3 reasons to buy real estate income stocks like there’s no tomorrow

Real estate income (A -0.62%) it has long been a favorite of income-focused investors, given its fairly regular monthly dividends. However, the share price performance has been a bit poor over the past five years, falling more than 15% during this period.

More recently, however, Realty Income shares have started to regain some momentum and are up more than 25% over the past year. With this momentum likely to continue, let’s look at three reasons why you should choose this name.

1. Real estate income provides a steady and growing dividend

When it comes to paying higher dividends each year, Realty Income is a star performer. The real estate investment trust (REIT) has raised its dividend for 29 consecutive years and posted 108 consecutive quarterly increases.

Over the past decade, its dividend has had a compound annual growth rate of 4.3%, from $0.90 per share in 2014 to an annualized run rate of $3.156 at the end of July. Its current monthly dividend was just raised to $0.2635 per share in October, good for a forward yield of about 5.1%.

Its ability to consistently increase its dividends stems from its stable and predictable business model. The way a REIT like Realty Income makes money is from the difference between the rental income it generates from the properties it owns and the interest expense to finance those properties. It uses what are known as triple net leases, whereby its tenants are responsible for utilities, property taxes and maintenance (along with rent).

Triple net leases help Realty Revenue avoid any unexpected expense increases while generally signing tenants to long-term leases with initial terms of 10 to 20 years and annual rent escalators. This, along with the acquisition of new properties, creates a steady and growing increase in its adjusted funds from operations (AFFO), which it then uses to increase its dividend.

2. Realty Income’s portfolio has increased its diversity

Realty Income has traditionally focused on the retail sector, preferring to lease to what it considers to be less economically sensitive retailers such as grocery stores, dollar stores and drug stores, which are better insulated from the pressures of e-commerce. However, the REIT has diversified its businesses in recent years.

First, it expanded into Europe, where it now has a real estate portfolio of approximately $11 billion. Recently, this has been the company’s largest new investment area, where it has been able to achieve higher capitalization rates (caps) than in the US. by its purchase price.

Meanwhile, the company increased its exposure to industrial properties by acquiring Spirit Realty earlier this year. These properties now represent approximately 14.5% of the annual contract rent.

Realty Income has also started making investments in other verticals such as casinos and data centers. It entered the gaming industry in 2022 with a $1.7 billion sale-leaseback deal with Encore Boston Harbor Casino, and later bought a nearly 22 percent stake in The Bellagio Las Vegas, operated by MGM Resorts.

Last year, the company invested about $200 million to acquire an 80 percent stake in two data centers built by Digital Realtyforming a joint venture with the data center REIT.

This diversification comes at a good time, as retail pharmacy and dollar store businesses have come under pressure, as have furniture and home decor stores. Walgreens is one of Realty Income’s largest tenants, and the drugstore chain plans to close about 25 percent of its locations. However, the REIT said only 26 basis points of its total portfolio annualized contract rent expires in the next 2 1/2 years with Walgreens.

On its last earnings call, the REIT’s management said it estimated the risk rent associated with Rite Aid, Red Lobster, Walgreens, The dollar treeHome and Large Lots represented only 2.3% of its total annualized contract rent portfolio until the end of 2026.

Management said that if it can achieve the 84% long-term average recovery rate it typically achieves in bankruptcies, the potential risk to AFFO is just $0.02 per share. Meanwhile, he said any advanced notice of store closings provides value because it typically gives the company years to plan for an optimal outcome.

Image source: Getty Images.

3. Lower interest rates will help real estate income

The lackluster performance of Realty Income stock in recent years has largely resulted from higher interest rates. Commercial properties are generally valued based on the cap rates mentioned above, which are heavily influenced by interest rates. As cap rates follow rising interest rates, the value of properties purchased at lower rates falls to reflect the current cap rate.

For example, if a REIT buys a commercial property for $5 million at a 4% cap rate, it would generate net operating income of $200,000 per year at the start of the lease. If after five years the rental escalators increased its net operating income to $220,000, but the cap rates increased to 6%, the REIT would have more income, but the current property value would now be closer to of $3.7 million ($220,000 operating). income/cap rate of 6% = property value of $3.67 million). Given that the Fed has raised interest rates in the past, that’s why Realty Income stock has struggled.

However, the Fed recently cut rates by 50 basis points in what is expected to be the start of a decline in interest rates over the next few years. Meanwhile, cap rates have also started to fall in the US and Europe after what has been a steady rise since early 2022. If this is the start of a trend, Realty Income should see the value of its real estate portfolio rise, and with him, his stock.

Is It Time to Buy Realty Income Stock?

While Realty Income has some difficulties for tenants, they seem very manageable, and the company has a long history of dealing with stressed tenants and recovering rent. More importantly, however, the REIT market appears to be at the beginning of a lower cap rate cycle, which will help reverse some of the reduced value the company has seen over the past few years. As such, I would be a buyer of the stock as it looks poised to be a big rate cut winner.