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The 10-year Treasury yield just hit its highest level since 2002 at over 5.3%. Most investors would assume that rising rates are bad news for REITs like Realty Income (NYSE:O). However, up until more recently, REITs have historically delivered positive returns during periods of rising rates.
Here's a look back at how an investment in Realty Income has historically performed as rates have risen, and what that means for investors today.
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The 10-year Treasury yield was below 4% in late February, right before the U.S. and Israel launched military strikes against Iran. That conflict has caused energy and shipping prices to spike, driving a resurgence in inflation. Add in massive deficit spending and a gigantic debt-funded AI infrastructure investment boom, and the 10-year Treasury rate has risen above 5.3%, its highest level since early April 2002. That's higher than it was during the 2008 financial crisis.
Nareit (National Association of Real Estate Investment Trusts) reviewed historical REIT return data from 1992 in both rising- and falling-interest rate environments. Contrary to popular belief, REITs have historically posted gains when rates rose (78% of the time). They also gained when they fell (78.1% of the time). The average return for REITs over four quarters during periods of rising interest rates was 19.7%. That was the highest result of the scenarios it studied.
We saw a similar result from Realty Income the last time the 10-year was this high. From April 2002 through April 2003, Realty Income's stock price rose 10.8%. That compares to a 22.1% decline in the S&P 500.
However, since 2022, REIT performance has generally had an inverse relationship with Treasury yields. As yields rise, REIT stock prices have declined. We saw this in 2022 when the 10-year yield spiked from less than 2% to more than 4% at one point, which put downward pressure on REIT prices, including Realty Income stock:
While REITs, including Realty Income, have historically risen as the 10-year Treasury yield has risen, that historical correlation broke down in 2022 because the underlying cause of the rate spike changed. Most of those positive periods included strong economic growth, which drove demand for real estate. As a result, REITs benefited from higher occupancy rates, stronger rent growth, and rising income.
Today, as in 2022, inflation is a major factor. Furthermore, while the economy is growing today, the growth isn't widespread. The biggest driver of economic growth is investment in AI infrastructure, such as data centers. While robust demand for data centers is driving strong occupancy rates and rental growth for these properties, other real estate sectors -- including apartments, offices, and some warehouse markets -- are seeing sluggish growth. That's partly due to inflation -- the same headwind that impacted real estate in 2022. It's likely why Realty Income's stock has followed a similar pattern to that period, with its stock price moving in the opposite direction as the 10-year:
Shares of Realty Income are currently down about 20% from their highs earlier this year. As a result, the REIT's dividend yield has surged to around 6%. That's a historically attractive level, above its sub-5% long-term average yield over the past decade.
Realty Income's valuation has also become more attractive. It currently expects to generate at least $4.44 per share of adjusted funds from operations. At its recent $54 share price, the REIT trades at just over 12 times free cash flow, implying a free cash flow yield of more than 8%. That's low in today's historically overvalued market.
REITs' stock prices have historically risen when the 10-year yield rises. However, that pattern broke down in 2022 and appears to be repeating this time around. As a result, Realty Income's valuation is falling while its yield is rising. The silver lining here is that investors have an opportunity to buy one of the highest-quality REITs at one of its best values in over a decade. With a fortress-like financial profile and growing private capital funding sources, Realty Income can continue to grow even as rates rise.
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Matt DiLallo has positions in Realty Income. The Motley Fool has positions in and recommends Realty Income. The Motley Fool has a disclosure policy.
The 10-Year Treasury Just Hit a 24-Year High. Here's What History Says That Means for Realty Income. was originally published by The Motley Fool
