Key Points
The real estate sector is slowing, with evidence of it everywhere; while some people may be worried, smart investors will see this as an opportunity to buy at a discount.
Realty Income has great potential based on its current valuations and recent financial results, creating a value gap that new buyers can take advantage of.
Analysts and markets agree, and the management of Realty Income is making the right moves to make this rally a reality.
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The real estate market in the United States is experiencing a downturn, as both builders and potential buyers are unhappy with the current mortgage rates. Shares of Realty Income NYSE: O have fallen by 14.7% in the past two months… Why?
As the FED tries to control high inflation rates seen in the economy between 2020 and 2022, higher financing costs act as a deterrent to bring down inflation and demand. This strategy has been somewhat successful, as building permits across the country have been declining for a few quarters now.
A decrease in permits means less activity in the real estate market; on one side, banks and developers are not optimistic about the future, and on the other side, consumers are not showing much interest in buying homes at the moment. As a result, the property sector is experiencing a bear market.
Discounts Upon Discounts
The Vanguard Real Estate ETF NYSEARCA: VNQ has reached the Wall Street definition of a bear market, with a 20% decline from recent or all-time high prices. Considering that Realty Income has fallen by 35% from its all-time high price of $84.9 per share, calling it a bear market is an understatement.
The valuations of REITs (real estate investment trusts) are determined by two factors. First, the net operating income (NOI) of their properties acts as earnings per share, so a traditional price-to-earnings ratio can be used. Second, the overall value of the properties held in the portfolio affects the stock price.
With this knowledge, investors can understand why Realty Income’s stock has been declining. As the entire industry slows down, so do the properties owned by Realty Income, which affects one side of the equation.
How can we be sure? The company’s second-quarter 2023 results show a 13% increase in FFO (funds from operations) on an annual basis, so the property income is not the reason for the stock decline; it’s the current valuations. So why did management acquire $2.7 billion worth of real estate in the quarter and raise their acquisition guidance to $7 billion?
Properties are currently cheap, and Realty Income’s management is taking advantage of the situation to build shareholder value.
Value Gap
Now, let’s address the question of whether Realty Income is a good buy. We need to evaluate the “cheap” aspect of these deals because when property values eventually return to normal and even reach new highs during the next bull market, it will drive significant appreciation in the stock.
Knowing that shareholders will have to wait until the next bull market to see most of their returns, Realty Income is sweetening the deal by offering an annualized dividend yield of 5.5%, which also acts as a hedge against inflation.
Speaking of appreciation, the current consensus price target set by analysts is $68.2 per share. Reaching this target requires a 23.6% increase from today’s prices, which, combined with the dividend, makes it an attractive deal.
When it comes to market sentiment and the value placed on the future of Realty Income, everything aligns for investors who decide to buy the stock.
Upside Catalyst
Looking at the forward price-to-earnings ratio, which reflects the market’s outlook for a stock’s future earnings, can give investors an idea of where the broader market sees the future potential of a company.
In the large-cap retail REITs space, where Realty Income competes with companies like Simon Property Group NYSE: SPG and Regency Centers NASDAQ: REG, Realty Income has a significantly higher forward price-to-earnings ratio of 40.0x compared to Simon’s 18.2x and Regency’s 31.3x. This indicates that investors are willing to pay a premium for Realty Income’s stock because they see higher certainty in future earnings and higher quality/growth potential.
Furthermore, Realty Income’s stock chart suggests an attractive entry level with a 61.8% Fibonacci retracement at $52.5, only 4.8% below today’s prices.
Whether buyers choose to wait for these levels or not, they can still enjoy a 5.5% dividend, along with the potential for the stock to rise based on positive factors mentioned above
