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Realty Income (NYSE:O) is a favourite stock among investors looking for passive income. And with a monthly dividend that’s increased quarterly for over 55 years, it’s easy to see why.
Investors, however, need to be careful when it comes to this type of investment. While receiving cash distributions every month is nice, the numbers need to stack up over the long term…
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice.
Dividend income
At the moment, 30-year government bonds yield 4.9% in the US and 5.4% in the UK. Compared to that, Realty Income shares look like a very attractive passive income opportunity.
The stock currently has a 5.6% dividend yield. And the firm has increased its distribution at an average of 4.2% per year since listing on the US stock market in 1994.
Past dividend growth doesn’t guarantee future increases. But Realty Income’s impressive track record hasn’t come about by accident – it’s the result of skilled management.
The headline numbers are attractive, but what you see isn’t always what you get with investing. And UK investors need to be especially aware of how returns can be lower than expected.
Hidden costs
The first thing UK investors need to keep in mind is taxes. Distributions from US companies are subject to a 30% withholding tax, though this falls to 15% for investors with a W-8BEN form.
In the case of Realty Income, it means the 5.6% yield is actually more like 4.75%. That means UK investors should expect a lower starting return than government bonds currently offer.
Inflation is another issue. Both the Bank of England and the US Federal Reserve are aiming for 2% currency depreciation per year, which would cut the starting return to 2.75% in real terms.
That’s less than half the 5.6% investors might have initially expected. But the bigger problem is that the annual dividend growth rate has slowed to 2.2% over the last five years, rather than 4.2%.
Long-term returns
A starting yield of 5.6% with 4.2% growth is very different to a starting yield of 4.75% with 2.2% growth. And the contrast can be quite dramatic over a 30-year time period.
Investing £10,000 at the former rate for three decades generates £32,477 in passive income, with £1,846 in year 30. The lower return, however, brings in £19,885 in total and £893 in the final year.
The higher number is what UK investors might hope for from a £10,000 investment in Realty Income shares. But I think the lower one is a more realistic expectation in real terms after taxes.
That’s why it’s important to pay attention to the various factors that can weigh on real returns. Sometimes investors can find themselves getting much less than they initially expected.
US stocks
I used to have a big (by my standards) investment in Realty Income. The reason I don’t any longer is that I think I’ve found better opportunities in the UK.
Over the long term, I’m not sure the potential returns are exciting. A combination of inflation, a slowing growth rate, and withholding taxes make me wary of what I might get back.
