Realty Income is trading at a lower valuation and higher dividend yield, setting investors up to potentially earn strong total returns.

Realty Income (O) has done a magnificent job creating value for its shareholders over the years. The real estate investment trust (REIT) has delivered a 13.9% compound annual total return since its listing on the New York Stock Exchange in 1994.

A big factor driving those returns is the company’s steadily rising monthly dividend. Realty Income has increased that payment 124 times since going public, growing the payout at a 4.3% compound annual rate.

The REIT’s dividend currently yields around 6%. That attractive passive-income stream is one of the many factors that make it a screaming buy right now.

A compelling entry point
Realty Income’s dividend is approaching a historically high level:

As that chart shows, the payout is near its peak from late last year and during the pandemic-driven sell-off of 2020. It’s much higher than its average range of 4% to 5% over the past decade.

The main factor driving the REIT’s higher yield is its lower valuation. Realty Income expects to produce $4.13 to $4.21 per share of adjusted funds from operations (FFO) this year. That implies 3.3% to 5.3% growth from last year’s level. With its stock price recently around $51 a share, it trades for slightly more than 12 times FFO and an implied real estate capitalization rate of more than 8%.

Those are dirt cheap levels, compared to the broader market and current market-cap rates. The S&P 500 trades at more than 21 times its forward price-to-earnings (P/E) ratio, while the Nasdaq 100 is even more expensive at over 27 times forward earnings. Meanwhile, Realty Income has been buying single-tenant net lease real estate at around a 7% cap rate in recent months.

A potential needle-moving catalyst on the horizon
Higher interest rates are the main reason Realty Income trades for a higher dividend yield and lower valuation. The REIT’s share price has lost about 30% of its value from the peak in early 2022, right before the Federal Reserve started raising interest rates. That’s because real estate values are highly correlated to interest rates.

As the rates on lower-risk investments like government bonds rise, investors require a higher yield on higher-risk investments like real estate. As a result, real estate values fall, increasing income yields.

However, this headwind should start fading in the coming months. The Federal Reserve has said it expects to start reducing interest rates this year, likely delivering three 0.25% reductions to the federal funds rate, with more coming in 2025 and 2026. While the Fed has had to delay the expected reductions due to persistently high inflation, it likely will deliver the promised cuts as cost pressures moderate. Interest-rate cuts would likely drive up real estate values, which should boost Realty Income’s stock price.

Visible growth ahead
Realty Income doesn’t need the Fed to grow value for investors. The REIT expects to grow its adjusted FFO by 4% to 5% annually over the long term. That should enable it to continue steadily increasing its dividend.

It anticipates that rents at its existing properties will grow by about 1% per year, driven by contractual rent increases and its ability to secure higher rents when existing leases expire. On top of that, Realty Income has the financial flexibility to continue acquiring income-producing real estate.

The company has a massive total addressable market opportunity ($5.4 trillion in the U.S. and $8.5 trillion in Europe), which is growing as it continues expanding into new property verticals. (It added data centers, gaming facilities, and additional European countries over the past year.)

Healthy total-return potential even without the Fed
At a minimum, Realty Income will supply investors with a 6% (and growing) annual income yield. Meanwhile, with earnings expected to rise by 4% to 5% annually, it should produce a more than 10% total annualized return, assuming no change to its valuation multiple.

On top of that, its share price has significant additional upside potential as the Federal Reserve starts cutting interest rates. These factors make Realty Income look like a screaming buy right now.

— Matt DiLallo

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Source: The Motley Fool