Realty Income Corp (O) — Q2 2015 Earnings Call Transcript

Thank you all for joining us today for Realty Income Second Quarter 2015 Operating Results Conference Call. Discussing our results will be John Case, Chief Executive Officer; Paul Meurer, Chief Financial Officer and Treasurer; and Sumit Roy, Chief Operating Officer and Chief Investment Officer. During this conference call, we will make certain statements that may be 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. I will now turn the call over to our CEO, John Case.

Thanks, Janeen and welcome to our call today. We had a very active second quarter and we are pleased to report excellent results from an acquisitions, capital markets and occupancy standpoint. Additionally, we were gratified to be added to the S&P 500 Index in the second quarter. Our AFFO per share growth was 6.3% and a record quarterly amount of $0.68. As announced in yesterday's press release, we are increasing our FFO and AFFO per share guidance for 2015, given the Company's positive year-to-date performance and the continued scalability of our business. We believe we are the most efficiently run net lease company with the highest EBITDA margin in the sector today. We are raising our 2015 FFO per share guidance to $2.72 to $2.77 from $2.67 to $2.72. We are raising and tightening the range of our AFFO per share guidance to $2.69 to $2.73 from $2.66 to $2.71. As we continue to anticipate another solid year of earnings growth. Now I will hand it over to Paul to provide additional detail on our financial results.

Thanks John. As usual, I will provide some brief highlights of our financial results for the quarter starting with the income statement. Total revenue increased 11.1% for the quarter; this increase reflects our growth primarily from new acquisitions over the past year as well as healthy same-store rent growth. Our annualized rental revenue at June 30th was approximately $983 million. On the expense side, interest expense increased in the quarter to $58.7 million. This increase was primarily due to our two bond offerings last year, the $350 million 10-year notes issued in June and $250 million 12-year notes issued in September. We also recognized a non-cash loss of approximately $900,000 on interest rate swaps during the quarter. On a related note, our coverage ratios both remain strong with interest coverage at 4.0 times and fixed charge coverage at 3.6 times. General and administrative or G&A expenses were approximately $12.6 million for the quarter. Included in G&A expenses is approximately $192,000 in acquisition costs. And note that we do include these acquisition costs in our calculation to both FFO and AFFO. Year to date, our G&A as a percentage of total rental and other revenues is only 5.3%. Our projection for G&A expenses in 2015 is now approximately $52 million, down from our prior estimate of $55 million, as we realized lower than expected expense growth given the efficiencies of our business. Property expenses, which were not reimbursed by tenants, totaled $3.3 million for the quarter. And our current projection for property expenses that we will be responsible for in 2015 remains unchanged at approximately $20 million. Provisions for impairment of approximately $3.2 million during the quarter includes impairments we recorded on three properties classified as held for sale and two properties classified as held for investment. Gain on sales were approximately $3.7 million in the quarter and just a reminder, we do not include property sales gains in our FFO or AFFO. Funds from operations or FFO per share was $0.69 for the quarter, a 7.8% increase versus a year ago. Adjusted funds from operations or AFFO or the actual cash we have available for distribution as dividends was $0.68 per share for the quarter, a 6.3% increase versus the year ago. Dividend paid increased 4% in the second quarter and we again increased our cash monthly dividend this quarter. Our monthly dividend now equates to a current annualized amount of $2.28 per share. Now let me briefly turn to the balance sheet. We've continued to maintain our conservative capital structure. As you know, in early April we raised approximately $276 million of new equity capital in conjunction with our addition to the S&P 500 Index. The index inclusion was an excellent opportunity to raise capital at a very low cost by offering shares to the index funds needing to buy our stock on that day. We raised an additional $106 million of equity capital during the quarter through our direct stock purchase plan. Our bonds, which are all unsecured and fixed rates, continued to be rated BAA1, BBB+ at a weighted average maturity of 6.7 years. At the end of the quarter, we recapped and expanded our unsecured acquisition credit facility from $1.5 billion to $2.25 billion, comprised of a $2 billion revolving credit facility and a $250 million term loan which is due in 2020, when we have no scheduled unsecured debt maturities. At our current BBB+ BAA1 credit rating, the borrowing rate on the revolver is LIBOR plus 90 basis points with a facility commitment fee of 15 basis points which overall represents a 20 basis point reduction for the all-in drawn borrowing rate of the previous facility. We very much appreciate the capital commitments from the 21 banks that participated in the syndication of this larger facility for us. Our new $2 billion credit facility had a $430 million balance at June 30th. We did not assume any mortgages during the quarter. We did pay off some at maturity so our outstanding net mortgage debt at quarter end decreased to approximately $757 million. Not including our credit facility, the only variable rate debt exposure we have is on just $15.5 million of mortgage debt. And our overall debt maturity schedule remains in very good shape with only $40 million in mortgages and $150 million of bonds coming due in 2015 and our maturity schedule is well staggered thereafter. Currently, our debt to total market capitalization is approximately 32% and our preferred stock outstanding is only 2.5% of our capital structure. And our debt to EBITDA at quarter end was approximately 5.9 times.

Thanks Paul. I’ll begin with an overview of the portfolio which continues to perform well. Occupancy based on the number of properties was 98.2%, a 20 basis points improvement from last quarter. At the end of the quarter, we had 81 properties available for lease out of 4,452 properties on our portfolio. Economic occupancy was 99.2%, and occupancy based on square footage was 98.8%, both up 10 basis points from last quarter. We continue to see good leasing activity and expect our occupancy to remain around current levels for the end of the year. We have leases expire on 80 properties during the quarter and we re-leased 81 properties. 73 of those properties were re-leased to existing tenants and 8 were re-leased to new tenants, recapturing 106% of expiring rents. This compares favorably to our historical recapture rate of approximately 98% of expiring rents. Additionally, four vacant properties were sold during the quarter. Our same-store rent increased 1.5% during the quarter and 1.4% year-to-date. The industry is contributing the most to our quarterly same-store rent growth for health and fitness and motor vehicle dealerships. We expect same-store rent growth to remain about 1.4% for the foreseeable future. 90% of our leases have contractual rent increases. So, we remain pleased with the growth we are able to achieve from our properties leased to both our investment grade and non-investment grade tenants. Approximately 75% of our investment grade leases had rental rate growth that averages about 1.3%. Our portfolio continues to be diversified by tenant, industry, geography, and to a certain extent property type. At the end of the second quarter, our properties were leased to 235 commercial tenants and 47 different industries located in 49 states and Puerto Rico. Our diversification contributes to the stability of our cash flow. 79% of our rental revenue is from our traditional retail properties. The largest component outside of retail is industrial properties at 13%. This quarter we reclassified 14 assets previously classified as manufacturing properties, representing approximately 2% of rent for our investor category, which better reflects these properties’ uses and clarifies our portfolio composition. We continue to focus on retail properties leased to tenants without service, non-discretionary, and/or low price point components to their business. Today more than 90% of our retail revenue comes from businesses with these characteristics, which better positions them to successfully operate in a variety of economic environments and to compete with e-commerce. At the end of the second quarter, our top 20 tenants continue to capture nearly every tenant representing more than 1% of our rental revenue. Our largest channel is Walgreens which now accounts for 7.1% of rental revenue, an increase from 5.5% at the end of the last quarter. We continue to like Walgreens’ business, their high-quality real estate locations, and the rent growth we receive. We also are confident in the strength of these properties given the visibility we have into their unit level performance. FedEx remains our second-largest tenant at 4.9% of rental revenue. This quarter, we added a new name to our top 20 tenants. Life Time Fitness is now our 13th largest tenant representing 2% of that. During the second quarter, we executed a sale leaseback transaction with Life Time Fitness. Life Time Fitness is the tenant we had been meeting with and pursuing for about 10 years now. We followed them through challenging and favorable economic conditions and have been impressed with the performance of their business. We also believe their well-located real estate and excellent surrounding demographics and the service orientation of their business make them a great addition to our portfolio. Drug stores remain our largest industry at 10.7% of rental revenue and increased from 9.6% at the end of the first quarter. The drug store industry continues to be an area we favor given the aging of our population and today's healthcare trends. The convenience store industry is our second largest at 9.4% of rental revenue. Dollar stores are at 9.1%, down 20 basis points from last quarter. As many of you may know, Dollar Tree completed its acquisition of Family Dollar this month, subsequent to our second quarter end. As part of the transaction, FTC identified 330 of the combined 14,000 stores for divestiture, there was no financial impact on our rental revenue as a result of these divestitures. Pro forma Dollar Tree will represent 4.3% of rental revenue. Health and fitness is our fourth largest industry at 7.2% of rental revenue, a 40 basis points increase from last quarter. Health and fitness is the sector we have been invested in since 1998 and it has performed very well for us. We continue to like health and fitness given the favorable demographics supporting this industry. We continue to have excellent credit quality in the portfolio with 48% of our rental revenue generated from investment grade rated tenants. The store level performance of our retail tenants remains sound, our weighted average rent coverage ratio for the retail properties is 2.6 times on a four-wall basis and importantly, the median is also 2.6 times. Moving on to acquisitions, we had a very active second quarter investing $721 million at an initial cash cap rate of 6.3% and an initial average lease term of over 18 years. This is the second highest quarterly volume and property level acquisitions in the Company's history. Our straight line cap rate during the quarter was 7%, which reflects the attractive rent growth of the acquisition. For the first half of the year, we completed $931 million in acquisitions at an initial cash cap rate of 6.4% and an initial average lease term of nearly 18 years. Cap rates remain aggressive but stable. However, our investment spreads continue to be favorable and remain above their historical norms. We continue to see a high volume of acquisition opportunities. During the quarter, we sourced about $10.5 billion in acquisition opportunities, which brings us to $20 billion in sourced opportunities for the year. Given our acquisitions activity to date and the high volume of opportunities we continue to see, we are increasing our acquisitions guidance for 2015 to approximately $1.25 billion from our previous estimate of $1 billion. We continue to selectively sell non-strategic assets and redeploy that capital into properties that better fit our investment strategies. During the first half of the year, we sold 14 properties for $30.5 million. We sold our least non-strategic assets at a cap rate of 7.8%. We continue to expect a minimum of $50 million in dispositions for 2015 and that figure could go up a bit. Now I'll hand it over to Sumit to discuss our acquisitions and dispositions in more detail.

Thank you, John. During the second quarter of 2015, we invested $721 million in 100 properties located in 33 states at an average initial cash cap rate of 6.3% and with a weighted average lease term of 18.2 years. We define cash cap rates as contractual cash net operating income for the first 12 months following the acquisition date, divided by the total cost of the property including all expenses borne by Realty Income. On a revenue basis, 49% of total acquisitions are from investment grade tenants, and the rest of the revenues are from retail tenants that are non-investment grade or not rated. 98% of the revenues are generated from retail, and 2% are from industrial. These assets are leased to 21 different tenants and 13 industries. Some of the most significant industries represented are health and fitness, drug stores, and home improvement. Of the 16 independent transactions closed in the second quarter, two transactions were about $50 million. Year to date, in the second quarter 2015, we invested $931 million in 166 properties located in 35 states at an average initial cash cap rate of 6.4% and with a weighted average lease term of 17.5 years. On a revenue basis, 52% of total acquisitions are from investment grade tenants, and the rest of the revenues are from retail tenants that are non-investment grade or not rated. 92% of the revenues are generated from retail, and 8% are from industrial. These assets are leased to 27 different tenants in 16 industries. Some of the most significant industries represented are health and fitness, drug stores, and quick service restaurants. Of the 25 independent transactions closed year to date, three transactions were about $50 million. Transaction flow continues to remain healthy; we sourced more than $10 billion in the second quarter. Year-to-date, we have sourced approximately $20 billion in potential transaction opportunities. Of these opportunities, 66% of the volumes sourced were portfolios, and 34% or approximately $7 billion were one-off assets. Investment grade opportunities represented 21% for the year-to-date. Of the $721 million in acquisitions closed in the second quarter, approximately 5% were one-off transactions. We remained selective and disciplined in our investment approach, closing on less than 7% of deals sourced and continuing to capitalize on our extensive industry relationships. As to pricing, cap rates continued to remain tight 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. As John highlighted, our disposition program remained active. During the quarter, we sold five properties for $8 million at a net cash cap rate of 8.1% and realized an unlevered IRR of over 11.6%. This brings us to 14 properties sold year-to-date for $30.1 million at a net cash cap rate of 7.8% and realized an unlevered IRR of 12.3%. Our investment spreads relative to our weighted average cost of capital were healthy, averaging 140 basis points in the second quarter, which were around our historical average spreads. We define investment spreads as initial cash yield less the nominal first year weighted average cost of capital. Year-to-date, based on the weighted average cost of the long-term capital raised, our estimated investment spreads were approximately 200 basis points, notably above our historical average. In conclusion, the second quarter investments remain solid at $721 million while sourcing more than $10 billion in transactions. Our year-to-date spreads remain about historical levels. We continue to be very selective in pursuing opportunities that are in line with our long-term strategic objectives and within our acquisition parameters. We are also taking advantage of an aggressive pricing environment to dispose of assets that are no longer a strategic fit. As John mentioned, we are raising our acquisition guidance for 2015 to approximately $1.25 billion. With that, I'd like to hand it back to John.

Thanks, Sumit. We are pleased to have taken advantage of the capital market conditions during the first half of the year, that satisfied the majority of our capital needs for acquisitions year-to-date, raising $484 million in equity capital at an average per share price of approximately $50 and issuing a $250 million unsecured term loan at 2.7%. Additionally, our new $2 billion revolving credit facility was recapped at a lower rate than our previous revolver and provides for additional financial flexibility as we continue to grow our company. Our sector-leading cost of capital continues to allow us to drive earnings growth while investing in high-quality assets. We increased the dividends paid this quarter by 4% on a year-over-year basis. We have increased our dividend every year since the Company's listing in 1994, growing the dividend at a compound average annual rate of almost 5%. Our payout ratio in the second quarter was 83.7%, which is a level we continue to be comfortable with. Finally, to wrap it up, we continue to maintain excellent momentum in our business. We continue to have very active dialogues regarding potential acquisition opportunities with existing and prospective tenants. We remain well-positioned to execute on acquisitions with approximately $1.6 billion available on our new $2 billion revolving line of credit. At this time, I would like to open it up for questions, operator?

This is actually Josh Dennerlein with Juan Sanabria. Two questions for you guys. First, can you talk about the specific cap rates, rent coverages and annual rent bumps for the Walgreens and Life Time Fitness portfolios?

No, we're not allowed to talk about the specifics of the Walgreens transaction based on the non-disclosure agreement we've executed with them.

Okay. How about Life Time Fitness, could you maybe talk about how you thought about alternative values and residual values for the assets?

Yes, I can walk you through Life Time Fitness. Obviously, it is an industry we like; we've been in that industry since 1998. There continues to be a secular shift to healthy lifestyles, and we're seeing that in the health and fitness facilities. We see that with both baby boomers and millennials. And health club usage continues to rise. We saw attractive risk-adjusted returns in this investment. It's well structured with a strong cash flow coverage of 3.2 times and a drop in sales to breakeven on our property to 45%. If you look at the last recession, the great recession, Life Time same-store revenues fell by just under 3% in 2008 and about 7% in 2009 and then turned positive in subsequent years. So, they performed quite well during some very challenging times. The properties that we own are located in affluent dense markets with high average household incomes of $74,000 within a 5-mile radius and in densely populated areas with 217,000 people within a 5-mile radius of our properties. We were able to execute this transaction at about a 20% discount to replacement cost and have a portfolio of properties that are well above the average sales and EBITDAR levels of the overall cost, so we were quite pleased with it. The going in cap rate was 6.5%, and the straight line cap rate, which would reflect the growth and the cash growth in the lease over the lease term, was about 8%. So, we were pleased with the growth. As we look at the transaction, we really viewed it more as something; and when you ask 10 years of financial and operating history and our credit and research team analog that quite subtly. And we were convinced that these would continue to be operated as health and fitness clubs. If there had to be a residual use, the most likely residual use would be office, if they could not be used as health clubs. But there are other companies that have operated large health clubs of this size including Club Core, Equinox, and Bay Club. So they could be potential tenants as well. So, if we were to convert these to office, they are probably looking at something from $50 to $75 a foot to make these office properties, but that's not really how we looked at it.

I'm curious, what the impact is of interest rate volatility in terms of your conversations with potential sellers?

Well, it comes up some. There's been a fair amount of it and it comes up in discussions where we're talking about pricing, and it is something certainly that we witnessed a downswing, sellers are trying to put pressure on us, and when there's an upswing in the 10-year treasury rate, we are certainly pushing for more yield with regard to our initial cap rates and our overall cap rates.

You've historically seen a correlation between increased volatility and less acquisition volume, or do you think it's more just on the pricing?

No, I mean we've been in an environment that has been volatile with regard to interest rates as you've seen, and we've sourced year-to-date $20 billion in acquisition opportunities, which puts us on a pace that would break our all-time high in terms of sourced acquisition opportunities.

And then tell us about the decision to issue the five-year debt versus doing a longer dated maturity?

Yes, sure, we did issue the $250 million of five-year unsecured note with our bank growth, and it was really done for several reasons. One is we did have a window in our maturity schedule at five years, and one of the issues with the banks has been that we typically have not kept a lot of outstandings on our revolver. They were looking for more funded balances, so when we had 21 banks step up and connect to a recast new expanded facility of $2 billion, we wanted to make sure we were meeting some of their demands and some of their desires as well, and something they had asked for was a concurrent term loan with a revolver, and they were much more comfortable and desirable on a five-year term than a 10-year term, where we also have a window on our maturities. So, that drove it and very attractive pricing, pricing well inside of where we could have gotten a five-year unsecured note issued in the unsecured debt market.

Thanks, and then I guess with over $400 million on the credit facility and then $150 million coming due later this year. Should we expect a 10-year offering later?

We're going to look at our capital options as the markets evolve over the remainder of the year and determine how we want to fund the business based on what the market shows. So it could range from all types of capital now from 10-year longer to equity as well.

Just to clarify on Life Time. Can you maybe, I guess, you looked at some of the other tranches or portfolios or with tranches within Life Time that were being marketed. What were maybe some of the differences? It sounds like maybe the term of the rent bumps were different from something that one of your peers talked about.

The portfolios were all very similar. And we were obviously pleased with the portfolio we received and were able to work with Life Time in structuring that portfolio and it met our demands and it also met the desires of the Life Time team.

But your rent bumps were higher or your term was different from the other portfolios?

Our lease term was 25 years which I think is different than the lease term on some of the other portfolios I believe.

Okay, regarding the portfolios you've created, are they under a master lease? Also, do you have the option to sell some of the assets if you decide to?

Yes, they're under a master lease, but we have no intention of selling the assets that are in that portfolio.

Okay, and then just maybe last one if you look forward if you look at your guidance obviously it bakes in about $150 million a quarter, which is a bit lower but I'm assuming that’s just kind of the baseline acquisitions, the relationship-driven ones. And so over and above that there could be other portfolios that you may close?

Yes, the acquisitions status we have provided for the year assumes our one-off transactions as well as our smaller portfolio transactions, and we did not factor in any large sale leaseback or very large portfolio transactions.

And just what cap rate are you assuming for the back half of the year?

As we look forward, we think cap rates will be in the mid to high 6s for the type of properties we buy.

You guys have done a good job raising the bar for the net lease sector on real estate-related disclosure. With that said, it seems that a good next progression should be to improve disclosure related to the quality of the lease contracts. So, for example, the percentage of tenants that report unit level financials, investment amounts relative to replacement costs or the proportion of assets that are not operating but are paying rents. Can you provide some numbers for lease data points now and maybe for similar data points that you believe are worth mentioning? And then also going forward, what's the feasibility of providing this type of data systematically within your quarterly financials?

Yes, I mean we will continue as we have done this quarter to add data to our supplemental investor package, which we agree with you is the most robust in the industry. A lot of our competitors are not providing anywhere near the level of information we are, and we certainly have issues with some of the information that present competitive issues for us to consider. So we're going to see where the industry evolves and continue to add and tweak our supplemental package. But in terms of just a full dump of everything, we're not anticipating doing that for competitive reasons at this point.

And I guess if I look at it, even if we got aggregate numbers. So for example, the coverage ratio of 2.6 that you guys disclosed, what percentage of your retailers are actually providing you with financials so that you can arrive at that figure?

Yes, just under 70% of our retail tenants provide sales and profit and loss information. So that should give you an idea of what that number is.

John or Sumit, we're just curious, the releasing spread of 107 was up nicely versus the first quarter and seems to be quite higher than I would have expected given kind of the nature of your business. Can you maybe talk about why the leasing spread was so positive? Was it any one tenant or any detail would be helpful?

Yes, I mean the primary reason why is we were able to retain 90% of our existing tenants this quarter. And those tenants typically have options to renew; those options have a fairly significant cost to them. So they exercise the options to renew, and that resulted in the high rent relative to the expiring rent.

Okay. And then just... Yes, and I was asking another question, the tenants that are not rated, could you maybe give us a percentage of those tenants that are not rated because they don't have any debt? In other words, they would be investment grades but they just don't have any debt, or do you have any metrics on that?

Well, we do, and I don't have them off the top of my head. There are a number of tenants you're talking about the 52% non-investment grade rated tenants? I would say that you can get that figure but we don't have that right now. I mean some are rated and are below investment grade, and some are simply not rated and have excellent balance sheets but are just not rated.

Okay. And then I guess a question for Paul. The $20 million of unreimbursed property expenses seems fairly high, given that you've only recognized, I think, $7.3 million year-to-date. So just kind of curious, is there some type of seasonality in this number or are you just being conservative, or is there some type of one-time items you're expecting?

And that's a good observation. So, the property expenses have come in a little bit lower; maintenance, utilities, bad debt expense is lower kind of across the board. There is a little bit of seasonality; typically, the second half of the year, unreimbursed property expenses are higher. But to be candid, that $20 million is a number we're monitoring, and we suspect that that could be a high estimate; we shall see as the year progresses. But the second half of the year typically is a little bit higher.

Okay. I appreciate that. And then just on the G&A, coming down $3 million, you briefly touched on it, but we are just kind of curious if you could give us a little bit more detail, I mean, did you just not need to hire as many people, or kind of what was more detail would be helpful?

I can provide that; we did realize some specific cost savings that we had not anticipated in October when we originally constructed the G&A budget for this year, and those were really in our legal area with insurance and with our annual report. And when you handle that this year and those on a combined basis were a seven-figure number with regard to savings. We also saw that we were more appropriately staffed for our activity than we had expected to be last October. Over the last four years, we have increased our headcount here by 50%, and we have added a lot of skilled excellent staff members, team members who have done a great job. So, we're really beginning to realize the efficiencies and the scalability of our business, and this was a conscious decision we made several years ago, that build the team anticipating the growth in the sector and certainly our continued growth. So, that's what you're seeing in that G&A line. And we're certainly pleased to see it. And I would expect our G&A margins to continue to be at this level or even continue to decline.

And then just the last one for Paul more or John. Just kind of curious on the decision to swap out that term note; you really don't have a lot of floating rate debt, and I can understand being conservative, but why not just have a little bit more floating rate debt at this point in time? What's the thought process there?

We looked at that. In fact, when we were making that decision, we took a look at our peer group inclusive of not only the net-lease sector but our S&P 500 peers and what our floating rate debt exposure looks like in our balance sheet. We compared very favorably. Even if we had not swapped out that term loan, we would still be very much in the low end of that spectrum in terms of exposure to variable rate and floating rate debt in our balance sheet. But ultimately we came to the decision that we wanted to continue to handle the balance sheet as we have historically, which is to lock in longer term, generally unsecured fixed rate alternatives there that much fund our acquisitions and not to be exposed to any rising interest rates going forward and the volatility that that's associated with. But right now, other than our credit facility, the only exposure we have to variable rate debt is the $15.5 million of mortgage debt exposure.

Just one on the same-store rents, I noticed motor vehicle dealerships were a large contributor, up 17% in the quarter. Can you just explain how you got such a big jump? Is that just bigger re-leasing spreads upon expiration and renewal or is there something else going on there?

Really it was a function of percentage rents that drove that. Trading with those, which is our largest motor vehicle dealership, kind of had a particularly strong first half of the year. And as we see the economy recover, we've seen RV sales grow quite a bit; and as a result, they took in some percentage rents which derive that number.

Is that something that resets the base rents higher then, or is that potentially a headwind at some time in future quarters?

No, it doesn't reset the base rent.

And then I think historically you guys have had a bit more preserved equity in the capital structure. I'm just wondering if you could go through your thought process on that; is it likely to increase again on a go-forward basis? Is preferred too expensive at this point relative to other funding sources?

Right now, it is not priced appropriately. It's something we always looked at, and we do have about 2% out there in preferred right now. But it's been more efficient and effective for us to use alternative forms and capital, given where that market is right now. There are certainly windows in that market where it's attractive and we will consider reassuring, but currently that opportunity does not exist.

Okay, and then just one last one from me. Can you comment on what percentage of the transactions that you evaluate and maybe also the percentage of transactions that you close, if the number is different, that are off-market as opposed to being marketed to a number of potential buyers? Or is everything just so competitive that it is all on-market stuff?

Well, I mean most of what we did this year has been relationship-oriented. It's over 90%, but that doesn't mean we were the only firm to look at the acquisition. That could be a strictly negotiated transaction with the tenant or seller, which some have been, but it also could mean they accepted our price at a lower price in order to do business with us, given the strength of our relationship, or they gave us a last look at the pricing on the transaction and an opportunity to top the competitor based on the relationship. The two large sales lease backs that we did this quarter were primarily driven on a relationship basis, although as we have already discussed, the Life Time was shown to a select few players in this sector.

Just to beat a dead horse on the Life Time deal, I recall you get to pick and choose somewhat when the BJ's wholesale portfolio went to a few buyers, was that the case with this deal? I mean how much more real estate could you have acquired, and did you get first look?

There were just a select few firms in this business that got the first look, so we were not the exclusive one. And we did have an opportunity to help construct the portfolio that we ended up with.

And then just as part of the underwriting with the tenant now that's owned by a private equity firm, is there an extra margin of safety that you factor in versus say doing a sale-leaseback with an owner that may have a longer-term ownership time horizon?

No, we certainly approached the private equity-driven transactions with caution for a good reason. Generally their time horizon is shorter in terms of their investment in the business than a corporate tenant-driven transaction. However, in this case, the senior and executive management team are likely to remain major owners of the company and continue to own it. So, that was a bit unique, but even given that you heard me earlier, Todd, walk through the metrics. We structured this transaction very conservatively, so we feel very comfortable with that. But we certainly have the added comfort of knowing that the CEO and the management team are heavily invested in the equity of this company going forward.

Okay, thanks John. And Paul, your line is credit, obviously expanded. It now has a $430 million balance. How do you evaluate how big a balance remains comfortable I guess in your eyes? Is it relative to how much availability you have? Is it a percentage of total debt? What kind of measurement steps do you use?

Overall, we are always going to look at the overall leverage in the organization. And that would be a piece of that leverage, right? So, you can’t just look at it by itself. The nice thing about having a larger facility is it just generally gives us more flexibility. It allows us to, I don’t want to say time to permanent capital markets, but at least be available when something is attractive, either in equity or in bonds or whatever it might be. Having a larger line carrying a little bit more balance still doesn’t jeopardize the liquidity that we like to have available there for our acquisition efforts. So it is just a net positive for us in terms of our acquisition approach going forward, having that liquidity and then having the flexibility to do something when the timing is right relative to the market. But we don’t look at it by itself; we look at it as a piece of the raw capital structure and that our primary exposure, if you will, to variable rate debt.

Okay, and then looks like you used the five-year term loan at a pretty low coupon to fund some of the Q2 acquisitions. That would have been done at a cap rate closer to six than say your traditional 7%. Is it fair to say that we won't be seeing those low cap rates in your acquisitions going forward, just because you'll be probably tapping longer-term capital?

Yes, I think from a cap rate standpoint, what we'll be looking at are cap rates for the remainder of the year in the mid to upper 6s. And we really didn’t find that finding acquisition sort of luring the year at more aggressive cap rates at shorter term debt because the cap rates were lower; it was really more a function of what I explained earlier, and that once that we had the five-year window in our maturity schedule and the banks were very supportive about having a balance outstanding through them since our historical utilization of the line of credit had been minimal.

And Paul, I have a question for you too on the expenses and the tenant reimbursements. We calculate an expense recovery ratio, and so we look at the percentage that you get back, and that jumped in the quarter because you got a bunch of tenant reimbursements and a lot of extra operating expenses. Is that the right way to think about it? Because as you do more acquisitions, right, you're going to assume some of sort of tenant recovery rate that isn’t 100%. And then why do you think that would have jumped in the second quarter?

Yes, I saw that dialogue in your piece, and I think is a very good way to look at it. Because we think we’re very efficient not only in our G&A but in our property expense side. There is no trend there, Rich; each lease has its own element of negotiation or if it is an existing lease that we assume relative to the nature of what might be reimbursed or what we may or may not be responsible for. So there is no real trend to look to there in terms of expenses being reimbursed any more or less now or going forward. Other than to say that we expect that to continue to be a very efficient line item, less than 2% of our overall revenues in the portfolio in the property expense area.

And then as you get acquisitions, I assume going forward you're not going to get 100% recovery. So we got to think about as we grow your portfolio with acquisitions, we got to put some of that as non-recovered expenses as well?

It depends on the type of acquisitions we're doing. The majority of them are all recoverable, so we would not anticipate that percentage 2% moving very much; in fact, it may come down a bit, especially given some of the recent acquisitions we've made.

Then I'm curious when you guys did your 200 basis points spread calculation to the cost of assets with the cost of capital. What stock price did you initially said it was a long-term sort of view? But I mean, like what roughly was the stock price used to get something like that?

Yes, so it was just a shade under $50; it was $49.70. If you look at the V-Lock of our capital for the first six months of the year and look at our spreads on our acquisitions year to date based on that number. The spreads are 170 basis points, so 80%, we funded 80% of the acquisitions we've done year to date, and based on the cost of the actual funding we viewed our spreads to our weighted average cost of capital were 200 basis points, which was the number you heard too, as I said earlier. Does that answer your question?

Yes, it does, yes, thank you John. So as I think about, yes, it does very much thank you, as I think going forward then at the current share price they are not substantially below then. I mean a little bit below that. But I guess it wouldn’t hurt your spreads significantly even the issue equity here?

Our cost of capital is currently just below 5%, which is still attractively priced. If we can continue acquiring assets with initial spreads of 150 to 175 basis points based on our anticipated cap rates for the rest of the year, those cap rates remain comfortably above our historical averages, and we would be satisfied with that. Our cost of equity is reasonable at this level. Additionally, although our debt costs have slightly increased, we can still issue 10-year debt at around 4%.

Okay. Good, thanks. And then the last thing I had was on your build to suit or your development pipeline; it seems like just I'm assuming it is moving in and out of there because you had fewer projects, I think with higher cost. I mean do you have any sort of summary of what happened in the quarter? I mean, deliveries, that kind of thing?

Sure, Sumit can handle that. That fluctuates, it's a little higher, and we have just under $92 million under development right now. And we have funded it at this point about $25 million of that.

Yes, that's exactly right, John. You've got $65 million of unfunded obligations. Most of the developments that you're seeing, Rich, is with our FedEx expansions. That continues to be a higher yielding investment for us, and those are investments that allow us to continue to push out the leases beyond the original expiration when we do an investment for them. Along with FedEx, we're also doing investments in AMCs; that continues to be a good investment. And we do have some build to suit on the retail side that I do not wish to disclose the name at this point, but those continue to be a higher yielding form of our investment opportunity set.

Okay, and so each quarter, Sumit, what do you think you’d add roughly to the pipeline?

Each quarter, our run rate has been right around this $90 million; it has fluctuated from anywhere between $70 million, it's been as high as $110 million. So, about $90 million seems to be right; we'd like to be a bit more, given the size of the company. I think you've heard John mention that we would like to see it go as high as $250 million, but we've not been able to achieve that. So the run rate historically has been right around what you see it today.

I guess my first question just as far as the mix of industrial going forward. I know obviously few large deals impacted the mix here in the second quarter, but can you just talk about in the deal pipeline as you are looking at more industrial deals and has there been any shift to how you think about the investment grade mix historically? Pretty high on the industrial front, so just put just more color on that if you could?

Yes, we're really reacting, Collin, to the opportunities we see in the marketplace. So, we have very high retail numbers year-to-date and for the quarter, and we continue to see attractive industrial opportunities, but some of those opportunities are very aggressively priced today and we've elected to pass on them. So it's hard to predict the future, but we will continue to be active on the industrial front and look at the opportunities that our investment parameters and are priced appropriately for us. And we will certainly continue to look at those investment grade and non-investment grade retail investments as we've done.

Okay, and then I guess, kind of switching gears, just as far as casual dining, I am just curious here about, I mean you guys have brought exposure down, I think it was north of 10% a few years ago now down to about 4%. Can you just remind us how you are thinking about that sector, particularly just in context of going out there looking to sell assets at a 55 cap?

Yes, I mean we continue to look at the QSR and casual dining sector; they each separately represent 4% of our revenues, and we've always been cautious on casual dining as you know, as you alluded to. For our casual dining investment for us, we want to see an operating concept that has positive trends; we want to see really healthy coverage, coverage beyond what we seen in our overall portfolio, probably three times or greater. We want to see rents that are approximately at market and we want to be ad approximately replacement cost on our investments. So, we have a high hurdle there. We have looked at some casual dining investment opportunities and we continue to do that. We haven't seen any on a large scale portfolio basis that meet our parameters for, I'd say, quality and pricing, but we would certainly consider the right type of casual dining transaction.

Okay. Now that's helpful color. Then just real quickly, can you give us any what the watch list is as a percent of revenue? I don't know if I missed that, and has there been any shift on that front?

Yes, it's still at 1.2% which represents about $150 million in properties, and what I have said earlier was on the dispositions front, if anything, I mean we had budgeted for $50 million in dispositions; if anything that could check up a bit, and we may sell a little more, and that is obviously coming from that watch list, so we prepared it down just a shade, but it's been kind of steady right around 1.2% for the last several quarters.

Hi everyone, it's been a lengthy call, but I have two questions for you. The first concerns your re-leasing spreads, specifically the spreads when you lease to a new tenant. Reflecting on the past 10-15 years with Realty Income, there was a strong emphasis on ensuring that the rents for acquired properties in the portfolio were close to market value, which was a key consideration for acquisitions. Therefore, it's somewhat disappointing to see these properties being re-leased at a decrease of 30% to 35%. Can you clarify what's happening? This isn't an insignificant number of properties, and the drop in rent is quite dramatic.

So, if you are looking at the year-to-date, I guess that's in our supplement as where you're getting that information on Page 24, for everyone re-leasing to new tenants, with and without vacancy, you're seeing a 30% low down in rents. The issue there is simply, that's the market; I mean we're also disappointed that it's not higher. Overall, our re-leasing spreads are positive at just under 103%. We've executed more than 1,900 lease rollovers in the Company's history and have a lot of experience at this. The majority of the assets that we do re-lease are re-leased at a positive spread, and year-to-date, 105% of expiring rents to the same tenant.

If I evaluate the entire portfolio today, do you have an estimate of the market value for the entire portfolio?

Yes, I mean you can see it that we're roughly at market rents; it's slightly on the entire portfolio just slightly above. So, there's not a very big differential between our contractual rents and market rents.

Second question I had is regarding the Walgreens acquisition. I understand there's limited information you can share, but if I estimate based on the cap rate of the Life Time Fitness deal and the average cap rate for your property purchases, it suggests that the Walgreens pricing was around 6%, or possibly even lower. My question is, why does this acquisition make sense at this point in the cycle, especially when the private market is so active? Why invest in a top-tier Walgreens location? What makes this transaction more appealing compared to potentially taking on a slightly lower credit risk or passing on the opportunity altogether?

Yes, well, that was a well-structured transaction for us, and I can't go into details on it, but it looks certainly more favorable than what you see in the 1031 market. And that's an industry and a tenant that we like a lot; you've heard us discuss quite a bit given what's happening in the healthcare industry and with our aging population and the performance of that company. So, it was an attractive investment, and I would say this: we don't do large institutional sale-leaseback transactions without rental rate growth. In the private market, the 1031 market has been back as you alluded to, and we're seeing quite pricing there at the 5% area. We've even seen some four handles there, so there is a certainly premium for the one-offs that don't necessarily exist for the larger portfolios and then certainly a relationship element to our business with them as well.

John, just a follow-up question on the comments you just about sort of the intensity or the competitiveness of the 1031 market. Just wondering does it make sense to sort of start ramping up your disposition program to take advantage of some of that arbitrage?

What we are seeing now is we have been in a period for a while where there has been a portfolio premium, where people were looking to get more capital out the door. That pricing has not become less expensive; what's happened is the banks have returned to the market for the one-off and the smaller portfolios and are lending quite aggressively. So you’ve seen that 1031 market pricing surge, and they are fairly equivalent across the board there are very few opportunities as the one that I just described where the arb there is more significant. But we don’t want to sell properties and we don’t want to own long-term, and so we're not seeing enough of an arb yet to crank the crest back up. But it's something we look at every quarter so that’s a good question.

Given the current conditions in the capital markets, do you have a preference between raising equity or opting for more long-term unsecured debt?

We'd be comfortable with either given the strength of the balance sheet and the pricing of both. Yes, we’d be comfortable with either right now.

And then maybe a little more detailed question on the term facility. Paul, is there flexibility or ease that the capital markets present every opportunity to easily prepay that and replace it with some more permanent capital?

Yes, it is fully prepayable without penalty at any time.

Thanks Ricky and thanks everyone for joining us today. We look forward to speaking with you this fall at the various conferences and we hope everyone has a great end to their summer. Thanks again.