Is Realty Income's Nearly 6% Yield a Bargain or a Trap?

Realty Income's (NYSE:O) dividend yield has risen sharply over the past month. Its stock price has tumbled from over $65 a share to around $55 per share, pushing the yield up from about 5% to nearly 6%. That's significantly higher than the S&P 500's low 1% current yield.

With its yield on the rise, some investors might wonder whether the high-dividend REIT is a bargain or a yield trap. I think it's now a screaming bargain. Here's why.

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The case for a yield trap

I wanted to start with the bear case. The main factor weighing on the company's stock price over the past month is rising interest rates. The 10-year U.S. Treasury yield is up over 5%, its highest level since 2007. It has been rising due to persistently elevated inflation. That recently caused the Federal Reserve to increase interest rates for the first time in three years. Many Fed watchers expected it to continue hiking rates until it gets inflation under control.

Higher rates have direct impacts on REITs like Realty Income. It increases their borrowing costs, making it more expensive to refinance existing debt and issue new debt to fund acquisitions and expansion projects. That can slow growth for REITs.

The other impact of higher rates is that they make lower-risk income investments, such as government bonds and bank CDs, more appealing to investors. As a result, the value of higher-risk investments (such as REITs) falls, increasing their yields to compensate investors for their higher risk profile. That makes it more expensive for REITs to issue stock to fund acquisitions.

The case for a bargain

Realty Income currently expects to generate between $4.44-$4.45 per share of adjusted funds from operations (AFFO) this year. With its stock price down $10 per share over the past month or so, its valuation multiple has declined from 14.6x to 12.4x. That's a bargain for such a high-quality REIT that has taken steps to reduce the impact of market conditions on its ability to continue growing.

The REIT has a fortress balance sheet (A/A-/A3) with a conservative dividend payout ratio (around 75% of its AFFO). That strong credit rating enables it to borrow money more cheaply than financially weaker REITs, lessening the impact of higher rates on its business. Meanwhile, its conservative payout ratio allows it to retain nearly $1 billion in cash each year to fund new investments.

Realty Income has also formed several strategic partnerships over the past year. Many of these deals brought in low-cost private capital, giving the REIT additional growth funding. Meanwhile, other deals have provided new investment opportunities, including a partnership to invest in data centers across the U.S. and Europe. This strategy puts Realty Income in a strong position to continue growing its monthly dividend, which it has raised 136 times since going public in 1994.

Realty Income is a bargain worth buying now

Realty Income's stock price has slumped on rising rates, pushing its dividend yield up near 6% even though it has much less exposure to higher rates than most REITs. That drives my high conviction that it's a bargain buy right now. It should continue to pay a growing dividend, positioning investors to earn strong total returns from here over the long term.

Matt DiLallo has positions in Realty Income. The Motley Fool has positions in and recommends Realty Income. The Motley Fool has a disclosure policy.