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Over the 22 years that it has been listed on the NYSE, retail REIT Realty Income (NYSE: O) has produced a total return of more than 3,700%. No stock that is capable of returns like this is without risk, and Realty Income is certainly no exception. But just how risky is Realty Income?
How Realty Income keeps its risk low
The retail industry isn't necessarily low-risk -- as you probably know, several high-profile retailers have gone bankrupt in the past few years. However, the retail properties Realty Income owns are. Most of the retail portfolio falls into one or more of these three categories:
Non-discretionary retail -- Top Realty Income tenants in this category include Walgreens and Circle K. These businesses sell items people need, making them recession-resistant. In tough times, people can cut back on high-end clothing and entertainment. However, they'll still need to fill their prescriptions and put gas in their cars.
Service-based retail -- These are businesses that need to have a physical location. Examples among Realty Income's top tenants are AMC Theatres and LA Fitness, as well as restaurants such as Taco Bell and Bob Evans. These types of businesses are naturally immune to online competition.
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Deeply discounted and low-price retail --Dollar General, Family Dollar, and Sam's Club are good examples of this. These businesses offer discounts even the top online retailers generally can't match, and dollar stores are the fastest-growing type of retail there is. Businesses like these actually tend to do better during recessions.
In addition, National Retail Properties' lease structure is another thing that makes the company low-risk. Tenants sign net leases with 15-20 year initial terms, which minimizes turnover. In fact, the company's properties are currently 99% occupied. In addition, a net lease requires the tenant to pay variable costs such as property taxes, building insurance, and maintenance. National Retail Properties simply finds a tenant and collects a steadily increasing monthly rent check for years.
Interest rates are a major risk factor
Having said all of that, Realty Income is not without risk by any means. For starters, like most other REITs, Realty Income is quite vulnerable to rising interest rates for a couple of reasons.
First, higher interest rates make it more expensive to borrow money, and virtually all REITs rely on borrowed money to some degree when acquiring or developing properties. Higher rates typically translate to lower profit margins on investment properties.
Second, higher interest rates create selling pressure on high-dividend stocks like REITs, as they make lower-risk income investments look more attractive. As a simplified example, if a REIT pays a 4% dividend and a Treasury bond pays 2%, the REIT may seem worth the extra risk to an income investor. On the other hand, if they both pay 4%, taking the extra risk may seem less appealing.
Realty Income relies on a combination of borrowed money and newly issued stock for growth, both of which are less attractive with higher interest rates. The higher borrowing rates lead to spread compression and the lower share prices mean that Realty Income needs to issue more shares to raise the same amount of money. In fact, the speculation of an upcoming interest rate hike is a primary reason Realty Income has fallen more than 25% since August.
Other risk factors
Interest rates aren't the only thing that could cause Realty Income's stock price to fall. There are many events that could possibly happen that would be negative catalysts to the company. For example, if one of Realty Income's largest tenants went bankrupt and defaulted on its lease agreements, the vacancy rate could rise and profits could drop.
In addition, a general drop in real estate values could hit, dragging down the value of Realty Income's properties and therefore, the shares that represent them. Or, a stock market crash could do the same. For example, the company's stock dropped by about 40% during the financial crisis, even though the company remained quite profitable, maintained occupancy over 96%, and continued to increase its dividend throughout.
This stock is for the long term
Everything about Realty Income's business model is designed to produce strong long-term returns for shareholders, and the company has been quite successful at doing that. Since its 1994 NYSE listing, Realty Income has averaged an annual return of 17.9% -- a remarkable level of performance to sustain for such a long period of time.
While I would definitely call Realty Income a "low-risk" stock, it's important to keep in mind that I say this from a long-term perspective. Realty Income will have good years and bad years, and it's quite possible that 2017 will be one of the bad years, especially if interest rates rise faster than expected. However, as long as you approach your investment in Realty Income with a long investment timeframe in mind (say, five years or more), you can invest and sleep soundly at night.
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Matthew Frankel owns shares of Realty Income. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.