Realty Income Corp (O) — Q4 2023 Earnings Call Transcript

Thank you all for joining us today for Realty Income's fourth quarter operating results conference call. Discussing our results will be Sumit Roy, President and Chief Executive Officer; and Jonathan Pong, Chief Financial Officer and Treasurer. During this conference call, we will make statements that may be considered 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-K. We'll be observing a two-question limit during the Q&A portion of the call in order to give everyone the opportunity to participate. If you would like to ask additional questions, you may reenter the queue. I will now turn the call over to our CEO, Sumit Roy.

Thank you, Steve, and welcome, everyone. Our fourth quarter and 2023 full-year results demonstrate the unique platform value that Realty Income has built, which differentiates us as a real estate partner to the world's leading companies. During the year, we accomplished several milestones, which illustrate the benefits bestowed to us by our size, scale and relationships. First, we set an annual high in property level investment volume closing on over $9.5 billion in high-quality diversified investments across eight different countries and through 271 discrete transactions at a weighted average cash yield of 7.1%. The year was punctuated with a particularly active fourth quarter as we closed on $2.7 billion of investments at a weighted average cash yield of 7.6%. Our fourth quarter activity included a $527 million sale leaseback transaction with Decathlon, one of the world's leading investment-grade rated sporting goods retailers and included properties located in Germany, France, Spain, Italy and Portugal. Despite a volatile capital markets environment, we achieved an investment spread of approximately 115 basis points in the fourth quarter and approximately 120 basis points in 2023. We were able to achieve these spreads without sacrificing our focus on the quality of real estate or security of cash flow, which is a testament to our experienced team and the merits that sophisticated sellers see in transacting with our platform. Second, during the year we established a presence in the data center sector through a build-to-suit development joint venture with Digital Realty. And we incubated new relationships with blue-chip partners such as Blackstone and the EG Group through large scale investments, including the $950 million investment for a 21.9% stake in the Bellagio and the $1.5 billion sale leaseback involving primarily Cumberland Farm convenience stores. Third, and in addition to the achievements noted above, we also announced the $9.3 billion merger with Spirit Realty Capital in an all-stock transaction in October, which closed subsequent to year-end on January 23. These accomplishments contributed to our 2023 AFFO per share of $4, representing an approximately 7% total operational return for the year, and importantly, together with the Spirit merger, set us up to deliver a compelling earnings growth backdrop in 2024. We believe that the close of the Spirit merger last month along with meaningful debt and equity capital raising activity completed at attractive prices in December and January that Jonathan will describe in more detail, leave us well-positioned to deliver robust growth in 2024. We here initiated an AFFO per share guidance range of $4.13 to $4.21 per share for 2024, which represents an annual growth rate of 4.3% at the midpoint. We believe we can achieve this growth rate without the selling of additional public equity. Inclusive of our dividend, this positions us to deliver a total operational return of more than 10% at the midpoint of the guidance range based on the trading price of our common stock as of February 20, 2024. In addition to the $9.3 billion Spirit merger, we're also providing 2024 acquisitions guidance of approximately $2 billion, which is expected to be fully funded via a combination of our portfolios internally generated cash flow now exceeding $800 million after dividend payments on an annualized basis, as well as approximately $605 million of unsettled ATM proceeds and our $3.7 billion of cash and unutilized availability on our revolving credit facility as of year-end. While we continue to source and review high-quality investment opportunities, we remain highly selective deploying capital only into attractive risk adjusted return opportunities that meet both our near-term and long-term investment spread requirements. Of our $2 billion initial investment volume forecast, approximately half is expected to come in the form of development financing, the vast majority of which is already identified. To reiterate, our favorable return profile in 2024 carries very little execution risk from an investment standpoint, allowing us the flexibility to remain patient, disciplined and opportunistic from a capital deployment standpoint. That said, as we demonstrated during the height of the pandemic, our platform affords us the opportunity to pivot quickly back into growth mode should market conditions change. While we intend to remain disciplined in our investments to ensure appropriate risk-adjusted returns for our investors, we continue to highlight why we are best positioned to capitalize on compelling opportunities over the long term. First, the opportunity to consolidate the fragmented net lease real estate market is vast. We estimate $14 trillion total addressable market in the U.S. and Europe across traditional net lease and emerging verticals like data centers and gaming. Second, we have firmly demonstrated our capabilities deploying capital, having invested $9 billion or more including public M&A in each of the last three years since exiting the pandemic year of 2020. Over this time, we have generated annualized AFFO per share growth of approximately 6% and we have provided a total operational return to stockholders of approximately 10% per year. Looking to 2024 and beyond, we are on track to achieve similar capital deployment and AFFO per share growth objectives this year. We are particularly energized by the prospect to participate meaningfully in verticals like data centers and gaming, where we are seeing opportunities to earn healthy initial yields with attractive contractual rent escalators. Third, the Spirit merger deepens our ability to access capital markets through increased trading volume in our publicly-listed stock, which has averaged more than $400 million of daily trading volume since the Spirit transaction was announced. This places us in the top 150 of S&P 500 companies and is more than 7 times the net lease peer average over the same timeframe, leaving us even better situated to fund our business in a highly efficient and non-disruptive manner through our ATM equity program. Fourth, our real estate portfolio is becoming increasingly diversified over time and consists of properties leased to relationship clients representing some of the world's leading companies in their respective industries. Diversified exposure to these clients reinforces the stability of our platform and accordingly are growing monthly dividend payments. Finally, the power of our platform is a crucial differentiator as we leverage our expertise across ownership of over 15,400 properties globally, inclusive of the Spirit portfolio. Our experience managing over 5,900 lease outcomes since 1996 provides learnings that feed into analytic AI tools that provide actionable insights, enabling us to more accurately identify acquisition opportunities and to maximize the value of our existing holdings. Continuing with our key operational results from the fourth quarter, investment volume of approximately $2.7 billion was allocated to high-quality investments at a weighted average cash yield of approximately 7.6%. We completed $1.1 billion of total investment volume internationally at a weighted average cash yield of 7.8%. Investments were made across 119 distinct transactions, including 29 sale leaseback transactions equating to $884 million of volume. Our full year investment activity was $9.5 billion, of which 35% was derived internationally, serving as a testament to the value of our investment platform’s global footprint. Included in fourth quarter volume was a loan we made to ASDA stores in the UK at a 10.9% yield. The loan is backed by ownership interests and properties containing grocery stores and supermarkets and was extended as part of a sale leaseback transaction with ASDA. In addition, fourth quarter volume included our previously announced $650 million of preferred equity investment in the Bellagio joint venture with Blackstone, which earns an 8.1% yield. Similar to the loan investment in ASDA, the Bellagio preferred equity investment was paired with investment in high-quality real estate. For both investments, our ability to offer a broadened suite of capital solutions to clients granted us access to high-quality net lease real estate investments at superior risk adjusted returns than we could have achieved otherwise. These transactions serve as templates for future sale leaseback transactions. Also in the fourth quarter, we made our initial investment in a data center development joint venture with Digital Realty. The initial $200 million investment represents an 80% equity investment in the venture and is expected to generate a 6.9% initial cash yield, 2% annual rent escalators and a long-term triple-net lease with an S&P 100 investment grade client upon completion. Turning to portfolio operations, same-store rent grew 2.6% in the fourth quarter and 1.9% for the year, benefiting in part from lower net bad debt expense compared to the prior year. On a normalized basis, our contractual rent growth approximates 1.5% on an annual basis based on the current composition of our portfolio. This amount is up over 50 basis points from just five years ago and is a result of an intentional push by our team to generate enhanced organic growth. We remain committed to walking this growth rate higher over time through our deliberate underwriting strategy. Our diligent asset management efforts led to a recapture rate of 103.6% during the quarter and 104.1% for the year excluding the impact of the Cineworld bankruptcy. At year-end, occupancy was 98.6%, a 20 basis point decline from the prior quarter as a result of expected client move outs.

Thank you, Sumit. We completed an active quarter in the capital markets during the fourth quarter raising $1.6 billion of equity at a weighted average price of $56.25. Including activity subsequent to year-end, we currently have approximately $605 million of outstanding forward equity available to finance a portion of our equity needs in 2024. When combined with over $800 million of annual free cash flow available to us following the Spirit merger, we have the ability to finance all of our equity needs for our $2 billion investments guidance without having to tap into the public equity markets for the remainder of 2024. And this is before any capital recycling opportunities throughout the sales, which we expect to be north of the $116 million volume we achieved in 2023. As Sumit mentioned earlier, our AFFO per share guidance midpoint implies 4.3% annual growth and assumes only $2 million of investments volume, with almost half are re-accounted for in our development pipeline. From a debt capital market standpoint, we de-risked our 2024 maturity schedule through approximately $2.2 billion of bond issuance activity in a 45-day span, beginning with our GBP 750 million sterling notes offering in December and culminating in our US$1.25 billion offering that closed last month. Combined, the two offerings blend to a weighted average tenure of approximately 10.2 years and weighted average yield to maturity of approximately 5.5%. Near-term, these two offerings allow us to fund our business given our current investment outlook without needing to tap into the debt capital markets in 2024, which we believe was a prudent approach given the persistent instability that has permeated the capital markets over the last two years. There are also longer term strategic considerations that dictated this approach. Following our debut euro offerings in the summer of 2023, we believe these offerings also support our steadfast desire to maintain investor diversification across our multi currency debt complex, while pocketing future debt repayment risk in years with meaningful capacity. Last month, we also exercised the first of two one-year extension options available to us on our $1.1 billion multi currency term loan that we established in January of 2023. In conjunction with the extension, we entered into a two-year floating to fixed interest rate swap that effectively locked in a fixed rate of approximately 4.85% on this principle through its maturity date in January 2026. In conjunction with the closing of the Spirit merger, we also assumed $1.3 billion of term loan debt from Spirit, as well as $1.3 billion in existing floating to fixed interest rate swaps, which resulted in an effective weighted average fixed rate of 3.9% on that debt. Of this term loan principal, $800 million matures in 2025 and $500 million matures in 2027. Moving on to key credit metrics at year end, we finished the year with net debt to annualized pro forma EBITDA of 5.5 times, in line with our targeted leverage ratio and this excludes the $605 million of outstanding forward equity we currently have available to us. Our fixed charge coverage finished the year at 4.7 times, which was the high watermark for us in 2023, benefiting from higher investment yields in the fourth quarter and less and lower cost short-term borrowings outstanding. In 2024, we do anticipate an increase of $45 million in annualized non-cash interest expense we expect to recognize from the amortization of below market debt on the Spirit debt we assumed. Note that this non-cash interest expense adjustment does lower annual FFO per share run rate by approximately $0.05 per share, but is not reflected in AFFO, thus explaining the primary reason why our initial FFO and AFFO guidance ranges are more closely bound than in 2023. We would note that purchase price accounting adjustments are ongoing for the merger and thus straight line rents and FAS 141 adjustments from the merger are likely to push FFO higher once finalized, and we will adjust our FFO guidance at that time. Of course, these are non-cash adjustments that do not impact AFFO. Looking forward, I would like to reiterate Sumit's opening comments about our lack of reliance on the capital markets to fund our growth in 2024. From a liquidity perspective, we view our near-term capital availability as a strength of following our bond yield last month, we had into the rest of 2024 with approximately $4 billion of liquidity at year-end, variable rate debt representing less than 5% of our total debt capital stack and no capital market execution risk to fund our growth for the remainder of 2024.

Thank you, Jonathan. Before concluding, I would like to extend my immense gratitude to Ron Merriman for his valued service to Realty Income on our Board of Directors the past 19 years. Ron's leadership, guidance and mentorship have been invaluable and we all owe him our sincere thanks. I would also like to extend a warm welcome to Jeff Jacobson, who will be joining our Board. I'm thrilled for all of us at Realty Income to benefit from Jeff's perspective as a former CEO of one of the world's premier global real estate asset management firms, LaSalle Investment Management and in his current role as the Chairman of the Board of Cadillac Fairview Corporation. In conclusion, our results in 2023 underscore the multiple avenues of growth at our disposal in the global commercial real estate industry, including through one-off and portfolio acquisitions, multiple asset types, corporate sale leasebacks, development and joint venture partnerships and via public M&A opportunities. The depth of our platform, team and relationships enable us to leverage some or all of these sourcing avenues concurrently as opportunities arise. In 2023, we completed five transactions greater than $500 million in size and two of which were greater than $1 billion excluding the Spirit merger. These are transactions that Realty Income was uniquely positioned to execute given our size, scale and access to capital globally. These distinct competitive advantages support us in serving as a real estate partner to the world's leading companies at an unparalleled scale. Moreover, we believe that serving as capital provider to a diverse spectrum of clients, who are leaders in their respective industries, furthers our core mission to deliver dependable monthly dividends that grow over time. We will now open it up for questions.

Good afternoon. Thanks a lot for taking my question. First question is just on the acquisition guidance. You're starting the year with $2 billion of acquisitions. It sounds like you have visibility into half of them. Really like the execution risk for the year is only for $1 billion. What has to change in order for that number to kind of move higher through the year? Is it interest rates? Is it opportunities that come to you? Is it your ability to do deals kind of like what you've done with the Bellagio with preferred equity or with the loan with ASDA to get it done? Like, how should we think about the potential for upside for that number and that number moving higher through the year?

Thank you for that question, Michael. It's a lot of what you just said. If you look at the market today and you look at the cap rate environment, the adjustments that we have seen have not been commensurate with the movement in the cost of capital. And we are coming out with a business plan that basically says, okay, these two variables that we don't control are not going to be part of how we deliver the 4.3% growth and north of 10% total return growth. And that's the reason for the numbers that we have shared with you. If the cap rates were to adjust, we will be first in line to take advantage of that. If the interest rate environment were to start to go down, which would then have an impact on our cost of capital, i.e., lower cost of capital, we would be first in line to react. We wanted to come out with a business plan that had no reliance on the capital markets on the funding side and come up with a number which we all believe very, very confidently that we will be able to meet, if not exceed. If the environment were to change, i.e., interest rates were to start to go down, et cetera, which would have a positive impact on our cost of capital. I do believe that a lot of the conversations that we are having, so it's not the conversations that have dried up, it's the expectation in the market around what the reservation price needs to be that needs to move. And that can happen either through the movement of cap rates or through our cost of capital getting better. And right now, we feel very confident in saying the plan that we have has very little to no risk and we can deliver a 10% plus return without having to be aggressive in the market. And that's really the thesis around what we've come out with.

That's helpful, Sumit. My follow-up question relates to the upcoming year. Currently, we still have a lot to address for 2024. This question isn't specific to 2025 but rather reflects on the overall philosophy concerning the current environment. If the market remains in a similar situation where not many deals are being executed and the transaction landscape seems unclear, you have secured growth for 2024 through an acquisition. How would you approach navigating what could potentially be a prolonged uncertain environment?

So Michael, the reason I believe that cap rates haven't moved is because of the volatility in the market. If there was certainty that, hey, this cost of capital environment is going to remain at these elevated levels for the next three years, guess what? Cap rates will adjust, will move, and there will be more willingness on the part of sellers to transact today. We had the tenure at a 4.2 towards the end of last year, it dropped down to 3.75 in January, and then it's back up to 4.2. In that sort of environment, you have sellers that are saying, we expect the Fed to start cutting interest rates later in the year. I think it can hold off another six to seven months. So why transact in this environment today? And I think that's the reason why we have hesitation and lack of this widespread movement in cap rates that one would expect if people were to bind to the fact that this cost of capital environment has been permanently impaired. So I think in this scenario that you've sort of dictated, if that were to be the norm and if everybody were to accept that, that, hey, for the next three years, the cost of capital environment is not going to change, I do think transactions are going to come back. I do think cap rates will move much more than they have done so. And yes, we'll be the ones first in line to take advantage of that.

I appreciate the time. I had a question about the development funding. How do we view the NOI from that development funding as it comes online? Do we only receive NOI or returns once the project is completed, or do we receive returns as the funds are drawn down for that development?

Josh, this is Jonathan. One way to think about it because the answer is really going to vary depending on the lease. But if we're doing a development takeout, obviously, we put the funds down when the project is done, we get those assets and the rent starts and there's really no lag. If it's a development build-to-suit we're funding along the way. A little bit more nuance associated with that, where you're not quite getting the economics that we are entitled to as we put this funding out. However, from an accounting standpoint, the way that it flows through to the income statement is through essentially our cost of short-term debt. And so from a modeling perspective, the most clean way to do it, in my view, would be to just assume when you see us developing and deploying capital, that's when the yield begins because in most cases, that's going to be the case.

Yes, the vast majority of the pipeline are takeouts, Josh. So this is really entering into a forward contract. We are not deploying capital as the assets being developed. And once it's developed and the certificate of occupancy is received, we are essentially buying the asset at that point. And obviously, rent is commencing at that point. So that's how one should think about the development pipeline.

And I appreciate all that color. Maybe one more on development. I guess just how do we think about development as kind of like when you look across like your appetite to acquire new assets, like how do you think about like development? Is this something you're going to lean into more? Are there better yields on developments versus just straight-up acquisitions?

Yes, it's just another tool for driving growth. We focus on our existing client relationships, which have ambitious expansion plans. They approach us to see if we would be interested in offering slightly higher yields than the current market would dictate for available assets. By lending our balance sheet, we help them expand. This is part of how we're developing our pipeline, as we expect that yields from development will exceed those from fully operational assets in the transaction market. While some yields we posted for developments were slightly lower than those from the acquisitions market, this was largely due to the rapid changes in the cost of capital and adjustments on the cap rate side. As the cost of capital decreases, we anticipate a positive impact on market conditions. Therefore, the transactions we are currently entering on the development side reflect today's yield environment. If the cost of capital improves within the next year to a year and a half by the time these assets are delivered, you should see a positive spread in development yields compared to the cap rates in the market at that time. While this won't be a dominant part of our business, it is a valuable tool that we want to offer our clients to help them grow their operations.

Got it. If I can ask one more question, I know your guidance is $2 billion, but regarding your broader pipeline, are there many portfolio deals available? Are there larger transactions? I understand these take time to close, but I'm just curious.

So Josh, I hinted at this in our last conversation when someone asked about the market movements. We are continuing to engage in numerous discussions with our clients, but there is a disconnect regarding the price they are willing to transact at. It's not that we are not communicating with our clients; in fact, we recently spoke with one of our largest clients, and the conversation highlighted their expectations for cap rates versus what we need to achieve the spreads necessary for a transaction. This is the nature of our discussions. Last year, we successfully completed more than five transactions over $500 million, with two exceeding $1 billion. We are capable of delivering significant solutions to substantial challenges. Once the market stabilizes and their price expectations align with our capital costs, we will be able to expand our pipeline, just as we did over the last three years.

Just one on the pipeline excluding development. I'm just curious if you've closed on anything so far in Q1? And if so, what was the pricing on that? And then my second question is the occupancy guide was a bit below current levels. So maybe you can just give us a little color on that? And what's on the watch list right now that we should be tracking?

Hi, Nate. I won't provide specific cap rates for the assets we've closed in the first quarter. However, we have completed some transactions that reflect our earlier comments. There has been some movement in cap rates, which will be evident in our first quarter report, but this movement isn't as widespread as we would prefer. It's not indicative of the changes in the cost of capital. Our flow business is continuing, and we are being more selective to ensure our spreads are not compromised just to boost volume. We began the year with a business plan that supports this approach. Regarding occupancy, we've indicated it will be above 98%. Many of these vacancies were anticipated at lease expiration, and we typically guide towards a low 98% occupancy. What sets our business apart from some competitors is our strategy of holding onto certain vacant assets for their potential to be repositioned to generate greater economic value. While we've maintained around 99% occupancy for the past six quarters, which was unusual for us, we're comfortable with generating more economic value that outweighs the holding costs of vacant assets. Thus, we see a normalized occupancy level around 98.5%. The 1.5% vacancy allows us to execute our outlined plans.

Sumit, can you talk about the relative attractiveness of Europe right now versus the U.S.? It seems like you don't think anything is all that attractive overall, but at least in Europe, you have the better cost of debt?

Yes, that's a great question, Brad. I will tell you that even in Europe, the volume of transactions is a lot lower, again, because of this disconnect between buyers and sellers and what each requires to perpetuate a transaction. However, having said that, we are seeing pockets of opportunities, especially in the UK, where we feel like even in this environment, transactions can get done. And so that, along with the fact that at least in Europe, our cost of debt is significantly lower by 110, 120 basis points. We are continuing to look for opportunities. But the volume being low is not just unique to the U.S. It is across the geographies that we play in.

Brad, there’s always going to be a fair amount of conservatism sitting here in mid-February on line items like that. We did have quite a bit of growth from a resource standpoint in the back half of 2023, so you’re going to see the full annualized effect of that. And it’s still too early to tell on the synergies front with Spirit, what ultimately is going to be achievable, but in the first month or so less than that of ownership, everything is trending better than we expected from a synergy standpoint. And as a reminder, on a cash basis, we expected $30 million of synergies off of a $40 million cash G&A load annualized. So we’re hopeful, but look, we’re trying to create a platform. We’re trying to refine certain areas of the business, but we’re really trying to resource with everything going on, all of our groups to create this moat, if you will, that can persist for a long time. So with that comes a little bit of investment in things like technology and in people. So that’s really the driver of that.

Good morning. My first question is about the investment spreads. You previously mentioned expectations for a minimum of 200 basis points spread on new investments compared to your cost of capital, which is significantly higher than what you experienced last year. Is the 200 basis points still your minimum required spread? If so, how do you achieve that today considering your cost of capital seems to be in the 6s? If reaching that spread involves using some of your free cash flow, how are you approaching the required return for that portion of your capital?

Thank you for your question. I want to clarify a few points regarding free cash flow. We expect to generate over $800 million in free cash flow. This aligns with our $2 billion acquisition guidance, which amounts to 40% of our total volume and 60% of our total capital on a leverage-neutral basis. We can generate a 200 basis point return on free cash flow, allowing us to make deals at 2% cap rates while still achieving that return. However, that isn't our primary focus. It's important to note that achieving 200 basis points was easier about 2.5 to 3 years ago when our cost of capital was significantly different. Historically, we've tracked that the average spread has been around 150 basis points, but there have been instances, like last year, where we only managed 120 basis points. This variation is due to changes in the cost of capital environment, affecting deals we had entered into based on earlier expectations. When we financed transactions in 2023, the spread we achieved was closer to 140 basis points, specifically 136 basis points, which is closer to our historical average. I want to emphasize that expecting a minimum of 200 basis points on every transaction isn't our approach. We utilize a barbell strategy, which means we may engage in investments that generate only 100 basis points if we believe they are appropriate on a risk-adjusted basis. We also aim to balance these with transactions targeting a 200 basis point return. However, the volatility in spreads in the current environment makes predictions challenging, which is why we have our current plan that allows us to deliver over 10% without solely depending on acquisitions.

I appreciate that. I just want to be clear, it sounds like 200 basis points is not the absolute minimum that you're seeking, which I think is a little different from what I think we talked about a few months ago. But my next question, I guess, is on what's embedded in the guide here regarding credit loss and the integration of the Spirit portfolio? Can you touch on that a little bit?

The integration is progressing smoothly. We completed the transaction on the 23rd, and we remain very enthusiastic about the portfolio we have taken on. As part of this deal, we have permanently hired eight individuals from Spirit, and we also have seven temporary staff members assisting us with the integration process over the next six to nine months. Regarding the portfolio itself, we haven't faced any negative surprises since taking control of this asset and the associated client portfolio. There have been some positive developments concerning resolutions with certain clients, yielding slightly better outcomes. However, I must emphasize that it is still too early to draw definitive conclusions. This caution is one reason we adopted a conservative approach in our underwriting and what we communicated to the market. We felt confident in our delivery, but we acknowledged the conservatism, hoping for potential upside, which we will update you on in the future if it materializes.

Got it. But are you able to quantify within the guide for potential credit loss or any added color on that?

What we can share with you, Haendel, is the range that we have shared with you accommodates for any level of credit loss that the Spirit portfolio and/or our portfolio would generate.

Given the dearth of deal volume right now, especially compared to recent years, what is the highest and best use of time right now? So I know you have a massive portfolio but outside of routine asset management, I'm just curious at this quiet period, if you will, is a good opportunity to underwrite new geographies or property types?

It's all of those things, Spenser. I think you've been following us for a while. We are constantly looking for ways to grow our portfolio and exploring non-traditional methods for increasing our earnings. This will remain a major focus for us in 2024. You're correct that we need to absorb an additional 2,000 assets with 400 new clients, not all of whom are new, but 400 coming from Spirit. We plan to engage in significant asset and capital recycling, which the team is very focused on, making the most of our time to play a bit of defense rather than offense. However, I believe the acquisition environment can change quickly. The investment team remains proactive with clients, engaging in conversations and creatively seeking solutions. Despite our guidance of $2 billion, I can assure you that we will be undertaking a lot of work this year, perhaps even more than last year, in creating the right tools and efficiencies. We've had to put some of these initiatives on hold due to the strong investment environment over the past three years. I believe all of this will lead to a much more scalable business, and we'll be happy to share more details as we implement these strategies and see the benefits of scale.

Okay. Great. And do you guys have a target date for when you'd like to get through the kind of the Spirit portfolio in terms of pegging some potential disposition candidates and things of that nature? Do you guys have a target date when you want to get to the portfolio?

We are not waiting on a particular date. There’s obviously a priority of assets that we have identified that we don’t believe to be core to our overall portfolio. Those are already in the market. And then we are culling through the rest of the portfolio to continue to add to our capital recycling program for 2024. So there isn’t a particular target date, but we’ll be happy to share with you more on this front during the first quarter earnings when we’ll have assumed control of this portfolio for about 2 months and 10 days.

I wanted to go back to something you mentioned in your opening remarks where you were talking about being able to put in more growth opportunities into your leases? I think you mentioned it's up 50 basis points versus five years ago. And as you speak to, I guess my question is, I'm wondering, does the quality or sort of the credit quality of the client vary by the ability to push through higher escalators? It sort of feels like the higher quality or higher credit would have more bargaining power on their side to resist those kinds of changes. But I'd just be interested in kind of if you could just maybe talk about that a little more.

Sure, Smedes, your understanding is correct. In the U.S. retail sector, when discussing investment-grade clients who engage in long-term leases, it can be challenging to obtain what one might consider market growth rates. The clients that typically fall into the BBB, BBB minus, and sub-investment grade categories are the ones from whom we can drive internal growth. However, I want to clarify that the 50 basis points increase was not achieved by targeting lower credit ratings in retail, but rather by expanding into different asset types that exhibit different growth profiles compared to retail assets. Some of the steps we took included a significant move into the industrial sector. Industrials generally provide, even from investment-grade clients, about 2% to 2.5% growth. This was one factor influencing the change in our growth profile. Additionally, we ventured into new asset types like data centers and gaming, which also tend to offer higher internal growth rates. The most significant contributor to our growth is our international business, where we see substantial growth even among retail clients with investment-grade ratings. For instance, our initial transaction was a $0.5 billion sale leaseback with one of the largest grocery chains in the UK, which exhibited a growth profile that greatly surpassed what we can achieve in the U.S. Therefore, a combination of different asset types and international expansion has enabled us to increase our internal growth from around 1% to approximately 1.5%. We aim to continue focusing on how to boost this growth by an additional 50 basis points or potentially more, thereby reducing our reliance on external acquisitions.

Okay. That's very helpful. I wanted to ask quickly about your plans to recycle capital, mentioning over $160 million for 2023. This seems tied to the non-core assets identified with the Spirit acquisition, which may explain the increase compared to historical numbers.

Yes. I think one of our comments was that you should expect to see a higher number than the $116 million that we accomplished in 2023. As to the actual number, we will be in a position to share that with you during our first quarter earnings call in May.

I'm just curious if you could talk about the potential opportunities you're seeing today as it relates to the credit lending platform. And what are the different types of tenant credit in industries that you're targeting today?

So Eric, the way we think about the credit business is how can we be a one-stop shop for our clients. Clients with whom we've done traditional sale-leaseback business, that have a need to continue to grow their real estate portfolio. And if there is a disconnect, which we kind of saw last year where what you could get in terms of a sale leaseback in terms of yields versus playing in a much more secured position on a balance sheet and yet get 300, maybe even more basis points of yield on investments, it's a win-win for us as well as for our clients. And they would much rather do business with somebody that they understand and that they have a relationship with, and we can offer more of these products to them and enhance the economics on our transactions. That's really what's going to drive the credit side of our business. Having said that, it's across the board. I think we've talked about doing a credit investment in the gaming side with Blackstone. We've talked about doing an investment on one of the largest grocers in the UK. Again, these are the types of examples that you should continue to see. But we are going to be very selective in terms of who we lend to, given that, that is not a core element of our business.

That's helpful. And then I just wanted to ask one question on the free cash flow. On the $800 million plus of expected free cash flow for 2024, does that guidance include the potential income generated from holding cash in a money market account?

Eric, it includes everything. So in our AFFO guidance, first of all, all of those outcomes, if we're sitting on cash like we have been, where we're relentless and trying to get as much as we possibly can while it’s there. That flows through to FFO. And then you have to deduct obviously, for the dividend, that in effect is the free cash flow.

Can you just take us through some puts and takes regarding the high and low end of your AFFO per share guidance?

On the low end at 413, we're looking at a very extreme scenario. It suggests that short-term rates will continue to rise, which is uncertain, but unpredictability is common. This scenario also assumes a complete halt in acquisitions, meaning that the $2 billion estimate could be significantly lower. From a credit loss standpoint, we've included a very conservative number that we don't believe is likely to happen, but it's part of our bad debt considerations. There are also cost elements like leasing commissions and property expenses not covered in G&A, which require planning for potential negative surprises. On the high end, we're envisioning a scenario where both the macroeconomic and capital cost environments improve, allowing for increased investment volume. It implies that spreads remain above 150 basis points. Bad debt expenses are expected to align more closely with our historical averages, around 40 basis points of rent during the pandemic and about 25 basis points outside of it. A better outcome is expected for certain identified credits in our portfolio, for which we've taken a conservative approach in establishing our guidance. It also presumes that our short-term rate mix, be it euro commercial paper, sterling denominated borrowings, or U.S. commercial paper, leans slightly more toward the European side. Currently, indicative euro commercial paper rates are in the low 4% range, U.S. rates are in the mid-5s, and sterling is at 6% on the revolving side. All these factors need to align for us to reach these scenarios.

Really helpful. And then just my second question is in your pipeline right now, what percentage is domestic versus international?

We don't have precise figures on the non-development side, which amounted to $1.2 billion. While some of it is accounted for, a significant portion consists of ongoing discussions in both the U.S. and international markets. Last year, 35% of our activity was international, while 65% was domestic. That ratio might shift since the total is relatively small. Based on today's discussions, it seems there may be a greater emphasis on international opportunities, but it's too early to make definitive statements. Historically, our distribution has been around 30% to 40% international and 60% to 70% U.S., and we expect that to hold under normal circumstances.

So I have one on income taxes. So for the full year, the year-over-year increase in 2023 was about 15%. And the midpoint of guidance is implying about a 35% year-over-year increase in 2024. Can you provide some more color on what is driving that large increase in income taxes?

Alec, this is really a function of the international business. So the way that we're taxed on that income, it's primarily in the UK. First of all, as a U.S. domiciled company as the 100% owner of the UK, but we are subject to some withholding taxes there. Now what we've done to combat that is we have intercompany loan interest expense and other ways that we can lower taxable income, where the effective tax rate on that NOI is around 11%. But the growth that you see year-over-year is really just a function of the growing platform and portfolio that we have abroad, which is now north of $9 billion. So it shouldn't be a surprise that as the UK grows in particular, you see that line item for income tax start to increase year-over-year. It's something that we obviously take into account in our underwriting and investment committee. It's a factor, obviously, in our long-term IRR underwriting, which is really what dictates the investment decision in most cases. And so it's a known cost that is fully built in to this business model.

Thank you all for joining us today. We look forward to seeing many of you at upcoming investor conferences in Spain. Thanks. Bye.