Realty Income: Narrower Investment Spreads But Still A Buy

seekingalpha03-28

The current spread between the cap rate of the Free Standing Retail subsector and the 10-year Treasury is only 233 basis points versus a historic average of 350 basis points.Despite this, Realty ...

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}\n.meta {color:#5e5c6d;font-size:13px;margin:0 0 .5em; }\na{text-decoration:none; color:#2a4b87;}\n.meta .head { display: inline-block; overflow: hidden}\n.head .h-thumb { width: 30px; height: 30px; margin: 0; padding: 0; border-radius: 50%; float: left;}\n.head .h-content { margin: 0; padding: 0 0 0 9px; float: left;}\n.head .h-name {font-size: 13px; color: #eee; margin: 0;}\n.head .h-time {font-size: 11px; color: #7E829C; margin: 0;line-height: 11px;}\n.small {font-size: 12.5px; display: inline-block; transform: scale(0.9); -webkit-transform: scale(0.9); transform-origin: left; -webkit-transform-origin: left;}\n.smaller {font-size: 12.5px; display: inline-block; transform: scale(0.8); -webkit-transform: scale(0.8); transform-origin: left; -webkit-transform-origin: left;}\n.bt-text {font-size: 12px;margin: 1.5em 0 0 0}\n.bt-text p {margin: 0}\n</style>\n</head>\n<body>\n<div class=\"wrapper\">\n<header>\n<h2 class=\"title\">\nRealty Income: Narrower Investment Spreads But Still A Buy\n</h2>\n\n<h4 class=\"meta\">\n\n\n2024-03-28 03:45 GMT+8&nbsp;&nbsp;&nbsp;<a href=https://seekingalpha.com/article/4680811-realty-income-narrower-investment-spreads-but-still-a-buy><strong>seekingalpha</strong></a>\n\n\n</h4>\n\n</header>\n<article>\n<div>\n<p>The current spread between the cap rate of the Free Standing Retail subsector and the 10-year Treasury is only 233 basis points versus a historic average of 350 basis points.Despite this, Realty ...</p>\n\n<a href=\"https://seekingalpha.com/article/4680811-realty-income-narrower-investment-spreads-but-still-a-buy\">Source Link</a>\n\n</div>\n\n\n</article>\n</div>\n</body>\n</html>\n","isBrief":false,"type":0,"news_type":1,"symbol":"BK4588","symbol_name":"碎股","start_time":0,"source_url":"https://seekingalpha.com/article/4680811-realty-income-narrower-investment-spreads-but-still-a-buy","article_id":"2422784928","we_media_id":null,"thumbnails":["https://static.seekingalpha.com/cdn/s3/uploads/getty_images/1266454819/image_1266454819.jpg"],"rights":null,"url":"https://stock-news.laohu8.com/highlight/detail?id=2422784928","pubTimestamp":1711568724,"sourceInfo":{"source_id":"seekingalpha","name":"Seeking Alpha"},"weMediaInfo":null,"summary":"The current spread between the cap rate of the Free Standing Retail subsector and the 10-year Treasury is only 233 basis points versus a historic average of 350 basis points.Despite this, Realty Incom","collect":0,"end_time":0,"defaultTopTitle":"seekingalpha.com","property":[],"viewcount":null,"language":"en","relate_stocks":{"BK4588":"碎股","NNN":"NNN REIT INC","CFA.SI":"NikkoAM-STC Asia REIT","BK4080":"零售业房地产投资信托","O":"Realty Income Corp","BK4231":"零售房地产信托","BK4585":"ETF&股票定投概念"},"translate_title":"房地产收入：投资利差收窄，但仍值得买入","themeId":null,"isJumpTheme":false,"ttsUrl":null,"symbols_score_info":{"NNN":1,"O":1,"CFA.SI":0.9,"US10Y.BOND":0.9,"US12M.BOND":0.9,"US2Y.BOND":0.9,"US30Y.BOND":0.9,"US3Y.BOND":0.9,"US5Y.BOND":0.9,"US6M.BOND":0.9,"US7Y.BOND":0.9,"US912797GK78.BOND":0.6,"US912797HH31.BOND":0.6,"US912797GL51.BOND":0.6,"US912797GW17.BOND":0.6,"US912797HE00.BOND":0.6,"US912797HG57.BOND":0.6,"US912797GB79.BOND":0.6,"US912797FS14.BOND":0.6,"US912797FH58.BOND":0.6,"US912796CX52.BOND":0.6},"content_text":"The current spread between the cap rate of the Free Standing Retail subsector and the 10-year Treasury is only 233 basis points versus a historic average of 350 basis points.Despite this, Realty Income is able to achieve an investment spread of  86 basis points, within reach of their 100 to 200 basis points long-term average.The 86 basis points of value created is available to equity investors at a discount to an unbiased measure of fair value.   DenisTangneyJr Introduction In June 16, 2023, we published a comparative article between Realty Income (NYSE:O) and NNN REIT (NNN) and concluded that Realty Income offered a better value at that time. Today, Realty Income is down about 14% since the last article and we take the opportunity to evaluate the economic underpinnings of Realty Income’s business model and gauge their ability to create value incorporating the current macroeconomic conditions. In this article, we quantify the amount of value their business is able to generate at present and opine on how this compares to historic levels. We review Realty Income’s capitalization rate, or cap rate, and compare this with their cost of capital. We then move to measure how much of the value created accrues to equity investors of Realty Income stock and compare that with an unbiased estimate of fair value for the shares. Throughout the article, we connect salient aspects of Realty Income’s business model with the quantitative metrics employed. At the end, a conclusion is presented and an investment recommendation offered. Three Ways Interest Rates Affect REITs Please take a look at Exhibit 1 which presents the spread between the implied cap rate of the Free Standing Retail subsector and the US 10-year Treasury from January 2001 to December 2023.   Exhibit 1: Spread between Free Standing Cap Rates and 10-year Treasury (Nareit and St. Louis Fed) Source: Nareit T-tracker for Q4, 2023. St. Louis Fed. Reitwatch. The figures for the US Treasury are lagged four quarters. We found a higher predictive power with the lag and interpret it to mean that it takes about a year for change in interest rates to have an impact on the implied cap rates. Another consideration is that Realty Income has an outsized impact on the subsector that has only gotten more pronounced. In January, 2001, Realty Income was 23.38% of the subsector in terms of equity market capitalization and in January of this year, after the Spirit acquisition, it was 67.71% of the subsector. The average spread between the US 10-year Treasury and the implied cap rate during the period was 350 basis points. For Q4, 2023, that spread was only 233 basis points. Having a narrower-than-usual spread is a headwind for REITs. Investors could potentially shift their allocation from REITs into safer and relatively high-yielding fixed-income investments which would have the effect of depressing the stock price of REITs. For example, for the time period from January 2001 up until December 2023, the dividend yield of the FTSE Nareit Equity Free Standing Index was, on average, 60 basis points above the effective yield of the ICE BofA BBB US Corporate Index. In February of this year, the yield differential was only 16 basis points. In terms of acquisition, if it costs more to fund acquisitions, then sellers might decide to sit on the sidelines until more favorable times when buyers are plentiful. This would curtail the deal flow for REITs and will constrain an important means of growth. This is what Sumit Roy, the CEO of Realty Income, had to offer in the recent earnings call about the issue:  “Thank you for that question... It's a lot of what you just said. If you look at the market today and you look at the cap rate environment, the adjustments that we have seen has not been commensurate with the movement in the cost of capital.” “… the reason I believe that cap rates haven't moved is because of the volatility in the market. If there was certainty that, hey, this cost of capital environment is going to remain at these elevated levels for the next three years, guess what? Cap rates will adjust, will move, and there will be more willingness on the part of the seller to transact today.” “In that sort of environment, you have sellers that are saying, we expect the Fed to start cutting interest rate later in the year. I think it can hold off another six to seven months. So why transact in this environment today?”  The third reason that interest rates unfavorably impact REITs doesn’t apply to Realty Income, at least not recently. In fact, they were a beneficiary of this third dynamic. Let us explore this further. REITs are required to distribute an amount equal to at least 90% of taxable income each year, therefore, they are reliant on external forms of capital. In an elevated interest rate environment, REITs are potentially exposed to refinancing loans that are coming due at a higher interest rate which would crimp profitability. Higher interest expense means lower profit. Realty Income is not immune from having to refinance loans coming due at a higher interest rate, but the dynamic affects them differently because they enjoy an A3 credit rating that exceed most other REITs. When Spirit Realty’s board of directions were contemplating on whether to entertain Realty Income’s acquisition offer late last year, one of the key reasons the board eventually accepted the offer in my view was because a significant portion of Spirit’s existing debt matures in a few years and it would be challenging to access new debt at attractive rates. Even with their investment grade, BBB credit profile, it would have been challenging to generate value in the current environment because cap rates have not yet sufficiently adjusted to the elevated interest rate environment. By accepting Realty Income’s offer, Spirit’s debt would be refinanced at the rates available to Realty Income after the acquisition. Now that we have a general idea of macroeconomic setting that Realty Income operates in, let us quantify the value that Realty Income can generate in the current environment. Spread investor Realty Income actively manages a diversified portfolio of commercial properties under a long-term, net lease agreement. A net lease typically requires the tenant to be responsible for rent and property related operating expenses including taxes, maintenance and insurance. Essentially, Realty Income is a spread investor. They obtain capital from creditors and investors and put that capital to use by acquiring real estate assets and leasing them out. Realty Income earns an economic profit that is the difference between the rent earned and the cost to acquire the real estate for which the rent is generated. For us to evaluate the health of Realty Income’ business, we need some measure of this economic profit or spread. The wider, the better. For a REIT, this spread can be estimated as the difference between the cap rate and the cost of capital. The cap rate is the net operating income divided by the asset value and the cost of capital is the cost of debt financing and the cost of equity financing in proportion to how much of each is used by the business. Let us evaluate each of these. Cap Rate Please take a look at Exhibit 2 which presents Realty Income's recent transaction activity.   Realty Income Cap Rate for Q4 (Realty Income Q4 2023 Supplemental Information) Source: Realty Income Q4 2023 Supplemental Operating and Financial Data. In Q4, 2023, Realty Income achieved an initial weighted average cash yield of 7.6%, which we will use as our estimate of their cap rate. For Realty Income to pursue accretive transactions, their cost of capital must be less than 7.6%. Cost of Capital: Debt Realty Income enjoys an A- credit rating from S&P and an A3 rating with Moody’s. Both have stable outlooks. Realty Income has a fixed income instrument that matures in October 2032 that exchanged hands recently at a yield of 5.36%. This is reflective of the cost of debt financing Realty Income would face should it tap debt markets. A firm’s credit rating is focused on its credit risk. And credit risk has to do with assessing the obligor’s capacity to make promised principal and interest payments in accordance with the bond indenture.   Table 1: Issuer Rating and Cost of Debt  Description Rating/Yield Outlook/Maturity   Standard & Poor's A- Stable   Moody's A3 Stable   5.625% Note 5.36% October, 2032   Click to enlarge Cost of Capital: Equity There are different methods and philosophies around calculating the cost of equity. We use the Capital Asset Pricing Model (CAPM) in which we essentially add a spread to the risk-free rate and scale the spread by the beta statistic of the particular stock. Let us review this in some detail. Please take a look at Table 2.      Table 2: Cost of Equity  β 0.92   Risk-free rate 4.23%   Equity risk premium 3.50%   Cost of equity 7.45%   Click to enlarge Source: www.cnbc.com The beta statistic is a measure of systematic risk. It is measured by regressing the returns of the stock against the market. The stock's beta is a measure of risk that is of a different dimension than of the credit risk measured as part of the estimate of the cost of debt. The emphasis with beta is how the levels of debt and the variability of the revenue stream impacts the stock price in relation to the market as a whole. The market as a whole has a beta statistic of 1.0. Given their revenue stream that is contractual in nature and their conservative financing profile, Realty Income has a below market beta statistic of 0.92. For the risk-free rate, I use the US 10-year Treasury which is a commonly used proxy for the risk-free rate. The equity risk premium is simply the 350-basis point spread observed between the implied cap rate of the Free Standing Retail subsector and 10-year Treasury as mentioned at the top of the article. It is a measure of the premium required by investors over the 10-year Treasury given the risk profile of the asset class. Now that we have the cost of debt and the cost of equity financing, we now weigh each source of capital in proportion to how much of each is used in the business. Please look at Table 3 for Realty Income’s capital structure.       Table 3: Capital Structure  Form of Capital Value($ 000) Weight   Equity market capitalization $ 43,309,322 66.17%   Total debt $ 22,140,059 33.83%   Total $ 65,449,381 100%   Click to enlarge Source: Realty Income Q4 2023 Earnings and Financial Supplement. We now have the inputs we need to estimate Realty Income's weighted average cost of capital. Please see Table 4.      Table 4: Weighted Average Cost of Capital ('WACC')  Weight of debt 33.83%   Weight of equity 66.17%   Cost of debt 5.36%   Cost of equity 7.45%   WACC 6.74%   Click to enlarge The tax shield normally included in the calculation of the WACC is ignored because REITs do not pay taxes at the corporate level. In Table 5, we calculate the difference between Realty Income’s cap rate and the weighted average cost of capital. This spread is a measure of how much economic profit Realty Income is able to generate given their operating environment and their cost of capital. Realty Income is able to generate an economic profit of 0.86 basis points.      Table 5: Cap Rate Minus WACC  Cap Rate 7.60%   WACC 6.74%   Difference 0.86%   Click to enlarge Realty Income estimates their long-term WACC using different assumptions and their estimate of their long-term WACC is 7.1% which would mean 0.50 basis points of value created using recent transactions as an indicator of the cap rates they would achieve. Realty Income also estimates “realized WACC” and “Nominal 1st Year WACC” which is not germane to our analysis. Source: Realty Income Investor Presentation for February 2024. The 86 basis points of value created is below Realty Income’s target of 150 basis points. Here is Mr. Roy’s view on the matter: Realty Income’s average, from the time we've been tracking spreads, we have always said that the average spread has been 150 basis points...We also use a barbell strategy where there might be transactions that are precisely the right investment for us. And if it only creates 100 basis points, we believe that on a risk-adjusted return basis, that is the right profile for that investment, we are comfortable doing that particular investment…But then we will always try to balance it with transactions that have a 200-basis point profile.” The key takeaway is that Realty Income’s business currently creates value in the marketplace but their value creation ability is below its historic norm. This is not necessarily a bad thing. A glass half full version would be that Realty Income is able to generate an economic profit despite major macro headwinds and are taking advantage of market opportunities in light of the environment (i.e. Spirit acquisition). As long as they are generating economic profit and there is some plausible reason to believe that the spread will revert to historic norms, the investment could be worthwhile. There are at least two ways that the spread will revert to the historic average. Either cap rates could increase or the cost of capital decreases. We have already discussed how cap rates are not increasing commensurate with the cost of capital. Therefore, the most plausible scenario is that the spread will revert to historic norms if Realty Income’s cost of capital decreases. And in both the cost of debt and cost of equity calculations, a lower level of interest rates will have a meaningful impact. The CME groups FedWatch Tool has a 61.0% probability of a 25-basis point cut in the Federal target rate in the June 12 FOMC meeting. So far, we have said that Realty Income’s business currently creates value in the current environment but that value is below its historic average. We have also said that it is likely that a lower interest rate environment will lead to Realty Income’s investment spread widening. We could wait until a lower interest rate regime takes hold and begins to impact Realty Income’s business positively, but then, the share price might not be where it is today. A perhaps more relevant question to ask is how much of that 86 basis points of value accrue to equity investors? If I am going to buy into a business that may do better in the near future, then am I getting some discount for this additional risk that I am undertaking today? To answer this question, we revisit the cost of equity calculation we performed when we estimated the cost of capital. We estimated the cost of equity using CAPM which is a statistical method of ascertaining the cost of equity. There are other methods to calculate the cost of equity. Also, cost of equity is the terminology used from the company's perspective. It is the cost for them to obtain equity capital. From an investor's point of view, the cost of equity is the required rate of return. And for many investors, particularly REIT investors, the required rate of return has two components: the current dividend yield and the growth rate of the dividends. Please take a look at Table 6 which presents Realty Income’s total return as a combination of the current dividend yield and the growth rate of the dividends.   Table 6: Total Return  Dividend yield 5.91%   Five-year dividend growth rate 3.63%   Total return 9.54%   Click to enlarge Source: Seeking Alpha. In Table 7, we compare the total return with the cost of equity calculated using CAPM. The cost of equity in this case can be thought of as the opportunity cost for investing in the stock akin to a \"hurdle rate\".   Table 7: Total Return Minus Cost of Equity  Total return 9.54%   Cost of equity 7.45%   Difference 2.09%   Click to enlarge The spread of 209 basis points is narrower than the 233 basis points in my previous article but still wide enough to suggest that there is currently enough of a margin of safety for investors in Realty Income’s stock. Conclusion  It is not surprising that Realty Income’s investment spread is narrower than it has been historically. Realty Income’s cost of financing has increased roughly since the Federal Reserve began their recent tightening cycle. Moreover, cap rates have not moved commensurate with the increase in cost of capital as we would have expected. These items are largely beyond management’s control and has more to do with market expectations on the general direction of interest rates which is not an exact science. What is within management’s control is to make the most of the current environment. And in the current environment, Realty Income has maintained a positive investment spread, they have made a strategic acquisition with the Spirit deal and they continue to reward shareholders with a generous dividend that is growing in line with what we’ve come to expect. Investors today are getting a solid value even without consideration to the possible price appreciation should the macro picture unfold as forecasted. Realty Income is a worthwhile addition to a prudent investor’s portfolio.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2422784928"}