Realty Income Corp (O) — Q4 2015 Earnings Call Transcript

Thank you, operator, and thank you all for joining us today for Realty Income's fourth quarter 2015 operating results conference call. Discussing our results with me are 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 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-K. We will observe a two-question limit during the question-and-answer portion of the call to give everyone the opportunity to participate. I would now turn the call over to our CEO, John Case.

Thanks, Janeen, and welcome to our call today. We had a solid fourth quarter, which concluded an excellent year for our company, with annualized rental revenue exceeding $1 billion for the first time in our history. AFFO per share during the fourth quarter increased 4.6% to $0.68, and 2015 AFFO per share increased 6.6% to $2.74. As announced in yesterday's press release, we are reiterating our AFFO per share guidance for 2016 of $2.85 to $2.90, as we anticipate another attractive year of earnings growth. Let me hand it over to Paul to provide additional details on our financial results.

Thanks, John. I'm going to provide a few highlights, just a few items in our financial results for the quarter, starting with the income statement. Interest expense decreased in the quarter by $7.1 million to $52 million. This decrease was driven by less overall debt on our balance sheet. We repaid $150 million of bonds and almost $200 million of mortgages last year. The decrease was also partially due to the inclusion of preferred dividends that were treated as interest expense in the fourth quarter of last year when we redeemed our series E deferred equity shares in October 2014. Another larger impact was from the recognition of a non-cash gain of approximately $4.1 million on interest rate swaps during the quarter, which caused a decrease in that liability and lowered our interest expense. As a reminder, these mark-to-market adjustments on our floating to fixed interest rate swaps tend to cause volatility in our reported interest expense and FFO on a quarterly basis, particularly when there is significant movement in short-term forward curve rates as we saw at the end of the fourth quarter. We do adjust for this non-cash gain when computing our cash AFFO earnings. On a related note, our coverage ratios remain strong, with interest coverage at 4.5 times and fixed charge coverage at 4.0 times. Our fixed charge coverage is the highest it has been in over ten years. Our G&A in 2015 as a percentage of total rental and other revenues was only 5%. We estimate this will remain our approximate run rate for G&A in 2016 as well. Our non-reimbursable property expenses in 2015 as a percentage of total rental and other revenues was only 1.4%. These expenses came in lower this year due to lower portfolio vacancies, faster releasing of vacant properties, lower property insurance premiums, and fewer one-time expenses. We estimate our run rate for property expenses in 2016 to be approximately 1.5%. Briefly turning to the balance sheet, we continue to maintain our conservative capital structure. In September, we established an ATM or at-the-market equity distribution program. In Q4, we utilized this program to issue approximately 714,000 shares, generating net proceeds of $35.8 million. In October, we raised $517 million in net proceeds in a common stock offering. We used the proceeds at that time to pay down all outstanding borrowings on our unsecured revolving credit facility. This $2 billion credit facility today has a current balance of $370 million. Other than our credit facility, the only variable rate debt exposure we have is on just $15.5 million of mortgage debt. Our overall debt maturity schedule remains in very good shape, with only $170 million in mortgages and $275 million of bonds coming due in 2016. Our maturity schedule is well-laddered thereafter. Finally, our debt to EBITDA ratio stands at approximately 5.1 times and is only 5.5 times inclusive of preferred equity. Now, let me turn the call back over to John to give you more background on these results.

Thanks, Paul. Let me begin with an overview of the portfolio, which continues to perform well. Occupancy based on the number of properties was 98.4%, ten basis points higher than last quarter and unchanged from a year ago, despite having managed our most active year ever for lease expirations. Additionally, economic occupancy remains strong at 99.2%. During the year, we released 253 properties with leases expiring, recapturing 101% of the expiring rents. As is typical for us, we achieved this without spending on tenant improvements. At the end of the year, we had 71 properties available for lease out of 4,538 properties in the portfolio. Over the last 20 years, we have re-leased or sold more than 2,000 properties with expired leases, recapturing approximately 98% of rents on those properties that were re-leased. Our same-store rents increased 1.3% during the quarter and also for the year. We expect annual same-store rent growth to remain approximately 1.3% in 2016. Ninety percent of our leases have contractual rent increases; approximately 75% of our investment-grade leases have rental rate growth that averages about 1.3%. Additionally, we have never had a year with negative same-store rent growth since we started reporting this metric 20 years ago. Our portfolio continues to be diversified by tenant, industry, geography, and to a certain extent, property type, all of which contributes to the stability of the cash flow. At the end of the year, our properties were leased to 240 commercial tenants across 47 different industries located in 49 states and Puerto Rico. Seventy-nine percent of our rental revenue is from our traditional retail properties. The largest component outside of retail is industrial properties at about 13% of rental revenue. There was not much movement in the composition of our top tenants and industries during the fourth quarter. Walgreens remains our largest tenant at 6.9% of rental revenue, and drugstores remain our largest industry at 10.9% of rental revenue. We continue to have excellent credit quality in the portfolio with 44% of our rental revenue generated from investment-grade rated tenants. This percentage will continue to fluctuate and should be positively impacted in 2016 by Walgreens' pending acquisition of Rite Aid, which represents 2% of our annualized rental revenue. The store-level performance of our retail tenants remains sound. Our weighted average rent coverage ratio for the retail properties continues to be 2.6 times on a four-wall basis, and the median is also 2.6 times. Moving on to acquisitions, during the quarter we completed $204 million in acquisitions, and we continue to see a high volume of sourced acquisition opportunities. In 2015, we sourced approximately $32 billion in acquisition opportunities, which is our second most active year ever for sourced volume. We remain disciplined in our investment strategy, acquiring just 4% from nearly $1.3 billion of the amount sourced, and continue to see a strong flow of opportunities in our target property types. We expect to complete approximately $750 million in acquisitions for 2016, as always this principally reflects our typical flow business and does not account for any large-scale transactions.

Thank you, John. During the fourth quarter of 2015, we invested $204 million in 104 properties, located in 26 states at an average initial cash cap rate of 7.1% and with a weighted average lease term of 15.7 years. On a revenue basis, 28% of total acquisitions are from investment-grade tenants. Ninety percent of the revenues are generated from retail and 11% are from industrial. These assets are leased to 23 different tenants across 17 industries. We closed 14 independent transactions in the fourth quarter, and the average investment per property was approximately $2 million. By the end of 2015, we invested $1.26 billion in 286 properties located in 40 states at an average initial cash cap rate of 6.6% and with a weighted average lease term of 16.5 years. On a revenue basis, 46% of total acquisitions are from investment-grade tenants. Eighty-seven percent of the revenues are generated from retail and 13% are from industrial. These assets are leased to 45 different tenants across 21 industries. Of the 49 independent transactions closed during 2015, three transactions were about $50 million. Transaction flow continues to remain healthy. We sourced more than $7 billion in the fourth quarter. During 2015, we sourced nearly $32 billion in potential transaction opportunities. Of these opportunities, 60% of the volume sourced were portfolios and 40%, or approximately $13 billion, were one-off assets. As to pricing, cap rates remained flat in the fourth 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 disposition program remained active. During the quarter, we sold 16 properties for $13.9 million at a net cash cap rate of 8.1% and realized an unlevered IRR of 10.3%. This brings us to 38 properties sold in 2015 for $65.4 million at a net cash cap rate of 7.6% and realized an unlevered IRR at 12.1%. Our investment spreads relative to our weighted average cost of capital were healthy, averaging 236 basis points in the fourth quarter, which was above our historical average spreads. For the year, spreads averaged 183 basis points. In conclusion, given the continued activity in our space, we remain confident in reaching our 2016 acquisition target of approximately $750 million and disposition volume between $50 million and $75 million. With that, I'd like to hand it back to John.

Thanks, Sumit. We had a very active year in the capital markets front. In 2015, we raised approximately $1.2 billion in equity capital, positioning us well as we entered 2016. We are now at the lowest leverage levels we've been at in ten years, with debt to total market cap at approximately 25%. Our balance sheet remains in excellent shape, with plenty of liquidity and financial flexibility. Our sector-leading cost of capital continues to allow us to drive strong earnings and dividend growth while remaining disciplined with our investment strategy. Last night, we announced our 84th dividend increase, representing a 5% increase from this time last year. We've 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%. Our AFFO payout ratio in 2015 was 82.9%, which is a level we are quite comfortable with. To wrap it up, we had a great year and remain optimistic for 2016. Our portfolio is performing well, and we continue to see a healthy volume of acquisition opportunities. We remain well positioned to act on high-quality acquisitions, given our strong balance sheet, ample liquidity, and cost of capital advantage. At this time, I'd like to open it up for questions.

Hi, thanks for the time, guys. On the acquisition front, could you just comment about how you're feeling about opportunities maybe versus three or six months ago? Are you looking at more portfolio deals given it seems like some of the premiums have gone away and any possibilities to partner with third parties to take down larger deals?

Sure, Juan. First of all, as we look forward on the acquisitions front, we're still seeing a good steady flow of opportunities. We're still confident in our $750 million acquisition guidance for this year, and that doesn't include any large-scale portfolios or entity-level type transactions. But we are constantly scouring the market for opportunities and considering opportunities on a large scale. Working with third parties is something we would consider. We haven't done that before, but if there were a transaction, where perhaps there was a large portfolio, where part of the real estate made a lot of sense for us and part of it didn't, we would certainly consider partnering with someone who wanted the portion of the real estate that was not consistent with our investment philosophy.

Thanks. And just on your cost of capital front, have you guys thought about taking advantage of where your share price is today and hitting the market now ahead of any potential bigger deal flow that may be coming your way in 2016? Or have you thought about that?

We're constantly monitoring all of the capital markets—equity, debt, preferred. Right now, we only have about $350 million outstanding on our lines, so we've got the capacity of about $1.7 billion, and there's no need to access the markets unless they were particularly appealing or we had an immediate use for the proceeds. So we're paying attention to what's happening out there, looking at it, but right now we're comfortable where we are as we speak today.

Thanks. I guess, sticking with acquisitions, what are you seeing in terms of pricing of portfolios compared to individual assets?

Individual assets are now priced a bit more aggressively than the portfolios, which is a flip of where we were a couple of years ago. So, we ended up looking at one-off acquisitions that are probably trading at cap rates of 20 to as much as 50 basis points inside of where midsize portfolios of comparable properties are trading. So there is a little bit of an anomaly there.

Hey, John. It's Michael Bilerman. As you think about the other side of using your currency instead of just issuing new equity and raising that capital, you certainly can use that equity in any sort of M&A. And I'm just curious how—you're a former banker—are you trying to shake the tree loose out of any of your competitors, just given how high your stock trades and where your multiple is in trying to drive some of that in a public-to-public M&A and leveraging your currency in that fashion?

We are constantly looking at entity-level opportunities, and given the multiple advantage we have relative to the sector today, it makes sense for us to consider those opportunities. But, you have to have willing logical sellers and buyers. So we'll see what may or may happen on that front. But it is certainly something that we're considering.

Thanks. Just following up on that M&A question, just trying to understand. Obviously, you have the cost of capital, but if you were to prioritize what do you do with this cost of capital from here? Historically, you've created premiums to the broader REIT group, but that premium has not remained there for a considerable amount of time. So it seems like there's a window, and I'm just trying to understand if you were to prioritize what you do with it?

Yes. We have typically traded at a premium to the sector. The premium widens during periods of market volatility and uncertainty like we're seeing today. But for the vast majority of our history, we've traded at the highest multiple in the sector. As we look at what we may do with the capital advantages from a cost perspective that we have today, we really want to stay consistent with our investment strategies. On the retail front, it's looking for service-oriented, non-discretionary, low price point businesses that have good real estate. We think those assets and property types and tenants are better equipped to work through a variety of economic cycles and to compete with e-commerce. And then on the investor side, it's high-quality real estate leased to Fortune 1000 companies with investment-grade credit ratings, so those are the buckets we're really focused on.

Okay. And then just if there were, say hypothetically, two portfolios—of a public portfolio and a larger private portfolio, somewhat similar return profiles, similar properties—how do you think about those two? Are there factors that drive you towards one or the other at this point?

We love to do transactions on a leverage-neutral basis, and that's what we've done in the past. Whether it’s on the private side or entity-level side, what's going to drive which opportunities we pursue is the most value for the shareholders of our company. We have shown in the past that we can execute public transactions, entity-level transactions, or large portfolio transactions. We do have some leverage capacity today.

John, to those comments—obviously attractive cost of equity here, but how do you think, or Paul, how do you think about your cost of debt here? How has it changed over the past couple of months? Do you have any visibility where you could issue long-term debt today?

Ten-year debt is in the low 4s, 4.10%, 4.20%. Spreads have capped out as rates have declined, so there hasn't been a big pickup there. Paul, anything?

The bandwidth, all in, has really stayed in the 4% to 4.2% range in spite of wherever the Treasury or spreads have moved.

Okay, in terms of acquisitions this year, has the spread between investment grade and below investment grade shifted at all, given the macro volatility? Or would you say that it is still, on a risk-adjusted basis, more attractive to go after the investment-grade tenants?

We are going to continue. The spreads really haven't changed in relation to those spreads. We'll pursue opportunities in both sectors, the ones that meet our investment parameters and make the most sense for us. On the investment-grade side, you're seeing some fairly aggressive pricing as Sumit alluded to earlier, around the 5% area on the really higher-quality product. The non-investment grade you're still seeing right around 6% on the higher-quality product. Cap rates have remained stable, but the ranges on investment-grade go up to as high as the high six’s and on non-investment grade they go up to as high as 8%. The spreads are better today from an investment standpoint given our cost of capital.

Hi, thanks for taking my questions. So just for those tenants that provide unit level financials, is there anything in those results that suggest a change in economic activity, or are there geographies that are doing better than others or anything like that?

No, and we are constantly looking at that. The tenant base is in excellent shape. There are some non-material issues, as there always are, factored into our guidance. Right now, we feel good about the tenant base and their health and condition.

Sure. And then as it pertains to acquisitions, are there any industries that you are looking to invest in or not invest in? And then has there been any change in sort of the buyer or seller pools?

No significant changes on the buyer-seller pool, and the industries are consistent with the ones that we're in. So if you look at the 47 industries we are in today, with very few exceptions, we want to align with those industries. We want to stay away from discretionary industries and businesses.

It looks like in the fourth quarter, according to the supplemental data, that you guys bought 10 Rite-Aids. Are those basically straightforward ten-year-plus leases, or have you guys started to look more opportunistically at some of the Rite Aid locations or even Walgreens locations that have five years or less in them to possibly do a re-tenanting?

That was a sale-leaseback transaction we did directly with Rite Aid, who is an existing tenant of ours, and it was done before the Walgreens announcement, so it worked out very well for us. Those weren't one-off transactions; it was just a fortuitous timing, I would say, in terms of when the transaction was executed.

Is there the capability to do anything on an opportunistic basis with short-term lease Rite Aids or even Walgreens where the current owner might be across the street from something else from one or the other locations and might be getting worried that they are going to close down on the location where you guys can buy it at an attractive rate and repurpose it to some other tenant?

That is not a big emphasis of our business. We pay attention to those opportunities, but we are really looking for assets with long lease terms that are well-positioned competitively. If we saw something incredibly compelling, we would certainly take a look at it where we had a kind of tenant in our back pocket, and we knew we were going to sign a 20-year lease on favorable terms on a building that was going to become vacant or is vacant, we would certainly look at that. We've done that in the past. It's not a major component of our business, but we have done that in the past.

Hey, John, good afternoon.

Hey, Ross.

It sounds like from some of your earlier comments regarding acquisitions, and in particular M&A, it sounds like you are more open to M&A today than you have been in the recent past. Do you think that's a fair characterization?

I would say, given the multiple advantage we have relative to the other 13 or 14 companies in the sector, that it's a bit more interesting today. But at the same time, I would say that we want to end up with assets that are consistent with our investment philosophy. So we're not signaling that we're going to go out there just to do a large transaction and take on assets that we would consider to be of risk in the intermediate to long-term.

Okay. And you and I have talked about this topic before, but how do you think about net asset value or property value versus investment spread? Even if you could theoretically buy another public player at a multiple that would be accretive to your FFO, what if that meant paying a reasonably high premium to the actual value of the assets when you know you can go into the private market all day long and pay actual NAV or property value? How do you balance that thinking?

We want to be paying NAV, whether we're buying in the private market or the public market. There would have to be something incredibly compelling about the opportunity, strategically, for us to do that, but we're focused both on spreads and accretion as well as the value of the assets. We would not want to do anything that would be NAV dilutive.

Hi, good afternoon. Can you guys comment on the difference in cap rates for industrial versus retail?

Yes, Sumit, industrial versus retail?

We haven't really seen much of a movement in cap rates for the type of industrial assets that we pursue, which is Fortune 1000 clients with ten plus years. In terms of the cost, you're paying around $65 to $75 to $80 per square foot for brand new concrete tilt-up type buildings, and that seems to still be the case today. With retail, it ranges depending on the product type from anywhere between $150 to $250 square feet all the way up to $400, $450 for a convenience store. Again, with regards to pricing, despite all the volatility that we're seeing in the market, we have not seen cap rates move in one direction or the other. They have stayed fairly steady for both products over the last six to nine months.

Got it. And just bigger picture, any changes to the watch list or anything else we should be aware of on that front?

No. The watch list is down to 1% of revenues, which is the lowest it's been in the last five years. Again, the portfolio is in good health. There are no material issues for us.

Hello, guys. Just a quick question for me. What do you see as being the right size for Realty Income in terms of assets?

The right size? In terms of assets? I don't think there is necessarily a right size, but we will continue to grow the company consistent with our investment strategies and take advantage of the opportunities available in what is a vast marketplace. We do not have a target in terms of size. It's really more about delivering earnings growth and dividend growth and total shareholder return.

In terms of, do you think that there would be anything more attractive about just having $25 billion worth of assets instead of having, call it, $18 billion worth of assets?

No, I don't think so. This is a very scalable business. When you look at our EBITDA margin that's nearly 94%, it's sector-leading. We're delivering more of our revenues to our shareholders than the rest of the sector. Our G&A margin of 5% is very efficient. With size and scale comes increased efficiencies, which lead to a competitive advantage based on size. But we wouldn't grow just to grow; we would grow to create earnings growth and dividend growth with assets consistent with our investment philosophy.

The deal flow you're seeing continues to be pretty steady and robust. Can you provide what the mix is, maybe just share what the percentages are if you look at where the opportunities came from, investment opportunities, last year—were they marketed deals, existing relationships, or pension funds bringing you opportunities?

Sure. Sumit, do you want to take that?

Yes, sure. Todd, in terms of the portfolio and one-off mix, I would say it's about 25% of what we sourced last year versus 2015, which was about the same. Twenty-five percent is one-off, and 75% are portfolio deals. In terms of the portfolio deals, what we've started to notice is that many companies that were hesitant in years past to engage in conversations dealing with sale-leasebacks became far more open to those types of conversations, and in fact, some of them even resulted in transactions that we were involved in last year. Whereas in 2014, most of the product we saw were from companies that were very familiar with the sale-leaseback market. So the only real change in terms of the product mix I would say that we saw was new entrants coming in that had not engaged in conversations in years past. Outside of that, one-off versus portfolio, the mix is about the same. It was 26% in 2014 and 25% in 2015. So, I'd say the mix is about the same.

Is it more compelling, Sumit, just because commercial real estate prices have been so good that people are at least considering it now?

I would say pricing is definitely one piece of it, but I would also say that there has been a fair amount of external pressures by investors, etcetera, rattling the cages and talking about what is it that a particular operating company should focus on. The debt markets have helped. The fact that our cap rates have compressed has helped, but I think the single biggest issue has been some of the investors talking about monetizing real estate and getting back to the core business, which has been the single biggest factor.

So, Sumit, are you sort of saying that—and John, that the—remember when we had all these retailers that wanted to do spins, spins of their real estate, and that is sort of not happening now. The government has kind of shut that down, so is that group of potential sale-leaseback guys coming to? Are you seeing more of those pre-spin guys that can't do the spins anymore?

Yes, I think that was favorable news to the net lease industry and companies like ours. To the extent they want to monetize their real estate, they're going to be talking to us. I do think to add on to what Sumit was saying is that these companies with large real estate holdings that are not real estate companies are under pressure to increase their own returns on investment. Carrying that real estate when it could be sold to someone like us or someone in our sector can certainly enhance their return on investment, so there is that pressure and we're seeing that. The recent news regarding the ability to do these spins is certainly a net positive to the sector.

Okay, good, thank you. And then it's interesting because you guys probably don't sit and look at the stock market all day long like a bunch of us on the phone do, but pretty much the only thing green on my screen is you guys. That means the market is worried about something, and I'm curious how you guys monitor for bankruptcies? I mean what's the chance among your tenant base that you can have a surprise in there, and how close are you in touch with the health of each of these retailers?

We have our own internal credit and research team that continuously analyzes and scours the portfolio in terms of credit and industry trends. Currently, our watch list is at 1%. Tenants we have potential credit issues with are just under 6% of the entire portfolio, but most of that doesn't make it onto the watchlist because it's really good real estate and we'd like to have it back, and we think there's upside there. In terms of our coverages, they've held steady right around 2.6, 2.7, so we're not anticipating any sort of material tenant issues. We track that very closely and don't see anything there.

Thank you, good afternoon. John, given your comments on M&A, I think you said that the public debt REITs would have to have to hold assets that are consistent with your investment philosophy. How many REITs out there do you think have such assets?

There are a number of them. Are there any that are completely pure? Maybe one or two, but in terms of the REITs that have assets that are consistent with what we're looking for and have a material amount of them, maybe they represent 50% or more. There are a lot of companies out there.

And I’m just kind of curious on the casual dining front. It's been a sector that you guys have steered clear of since the last recession, I was just kind of curious about your appetite there. Just going back to Rich's question, given the inability of these REIT conversions to happen, there's a lot of restaurants out there that still own a lot of their own real estate, so just kind of curious your thoughts there?

Yes, so right now, casual dining for us is about 3.5% of our overall revenues, and some of the stumbles the Company has made in the past have been related to casual dining. We've learned what we want on that front, and so we have a fairly high bar in terms of what we will consider there. We want operating concepts that are stable to growing. We want box sizes that if we ever get them back are of the size that we can easily re-let. We want market rents. We want something close to replacement cost as well, and we want coverages that are in excess of what our portfolio averages, somewhere around three times. If we find those types of opportunities, and of course the real estate needs to be attractive as well, we will pursue them. The fact that we've not done many of them is more a function of the quality and structure of some of the transactions that have been done versus us saying we won't look at casual dining because we will look at casual dining. But the parameters around what we will invest in are fairly tight.

First question for me: you guys mentioned the watchlist remains low and hasn't changed much. But can you maybe just highlight what the themes are as you think about the planned dispositions for this year? Can we see some shift towards more occupied versus vacant properties? And then, just as it relates to that issue, going back to Rich's question, could some of the dispositions be in that pool of tenants that aren't necessarily on the watchlist but maybe in lower quality given some of the economic concerns?

On the dispositions front, I think in terms of what we would be selling, it will look similar to what it looked like in 2015, maybe a bit more occupied than vacant. We had more vacant than we typically have. The types of properties on the dispositions front are casual dining, childcare, older generation non-discretionary—I'm sorry, discretionary tenants in theory or real estate locations perhaps with credit issues. Or they are higher quality properties, but we're looking to reduce our exposure to certain tenants or certain sectors. So on the sales front, I think you'll see a little more occupied than vacant in terms of the ratio, and we're looking to sell $50 million to $75 million this year, and that's incorporated into our guidance.

I guess along those lines just as far as how does your economic outlook maybe factor into that at all? I think last year there was some acceleration in your disposition activity. Is there anything from a broader economic perspective that might again cause you to accelerate or want to jettison some more of that exposure that you highlighted that you are relatively more concerned about?

No. Again, when you look at the size of the watch list at 1%, it's fairly small. Possibly, we've had our most active year on the dispositions front at about $135 million, and we've been as low as $50 million, $60 million. We're kind of thinking $50 million to $75 million, but we remain flexible there. We certainly did factor in macroeconomic conditions, but it's really taken down to the micro level: does it make sense for the reasons I outlined to sell an asset or not.

Okay, thank you very much, and thanks everyone for joining us. We look forward to seeing you at the conferences coming up, and everyone have a good afternoon. Take care. Bye.