Realty Income Corp (O) — Q1 2019 Earnings Call Transcript

Thank you all for joining us today for Realty Income's first quarter 2019 operating results conference call. Discussing our results will be Sumit Roy, President and Chief Executive Officer, and Paul Meurer, Chief Financial Officer and Treasurer. During this conference, we will make statements that may be considered 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’ll now turn the call over to our CEO, Sumit Roy.

Thanks, Andrew. Welcome to our call today. We are pleased to begin 2019 with another successful quarter. During the quarter, we invested approximately $520 million in high-quality real estate and investment spread, well above our historical average, and we continue to see ample transaction flow that meets our investment parameters. Subsequent to the quarter end, we announced our international expansion through a GBP429 million sale leaseback transaction in the UK with Sainsbury's under long-term triple-net leases. This represents a natural evolution of our Company's strategy, and we will continue to grow our international platform as we are well-positioned to capitalize on a significant addressable market in the UK and mainland Europe. From a strategic standpoint, we believe there is a dearth of large institutional buyers pursuing the quality of single tenant net leased assets in Europe that we intend to invest in. Given our portable size, scale, and cost of capital advantages, we believe we have a unique ability to execute sizable portfolio transactions with best-in-class operators. This transaction was relationship-driven and was completed on an off-market negotiated basis. We look forward to further developing relationships with other industry leaders like Sainsbury's as we expand our international platform. Concurrent with the announcement of our sale leaseback transaction with Sainsbury's, we increased our 2019 AFFO per share guidance to a range of $3.28 to $3.33 from a prior range of $3.25 to $3.31, and we increased our 2019 acquisition guidance to a range of $2 billion to $2.5 billion. 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 quarter end, our properties were leased to 261 commercial tenants in 48 different industries located in 49 states and Puerto Rico. 82% of our rental revenue is from our traditional retail properties. The largest component outside of retail is industrial properties at nearly 12% of rental revenue. Walgreens remains our largest tenant at 6.1% of rental revenue. Convenience store remains our largest industry at 12.2% of rental revenue. Within our overall retail portfolio, approximately 95% of our rent comes from tenants with a service nondiscretionary 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. retail 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 rated tenants. The weighted average rent coverage ratio for our retail properties is 2.8 times on a four-wall basis while the median is 2.6 times. Our watch list at 1.6% of rent is relatively consistent with our levels over the first few years. Occupancy, based on the number of properties, was 98.3%, a decrease of 30 basis points versus the year-ago period. We expect occupancy to be approximately 98% in 2019. During the quarter, we released 71 properties, recapturing approximately 105% of the expiring rent. Since our listing in 1994, we have released or sold over 2,900 properties with leases expiring, recapturing over 100% of rent on those properties that were released. Our same-store rental revenue increased 1.5% during the quarter. Our projected run rate for 2019 continues to be around 1%. Approximately 86% of our leases have contractual rent increases. Let me hand it over to Paul to provide additional detail on our financial results. Paul?

Thanks, Sumit. I will provide highlights for a few items in our financial results for the quarter starting with the income statement. Effective in the first quarter we adopted the new lease accounting guidance. As a result, we are now consolidating tenant reimbursement revenue within rental revenue in our income statement. To aid financial statement users, we will continue to separately disclose the component of revenue attributable to reimbursable tenant expenses in both our 10-Q and in our financial supplement. Our G&A expense as a percentage of revenue, excluding reimbursement, was 4.5% for the quarter, below our G&A expenses in the year-ago quarter from both a margin basis and a dollar basis. We continue to have the lowest G&A ratio in the net lease REIT sector and expect our G&A margin to remain below 5% in 2019. Our non-reimbursable property expenses as a percentage of revenue, excluding reimbursements, was 1.3% for the quarter, which also remains ahead of our full year expectation in the 1.5% to 1.75% range. Adjusted funds from operations, or AFFO, representing the actual cash we have available for distribution as dividends, was $0.82 per share for the quarter, which represents a 3.8% increase. Briefly turning to the balance sheet. We have continued to maintain our conservative capital structure and, of course, we remain one of only a few REITs with at least AA rating. During the first quarter, we issued $2.2 million of common equity through our dividend reinvestment stock purchase plan. Note that we entered 2019 with a very low leverage after issuing almost $540 million of common equity in the fourth quarter of 2018. We finished this quarter with a debt-to-EBITDA ratio of 5.5 times and ended the quarter with approximately $2.2 billion available on our credit line. Our fixed charge coverage ratio increased from 4.4 times to 4.5 times. The weighted average maturity of our bonds is approximately 8.5 years which closely tracks our weighted average remaining lease term. Our overall debt maturity schedule remains in excellent shape, with only $19 million of debt coming due for the remainder of 2019 and our maturity schedule is well-laddered thereafter with just over $300 million of debt maturing in both 2020 and 2021. In summary, our balance sheet is in great shape, and we continue to have low leverage, strong coverage ratios, and excellent liquidity. Now let me turn the call back over to Sumit.

Thanks, Paul. I'll now move to our investment activity during the quarter. During the first quarter of 2019, we invested approximately $520 million in 105 properties located in 25 states at an average initial cash cap rate of 6.7% and with a weighted average lease term of 17 years. On a revenue basis, approximately 31% of total acquisitions are from investment-grade tenants. 98.7% of the revenues are generated from retail. These assets are leased to 25 different tenants in 14 industries. Some of the most significant industries represented are health and fitness, automotive services, and grocery stores. We closed 25 discrete transactions in the first quarter. Transaction flow continues to remain healthy as we sourced approximately $11.7 billion in the first quarter. Investment-grade opportunities represented 31% of the volume sourced for the first quarter. Of the opportunities sourced during the first quarter, 53% were portfolios, and 47%, or approximately $5.0 billion, were one-off assets. Of the $519 million in acquisitions closed in the first quarter, 42% of the volume were one-off transactions. As to pricing, cap rates have essentially remained unchanged in the first quarter. Investment-grade properties are trading from around the 5% to high 6% cap rate range and non-investment-grade properties are trading from high 5% to low 8% cap rate range. Our investment spreads relative to our weighted average cost of capital were healthy, averaging approximately 261 basis points in the first quarter, which was well above our historical average spreads. We define investment spreads as initial cash yield less our nominal first-year weighted average cost of capital. Our domestic investment pipeline remains robust and we continue to see a steady flow of opportunities that meet our investment parameters. We remain the only publicly traded net lease company that has the size, scale, and cost of capital to pursue large corporate sale-leaseback transactions on a negotiated basis. During the first quarter, approximately 50% of our acquisitions were sale leaseback transactions and we continue to identify strong corporate partners for future sale-leaseback transactions. As previously mentioned, due to the strength in our current domestic investment pipeline as well as our international expansion, we have raised 2019 acquisition guidance to a range of $2 billion to $2.5 billion. Our disposition program remains active. During the quarter, we sold 18 properties for net proceeds of $21.4 million at a net cash cap rate of 9.5% and realized an unlevered IRR of 5.4%. The low IRR on our disposition activity during the quarter was primarily driven by one sale of a vacant property previously leased to a sporting-goods retailer. Absent this disposition, our IRR on dispositions during the quarter was 7.2%. We continue to improve the quality of our portfolio through the sale of non-strategic assets, recycling the sale proceeds into properties that better fit our investment parameters. We continue to anticipate between $75 million and $100 million in dispositions in 2019. In March, we increased the dividend for the 101st time in our Company's history. Our current annualized dividend represents a 3% increase over the year-ago period and equates to a payout ratio of 82.1% based on the midpoint of 2019 AFFO guidance. We have increased our dividend every year since the Company's listing in 1994, growing the dividend at a compound average annual rate of 4.6%. We are proud to be one of only five REITs in the S&P High Yield Dividend Aristocrats Index. To wrap it up, we completed another strong quarter. Our portfolio continues to perform well. Our investment pipeline remains robust, and we are excited about the Company's next chapter as we continue to pursue new opportunities for growth, both domestically and internationally. At this time, I would like to open it up for questions.

Hi, good morning guys. Given that ATM issuance is pretty wide in Q1 relative to your normal pace, I'm wondering if you were in a quiet period given the timing of the Sainsbury deal and would you expect it to pick up again now that the deal has been announced? And maybe have you issued any equity post the announcement?

Good question, Christy, and you're spot on. Because of the nature of the transaction with regards to Sainsbury's, we were in a blackout period. And so that was the primary reason. The second and equally important reason was in the fourth quarter we had over-equitized our balance sheet in anticipation of this particular transaction. So even at the end of the quarter, if you look at where the balance sheet is, it's 5.5 times debt-to-EBITDA, north of 4.6 times coverage on a fixed charge basis. It leaves the balance sheet in a very good standing. So with regards to capital raising, all avenues are open to us, and we will perpetually choose the best available avenue going forward. But those were the primary reasons.

Okay. And then just looking at the occupancy rate ticked down a bit, any main drivers of that that we should be thinking about and maybe comment on sort of what the outlook looks like for the rest of the year? I think you said 98%, but I wasn't sure if that was sort of a year-end number or an average number.

Yes. Again, good question. These two were anticipated which is why if you look at what we guided the market and which is what's reflected in our earnings guidance, we had guided the market to a 98% occupancy number. We had 101 leases expiring in the first quarter, which was disproportionately high. For the remaining three quarters, we've got 158 leases expiring. So we anticipated that the 98% would come down. As we've always shared with the market, we believe our operational occupancy is right around that 2% range. So having an occupancy number at 98% is what we forecast and is what we believe we're going to be running our business at.

Okay. And then if I could, just one last quick one. Paul, I thought I heard you mention that you'll continue to disclose the revenue component breakout in the Q also. I'm just curious, will that be in the footnotes or the MD&A?

You can see it right now, by the way, in the supplement so that you have it immediately.

We have it in the supplement. I'm just curious about what the SEC and FASB guided you regarding allowing that in the Q.

It will be in our MD&A.

Great, thank you.

Thanks. I guess I was just wondering in terms of, you know, when you look at the retail industry in the US, has your thinking evolved on drugstore exposure given what seems like a little tougher operating environment? Are there any other industries where you might be making more or less of a capital investment based on some changes in the retail environment?

Good question, Nick. This is a question that we often get asked based on our exposure to the drugstore industry. It continues to be our second largest industry exposure. And it's primarily driven by two operators, Walgreens and CVS. If you look at Walgreens for instance, they're generating north of $5 billion in free cash flow. If you look at CVS, it's one of the best operators out there in the drugstore industry. We are very positive about the drugstore business. Is it going through some changes? Absolutely. But we believe that by and large these two operators are very well-positioned to take advantage of these changes that we see unfolding before our eyes. Some of which, the answers are not very clear regarding what the drugstore layout of the future looks like today. But what is clear is that both CVS and Walgreens have made it part of their strategy to figure out how to optimize their stores. If you look at the pharmacy same-store sales growth, they continue to comp positively, both for CVS and for Walgreens. They are trying to figure out how to provide healthcare services, both for acute and chronic illnesses, using the footprint that is already available. Another piece is being closer to the consumer, which they believe, will be the best way to lower the cost of delivering healthcare. Not all of that has played out, but they're certainly experimenting with different formats, etc. We believe these are the two operators that will continue to do well and will figure it out eventually.

Okay. That's helpful. And then I guess just in terms of any sub-sectors within retail where you would like to have less exposure?

Yes. Look, casual dining continues to be an area that we focus on. It used to represent a very large portion of our portfolio 10 years ago. And today, it's right around 4%, sub-4%. The ones that we are exposed to, by and large, we are very happy with. However, that's an area that we continue to be very cautious about and an area that we continue to focus on closely. Anything that falls in the discretionary bucket of retail, from furniture stores to other types of discretionary product like sporting goods, etc., those are again industries that we are very cautious in looking at and certainly trying to invest in. There are certain other asset types that are much more demographically driven, such as childcare centers. We like the childcare business, but the format of the 1980s has shifted in the neighborhoods where some of these concepts used to work 20 years ago but don't seem to work today. Those are assets that we have on our watch list and are looking to dispose of, and at very good total return profiles. A similar story with regards to the format of the kiosk c-stores. We love the c-store business, but we like the 3000-plus square foot convenience store business. The ones with kiosks selling lottery tickets and tobacco products are ones that we are actively trying to dispose of. So that's the area that I would say we are either trying to minimize our exposure to or not invest in at all.

Thank you. Just one last question if I may. On the leasing activity page in the supplement you have where you give the recapture rate, could you give a little bit more detail on the four leases where you had essentially about a 30% markdown in rents? It says it's without vacancies. So I guess I'm just wondering why if you had a tenant, why you released it at a lower rent?

Well, those are the ones where the tenant decided not to stay. For us, you're always looking at those assets and trying to devise the economic scenario of selling those assets vacant or releasing them. It is not atypical. If you go back and look at our supplemental, to have assets that have even with zero vacancy lease rates that are sub-100%, so the fact that this was right around 70% doesn't really drive the overall profile. We still came out at 105% recapture rate. It’s largely driven by leases with tenants that choose to exercise the existing options. Our goal is to make sure that the retail product remains relevant for the existing tenants, which tends to give us positive spreads without additional investment. In situations when we have had vacancy or even with no vacancy, when you're trying to attract new tenants, sometimes taking a 30% drop in a recapture rate proves to be, in our analysis, a much better economic outcome than trying to sell those assets vacant. And that's the story behind that.

Okay, appreciate it, thank you.

Sure.

Good afternoon guys. Just follow-up on Nick's question. So there's roughly 100 vacant assets in the portfolio. What's the sort of mix between what you guys expect to retenant versus market for sale?

It's been roughly, if you look at it historically speaking, 80% of every lease that comes up for renewal gets exercised by the existing tenant. I would say 10% to 15% of the remaining leases we end up leasing to new tenants and 5% to 10% we end up selling. More recently that mix has shifted. We are tending to dispose off vacant assets because we feel like the economic recapture rate is superior to going down the path of retenanting. This is where some of our active asset management comes into play, because we believe we can reposition those assets and actually recapture well north of the expiring rents. But it does take time, which is why we have said that our frictional vacancy rate is around that 2% because we are more than happy holding on to these assets and repositioning them, potentially holding them for 18 months to two years, believing that the economic outcome in those areas is superior to either retenanting them as is or selling them vacant.

Okay. What's your thoughts on adding casinos or hotel assets in the portfolio?

Good question. There are players in our space that are dedicated to pursuing casinos. We feel like they're very well suited to pursue that strategy. We monitor the asset type, but we really don't have a thesis at this point as to whether we will do anything about entering that front.

And hotels as well?

Yes, I would put both of them in the same bucket.

Okay, thanks guys.

Great, thank you. Last week you provided a lot of detail on the opportunity to grow in Europe. Where do you want to take your international platform? Where could Canada fit in? Are you evaluating any opportunities there as well?

We've always looked at Canada. We've looked at countries south of the border as well. However, we haven't been able to pencil the economics. The product available in these alternative geographies hasn't aligned with what we want based on the economic profile. One of the main reasons we wanted to provide all that detail was to ensure you understood the thesis behind why we chose to go into the UK and possibly into mainland Europe. The economics work very well, especially given the current environment and the product aligns with what we pursue here in the US. Canada is certainly a country that we have looked at in the past, and if the right product with the right economic profile comes along, we will absolutely pursue it, but we haven't been able to find one yet.

Okay. It doesn't sound like there's any bigger push now that you've established an international platform necessarily to go in that direction, is that fair?

It's now that we've done, more people are aware of the fact that we're open to doing it. So I would say that that's not entirely fair, Collin. We are certainly getting a lot more inbound calls as was expected, and transactions perhaps that we may not have seen because people weren't aware that we were a potential player in the past. That dynamic has changed, which was completely expected, and the team here is ready to respond to those calls. So, time will tell.

Great. That's actually very helpful clarification there. Just switching to investment activity during the quarter, there were really no huge moves in your top tenant roster just as far as the Dollar General property, obviously that was up somewhat notably. Can you provide any additional color there and then talk about your Dollar Stores exposure overall at this point?

Yes. A lot of it was part of small portfolios that we acquired. We continue to like Dollar Tree and Dollar General. Both of those are operators filling a very specific market. They are outstanding operators in our mind. Dollar Tree has taken a bit longer than any of us had expected to unfold Family Dollar, but that is now well on its way. All signs are that those are the two operators we want to continue to partner with. Our exposure to that business is around 5.2%. Will we actively grow that piece? Absolutely, with the right trends, and with the right growth profile, we will continue to look to grow that. However, we are not going to actively pursue these development-driven Family Dollar, Dollar General, Dollar Tree assets since those tend not to have the right type of leases in terms of the triple-net nature we prefer to pursue.

Okay. Thank you very much for the color.

Hi, good afternoon. I was wondering, Sumit, should we still expect to see you broaden your verticals out in the US this year, or do you feel like you have enough on your plate with the international initiative that you announced?

I'm smiling, Karin. Last week we came out with something huge, and our hope is to continue to explore. The timing remains uncertain as to whether it's going to be next quarter or next month or maybe even a year from now that we can come up with something different. This international foray is a big step for us. It increases the potential market from $4 trillion to potentially $12 trillion now, and we want to ensure this is done right on the international front. However, that doesn't preclude us from continuing to explore other paths we've been looking at over the past three months. If something becomes actionable, we will again share that with you. But I can't tell you the timing on some of those other avenues.

Understood. Appreciate that. My second question is along the same lines. You've generated very consistent FFO and dividend growth over the years with below-average volatility. Is one of the goals of the new strategic initiatives to push earnings growth higher than it has been historically?

No. Our only goal is to look at expanding the potential viable investment set. The idea is to not compromise on either our balance sheet strategy or the types of businesses that we are pursuing. Those remain intact, Karin. Most people invest in us for our low-vol dependable growth business. We don't plan to compromise on that front. However, this does not preclude us from exploring new avenues of growth that align with our designed profile. In certain products, we believe there is a mismatch where the perception may be that it tends to be higher risk or higher volatility, and it’s for us to show why we believe they align with our profile. For us, growth is an output of this exercise rather than the driver, and that is nuanced but important to us.

Thanks for taking my questions.

Sure.

Good afternoon.

Hi, John.

As you stated, investment-grade rated assets as a percentage of acquisitions came down a little bit this quarter versus what you've done in the first nine months of 2018. Was this a similar situation to Q4 2018 where it was just the mix and there's a lot of assets in there that simply aren't rated? Or was there maybe a better risk-adjusted return you felt you were getting by going after sub-investment grade-rated companies?

Yes. I would say many of them fell into this non-rated bucket. Given our conservative nature, we do our own underwriting to determine the implied rating if they were rated. We categorized them as sub-investment grade for your purposes. People often say we only pursue investment grade-rated tenants and that compromises growth and yield, but that has never been our approach. This is an output of the strategy we've established. A lot of the assets we closed on in the first quarter have business models that are low-vol and predictable with high drop to breakeven in sales. It is important for us. Just because we had 30% investment grade-rated tenants in the first quarter, this is the result of the types of products we closed on. The industries and tenants are still of high quality. For instance, LifeTime Fitness is a business we like, and they have much higher coverage ratios than our overall portfolio. They'll fall into the non-investment grade category since they're private without a rating. So don’t read too much into that percentage. It will continue to move around.

No, that makes complete sense. Can you provide a little color on any tenant credit-driven vacancy in the quarter? If I heard you right, you had 101 leases expire. If I look on page 21 of the supplement, that would imply there were around 10 or so assets that were vacant because of not because of the expiring leases but because of tenant credit. What drove that? I know it’s not a huge number, but any color there would be helpful.

Sure. Happy to address that. We have eight Shopco assets and these were largely second-generation assets for us. Few of those 10-odd came from the Shopco assets. We expect most of them to come back to us. This only represents about 17 basis points of rent, so it's completely immaterial, but those definitely drove some of that 101 vacancies.

I appreciate the color. That's it from me. Thank you.

Thanks.

Hi, just one quick one for Paul. Any plans to refinance the line balance later on this year with the bond deal? And are you considering a commercial paper program or forward equity?

Yes. As Sumit commented earlier, given the new Sainsbury's, we felt compelled not to issue new capital in Q1 because that constituted material information for potential equity investors. We had raised a fair amount of capital at the end of last year. So we sit here today with that $800 million-plus balance, but it is a $3 billion line, so we have plenty of liquidity. We don't feel compelled at this time relative to a need for capital regarding our acquisition pipeline in the near term. All forms of capital are available to us. Equity and bonds are both well priced right now. Bonds are something we would certainly be considering as part of the mix by year-end. Typically, our mix is going to be two-thirds plus equity and the remainder thinking about unsecured bonds. We could see that being part of it. A commercial paper program is also on our list of new ideas we are considering. It very much could be part of our future, but you won't see it in the immediate near term.

Thank you everyone for joining us today. We look forward to seeing everyone in a few weeks at ICSC and in the summer at NAREIT. Thank you everyone.