Sell Alert: Realty Income (O)

On Monday, October 30, Realty Income (O) hit our 30% hard stop.

Sticking to our risk-management policy, we’ll remove it from our portfolio at $46.33.

We initially recommended Realty Income as part of our Money in the Bank portfolio when we launched on January 17.

Today, I’ll give you a brief recap of why we liked Realty Income and share what’s happened since we added it to our alternatives portfolio.

Founded in 1972, Realty Income was one of the first REITs in the country. It went public decades later. But with 52 years of consecutive dividend raises, it has established itself as one of the world's most reliable sources of monthly income.

That’s why it adopted the nickname “the monthly dividend company.”

When we recommended Realty Income in our Money in the Bank special report, it was as an alternative to our official Fortress recommendations. Not everyone is comfortable with the risk profile of insurance companies, pipelines, or tobacco stocks… So world-class REITs like Realty Income are a great alternative.

At the time of our recommendation, Realty Income was 14% historically undervalued. Since then, its share price has gone down another 30%... But the fundamentals have not deteriorated.

Relatively long-term interest rates have soared faster than they have in 42 years. And the market has reflexively sold off all the “bond-proxy sectors” like REITs and utilities.

The market is remembering that interest rates were all that mattered for 13 years in a zero-rate world. But it’s dead wrong.

Firstly, the previous decade of negative, zero, and near-zero interest rates was not the norm. It was a historic fluke that is unlikely to repeat.

But more importantly, over the last 50 years, no long-term relationships have existed between REITs and interest rates.

In the 1970s, interest rates soared from 6% to 13% on average, peaking at 16% in 1981. Realty Income was thriving and growing through all this, including borrowing costs peaking at 20% in 1981.

REITs initially sold off 34%, just like they did in the last few months. And then they turned around and rocketed higher. Stocks spent a decade going nowhere… Meanwhile, REITs soared 700%.

And that was during a time when interest rates kept rising at a historic rate.

(Source: NAREIT)

For 12 years, REITs’ total returns soared as rates rose due to high inflation. Ultimately, they turned $1 into $12 while stocks were flat.

The truth is that when inflation is high, rents go up… and REITs make more money. They grow their dividends as a result. And that’s why real estate is such a great hedge against inflation.

REITs should be valued on cash flow and dividends, not interest rates.

But in the short term, the market can be irrational. And even a world-class, A-rated dividend aristocrat can go from cheap to cheaper than it’s been in 14 years.

So what happened with Realty Income that caused it to hit our stop?

On Monday, the company announced it was buying Spirit Realty Capital (SRC) in a $9 billion stock deal.

The deal will automatically boost cash flow per share by 2.5%, making Realty Income’s dividend a bit safer. It will also grow the property portfolio by 40%, increase diversification to industrial properties, and make Realty Income the fourth-largest REIT in the world.

That’ll allow it to buy more properties and find more growth opportunities.

Realty Income has become a global company, operating on two continents. Its core triple-net-lease business model is an $18 trillion market opportunity in the U.S. and Europe alone. And now, it’s scaling up to target the larger global market.

But the acquisition announcement resulted in a knee-jerk reaction in the stock’s share price.

Normally, Realty Income would borrow $9 billion to make such a deal, or issue stock when it’s expensive. Low cost of capital is why Realty Income has an edge over smaller rivals.

But this time, with interest rates high and its share price at three-year lows… the market freaked out that Realty Income was going to spend money that was expensive, not dirt cheap.

But Realty Income is so good at what it does that the deal it put together would benefit investors by 2.5% on a per-share basis immediately. And that’s likely being conservative.

And the last time Realty Income did such a deal, cash flow per share rose 10%. So you can see why Wall Street was a bit disappointed.

After the announcement, shares sank 6%, pushing it below our 30% hard stop from entry.

While the market is upset that the growth boost wasn’t bigger in the short term, Realty Income’s management is focused on steady growth for decades to come.

Realty Income still has the same dividend safety and similar growth potential as when we recommended it earlier this year. But to remain sane in a volatile market, we must stick with our stop-loss policy and remove it from our portfolio today.

We’ll keep an eye on Realty Income to see whether it’ll make sense to add back into our model portfolio at a later date.

Action to Take: We’re removing Realty Income (O) for a 30% loss.

If you bought Realty Income after our recommendation at a lower price, stick to your own 30% hard stop.

In the next few months, we’ll find a replacement for Realty Income after carefully examining our 500-company database of the world’s best dividend blue chips. And we’ll continue to find you the best opportunities in safe, ultra high-yield investing.

Safe investing,

Adam Galas Chief analyst, Fortress Portfolio