Where Will Realty Income Stock Be in 5 Years?

Over the past five years, Realty Income (NYSE: O) has seen its shares struggle, down over 13% during that stretch. However, after dividends, the stock's total returns would be in positive territory. Nonetheless, the stock's performance still has to be considered disappointing given the approximately 80% gain in the S&P 500 index over the same period.

Investors no doubt remain attracted to Realty Income for the monthly dividend it pays out. Based on its most recent payout, the stock carries a forward dividend yield of about 5.4%.

While the past five years have not been good to the real estate investment trust (REIT) , let's see where the stock could be headed in the next five years.

Current struggles

Realty Income is a REIT that owns properties and leases them out to tenants. It primarily focuses on stand-alone properties in the retail space that it leases to retailers in more economically resilient industries, including grocery stores, convenience stores, pharmacies, home improvement centers, dollar stores, and restaurants.

The REIT rents out its properties using long-term, triple net leases , where the tenant is responsible for utilities, property taxes, and maintenance costs. This keeps Realty Income from seeing any surprising cost increases. Leases typically have 10- to 20-year initial terms that come with yearly rent escalators. This model has helped lead the company to generate steady results over the years.

More recently, though, the company has been getting into other areas. It added more industrial properties through its acquisition of Spirit Realty, while it has also gotten into the the data center space and gaming space in recent years. About 73% of its properties were in the retail space as of the end of last quarter.

While Realty Income has posted very consistent results and continually raised its dividend over the years, the stock has come under pressure largely due to higher interest rates. Commercial properties are typically valued based on something called capitalization (cap) rates , which for an individual property is its net operating income divided by its current value. This is the annual investment return (not including any appreciation or property depreciation) a property owner receives on their investment and is similar to the yield on a bond. Given the similarities, like bond owners, property owners face interest rate risk as well.

As the Federal Reserve has raised interest rates, cap rates have followed. Let's use an example of how cap rates can impact the value of a commercial real estate property. If a REIT buys a commercial property for $10 million at a cap rate of 5%, this means it would be initially generating $500,000 in net operating income a year. However, if in five years the property was generating $550,000 in net operating income due to rent increases but similar properties were now being sold at a 6.5% cap rate, the current value of the original property on the open market would decline to about $8.5 million given the increase in cap rates ($550,000 in operating income/6.5% cap rate = $8.46 million property value).

Given this dynamic, it is not surprising that Realty Income's stock has struggled during a period of rising interest rates, as it has caused the value of its portfolio of properties to decline as cap rates have risen.

More recently, some of the REIT's retail clients have begun to struggle as well. Red Lobster, which made up 1.1% of its annualized contractual rent at the end of Q1, recently filed for bankruptcy and will close some restaurants. Its second-largest customer, Walgreens (representing 3.4% of its annualized contractual rent), announced it will be closing many locations in the future.

This is likely to be a moderate headwind to the REIT over the next year, but given its strong dividend coverage it should not have any impact on future dividend increases. The REIT had a solid 74.8% payout ratio last quarter, paying out $0.77 per share in dividends compared to the $1.03 per share in adjusted funds from operations it generated.

Image source: Getty Images.

Better days ahead

Despite some likely headwinds from store closures, Realty Income's stock should see better days ahead as the Fed is still expected to begin lowering rates later this year. Fed officials are still projecting that rates will be cut from a current range of 5.25% to 5.50% today to 3.00% to 3.25% by the end of 2026.

Interest rates are not the only thing that can impact cap rates, and such things as property supply and demand and credit availability can also play a role. However, declining interest rates and lower debt costs are generally correlated to lower cap rates, which should lead to increased commercial property values in the years ahead. This would be a much different environment than the one that Realty Income has operated in over the past five years.

Given this, I expect Realty Income to be a strong performer over the next five years despite some current tenant issues and the struggles it has faced over the past five years. With the Fed appearing set to reverse course and begin easing rates, now looks like a good time to buy Realty Income ahead of this improving environment.

The combination of solid stock price increase potential plus steady dividend increases should make for solid returns over the next five years.

Geoffrey Seiler 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 .