Inflation Is Ticking Upward. Should Realty Income Investors Be Worried?

Key Points

• Inflation will likely boost Realty Income's property values and rent rates.

• Inflation could make debt more expensive, but Realty Income has managed that well in the past.

• Though the stock has underperformed over the past five years, it could be a fantastic buy today.

• 10 stocks we like better than Realty Income ›

Core U.S. inflation rose by 0.3% month over month in July, its highest increase in six months. That put the trailing-12-month inflation rate at 2.7%.

The Motley Fool has studied inflation, and it's a fascinating look at the prices we pay. In the past, the S&P 500 has performed well when inflation was within its current range. But, be careful. When inflation runs hot and prices increase too quickly, it tends to have an adverse effect on stocks.

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Realty Income (NYSE: O) is a real estate investment trust (REIT) that acquires and leases real estate, and inflation can impact it in multiple ways. Should Realty Income investors worry about inflation's recent uptrend? Here is what you need to know.

Image source: Getty Images.

Inflation could be a tailwind to Realty Income's real estate portfolio

REITs give investors the ability to invest in properties without having to acquire or manage them themselves. Realty Income operates using a net lease business model, which means that its tenants are generally responsible for most of the costs associated with the sites they occupy, including maintenance, utilities, insurance, and property taxes.

That puts Realty Income in a good spot, because it doesn't need to worry about how inflation may impact expenses it doesn't have to fund, as long as its tenants can still pay their rent. The company benefits as inflation increases the values of the properties it owns and allows it to boost its rents. Realty Income typically includes automatic inflation-driven rent escalators in its lease agreements.

Getting paid is the top priority for any landlord, and tenant quality is one of Realty Income's strengths. Its real estate portfolio is highly diversified, spanning 15,600 properties across the United States and Europe, and it largely caters to recession-resistant, retail-oriented tenants, like convenience store chains. Even when COVID-19 lockdowns froze the economy, Realty Income's same-store rent only contracted by 1.7%.

High interest rates could be a headwind

One potential problem that inflation could represent for Realty Income is that when inflation gets too high, the Federal Reserve tends to combat that by raising its benchmark interest rates and otherwise tightening its monetary policy. If rates are high, that raises Realty Income's borrowing costs. REITs distribute almost all of their taxable income to shareholders every year via dividends, so they often use debt to fund their purchases of new property.

Higher borrowing costs make it harder to financially justify such purchases, meaning slower growth for the REIT or a tighter spread between its cost of capital and the returns it generates. That's a jargon-filled way of saying that when interest rates rise, Realty Income might not be as profitable.

The good news is that Realty Income has historically managed to navigate less-friendly interest rate environments quite well.

Yields on 10-year U.S. Treasury notes heavily influence interest rates on corporate debt. The 10-year T-note's yield averaged 5% from 1996 to 2008. During that span, Realty Income's funds from operations (FFO) grew at an annualized rate of 5.2%. The 10-year yield averaged 2.3% from 2009 to 2022. During that span, Realty Income's FFO grew at an annualized rate of 5.4%.

So, dramatically lower rates (cheaper debt) didn't make all that much of a difference in how Realty Income's business performed.

Why Realty Income is a buy

Realty Income's track record indicates it is likely to handle a more inflationary environment just fine, barring anything extreme. Investors probably don't need to worry much.

That said, should investors buy the stock now? Its share price is roughly flat relative to where it was five years ago, despite its FFO per share increasing by over 20%. That makes Realty Income a fundamentally cheaper stock now. Today, shares trade at approximately 15 times FFO. Realty Income typically grows at a low single-digit percentage pace, so that low valuation is probably fair, at the very least, for the growth you'll likely get.

On top of that, the REIT does distribute a generous dividend that at current share prices yields 5.5%. It also has a roughly three-decade streak of annual dividend raises to its name. Investors can maximize their potential returns from this stock by reinvesting their dividends and letting the investment's growth compound over time. Just remember that due to their tax structure, REITs pay nonqualified dividends, so the government will tax them as ordinary income unless you keep them in a tax-advantaged account.

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Justin Pope has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Realty Income. The Motley Fool has a disclosure policy.