The real estate market in the United States is undergoing a tantrum, as neither builders nor would-be buyers are happy with how mortgage rates are behaving today. Shares of Realty Income (NYSE: O) have declined by 14.7% during the past two months... Why?
As the FED seeks to combat the wild inflation rates the economy experienced during 2020-2022, these higher financing costs act as a wall to bring inflation and demand down. The strategy is working so far since building permits nationwide have been on a steady decline for a couple of quarters now.
Permits going down means no traffic on this two-way street; on one side, banks and developers express their flattish outlook for the future; on the other, consumers do not express their desire to purchase homes right now. The result? A bear market in the property sector.
Discounts Upon Discounts
The Vanguard Real Estate ETF (NYSEARCA: VNQ) has entered the Wall Street definition of a bear market, a 20% decline from recent or all-time high prices. Considering that today, Realty Income has fallen back by 35% from its all-time high price of $84.9 a share, a bear market is an understatement.
REITs (real estate investment trusts) derive their valuations from two things. First, the composite properties' net operating income (NOI) acts as earnings per share, so a traditional P/E will do here. Secondly, the underlying value of the properties held in the portfolio, as a group, drives the value of the stock.
Equipped with this knowledge, investors can guess why Realty Income's stock has been declining this much lately. As the whole industry takes a break, so do the properties this trust holds, which clears one side of the equation.
How can you be sure? The company's second-quarter 2023 results will showcase a net annual advance of 13% in FFO (funds from operations), so the property income is not the one driving the stock down; it's the current valuations.
Again, how can a diligent investor be sure about this? There must be a reason why management acquired up to $2.7 billion worth of real estate during the quarter and raised their acquisition guidance to $7 billion.
Properties are cheap right now, and Realty Income management is taking advantage of the situation while building shareholder value.
Value Gap
Okay, now for the pressing question: Does Realty Income buy material? A proper assessment needs to be completed in order to answer this question.
Buying cheap properties ends up bringing investors a twofold benefit. Immediately after the acquisition, these properties will generate rental income, which will inevitably trickle down to the bottom-line earnings, driving the value of the stock up.
Now, the key lies in the "cheap" part of these deals, as when they eventually return to normal value and even reach the top-ends during the next bull cycle, this dynamic will turn into a massive appreciation driver for the stock as well.
Knowing that shareholders will need to wait until the next bull cycle to see the bulk of their returns, they have decided to throw in yet another sweetener to the deal. An annualized 5.5% dividend yield will act as a sure inflation hedge while the stock appreciates.
Speaking of appreciation, initial target investors can shoot for lies in the current consensus price targets set by analysts, which will land at $68.2 a share. Reaching this target would take a rally of 23.6% from today's prices; combined with the dividend, it makes for a juicy deal.
When it comes to market sentiment and the value it is placing on the future of this stock, the stars align again for investors getting the company on a silver platter.
Upside Catalyst
Looking at the forward P/E ratio, which seeks to value the next twelve months of earnings, can tell investors where the broader market is placing the future outlook of any stock.
A clear message is sent from above within the large-cap retail REITs space, where Realty Income competes with names like Simon Property Group (NYSE: SPG) and Regency Centers (NASDAQ: REG).
Carrying a forward P/E of 40.0x, Realty Income is significantly superior to Simon's 18.2x and Regency's 31.3x multiples. This willingness to pay a premium price for Realty Income tells investors that markets see increased certainty in future earnings and higher quality/growth within them.
Realty's stock chart is also nearing a lucrative entry level if all these factors are insufficient. A 61.8% Fibonacci retracement, known as the optimal entry-level, is $52.5, only 4.8% away from today's prices.
Whether buyers wait for these levels or not, a 5.5% dividend is still offered, and all the right pillars to bring this stock higher from here.
