One of the many ways in which investing is awesome?
There’s no “right” way to do it.
You get to do it however you want.
Of course, there are a number of known common mistakes to avoid (such as repeatedly trying to time the market).
And there are some “best practices” which are wise to abide by.
What’s worked for me?
The dividend growth investing strategy.
It’s so simple, yet it’s also so powerful and effective.
I’ve been applying this strategy for nearly 15 years.
It’s all about investing in terrific businesses that shower shareholders with steadily rising cash dividends – dividends which can be used to cover real-life bills.
You can find many examples of these businesses by browsing the Dividend Champions, Contenders, and Challengers list.
This list has invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
It takes a special kind of business to generate the ever-higher profit necessary to fund ever-larger dividends to shareholders.
And so this strategy tends to almost automatically funnel one right into terrific businesses.
I said it can be powerful and effective.
Well, it’s been that – and more – for me.
Let me just say, it’s been instrumental for me as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
This dividend income started covering my bills back when I decided to quit my job and retire in my early 30s.
It’s hard to articulate how cool it is to be able to live off of dividends.
It wasn’t easy to get here, but my Early Retirement Blueprint aspires to make it a lot less challenging.
Now, this strategy involves more than investing in terrific businesses.
There’s also the matter of valuation at the time of investment.
Whereas price represents what you pay, value represents what you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
While I would never say it’s the “right” way to invest, it’s hard to go “wrong” with buying undervalued high-quality dividend growth stocks.
Of course, all of this presumes you already understand the basic ins and outs of valuation.
If not, that’s where Lesson 11: Valuation can come in handy.
Written by fellow contributor Dave Van Knapp, it lays out the whole concept in simple-to-understand terms and even provides a template that can be used to estimate the fair value of almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Realty Income Corp. (O)
Realty Income Corp. (O) is a real estate investment trust that primarily leases freestanding, single tenant, triple-net-leased retail properties.
Founded in 1969, it’s now a $54 billion (by market cap) real estate titan that employs just over 400 people.
The company’s property portfolio of over 15,000 properties is diversified across the US, Puerto Rico, and parts of Western Europe.
The company serves more than 1,500 clients operating across 90 different industries.
The property portfolio has an occupancy rate of 98.8%.
Approximately 80% of the properties are retail in nature, while the remainder is mostly industrial.
No one tenant comprises more than 4% of annualized contractual rent.
Due to favorable long-term supply-demand dynamics, real estate can be highly alluring and lucrative.
First, let’s talk supply.
There’s an old saying about land: “They’re not making it anymore”.
The finite nature of available land means there’s a scarcity when it comes to how much real estate can possibly be built (because it has to be built on something).
Plus, it requires lots of capital and time investment to actually build out real estate.
Limitations constrain supply.
And since there’s a need for people to live in, and interact with, the physical world, real estate has built-in demand.
Realty Income capitalizes on this supply-demand setup by erecting profitable properties on valuable tracts of prized land.
Putting up a well-located property, then renting it out to a suitable tenant, results in a cash cow.
Realty Income has done this over and over again – thousands of times.
In the process, the REIT has amassed a large and diversified portfolio of individual cash cows.
Could an individual investor try to go out and do something like this themselves?
Sure, but it’s incredibly difficult, expensive, and time consuming.
Becoming your own landlord involves scouting, studying comps, lining up financing, leverage, closing, finding tenants, managing property, etc.
And that’s just one property!
Imagine doing that over and over again.
Buying shares of Realty Income and gaining a slice of ownership of a large portfolio of thousands of commercial properties with paying tenants already installed is a much easier way to go.
It’s a way to instantly become a scaled-up landlord – all with no headaches.
What’s especially powerful about Realty Income’s business model is that it largely employs commercial triple-net leases on its properties.
This is a lease agreement on a property in which the tenant agrees to pay all of the expenses of the property, including real estate taxes, building insurance, and maintenance.
This minimizes Realty Income’s overhead.
If all that weren’t enough, Realty Income has some of the best tenants a landlord could possibly ask for.
Top tenants include the likes of 7-Eleven and FedEx.
Most of the Realty Income’s properties are designed for everyday consumer convenience, such as convenience stores, pharmacies, and grocery stores.
A durable desire for convenience protects the company against e-commerce encroachment.
Realty Income’s has capitalized on favorable supply-demand dynamics in real estate by building out an empire of CRE properties featuring advantageous leasing structure.
It almost can’t help but to grow its revenue and profit over the long run, and that should mean plenty of growing dividends to shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Realty Income has already increased its dividend for 31 consecutive years.
This qualifies the company for its elite status as a Dividend Aristocrat – one of the few REITs in the world that can claim such a thing.
The reason why it’s somewhat rare for a REIT to rack up such a long track record of consistent dividend growth is because real estate is highly cyclical and the REIT model relies on constant debt and equity issuances.
Just to quickly harp on how consistent Realty Income has been, this 31-year record dates back to the company’s 1994 IPO.
It’s been a lock for reliably growing dividends straight out of the gate.
Realty Income actually lays all of this out in its official mission: “To invest in people and places to deliver dependable monthly dividends that increase over time.”
Sounds good to me!
The 10-year dividend growth rate is 3.6%.
That low growth rate is a common pain point with REITs.
In exchange for above-average income, you usually have to sacrifice growth.
While low-single-digit dividend growth like this does exceed the normal, long-term rate of inflation, it’s also not moving the purchasing power needle in a big way.
On the other hand, coming back to what I just mentioned about income, the stock yields 4.9%.
That’s well above what the broader market gives you.
It’s also 30 basis points higher than its own five-year average.
So an investor has to make the call on whether or not that current income is worth the growth trade-off; most income-oriented investors would probably lean toward it being so.
And not only is it a pretty high yield, but this dividend is paid monthly.
That makes it a large, growing, monthly dividend.
Checks a lot of boxes.
Realty Income takes its monthly dividend commitment to shareholders so seriously, it has trademarked its moniker: The Monthly Dividend Company®.
Gotta love it.
Based on midpoint FFO/share guidance for FY 2024, the payout ratio is 74.6% – a reasonable payout ratio for a REIT, indicating no issues with the safety of the dividend.
Realty Income is a hall-of-fame type of investment for dividend growth investors who lean toward income.
The company’s name and moniker are signs of just how seriously this company takes its role as a provider of steady and growing monthly dividend income to shareholders.
Revenue and Earnings Growth
As great as these metrics may be, though, many of the numbers are looking backward.
However, investors must always be looking forward, as the capital of today gets risked for the rewards of tomorrow.
That’s why I’ll now build out a forward-looking growth trajectory for the business, which will be highly useful when later estimating its fair value.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
And I’ll then reveal a professional prognostication for near-term profit growth.
Amalgamating the proven past with a future forecast in this manner should give us what we need to make an educated judgment call on where the business could be going from here.
Realty Income improved its revenue from $934 million in FY 2014 to $4.1 billion in FY 2023.
That’s a compound annual growth rate of 17.9%.
Very strong top-line growth; however, it’s not an accurate view of true growth.
First, Realty Income merged with former competitor VEREIT in 2021, which substantially increased revenue.
Second, REITs fund growth via debt and equity issuances.
With a REIT, it’s imperative to look at profit growth on a per-share basis.
And when assessing profit for a REIT, you want to use funds from operations (or adjusted funds from operations) instead of normal earnings.
FFO is a measure of cash generated by a REIT, which adds depreciation and amortization expenses back to earnings.
Realty Income grew its FFO/share from $2.58 to $4.07 over this period, which is a CAGR of 5.2%.
This is the accurate measure of Realty Income’s longer-term growth profile.
Explaining much of the delta between top-line and bottom-line growth is the fact that Realty Income roughly tripled its shares outstanding over this time period – a serious drag on per-share growth.
All that said, even though it’s not even close to what revenue has done, this FFO/share growth is still quite solid for a REIT.
Looking forward, CFRA currently has no three-year CAGR for Realty Income’s FFO/share.
Disappointing, but it’s not surprising, as CFRA commonly seems to lack growth forecasts for REITs.
Moving past this for a moment, I think this passage by CFRA sums it all up nicely: “We see robust demand continuing for freestanding retail space, driven by a favorable supply/demand environment. We believe [Realty Income] is poised to remain resilient in a more uncertain operating environment, given its top tenants are concentrated in industries deemed essential, such as convenience, drug, dollar, quick service restaurants, and grocery stores. [Realty Income]’s tenant diversification is strong with its top 20 clients accounting for 37.7% of annualized rent in Q2 2024 and 36% of tenants are rated investment grade.”
I think that translates out into Realty Income being in a position to continue performing as it always has.
Then again, the next few years could be even better.
On that point, there’s this tidbit from CFRA: “We forecast occupancy will remain higher than its historical average of 98% throughout 2024 due to the company’s desirable property locations and high non-discretionary retailer demand.”
Realty Income has historically maintained excellent occupancy rates, and seeing those rates go even higher than usual is very encouraging.
In addition, CFRA notes the following: “[Realty Income] has a long history of high occupancy rates, along with stable, growing dividend payments, that give us confidence in its ability to weather a variety of macro environments. We also have a positive view of [Realty Income]’s recent moves into the net-lease gaming and data centers industries.”
Indeed, the 2022 $1.7 billion sale-leaseback agreement of Encore Boston Harbor Resort and Casino catapulted Realty Income into the gaming space, opening up a whole new world of opportunities.
Seeing as how there are many types of commercial real estate across that vast landscape, Realty Income has lots of opportunities for expansion and the growth that can be had from this.
Even though CFRA has no growth forecast, we can use Realty Income’s own midpoint guidance for FY 2024 FFO/share and see that this year should see ~4.2% YOY growth.
A mid-single-digit (somewhere between 4% and 5%) growth rate – both in terms of FFO/share and the dividend – is basically what I’d expect from Realty Income over the coming years.
I base that expectation on what Realty Income has been doing for a long time, as well as what is currently happening.
Quite frankly, I’d argue that’s just about enough on a stock that already yields ~5%.
It’s not a “sexy” investment that’s putting up lights-out growth.
But it is a dependable source of large, monthly income, and the dividend is steadily chugging higher.
And the combination of yield and growth can propel the stock to a double-digit annualized total return from here.
This is something that Realty Income has been very good at, as the total return CAGR on the stock has been an astounding 13.5% since the 1994 IPO (through June 2024).
Financial Position
Moving over to the balance sheet, Realty Income has a relatively solid financial position.
Realty Income’s credit ratings are well into investment-grade territory: A3, Moody’s; A-, S&P Global.
Moreover, many of Realty Income’s top tenants have investment-grade credit ratings of their own.
A common measure for a REIT’s financial position is the debt/EBITDA ratio.
Most of the REITs I’ve come across tend to land in a range between 3 and 7 on this ratio.
Realty Income finished last fiscal year with a net debt/pro forma adjusted EBITDAre ratio of 5.5.
This is neither outstanding nor terrible.
It puts Realty Income somewhere in the middle of the pack.
Overall, the balance sheet is unconcerning to me, and Realty Income’s management has shown an ability to deftly manage the finances at scale.
Simply put, Realty Income is running one of the world’s biggest and best commercial real estate empires.
Combining triple-net leases with a diversified roster of top tenants is a simple approach that has led to one of the best long-term track records in all of CRE.
And with deep industry expertise, long-term contracts, and massive scale, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Real estate demand is inherently cyclical, and any kind of recession could impact Realty Income’s tenants and then Realty Income itself.
A REIT’s capital structure relies on external funding for growth (via debt and equity issuances), which exposes the company to volatile capital markets and interest rates.
Elevated interest rates, which are currently present, can hurt the company twice over: Debt becomes more expensive (through higher servicing costs), and equity can also become more expensive (because income-sensitive investors have alternatives, which can reduce demand for and pricing on the stock).
A recession can also hurt the company twice over: Demand for commercial real estate can cool, and equity issuances after a presumed drop in the stock’s price would come at a higher cost.
Realty Income is heavily tied to retail, which exposes the firm to various headwinds in this space (such as the rise of e-commerce, as well as physical retail theft).
The company’s scale is an advantage, but it also introduces questions around future growth and the law of large numbers.
I think the risks here are worth carefully weighing over, but these risks have been largely the same over Realty Income’s entire existence – an existence that has been extremely successful.
And there’s also the valuation to consider, which is seemingly pricing in a decent amount of risk…
Valuation
The forward P/FFO ratio is 15.1.
That’s roughly analogous to a P/E ratio on a normal stock.
It’s an undemanding multiple.
A multiple of cash flow is another way to gauge a REIT’s valuation.
The P/CF ratio of 15.9 is not particularly high, and it’s well below its own five-year average of 17,
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 4%.
This strikes me as a sensible and reasonable expectation for Realty Income’s long-term FFO/share and dividend growth power.
It strikes a balance between the demonstrated growth for both over the last 10 years (FFO/share growth has exceeded dividend growth).
It’s also close to the company’s own guidance for this year’s FFO/share growth.
I’d lack confidence in a much higher growth rate, but I’d also be surprised to see Realty Income fall far short of this mark over the coming years.
The DDM analysis gives me a fair value of $54.77.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
My view is that the stock is on the other side of what might be a fair price to pay, unless the growth comes in faster than I expect.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates O as a 4-star stock, with a fair value estimate of $75.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates O as a 3-star “HOLD”, with a 12-month target price of $65.00.
I came out on the low end, even though I don’t think a 4% dividend growth rate is overly conservative. Averaging the three numbers out gives us a final valuation of $64.92, which would indicate the stock is possibly 1% undervalued.
Bottom line: Realty Income Corp. (O) is a high-quality REIT that commands one of the most successful long-term track records in its space. Its portfolio is second to none, with incredible breadth, diversification, health, and occupancy. The company has been a dependable payer of growing monthly dividend income, funded by tenants’ rent payments, for more than three decades, and I don’t see that stopping. With a market-smashing yield, a reasonable payout ratio, inflation-beating dividend growth, more than 30 consecutive years of dividend increases, and the potential that shares are 1% undervalued, income-oriented dividend growth investors still have a chance to pay a fair price for this world-class REIT.
-Jason Fieber
Note from D&I: How safe is O’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, O’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Disclosure: I’m long O.
