterly or annually, shareholders can more quickly build wealth. 

Business Profile

Realty Income generates profits through its ownership of more than 2,800 properties that it leases to commercial entities, mostly retail chain store operators.  The company utilizes long-term leases to generate income.  The tenants that generate the most amount of revenue for the company are chain restaurants, movie theaters, and health and fitness centers.  The leases are typically for fifteen to twenty years, which allows the company dependable lease payments which are used to fund future property purchases and distributions to shareholders.

Other REITs include Health Care REIT (NYSE: HCN) and HCP (NYSE: HCP).  The business model for these two companies is similar to Realty Income’s:  purchasing rental properties, leasing them to commercial tenants, and collecting payments to fund shareholder distributions and future property purchases.  Health Care REIT and HCP operate in health-care properties, with tenants comprised of nursing homes, medical lab facilities, and hospitals.

Stock Run-Up and Current Valuation

During the depths of the 2008-2009 financial crisis, Realty Income’s stock hit as low as $15 per share.  Since then, the stock has enjoyed a near uninterrupted rise to over $40.  The company’s market capitalization is now over $5.5 billion.  Health Care REIT and HCP have enjoyed similar run-ups.  All three are now touching all-time highs, and the market capitalizations for Health Care REIT and HCP are now $16 billion and $20 billion, respectively.  Investors’ hunger for yield in a low interest-rate environment has resulted in soaring valuations for these three companies.

When performing valuation on REITs, Funds From Operations (FFO) is a better metric to use than Earnings Per Share, because it provides a clearer picture of the operating cash flow of a real estate investment trust.  For fiscal year 2011, Realty Income earned $1.98 in FFO.  At a share price of $40, investors are paying over 20 times trailing FFO.  Furthermore, during the first nine months of 2012, FFO was $1.42, a decrease of 2.7 percent year-over-year on a diluted per share basis.  Over the same period, dividends paid to shareholders totaled $1.32, meaning the company has limited room for dividend growth.  Going forward, it would be prudent to expect little more than low to single-digit percentage growth in Realty Income’s dividend.

Wait for a Better Opportunity

A conservative investor should hesitate purchasing a low-growth stock for more than 20 times earnings, or in Realty Income’s case, funds from operations.  Realty Income’s dividend is well-supported and should grow modestly in the future.  Realty Income has a solid business model and is financially successful.  However, even a financially successful company can be a poor investment if the investor pays too high a price.  At over 20 times Price-to-Funds From Operations, investors would be wise to wait for a more opportune entry price before purchasing shares of Realty Income. 

Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Health Care REIT, Inc.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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