Introduction

I am happy to share that my ‘Strong buy’ thesis for Realty Income’s (NYSE:O) stock as of June 2024 is doing well. The REIT delivered an 18% return to investors since my last thesis, looking really good against +3.3% from the S&P 500. My fundamental analysis update suggests that Realty Income continues to keep investors happy with its consistent dividend payouts, and I believe that the REIT is poised to thrive further. The valuation is still very attractive, and I see no reason to change my ‘Strong buy’ recommendation to anything else.

Fundamental Analysis

I want to start with underlining positive developments around the two mitigating factors I have mentioned in my previous analysis of O stock. High interest rates apparently added nervousness to REIT investors as high finance costs limit the ability of real estate companies to invest in growth as reliance on debt financing is inherently high.

The Fed became much less hawkish after the U.S. headline CPI metric dipped below 3% while the unemployment rate climbed above 4%. As a result, the Fed is expected to introduce at least three rate cuts this year, which is very positive for all REITs.

Another mitigating factor that I have mentioned in my previous bullish report about Realty Income’s stock was the soaring demand for growth stocks like Nvidia (NVDA) and other AI-exposed players. The FOMO effect around AI appears to be cooling, which I see from the market’s weak reaction on Nvidia’s stellar latest quarterly earnings, which were released last week. Weakening sentiment around AI winners coupled with O gaining momentum might be a strong positive near-term tailwind for the stock price.

Now, let me return to the core idea of my initial bullish outlook, which is O’s attractiveness as a dividend machine. The stock still offers a +5% forward dividend yield, which I find compelling as the U.S. inflation moderates. The company’s latest dividend declaration was on August 15, which was in line with the previous one. Consensus dividend estimates project around 3% dividend growth per year in the next few years, which is also quite positive.

These growth projections appear to be sound and even conservative, if we look at Realty Income’s recent financial performance and management’s prudent approach in capital allocation and selecting new projects. Realty Income’s latest earnings release was robust compared to consensus estimates. Key operating metrics like same-store rental revenue and portfolio occupancy also demonstrated strength in Q2 2024, which is a solid basis for Realty Income to maintain its FFO expansion.

In its latest presentation for investors, the company’s management reiterated its prudent approach to making investment decisions. The company will continue targeting a conservative 8% yield from new projects, which is higher than the estimated WACC (outlined in the screenshot below). The spread between the targeted yield from new projects and the company’s WACC will ensure dividend safety for investors.

Therefore, the dividend is highly likely safe and O will be able to drive an above-inflation payout CAGR over the long term. The stock is gaining momentum, which is likely to accelerate given weakening sentiment around AI winners like Nvidia.

Valuation Analysis

Realty Income’s cost of equity is 7.17%, which is the discount rate for my DDM (dividend discount model) formula. This one is softer than the previous 8% assumption because the Fed is expected to deliver three quarter-point rate cuts by the end of 2024. Current dividend is $3.23, an estimate of Wall Street analysts for FY 2025, which was upgraded from $3.12 compared to my June analysis. The growth rate remains the same as in my previous DDM, conservative at 3%.

According to the refreshed DDM, the fair value of the stock is $77.50, higher than the previous $62.40 estimate. Reasons for the upgrade are expected to improve monetary conditions (lower discount rate) and the upgrade to the current year’s dividend from $3.12 to $3.23 from consensus. Since all assumption changes appear to be sound, I believe that my target price upgrade is fair. The current share price is around 25% lower than the fair value.

Looking at a REIT’s Price to FFO ratios also helps in understanding valuation fairness. The forward P/AFFO ratio is 11.5% lower than O’s prior five-year average, which aligns with the outcome figured out using the DDM approach. I find the valuation attractive based on two approaches: the DDM and ratios analysis.

Mitigating Factors

I might be overestimating the extent of sentiment cooling around AI winners like Nvidia. NVDA’s after-earnings pullback might be just a temporary pullback, meaning we would be minus one positive catalyst for Realty Income’s stock. Secular trends in AI remain robust, which might help in accelerating the FOMO effect again. The new FOMO wave in AI winners might shift investors’ interest from dividend stocks once again, which is certainly a mitigating factor for my bullish outlook.

The recent rally in O’s price is also explained by positive developments around the Fed. It is highly likely that the market is pricing in three rate cuts this year, that I mentioned above. Therefore, if the Fed does not move in line with the market’s expectations, there might be a selloff in REITs. In this case, O’s investors will also highly likely experience a pullback.

According to the latest presentation for investors, O’s management has ambitious plans to expand its international footprint. The company’s success history in the U.S. increases the chances of increasing value for shareholders through international expansion. However, it is also important to acknowledge that expanding the overseas footprint means increased legal and foreign exchange risks for the company.

Conclusion

Realty Income’s attractive dividend yield is highly likely safe, and the stock is attractively valued. My confidence in dividend safety is based on the improving FFO profile and management’s prudent approach to investing in new projects. The likely pivot in the Fed’s monetary policy will also be a solid tailwind, both for the business and the stock price. Potential rotation to value stocks due to the cooling sentiment around AI winners coupled with O gaining momentum might also support further share price growth.