Realty Income Corporation
Q2 2017 Earnings Call Transcript

Published: 27 Jul 2017

[Operator:]

Good day and welcome to the Realty Income Second Quarter 2017 Earnings Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Ms. Janeen Bedard, Vice President. Please go ahead ma’am.

[Janeen Bedard:]

Thank you all for joining us today for Realty Income’s second quarter 2017 operating results conference call. Discussing our results will be John Case, Chief Executive Officer; Paul Meurer, Chief Financial Officer and Treasurer; and Sumit Roy, President and Chief Operating Officer. During this conference call, we will make certain statements that maybe considered to be forward-looking statements under federal securities law. The company’s actual future results may differ significantly from the matters discussed in any forward-looking statements. We will disclose in greater detail the factors that may cause such differences in the company’s Form 10-Q. We will be observing a two-question limit during the Q&A portion of the call in order to give everyone the opportunity to participate. I will now turn the call over to our CEO, John Case.

[John Case:]

Thanks, Janeen, and welcome to our call today. Our business continue to perform well in the second quarter with healthy AFFO per share growth of 7%. During the quarter we completed $321 million in high-quality acquisitions and increased portfolio occupancy to 98.5%, while maintaining in our conservative balance sheet. Given the confidence we have in our business, we are increasing in our 2017 acquisitions guidance from $1 billion to $1.5 billion. We’re also increasing our 2017 AFFO per share guidance, as we now expect 2017 AFFO per share to be $3.03 to $3.07, which represents annual growth of 5.2% to 6.6%. Let me hand it over to Paul now to provide additional detail on our financial results. Paul?

[Paul Meurer:]

Thanks, John. I’ll provide highlights for a few items in our financial results for the quarter, starting with the income statement. Interest expense increased in the quarter by $6.3 million to $63.7 million. This increase was primarily due to a higher outstanding debt balance in the second quarter following our March issuance of $700 million of long-term unsecured bonds. Our G&A as a percentage of total rental and other revenues was 5.5% for the quarter and 5.1% year-to-date. We’re so projecting approximately 5% for the year and we continue to have the lowest G&A ratio in the net lease sector. Our non-reimbursable property expenses as a percentage of total rental and other revenues were 1.6% in the quarter. Our guidance remains 1.5% to 2% for all of 2017. Funds from operations, or FFO per share, was $0.75 for the quarter versus $0.70 a year ago. We’re revising our 2017 FFO guidance to a range of $2.96 to $3.01 per share. I reported FFO follows the NAREIT-defined FFO definition, which includes various non-cash items, such as quarterly interest rates, swap gains or losses, amortization of lease intangibles and the $0.05 charge incurred in connection with the redemption of our Series F Preferred Stock in April. This $0.05 Preferred Stock redemption charge is the primary difference in our FFO and AFFO guidance. Adjusted funds from operations or AFFO, where the actual cash we have available for distribution is dividend was $0.76 per share for the quarter, representing a 7% increase over the year ago period. Briefly turning to the balanced sheet. We’ve continued to maintain our conservative capital structure. During the quarter, we raised $55.1 million in equity, primarily through our ATM program. Our senior unsecured bonds have a weighted average remaining maturity of 7.9 years. And our fixed charge coverage ratio is 4.4 times. Other than our credit facility, the only variable rate debt exposure we have is on just $23 million of mortgage debt. And our overall debt maturity schedule remains in very good shape, with only $213 million of debt coming due to the remainder of this year and our maturity schedule is well lathered thereafter. And finally, our overall leverage remains modest with our debt-to-EBITDA ratio standing at approximately 5.6 times. In summary, we continue to have low leverage, excellent liquidity and continued access to attractively priced equity and debt capital. Now, let me turn the call back over to John to give you more background on our results.

[John Case:]

Thanks, Paul. I will begin with an overview of the portfolio, which continues to perform well. Occupancy based on the number of properties was 98.5%, the highest occupancy we have achieved in 10 years. We continue to expect occupancy to be approximately 98% in 2017. During the quarter we re-leased 53 properties to existing and new tenants, recapturing approximately 113% of expiring rent, which is well above our long-term average. This quarter was the fourth consecutive quarter of leasing recapture rates above 100%. For the first half of 2017, we have re-leased 102 properties to existing and new tenants recapturing approximately 109% of expiring rent. Since our listing in 1994, we have re-leased or sold over 2,400 properties with leases expiring, recapturing over 99% of rent on those properties that were re-leased. This compares favorably to the companies in our sector who also report this metric. Our same-store rent increased 0.4% during the quarter, primarily due to the timing of percentage rent increases on a year-over-year basis. For the first half of the year, our same-store rent increased by 1%, which is consistent with our projected run rate for 2017. Our portfolio continues to be diversified by tenant, industry, geography and to a certain extent, property type, which contributes to the stability of our cash flow. At the end of the quarter, our properties were leased to 250 commercial tenants in 47 different industries located in 49 states in Puerto Rico. 80% of our rental revenues from our traditional retail properties, the largest component outside of retail is industrial properties at about 13% of rental revenue. Walgreens remains our largest tenant at 6.7% of rental revenue and drugstores remain our largest industry at 11% of rental revenue. As you all know, due to regulatory concerns Walgreens terminated its agreement to purchase Rite Aid and instead plans to purchase about 2,200 Rite Aid stores. All the proposal must still clear regulatory approval. The completion of the transaction would have benefits for both companies. Walgreens would fill in gaps in its geographic footprint and achieve additional financial and operational synergies. And Rite Aid has stated, it would deleveraged balance sheet and it would remain the third largest player in the industry, while gaining an access to Walgreens purchasing network. Within our retail portfolio over 90% of our rent comes from tenants with a service, non-discretionary, and/or low price point component to their business. We believe these characteristics allow our tenants to compete more effectively with e-commerce and operate in a variety of economic environments. These factors have been particularly relevant in today’s retail climate, where the vast majority of U.S. retailer bankruptcy’s this year have been in industries that do not share these characteristics. We continue to have excellent credit quality in the portfolio with 46% of our annualized rental revenue generated from investment grade rated tenants. The store level performance of our retail tenants also remains sound. Our weighted average rent coverage ratio for our retail properties remains 2.8 times on a four-wall basis, and the median remains 2.7 times. Our watch list has declined by approximately 15 basis points and remains in the low 1% range as a percentage of rent, which is consistent with our levels of the last few years. Moving on to acquisitions, we completed $321 million in acquisitions during the quarter at attractive investment spreads. We continue to see a steady flow of opportunities that meet our investment parameters. We remain selective in our investment strategy acquiring less than 4% of the amount we source. Our low cost of capital allows us to simultaneously acquire the highest quality properties that provide favorable long-term returns, while also creating meaningful near-term earnings growth. Given the continued strength in the investment pipeline, we are increasing our acquisitions guidance for 2017. We now expect to complete approximately $1.5 billion of acquisitions and increase from our prior estimate of $1 billion. This estimate does not account for any unidentified large scale transactions. Now, let me hand it over to Sumit to discuss our acquisitions and dispositions.

[Sumit Roy:]

Thank you, John. During the second quarter of 2017, we invested $321 million in 73 properties located in 27 states at an average initial cash cap rate of 6.6% and with a weighted average lease term of 13 years. On a revenue basis, approximately 33% of total acquisitions are from investment-grade tenants. 91% of the revenues are generated from retail and 9%, are from industrial. These assets are leased to 23 different tenants in 16 industries. Some of the most significant industries represented are health and fitness, quick service restaurants and theatres. We closed 26 discrete transactions in the second quarter. Year-to-date 2017, we invested $692 million in 126 properties located in 30 states at an average initial cash cap rate of 6.3% and with a weighted average lease term of 14.8 years. On a revenue basis 51% of total acquisitions are from investment grade tenants. 95% of the revenues are generated from retail and 5% are from industrial. These assets are leased to 34 different tenants in 20 industries. Some of the most significant industries represented our grocery stores automotive services and health and fitness. Of the 37 independent transactions closed year-to-date, two transactions were above $50 million. Transaction flow continues to remain healthy. We sourced approximately 7 billion in the second quarter. Year-to-date, we have sourced approximately $18 billion in potential transaction opportunities. Of these opportunities 46% of the volume sourced were portfolios and 54% or approximately $10 billion were one-off assets. Investment grade opportunities represented 35% for the second quarter. Of the $321 million in acquisitions closed in the second quarter, 72% were one-off transactions. We continue to capitalize on our extensive industry relationships developed over 48 years of operating history. As to pricing, cap rates continue to remain flat in the second quarter with investment grade properties trading from around 5% to high 6% cap rate range and non-investment grade properties trading from high 5% to low 8% cap rate range. Our investment spreads relative to our weighted average cost of capital remained healthy, averaging 221 basis points in the second quarter, which were well above our historical average spreads. We defined investment spreads as initial cash yield less our nominal first year weighted average cost of capital. Regarding dispositions, during the second quarter, we sold 14 properties for net proceeds of $12.3 million at a net cash cap rate of 6.6% unrealized and un-levered IRR of 9.5%. This brings us to 28 properties sold year-to-date for $43.5 million at a net cash cap rate of 7.9% unrealized and un-levered IRR of 9.7%. In conclusion, we remain confident in reaching our 2017 acquisition target of approximately $1.5 billion and disposition volume between $75 million and $100 million. With that, I’d like to hand it back to John.

[John Case:]

Thanks, Sumit. Last month, we increased the dividend for the 92nd time in the company’s history. The current annualized dividend represents a 6% increase over the year ago. We have increased our dividend every year since the company’s listing in 1994, growing the dividend at a compound average annual rate of just under 5%. We are proud to be one of only five REITs in the S&P High Yield Dividend Aristocrats Index. Our dividend represents an AFFO payout ratio of approximately 83% based on the midpoint of our 2017 guidance. To wrap it up, we’re pleased with our company’s operating performance and remain confident in our outlook. Our real estate portfolio is performing well. Our acquisition pipeline is robust and our balance sheet is conservatively capitalized. Our cost of capital remains a competitive advantage in the net lease industry, which we believe allows us to continue generating favorable risk adjusted returns for our shareholders. At this time, I’d like to open it up for questions. Operator?

[Operator:]

Thank you. [Operator Instructions] We’ll take our first question from Joshua Dennerlein with Bank of America Merrill Lynch.

[Joshua Dennerlein:]

Hey, guys, good afternoon.

[John Case:]

Hey, Josh.

[Joshua Dennerlein:]

So I saw on page 24, there’s an additional invested capital line, a bit higher than normal this quarter. Could you walk us through that line item? How we should think about it?

[John Case:]

24 of the supplement I think is what you’re referring to. Virtually all of that, what’s related to an expansion of an existing industrial distribution property, where we doubled the size of it, and extended the lease term with an investment grade credit by 10 years. Our incremental yield on that investment capital was 7.5%, which is about 150 basis points above where our acquisition yield would be on this type of property. So the value creation exercise for the company and shareholder, so we were pleased with that.

[Joshua Dennerlein:]

Great. And do you think this will become more common for your business on a go-forward basis. Or is this just – was this kind of one-off here.

[John Case:]

We hope so, I mean, these expansion opportunities are quite attractive for us and deliver attractive risk adjusted returns and returns beyond what the acquisitions typically yield the company. So I think as we move forward, we’ll see that number grow a bit and we’d like to see it grow a bit. Right now overall we have $90 million under development, which we have $16 million defined. We would like to see that number pick up, that does include expansions and redevelopments

[Operator:]

We’ll take our next question from Ryan Meliker with Canaccord Genuity.

[Ryan Meliker:]

Hey, good afternoon guys or good morning out there. I guess just – I wanted to talk a little bit acquisitions you obviously increase your guidance for the year by pretty lost to $500 million. Can you just give us some color on what you guys are seeing out there? Is it larger portfolios that seem to be coming to market? I know there’s been a lot of expectations that maybe volumes might slow this year or next year. Sounds like you guys aren’t seeing that, just any color would be helpful.

[John Case:]

Sure. We’re not seeing volume slow year-to-date we sourced $18 billion in investment opportunities and we’re still remaining quite selective and what we’re investing. Then a year-to-date 4% of what we’ve sourced, we’ve actually closed on. When we look forward, we’re seeing a combination of some larger portfolios, but also strong activity in our aggregation program where we’re looking at assets on a more granular basis or small portfolios. So the increase is predicated on both types of acquisitions, smaller portfolios as well as couple of large sale leaseback opportunities we’re working on and would expect, we would hope to hit those as well. So again not seeing any sign whatsoever of the transaction opportunities for, Ryan.

[Ryan Meliker:]

All right. Great, that’s helpful. This is a quick follow-up. Are you changing any of your underwriting standards driven by what’s going on in the retail environment and some of the uncertainties surrounding some retailers’ with regards to e-commerce?

[John Case:]

Well, on the retail side we continue to focus on service non-discretionary and/or low price point businesses, which we have done now for nearly 10 years. And we do that because those types of tenants have been much more resistant to the impact of e-commerce. So we’ve not changed our investment parameters on the retail front or on the industrial front. We continue to hear to those investment parameters. And when you look at the selectivity as I’ve said just a moment ago we’re not increasing the percentage of opportunities we see in terms of what we’re closing on over the last few years, that’s average probably 8% and this year we’re running at 4%. So again I think that selectivity metric is something the market can look at and be comfortable that we’re not changing our investment parameters.

[Operator:]

We’ll take our next question from Vikram Malhotra with Morgan Stanley.

[Vikram Malhotra:]

Thanks. Just on the pipeline – sorry, the watch list you mentioned some that watch list decline. Can you maybe give us some color, what actually fell off the watch list and has a composition changed in any way?

[John Case:]

Well, the overall watch list declined by 15 basis points. It’s still in the low 1% area and that’s a combination of some sales we made and also some improving financial metrics on some properties that were in that watch list that we took out given the improvement in the financial metrics for those particular properties. So Vikram, that’s a fluid concept, that’s changing almost on a daily basis based on conversations we’re having with our tenants and the information we’re receiving in our research and credit group. But it is trending down. Then I would add to that our credit watch list has been running around 6%, but this past quarter it was less than 5%. So we’re seeing the credit profile within the portfolio improved as well.

[Vikram Malhotra:]

Okay. That’s helpful. And then just as a quick follow-up in your expiration over the next two years. Are any of your top 10 or 15 tenants or any of them in there anything sizable we should be aware of?

[John Case:]

No nothing sizable on our top tenants rolling within the next one to two years.

[Operator:]

We’ll take our next question from Collin Mings with Raymond James.

[Collin Mings:]

Hey, thanks and good morning out there guys.

[John Case:]

Hey, Collin.

[Collin Mings:]

Just first one for me, can you guys just update us on how you’re thinking about capital markets activity over the remainder the year with about $650 million or so on the line at the end of June. Just remind us, how much you’re comfortable carrying on that. And how you see that the back half playing out from a capital markets perspective?

[John Case:]

So in our line of credit has a base amount of $2 billion and with an accordion future at our option of another $1 billion, and has two years remaining in terms of term plus one year extension option at our option. So we are seeing – we have plenty of liquidity today. As we look forward, what we’ll do with regard to financing is we’ll look at all of the markets, the unsecured market, the debt market, the hybrid markets and if they appropriate time pick the right form of capital to term out our line balance. So as we sit here today, we don’t have any specific plans in terms of what we want to issue, but asset line balance grows we’re comfortable with it up until billions, but we want to be opportunistic and access capital at the appropriate time and certainly the right types of capital.

[Collin Mings:]

Okay. And then maybe just switching gears as far as the entry of NPC International into the top 20 tenant roster, any color you can provide on that.

[John Case:]

Yes. NPC has been a relationship in a tenant for us for probably 20 years now and they are the largest Pizza Hut franchise in the U.S. and they’re the largest Wendy’s franchise in the U.S. and we did a Wendy’s portfolio last quarter that brought down back into our top 20. They’ve been in our top 20 before, but it’s a result to the portfolio acquisition of Wendy’s.

[Operator:]

We’ll take our next question from Nick Joseph with Citi.

[John Case:]

Nick?

[Operator:]

Hello, you may have [indiscernible] (31

[John Case:]

We got to the next question and Nick can rejoin.

[Operator:]

We’ll take our next question from Michael Carroll with RBC Capital Markets.

[Michael Carroll:]

Yes, thanks. John, can you provide some color on the health of the leapy market versus the historical trends. It looks like company has been driving much higher recapture rates over the past few years. Is this a trend and if so, what’s driving it?

[John Case:]

Well, it’s been a trend. We’ve had over the last five quarters of strong numbers on that trend. And I think it’s just speaks to the portfolio help of the tenants, quality of the properties, and specifically those tenants operations at those specific properties. So we’ve been pleased with it, over the life of the company, we have had recapture rates right at about 100% just a hair below, I think it’s 99.4%. So realizing these recapture rates in the 113% range very healthy. And I think it speaks to the quality and health of the portfolio. I’ll tell you, we have a tremendous team in our portfolio management group that is working these properties in some cases years in advance negotiating with our tenants to retain them in those assets, and if it makes sense for their business, but also for our business. So it’s been a real focus of ours over the last several years. And one which we continue to have and we hope that will yield some more results, it’ll vary from quarter-to-quarter. But the trend certainly has been positive for us.

[Michael Carroll:]

Okay. I might be nitpicking here a little bit, but given your success you had in the first half of 2017. Why was it necessary to remove the top end of the same-store rent guidance range this quarter?

[John Case:]

Yes, we went out with the same-store rent guidance at the beginning of the year 1% to 1.2% growth. So as we’re here at the mid-year point, we’ve got more visibility and of what the same-store pull is going to look like for the remainder of the year. And it looks like it’s going to be closer to 1% and this is the time of the year, typically, that we update our guidance numbers. And we thought it be appropriate to move that to 1%. It’s not related any tenant credit issues as I’ve said our credit watch list, as well as our overall watch list have continued to decline. It’s just fine tuning at the mid-year point, really nothing to read into that.

[Operator:]

[Operator Instructions] We’ll take our next question from Dan Donlan with Ladenburg Thalmann.

[Dan Donlan:]

Thank you. Just two questions for me. John, just curious if you can comment on what portion of the portfolio is taken, but still paying rent and then kind of how do you manage that down especially if you have a lot of lease term left. How do you guys kind of look at that?

[John Case:]

Okay. Well, we have – Dan, about 0.75% of rent that is current, but on they can assets. And that’s inline with where our company has been for a while now a number of years the average lease term remaining on those properties, it’s about 60 properties in six years. 61% of those closed current as we refer to them, our investment grade rated tenants. And we remain in close communication with those tenants in terms of releasing or subleasing and we’re not releasing those primary tenants from their rental obligations. We’re spending more time working on those properties expected to roll in the near-term, so within the next three years of course than we are properties that may not roll for six, seven, eight, nine years and have an investment grade tenant paying rent. So that’s part of the business and has been for a long time.

[Dan Donlan:]

Okay. And then just curious on our Gander Mountain, what the thought process is there are – I think if I look at the list there you’re maybe one of your nine properties is going to be kept. If you look at the new build list that they put out if you it may be three of nine. We’re just kind of curious, how your discussions are going there and you have any replacement tenants lined up? Any additional commentary would be helpful.

[John Case:]

Sure. Well, Gander is interested in the majority of our properties and they have been purchased by camping more on. So we know Freedomroads, Camping World very well they’ve been a tenant of ours for a long time. We’re in discussions with them, the list that are being put out there, I would say aren’t always completely accurate. But in some cases, Gander may want to stay, but not at a rent level that makes sense for us. So we’re having conversations with other tenants beyond Gander for those properties that may yield a better result than what Gander staying would be. So clearly, those start staying on a handful and we’ll see what happens to the others. We’ve been – we’re current on Gander rent through the month of July and we have factored I think fairly conservatively our expectations of the impact of Gander into our guidance for this year. And we’re not expecting any surprises from that standpoint. And collectively on an annualized basis, Gander is less than one half of 1% of our rent. So that’s not completely insignificant, but it’s not a large material issue for us. And we think the locations that we have are attractive than major metropolitan areas, and again we’ve seen good interest from other tenants in those locations. So I think we’re going to be buying there.

[Operator:]

[Operator Instructions] And we’ll take our next question from Karin Ford with MUFJ Securities.

[Karin Ford:]

Hi, good afternoon. Have you seen any change in the tone of your discussions with any of your retail tenants? Are they, say, more wary of extension plans less likely to renew anything like that?

[John Case:]

No, in our renewal rates are up more considering expansions in our conversations with them carrying, they’re optimistic about their business. The portfolio overall is in very good health and I’d say we’re not experiencing any more tenant credit issues when we have an any year and in the last four or five years of this cycle. So this year has been pretty much business as usual the largest issue we just talked about and that’s Gander that’s not that material for us. And then once you get beyond that there are few moms and pops that have had some credit issues, but even on a collective basis they’re not material for our company.

[Karin Ford:]

Okay thanks. And my second question is, given that success and the fact that your credit is held us so well with your service non-discretionary low price point tenant in the retail – on the retail side. Are you seeing more competition for those assets? Are people starting to chase some more? Are you seeing a widening of GAAP and cap rates between those types of retailers and deals with other types of retailers?

[John Case:]

Well, I think retailers that are e-commerce resistant and have proven to be at this point and are well capitalized, high credit, well managed businesses. We’re going to trade at cap rates that are more aggressive. And fortunately for us, we’ve got overall lowest cap cost of capital in the business. We have the greatest access to capital and we have the ability to do larger scale transactions with these larger companies without creating tenant revenue concentration issues for the company. But we’re really an advantageous position, we’ve developed great relationships with these – those tenants tend to be larger, and those relationships are resulting and some opportunities on the acquisitions front that are being done on a purely negotiated basis. So we’re happy with that.

[Operator:]

We’ll take our next question from Michael Knott with Green Street Advisors.

[Michael Knott:]

Hey, guys just a quick question on just more generally what’s happening with yields in the investment marketplace. Your yield that you achieved on acquisitions this quarter was higher than it had been the last couple quarters. So I just wanted to get your thoughts on what you’re seeing and what you expect to happen over the balance of the year in that marketplace?

[John Case:]

Yes, Michael. Yields vary from quarter-to-quarter. The yield this quarter was 6.6%, and the first quarter it was 6.1% year-to-date, it was 6.3%. That’s fluctuating yields really a – between the first and second quarter, the function of two items, one is we did more investment grade in the first quarter then we did in the second quarter. And that’s really a function of the opportunities available to invest in the market. And then the lease terms were slightly longer in the first quarter than the 13-year term that we had in the second quarter, and hence you had a bit of a pricing differential on cap rates. But year-to-date that leasing terms of 15 years and over the course of the last three or four years our lease terms by quarter vary quite a bit sometime, they’ve been as low as 10 years and as high as 17 years. So coming in at 15 year-to-date is fine. And the cap rate, we’re still guiding to something for the year in the low 6s. And what will impact that is just simply the quality of the properties in both quarters were very strong. And when you do get investment grade on top of strong real estate location with strong operating metrics, you’re going to – that is going to be reflected in a more aggressive cap rate.

[Michael Knott:]

And then can we get your views on traffic and trends in the restaurant space. Maybe more specifically on QSRs, I guess, if that’s the way you’re focuses more so. And then also with my last question, can I get you to make any comments on your view of grocery changes potentially with Amazon entering into whole foods?

[John Case:]

Sure. I’ll start with Amazon on the grocery front, obviously, there’s been a lot in the news about that. Our grocery exposures just under 5% virtually all of that is with two of the leading grocers in the marketplace, that’s Walmart neighborhood markets and Kroger, which are both developed successful online businesses, omni-channel businesses and continue to expand those businesses and incorporate their real estate locations, which are favorable. They’re also very well capitalized companies, who have the ability to continue to invest in their e-commerce initiatives and they’ve shown with their results to date in terms of their investments in those initiatives, good growth and good results. So they’re well positioned to compete with the Amazon Whole Foods. And I think we’ll see how this plays out. But we have very strong grocery stores there. And we have the ones we want, I think the ones that will be impacted or the ones that are smaller regional don’t have an omni-channel presence, and don’t have the capital strength to invest in that business. On QSR traffic, Sumit, you want to take that?

[Sumit Roy:]

Yes, sure. So we continue to invest in QSRs and we feel that this particular subs sector in the restaurant space this continue to improve. Our specific portfolio has coverages in the high-2’s in this particular area, and the fact that John alluded to Wendy’s portfolio that we just closed on. This is an area that we feel very good about and we’ll continue to invest in.

[Operator:]

This concludes the question-and-answer portion of Realty Income’s conference call. I will now turn the call over to John Case for concluding remarks.

[John Case:]

Thank you Casey, and thanks for everyone for joining us today. We look forward to speaking with all of you as we had into the fall and conference season. Have a good afternoon and a great remainder to your summer.

[Operator:]

That concludes today’s call. Thank you for your participation. You may now disconnect.