A falling-interest-rate environment is generally a positive catalyst for the stock market. With lower rates from risk-free investments such as CDs, more money rotates into riskier assets like stocks. Plus, lower borrowing costs make people more comfortable with spending money, leading to increased economic activity.
Having said that, there are some areas of the stock market that tend to benefit from falling rates more than others. One in particular is real estate, and it could be a great time to shop for top-notch real estate stocks while the Federal Reserve is still in the early stages of its rate-cutting cycle. Realty Income (O 0.25%) is one of the highest-quality real estate investment trusts, or REITs, in the market and is trading for a significant discount to its peak. Here’s why this 5.6%-yielding, monthly dividend stock could be a smart one to put on your radar right as we approach the end of 2024.
Realty Income’s business is built for compounding
Realty Income owns about 15,500 properties in the United States and Europe. About 80% of its rental income is from retail tenants, but don’t let that scare you away. The vast majority of the company’s retail tenants are in businesses that are recession-resistant, immune to e-commerce disruption, or both.
Specifically, 90% of its portfolio fits into one or more of the following categories:
- Non-discretionary retailers that sell things people need, regardless of what the economy is doing. Drugstores are a great example.
- Discount-oriented retailers sell things at prices even the online megaretailers can’t match and tend to actually perform better in recessions. Dollar stores are one of Realty Income’s top tenant types, as are warehouse clubs.
- Service-based retailers sell experiences or services instead of physical products. These businesses, such as auto repair shops and fitness centers, aren’t easily disrupted by e-commerce.
- Non-retail properties such as industrial, agricultural, and gaming properties are obviously not prone to any retail headwinds.
Not only are the tenants solid, but Realty Income’s tenants also sign long-term net leases that have built-in rent growth and require the tenants to pay taxes, insurance, and maintenance costs. All Realty Income has to do is get a quality tenant in place and enjoy year after year of reliable and growing income.
Realty Income has been a publicly traded REIT for 30 years and has handily beaten the total return of the S&P 500 over the same period. Plus, the stock has a 5.6% dividend yield as of this writing and has increased its payout for 108 consecutive quarters.
The stock has been an underperformer
Realty Income has underperformed the market in recent years. And while there is some tenant risk at play here, the primary reason isn’t the company’s business. It’s interest rates.
In fact, since the beginning of 2022, the Vanguard Real Estate ETF (VNQ -0.27%), which is a solid indicator of the overall real estate sector, has delivered a negative-7% total return. On the other hand, even including the effects of the 2022 bear market, the S&P 500 has returned a total of 32% during the same period.
Without getting into an economics lesson, REITs are highly sensitive to interest rates and specifically tend to have an inverse relationship with the 10-year Treasury yield. Notice that the peaks and valleys of the charts happen simultaneously, such as with the low point in real estate stocks that coincided with the peak in the 10-year Treasury in late 2023.
VNQ Total Return Price data by YCharts
Now, the 10-year Treasury doesn’t have a perfect correlation with Federal Reserve rate cuts, but it does tend to gravitate in the same direction. If the Fed ends up cutting rates several more times over the next couple of years, as is widely expected, Realty Income could be in an excellent position to outperform.
Matt Frankel has positions in Realty Income and Vanguard Real Estate ETF. The Motley Fool has positions in and recommends Realty Income and Vanguard Real Estate ETF. The Motley Fool has a disclosure policy.
