This article first appeared on Simply Wall St News.
Realty Income Corporation (NYSE:O) is one of the more popular dividend payers. It relies on a lease business model to deliver a stream of predictable monthly income.
The announced merger with VEREIT (NYSE:VER) sounds optimistic, but a 4.1% yield leaves a lot to be desired given the stock price. Sometimes, investors buy a popular dividend stock because of its yield and then lose money if the company's dividend doesn't live up to expectations.
In this case, Realty Income likely looks attractive to investors, given a payment history of over ten years. It would not be a surprise to discover that many investors buy it for dividends. There are a few simple ways to reduce the risks of buying Realty Income for its dividend, and we'll go through these below.
The stock has yet to fully recover from the 2020 downturn, as it is fighting to stay above the $70 level for the third time this year. This gives it a 4.1% yield at a price-to-earnings (P/E) ratio of 70. Although the P/E ratio is not the best way to evaluate a real estate investment trust (REIT), this is still beating the industry averages, with established REITs trading at 35-45x forward earnings.
The year's largest event is definitely a merger with VEREIT, which operates 3,800 single-tenant properties under a similar sale-and-leaseback business model. Combined, this will bring the portfolio up to 10,300 geographically diversified properties with the largest tenants concentrated in healthcare, financial services, and government sectors. However, the biggest advantage comes in a superior interest rate, as Realty Income can borrow at 0.6% cheaper on average.
In the last year, Realty Income paid out 87% of its profit as dividends. Paying out a majority of its earnings limits the amount to be reinvested in the business. REITs have different rules governing their payments and are often required to pay out a high portion of their earnings to investors.
Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. The company paid out 89% of its free cash flow as dividends last year. It's positive to see that Both profits and cash flow cover Realty Income's dividend since this is generally a sign that the dividend is sustainable. A lower payout ratio usually suggests a greater margin of safety before the dividend gets cut.
We update our data on Realty Income every 24 hours, so you can always get our latest analysis of its financial health here.
One of the major risks of relying on dividend income is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. For this article, we only scrutinize the last decade of Realty Income's dividend payments. During this period, the dividend has been stable, implying the business could have relatively consistent earnings power. During the past 10-year period, the first annual payment was US$1.7 in 2011, compared to US$2.8 last year. Dividends per share have grown at approximately 5.1% per year over this time.
Realty Income Dividend track record, Source: Investor Presentation May 2021
Dividends have grown at a reasonable rate over this period, and without any major cuts in the payment over time, we think this is an attractive combination.
Dividend Growth Potential
Dividend payments have been consistent over the past few years, but we should always check if earnings per share (EPS) are growing, as this will help maintain the purchasing power of the dividend. While there may be fluctuations in the past, Realty Income's earnings per share have basically not grown from where they were five years ago. Over the long term, steady earnings per share is a risk as the value of the dividends can be reduced by inflation.
We'd also point out that Realty Income issued a meaningful number of new shares in the past year. Companies that consistently issue new shares are often suboptimal from a dividend perspective. While this could have been a one-off event, given the extraordinary circumstances of 2020, the company has maintained leverage on the upper side of the average sector range.
When we look at a dividend stock, we need to form a judgment on whether the dividend will grow, if the company can maintain it in a wide range of economic circumstances and if the dividend payout is sustainable. Realty Income pays out more than half its income as dividends, but both reported earnings and cash flow cover the dividend.
It's not great to see earnings per share shrinking. The dividends have been relatively consistent, but we wonder for how much longer this will be true. A merger with VEREIT is an interesting story from the debt perspective but leaves a lot to be desired from subpar growth forecasts.
In sum, we find it hard to get excited about Realty Income from a dividend perspective. It's not that we think it's a bad business; just that other companies perform better on these criteria.
It's important to note that companies with a consistent dividend policy will generate greater investor confidence than those with an erratic one. Still, investors need to consider a host of other factors, apart from dividend payments, when analyzing a company. To that end, Realty Income has 5 warning signs (and 1 which doesn't sit too well with us) we think you should know about.
We have also put together a list of global stocks with a market capitalization above $1bn and yielding more than 3%.
Simply Wall St analyst Stjepan Kalinic and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.