The stock market appears to be getting a bit frothy. The S&P 500(SNPINDEX: ^GSPC) has rallied by more than 15% over the past year. The index now trades at more than 20 times forward earnings. This is a historically high level, often seen before notable market declines.
Given those historical trends, it is prudent to prepare your portfolio for a potential future downturn. One historically excellent shield against market crashes is Realty Income(NYSE: O). The high-yielding real estate investment trust (REIT) has several noteworthy characteristics that can provide your portfolio with important protection during the next major stock market decline.
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Recession worries are typically the biggest catalysts causing market crashes. Economic downturns can have a significant impact on the earnings of cyclical stocks, as slowing growth can sap demand for their products and services. The prospect of lower earnings can weigh heavily on their stock prices.
Realty Income is relatively immune to the impact of downturns. The REIT owns a diversified portfolio of commercial real estate, secured by long-term net leases. This lease structure requires tenants to pay all property operating costs, including routine maintenance, property taxes, and building insurance.
Most of its rent (90%) comes from tenants in recession-resistant industries, such as grocery, convenience, and home improvement stores. Realty Income owns properties leased to many of the world’s leading companies, including FedEx, Home Depot, and Walmart.
The REIT’s portfolio is so durable that it has had only one year in which it didn’t grow its adjusted funds from operations (FFO) per share (during the 2009 financial crisis). Meanwhile, it has increased its dividend every single year since its public market listing in 1994. Thanks to its high dividend yield (6% historical average and over 5% currently), Realty Income has delivered a positive operational total return (adjusted FFO per share growth plus dividend yield) every single year as a public company.
Realty Income’s reliable cash flows and positive returns have made it one of the least volatile stocks in the S&P 500. Its beta is 0.5, meaning it has half the volatility of the index, which has a beta of 1.0. If the S&P 500 dropped 20%, Realty Income would likely only decline about 10%.
The company’s high-yield dividend adds more downside cushion. Since the company has never cut or suspended its payout, investors have consistently earned about a 6% annual base income return. When adding that income yield to the average downside in its stock price, Realty Income provides an even greater shield during a down market. Since its initial public market listing in 1994, its total shareholder return downside volatility is just 3.5%, the fifth-lowest among S&P 500 members.
Realty Income’s fortress financial profile is another factor contributing to its durable earnings and low volatility. It has one of the 10 best balance sheets in the REIT sector. Its strong A3/A- bond rating, low leverage ratio, and significant liquidity support this distinction.
The company’s strong credit gives it lower borrowing costs and added flexibility. Realty Income can continue borrowing during periods of market stress to make acquisitions, giving it a competitive edge over rivals.
The REIT also has a conservative dividend payout ratio (about 75% of its adjusted FFO), giving it a comfy cushion in market downturns. That low payout ratio also allows it to retain plenty of cash for new investments. The company expects to generate more than $750 million in free cash flow after dividends this year. This internally generated capital allows it to continue growing its portfolio during stock market crashes.
Realty Income’s defensive real estate portfolio generates highly resilient cash flows that support its high-yielding dividend. It also has one of the strongest financial profiles in the REIT sector. These features have made it one of the least volatile stocks in the market and an excellent shelter against future market storms.
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Matt DiLallo has positions in FedEx, Home Depot, and Realty Income. The Motley Fool has positions in and recommends Home Depot, Realty Income, and Walmart. The Motley Fool recommends FedEx. The Motley Fool has a disclosure policy.
