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Realty Income Corporation (NYSE:O) is a popular blue-chip real estate investment trust (or REIT) that pays a monthly dividend, and now sports a 6.2% juicy yield. Regardless of what is happening in the macro environment, it has a strong business model and a relatively strong balance sheet. However, the recent rise in interest rates has led to a decline in the stock price; in fact, it has wreaked havoc. Real estate has been hit hard by rates, and so have financials like regional banks, and small caps. Trading and investing opportunities are growing, though we are in a precarious position and in the heart of a very busy earnings season. Now O is a stock we have gotten behind, after being short and then neutral for many, many months.
The thing is these REITs are generally considered to be sensitive to interest rates, as they borrow money to finance their acquisitions. At its most basic level, higher interest rates make it more expensive for REITs to borrow money, which can pressure their earnings and stock prices. Then there is macro pressure on tenants who need to pay rent. We encourage investors who are already long O stock to sell covered calls to generate income and reduce their risk, while new money should look for a better 2024 when rates stabilize, and perhaps are cut in late 2024.
So is Realty Income stock a buy? We think it bears repeating what we have told members, that right now, in the near-term, as in weeks or a quarter, probably best to avoid if you need the principal. For more risk-averse or longer-term investors, the stock is on sale. The stock is competing with bonds, cash, and other high-yield products. In today’s column, we are not going to discuss the basics or anything regarding the debt, or preferreds versus common stock, etc. We covered that in our coverage initiation. You can check that out here:
Realty Income Has Been Obliterated
Here in this column, we are looking ahead to Q3 earnings, which are just around the corner, being reported post-market on November 6th. We will be looking for several key updates from management. First, insights into property moves, particularly on the conference call. Recall coming into Q3, Realty Income owned more than 13,000 properties across the U.S., U.K., and other European nations with leases on its property to around 1,300 clients.
We will also look for signs of further economic strain which will be evidenced by Realty Income’s occupancy rate and any changes there. Folks, occupancy has been close to 99%. It is a high-quality operator with recurring revenues, but we want to see any signs of cracking here. We do not expect to see much flux in the tenant base, but do keep in mind the majority of the tenant base is retail. We have been monitoring retail earnings including many of the tenants of Realty Income, but there are many tenants like grocery stores and convenience stores that make up a fifth of the rents. We see no concern here. But the company made $3 billion of investments last quarter and took steps to raise cash. We will be looking for commentary on where that funding was deployed and where it will be going as we move forward.
What about fiscal performance? Well of course this is what it all comes down to, right? Tenant and occupancy updates are important of course, but we will be looking for cash flow and we expect cash flow to remain strong as does its funds from operations. We are coming off of a Q2 with net income of $195.4 million, or $0.29 per share, while AFFO was $1.00 per share. At the end of Q2, net debt to adjusted EBITDA (annualized) was 5.3x. The company had $3.5 billion of liquidity, which consisted of cash and cash equivalents of $253.7 million to start Q3.
Our expectations are as follows. We are looking for quarterly revenue of $985 million, net income of $200 million, and to generate funds from operations of $1.02. At or around this range should result in a muted reaction, but much below these figures will cause pain. Naturally, management’s commentary on conditions it is seeing on the ground, updates with troubled tenants (see our article above for more on that), and its leasing activities will be key. There are also a few other metrics we are looking at. The same-store rental revenue is a key measure, and we are looking for $715-$725 million on this front, with remaining revenue from other activities including new lease origination, lending, etc.
We see the company continuing to seek out investment opportunities that have strong future growth characteristics having CPI-based rent escalators that are uncapped. That feature is actually present in nearly 30% of the leases in the international portfolio. This will be a key source of growing same-store rental growth as well as overall revenue growth long term. Updates from management on what they are doing to push meaningful contractual rent escalators on the call will be key.
What we think will further be key, aside from the above figures will be the outlook for the year. Remember the company adjusted its guidance for 2023 normalized FFO per share to $4.07-$4.15, raising the lower end of its prior outlook of $4.05-$4.15, but this was weaker than the former $4.13 consensus. We want to also see progress. Acquisition volume guidance was at $7.0 billion for the year, so we will look to see if there have been changes there. With the recent rounds of cash raised, we expect the company may even increase this guidance further. We will also look at the initial cash lease yield. That is of interest, and are looking for at least 7.0% which would be a 10 basis-point increase compared to Q2, and over 100 basis points from a year ago. The realized investment spread should be around 130 basis points.
While one quarter will not make or break the company, there has been pain for a few quarters. What we know is that the rate environment will be higher for longer and we need to be concerned about the debt maturity schedule here, which should not change much from the recent quarterly filing, but there is some debt due in 2024, with many of the notes due later this decade. We will look for changes in their borrowings, extension schedules, and mortgages payable. Not just for this upcoming report, but for the medium-term we caution you to keep a close eye on new issuances and steps taken to raise money. New notes are likely to come with higher costs, the same with any new mortgage activity near-term.
Take home
These are a number of the thoughts we have shared with our group when asked and we wanted to provide you with the metrics we think are relevant. That said, we stand by our view. If you are worried about capital in the next few months, you should not buy much of anything. But if you are risk averse and/or have a long-term view, we like the monthly income here and long-term prospects. The near-term volatility is certainly scary, but we still think you see improvement in the REIT space when rate cuts arrive which we see in in 2024, likely in H2.
That said, considering the operations, $48 for Realty Income Corporation shares remains a great price for the long-term investor, but you need to monitor what the company is doing to understand what you own. It should be a very well-attended conference call, and we encourage you to participate.
