Realty Income Corp (O) — Q2 2018 Earnings Call Transcript

Thank you all for joining us today for Realty Income’s second quarter 2018 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 may be considered to be forward-looking statements under federal securities laws. 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.

Thanks Janeen. Welcome to our call today. We're pleased with our results in the second quarter. During the quarter we invested $347 million in high-quality property acquisitions and increased AFFO per share by 5.3%. Given the momentum we see in our business, we are increasing our 2018 acquisitions guidance to approximately $1.75 billion from the prior range of $1 billion to $1.5 billion. We’re also raising the range of our 2018 AFFO per share guidance from $3.14 to $3.20 to $3.16 to $3.21. Let me hand it over to Paul to provide additional detail on our financial results.

Thanks, John. I will provide highlights for a few items in our financial results for the quarter, starting with the income statement. Other revenue in the quarter was $3.6 million. Other revenue typically consists of easements, income, interest income and insurance proceeds and it will vary from quarter to quarter as we've mentioned in the past. Our G&A as a percentage of total rental and other revenues was 5.7% for the quarter and 5.4% year-to-date. Consistent with prior year, G&A tends to be slightly higher in the first half of the year due to the timing of stock vesting and the cost associated with their annual meeting and proxy. We continue to have the lowest G&A ratio in the net lease REIT sector and we continue to project G&A to be approximately 5% in all of 2018. Our non-reimbursable property expenses as a percentage of total rental and other revenues were 1.5% for the quarter and 1.6% year-to-date. We expect non-reimbursable property expenses to remain in the 1.5% to 2% range in 2018. Funds from operation or FFO per share was $0.79 for the quarter. As a reminder, our reported FFO follows the NAREIT-defined FFO definition. Adjusted funds from operations or AFFO or the actual cash we have available for distribution as dividends was $0.80 per share for the quarter, representing a 5.3% increase. Briefly turning to the balance sheet, we've continued to maintain our conservative capital structure. During the second quarter, we issued $300 million of common stock primarily through our ATM program. The weighted average maturity of our bonds is now 9.2 years and our overall debt maturity schedule remains in excellent shape, with only $8.5 million of debt coming due for the remainder of 2018, and only $91 million coming due in 2019, outside of our revolver. Our overall leverage remains modest as our debt to EBITDA ratio is currently 5.5 times and our fixed charge coverage ratio remains healthy at 4.6 times. In summary, we continue to have low leverage, excellent liquidity and strong coverage metrics. Now let me turn the call back over to John.

Thanks, Paul. I'll begin with an overview of the portfolio which continues to perform well. Occupancy based on the number of properties was 98.7%, an increase of 20 basis points compared to the year-ago period. We expect occupancy to remain north of 98% for 2018. During the quarter, we re-leased 47 properties recapturing approximately 108% of the expiring rent, making this our 8th consecutive quarter of positive recapture rates. In the first half of 2018, we have re-leased 102 properties recapturing approximately 105% of the expiring rent. Since our listing in 1994, we have re-leased or sold 2,750 properties with leases expiring, recapturing 100% of rent on those properties that were re-leased. Our same-store rental revenue increased 1% during the quarter and 0.9% for the first half of the year. These results were consistent with our projected run rate for 2018 of 1%. Approximately 90% of our leases continue to have contractual rent increases. 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 257 commercial tenants and 48 different industries, located in 49 states and Puerto Rico. 81% 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. Walgreens remains our largest tenant at 6.6% of rental revenue. In the second quarter, convenience stores became our largest industry at 10.8% of rental revenue. We continue to like the convenience store industry. We own high-quality real estate locations and profitable stores leased to leading national investment grade-rated operators. Additionally, our convenience store portfolio primarily consists of stores with a larger physical footprint. These stores tend to drive greater sales and volume, unrelated to fuel consumption, often featuring extensive prepared food options. Within our portfolio of retail properties, 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 recent U.S. retailer bankruptcies have been in industries that do not possess these characteristics. We continue to have excellent credit quality in the portfolio with over half of our annualized rental revenue generated from investment grade-rated tenants. The weighted average rent coverage ratio for our retail properties is 2.9 times on a four-wall basis, while the median is 2.8 times. Both of these store-level metrics represent improvements from last quarter as our retail store level performance remains strong. Our watch list 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 $347 million acquisitions during the quarter at a 6.5% cap rate at investment spreads consistent with our long-term average. Our investment spreads improved during the quarter, and we are pleased with the quality of our acquisitions. 52% of the rental revenue generated from these investments is from investment grade-rated tenants. Overall, we continue to see a steady flow of opportunities that meet our investment parameters. We remain one of the only publicly traded net lease companies that have the scale and cost of capital to pursue large corporate sale leaseback transactions on a negotiated basis. Year-to-date, approximately 80% of our acquisitions have been sale leaseback transactions. During the quarter, we sourced $7.7 billion in acquisition opportunities. We remained selective in our strategy, acquiring approximately 5% of the amount sourced. Given the continued strength and visibility in our investment pipeline and the current market environment, we are increasing our 2018 acquisitions guidance to approximately $1.75 billion from our prior range of $1 billion to $1.5 billion. I’ll hand it over to Sumit to discuss our acquisitions and dispositions in a bit more detail.

Thank you, John. During the second quarter of 2018, we invested $347 million in 190 properties, located in 24 states at an average initial cash cap rate of 6.5% and with a weighted average lease term of 13.6 years. 85% of the revenues are generated from retail. These assets are leased to 21 different tenants in 15 industries. Some of the most significant industries represented are quick service restaurants and convenience stores. We closed 15 discrete transactions in the second quarter. Year-to-date 2018, we’ve invested $857 million in 358 properties located in 32 states at an average initial cash cap rate of 6.3% under the weighted average lease term of 13.8 years. On a revenue basis, 71% of total acquisitions are from investment grade tenants. 94% of the revenues are generated from retail and 6% are from industrial. These assets are leased to 28 different tenants in 17 industries. Of the 25 independent transactions closed year-to-date, three transactions were above $50 million. Transaction flow continues to remain healthy. Of the opportunities sourced during the second quarter, 67% were portfolios. Year-to-date, we have sourced approximately $17 billion in potential transaction opportunities, and of these opportunities, 60% of the volumes sourced were portfolios and 40% or approximately $7 billion were one-off assets. Investment grade opportunities represented 24% for the second quarter. Of the $347 million in acquisitions closed in the second quarter, 25% were one-off transactions. As to pricing, cap rates were essentially unchanged in the second quarter. Investment grade properties traded from around 5% to high 6% cap rate range and non-investment grade properties traded from high 5% to low 8% cap rate range. Our investment spreads relative to our weighted average cost of capital were healthy, averaging 151 basis points in the second quarter, which were above our historical average spreads. We define investment spreads as an initial cash yield, less our nominal first-year weighted average cost of capital. Our disposition program remained active. During the quarter, we sold 26 properties for net proceeds of $33.7 million at a net cash cap rate of 7.1% and realized an unlevered IRR of 8.3%. This brings us to 40 properties sold year-to-date for $47.5 million at a net cash cap rate of 7% and realized an unlevered IRR of 8%. In conclusion, we look forward to achieving our 2018 acquisition target of $1.75 billion and disposition volume of approximately $200 million. With that I’d like to hand it back to John.

Thanks Sumit. We continue to have excellent access to the capital markets to fund our business and maintain our conservative balance sheet. We remain well positioned upon our growth through a variety of avenues for the rest of the year. We currently have approximately $1.1 billion available on our line of credit, excluding our accordion feature. In June, we increased the dividend for the 97th time in our Company’s history. Our current annualized dividend represents a 4% increase over the year-ago period. We have increased our dividend every year since the Company’s listing in 1994, growing the dividend at a compound average annual rate of 4.7%. And we are proud to be one of only five REITs in the S&P High-Yield Dividend Aristocrats Index. To wrap it up, we’re pleased with our Company’s momentum across all areas of the business and remain optimistic about our prospects. Our real estate portfolio, acquisitions pipeline, and balance sheet remain healthy, contributing to favorable risk-adjusted earnings growth for our shareholders. At this time, I like to open it up for questions.

Thanks for the question. Maybe you could talk about your views on Amazon’s entry into the pharmacy business and how that impacts CVS, Walgreens, and your portfolio?

Sure, Josh. I think that sort of the topic of the day is Amazon’s acquisition of PillPack and what the impact it’s going to have on the pharmacy industry. PillPack has about five percent of overall market share today, focusing on drugs that treat long-term conditions which account for about 25% of pharmacy sales, 50% of the drugs are for acute illnesses, and 25% are for specialty drugs and these are typically handled by the brick-and-mortar pharmacies. So, PillPack caters to a relatively small portion of the market. Walgreens and CVS are the top two drugstore tenants, each have about 23% of the market and both have been very successful recently, having positive same-store pharmacy sales for the last five years. Most consumers of drugs, based on surveys and industry trade information, prefer face-to-face interaction when purchasing drugs. This is especially true among the older portion of our population, the baby boomers. Walgreens and CVS have become competitive on pricing through integration alliances with PBMs. So, that’s helped them capture more market share and they are also able to create captive market share through this vertical integration. Additionally, both Walgreens and CVS offer same-day and overnight delivery in major markets today through partnerships with logistics providers like FedEx. Another statistic that gives us comfort is that, since 2010, brick-and-mortar drug stores have taken about 20% of the market share from mail-order pharmacies. Again, this is due to them becoming more price competitive and providing convenience. 80% of the population lives within a five-mile radius of either CVS or Walgreens, and the two leading brick-and-mortar pharmacies continue to add in-house health clinics to drive pharmacy sales. So, we see that trend continuing and growing, having a positive impact on those brick-and-mortar businesses. The overall pharmacy market is growing by 5% per year, which is expected to continue. It is not surprising to see new entrants. I’d add that, importantly, our pharmacies are in outstanding real estate locations that are versatile. And while our investment in the industry has declined by about 1.5% in the last 18 months, based on growth in other areas and selective asset sales, we remain really confident in our portfolio and specifically in that space. So, we’re certainly comfortable with our investments there.

You mentioned in the opening remarks that you’ve seen a good number of portfolio deals in the market. Is the increase in acquisition guidance for the year related to the expectation of closing some of these bigger portfolios or is this just a function of more one-off deals?

It’s a combination of portfolios as well as one-off transactions, Spenser. So, year-to-date, more than 80% of our acquisitions have been larger negotiated sale leaseback transactions where we were the only company negotiating with those tenants. What we found is we’re seeing a market that’s really different than the broader sector. Because of our access to capital and our cost of capital, we’re able to execute very large sale-leaseback transactions on a negotiation basis which enables us really to diversify. So, a lot of companies in the sector can’t compete on that level. Some of the growth is coming from that activity and some of it is continuing growth from one-off smaller portfolios, given a competitive net lease acquisitions market.

You mentioned that the cap rates on a blended basis were 6.5 for the quarter, I was wondering if you could break that down between the retail and industrial assets?

The industrial assets, specifically one large asset, a distribution center in Northern California that is a development take-out. We get yields on development properties that are anywhere from 100 to 150 basis points higher than on stabilized properties. So, this particular industrial property had cap rates that were actually higher than 6.5%. And then on the retail side, they were just slightly under that, Nick.

And you mentioned the watch list but are there any meaningful changes to the rent coverage ratio for any of your larger tenants?

The information that’s been coming in, sales from our tenants that report are continuing to improve. That’s why you saw our coverage levels pick up a little bit from where they were in the previous quarter. So, the news on a tenant level is positive, and we feel very good about the small percentage outstanding on the watch list.

With over $500 million out on the line and in an active pipeline, should we expect bond issuance in the second half of the year? And then if you could elaborate on the second quarter acquisitions, just your current thoughts on leverage in the current environment.

We’re pleased with the strength of the balance sheet today, with debt to EBITDA at 5.5x. When we look forward, including the accordion, we have about $2 billion of capacity on the revolver. Our overall floating rate debt exposure is manageable right now. We also have anticipated about $150 million in proceeds from asset sales, and we’re expecting probably about $75 million retained equity from our business operations to help fund our growth. All long-term capital markets are open to us right now, and the 10-year bond market is around four percent. That’s attractive. And as appropriate, we will evaluate all of our options with regard to financing the acquisitions.

And my second question is, what trends are you observing on investments this quarter compared to the previous one? Should we expect them to maintain above-average levels for the rest of the year?

Right now, they are coming at attractive levels. So, I think the second quarter levels are pretty indicative of where we are heading this quarter, and we’re optimistic that spreads will continue to widen out a bit, so our margins will improve.

Hi. On your industrial portfolio, are there any markets that you’re starting to look at or getting less interested in?

Well, we’ve had a strategy of being in significant markets where there are good re-leasing opportunities if needed or in mission-critical locations. The markets that we’re focusing on are very attractive right now, and the valuations are quite favorable. However, we’re not seeing any huge speculative supply issues in any of those markets. What developers are building is typically leased or pre-leased by the time it’s completed, so we’re not looking to exit any specific markets in the industrial sector.

Thanks. Sorry, just a quick follow-up regarding development. Development represents a small portion of your portfolio, and it looks like the pipeline has been winding down. I'm curious how you view development in the current environment, especially considering construction costs.

On the development side, it’s always been an attractive way for us to grow. We have $25 million under development today. The yields are more attractive on development than they are on acquisitions, so we remain bullish on it. We’d like to have more under development, and we anticipate a decent amount of development spend in the second quarter, but we’re looking to put more development projects on the books moving forward. Now to remind everyone, all development is pre-leased. We don’t do speculative development but work with existing clients, so it's certainly a low-risk form of development.

Quick modeling detail question. What specifically this quarter drove the sizable other income number? I know it’s variable quarter to quarter but I think Q2 2018 was higher than you guys do in most years.

So, that $2.6 million payment in insurance proceeds on one asset, an asset that was destroyed by a tornado and that showed up in our other income area.

Okay. That makes sense. And then kind of philosophically, I know with valuation, that is probably not something that’s top of mind. But how do you look at your industrial assets potentially as a sort of hedge if you were to see equity market volatility, given how robust that market has been even at the beginning of this year?

We always consider asset sales as opportunities for us to recycle capital and drive growth. Those asset sales are undertaken on strategic bases, sometimes involving credits we want to limit our exposure to, or markets we want to limit exposure to, or simply to decrease industry exposure. Sometimes those sales are driven opportunistically because we receive really attractive pricing, which makes it more valuable to the company and, hence, our shareholders to sell the property and recycle the proceeds rather than hold onto those assets. That’s how we evaluate our entire portfolio, and there’s no doubt that currently industrial pricing is attractive but a number of our areas have favorable cap rates as well.

All right. Well, thanks everybody for joining us today. We look forward to seeing you this fall in conferences and marketing meetings. I hope everybody has a good summer and thanks again for joining us.