Realty Income Corp (O) — Q2 2024 Earnings Call Transcript

Thank you all for joining us today for Realty Income's first 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 law. The company's actual future results may differ significantly from the matters discussed in any forward-looking statements. You'll 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. If you would like to ask additional questions, you may reenter the queue. I will now turn the call over to our President and CEO, Sumit Roy.

Thank you, Steve. Welcome, everyone. In the second quarter, I am pleased we were able to deliver strong results despite the challenges of the economy and the transaction market, navigating today’s rate environment. We see ourselves as real estate partners to the world’s leading companies, and the diligent efforts of our dedicated team resulted in AFFO per share of $1.06, representing a robust 6% growth compared to last year. Combined with our annualized dividend yield in excess of 5%, our shareholders experienced a total operational return of over 11%. The power of our global sourcing and acquisition platform was on display this quarter as we deployed capital in the U.S. and Europe across retail, industrial, data center real estate, and real estate-backed credit opportunities. In total, we invested $805.8 million into high-quality opportunities at a blended 7.9% initial cash yield, or an 8.2% straight-line yield, assuming CPI growth of 2%. Of this, approximately $262 million of volume was invested in the U.S. at a 7.6% initial cash yield. The balance of approximately $544 million was invested in Europe at an 8% initial cash yield, including a $377.5 million investment in a secured note at an 8.1% yield issued by Asda, a leading U.K. grocery operator. As we discussed in the past, we intend to pursue credit investments selectively, and only when it may eventually facilitate access to high-quality real estate opportunities, as has been the case with Asda. We also believe these credit investments represent a profitable means for Realty Income to participate in and benefit from the current rate environment. Furthermore, from a risk management perspective, we view these credit investments as a prudent, natural hedge to the inherent rate exposure on the liability side of our balance sheet. Providing further detail on investments in the quarter, we executed 79 discrete transactions with 55 clients, including two new clients across 22 industries. 31% of direct real estate investment volume was allocated to new sale leasebacks. Touching on our sourcing activity, we were pleased that our transaction discipline earlier this year is bearing fruit. This quarter, we began to see a greater number of opportunities available at pricing that aligns with our cost of capital. This improvement supported a $200 million increase in transaction volume sequentially and drove the investment guidance increase to $3 billion in June, a 50% increase from our prior guidance. We believe the higher closed volume paired with investment spreads that are largely consistent with last quarter are signs the transaction market may be moving towards normalization. Investment activity this quarter was funded in large part by adjusted free cash flow, totaling approximately $200 million in the second quarter. Not having to rely on public equity enhanced the accretive nature of these transactions. The deployment of excess cash flow represents an important contributor to our growth. In fact, we believe we can utilize excess free cash flow together with our portfolio's internal rent growth to deliver an approximate 7% to 8% total operational return annually to shareholders without relying on public equity issuance. The portfolio's stabilized internal growth rate has risen in recent years and now stands at approximately 1.5% on an annualized basis, in part because of the expansion of our European platform, where many leases are subject to uncapped CPI increases, as well as our expansion into the gaming and data center verticals, where leases often include healthy annual rent escalators. With the benefit of excess free cash flow, second-quarter capital deployment activity resulted in an investment spread of approximately 293 basis points, which, like the first quarter, is well above our historical spread of 150 basis points, in part due to the utilization of excess free cash flow. These disclosed investment spreads utilize our short-term nominal cost of capital, which measures the estimated year-one earnings dilution from raising capital on a leverage-neutral basis to fund our investment volume. This differs from a higher long-term cost of capital, which applies a growth premium to our cost of equity to account for the long-term return requirements for our investors. While we remain vigilant in today's volatile environment, seeking only the most attractive risk-adjusted return opportunities, we will also only utilize external capital opportunistically, aiming to augment our growth rate at times when our cost of capital becomes increasingly attractive compared to prevailing market investment yields. An additional source of capital in the second quarter was dispositions. We utilize proprietary predictive analytic tools in combination with the insights of our asset management and research teams to drive the decision to sell 75 properties for total net proceeds of approximately $106 million, bringing the year-to-date total to approximately $202 million. For the year, we expect to sell between $400 and $500 million of assets. As we continue to calibrate and hone our predictive analytic tools, advancing our investment pieces on each property in our portfolio, we may be more active on dispositions than in the past. We continue to optimize our portfolio composition and investment returns while broadening our use of organically generated capital to finance growth. Another critical point of differentiation for Realty Income is the strength of our balance sheet, underpinned by our low leverage and strong credit ratings from Moody's and S&P, and our access to capital on a global basis. During the second quarter of 2024, the combination of internally generated cash flow and disposition sale proceeds allowed us to fund most of our investment activity without settling any newly issued equity capital while still maintaining our leverage metrics at or below our long-term targets. Shifting to operations, our portfolio continues to generate very solid returns and perform in a very stable fashion. Occupancy rose to 98.8% as of June 30th, a 20 basis point increase from the prior quarter. Additionally, our rent recapture rate across 199 leases was 105.7%, totaling approximately $34 million in new annualized cash rent. The size, scale, diversification, and consistency of performance from our global real estate portfolio continue to provide us with excellent visibility to revenue and are key reasons why we have not had a single year of negative operational return in our 30 years as a public company. Managing through periodic store closures is a natural part of our business model, and our top-tier credit research and asset management teams offer distinct competitive advantages, which have consistently enabled us to optimize value in these situations. To that end, we would like to provide remarks on a few clients that are currently managing through store closures or have been in the news due to credit-related concerns. Importantly, in the context of our portfolio's size and scale, the aggregate financial exposure of potential lost rent is not expected to materially impact our ability to generate the consistent operational returns our shareholders are accustomed to. It is important to emphasize our recent increase in earnings guidance takes all credit considerations into account. Rite Aid, which represents 30 basis points of our total portfolio analyzed contractual rent as of June 30, 2024, is expected to emerge from bankruptcy in the third quarter. Through the remainder of the bankruptcy process, we expect to lose 12 basis points of rent prior to the resolution of assets vacated in the proceedings, which are ultimately released or sold. Red Lobster represents 1% of our total portfolio annualized contractual rents and it is currently moving through the bankruptcy process. At present, as publicly stated, Red Lobster is targeting to emerge from bankruptcy in the third quarter of 2024. We continue to believe that our visibility into rent coverage and our master lease structure across most of our properties mitigate some of our potential risk. While not finalized, we currently believe our recapture rate will be roughly in line with our historical portfolio-wide average of 84% for client bankruptcy restructurings. Walgreens is considering closing certain stores. Looking out over the next two and a half years, we have leases representing only 26 basis points of our total portfolio annualized contractual rent that will expire over that time. Outside of a bankruptcy strategy, which we view as unlikely with Walgreens, these are the only stores Walgreens can legally seize contractual rent payments on once each lease expires. To provide context on historical capture rates in the drugstore industry, we have managed 166 lease expirations since 2013. 80% of these were renewed, resulting in a blended recapture rate in excess of 100% of prior rent. Dollar Tree, which is investment-grade rated, announced the potential split of their Family Dollar brand from Dollar Tree. If this were to result in store closings, Family Dollar leases representing only five basis points of our total portfolio annualized contractual rent are set to expire between now and year-end 2026. In the interim, they are obligated to continue paying rent through lease expiration. Our historical recapture results in the dollar store industries have been similarly favorable. We have managed 263 lease expirations since 2013, of which 86% of the clients renewed at a weighted average rate well north of 105%. In case of our tier 1, 5% of exposure, we feel the risks have notably diminished in the past 12 months. Cineworld reduced its debt by $4.5 billion through its restructuring, and AMC recently made improvements to its financial position by extending debt maturities and additional equity issues. It is important to note that in total, the rent at risk from Rite Aid, Red Lobster, Walgreens, Dollar Tree, as well as At Home and Big Lots, which constitutes 11 basis points of rent, represents only 2.3% of our total portfolio annualized contractual rent through year-end 2026. If we achieve the recapture rate in line with our long-term average for bankruptcies, which is 84%, this suggests only approximately 37 basis points of rent is at risk of ceasing, or an approximately $0.02 of AFFO per share impact. Additionally, if they do take place, advance notice of potential store closures proves valuable because it provides years to plan the optimal outcome for those locations while we continue to receive rent. The potential impact of $0.02 per share is manageable and is counterbalanced by the power and stability of our net lease business model, which is underpinned by diversification across more than 15,000 properties, 1,500 clients, and 8 countries on 2 continents. Hence, we believe it is important to separate the store closing headlines from the manageable impact they have on our financials. With that, I would like to turn it over to Jonathan to discuss our second-quarter financial results in more detail. Jonathan?

Thank you, Sumit. Consistency has long been a benchmark by which we manage our business. To that end, we ended the second quarter with leverage at 5.3 times without settling any ATM equity during the quarter. This was the 25th consecutive quarter of leverage at 5.5 times or lower, reflecting our commitment to our A3, A- credit ratings, which we have maintained since 2018. As a reminder, we manage our leverage through the lens of net debt and preferred equity to annualize pro forma adjusted EBITDA. During the second quarter, we generated approximately $200 million of adjusted free cash flow, over $100 million in real estate sales proceeds, and approximately $185 million of forward unsettled equity sold through ATM. After modest ATM issuance activity subsequent to quarter end, we currently have almost $450 million of unsettled forward equity, which we estimate will be more than sufficient to finance our equity needs for the remainder of 2024 and still remain within our target leverage ratios. Our balance sheet remains healthy with a well-staggered debt maturity schedule that allows us to be active should borrowing costs trend lower over the maturity cycle. Last month, we repaid $350 million of maturing public notes, leaving us with only $118 million of maturing mortgage debt for the balance of the year. Our exposure to variable-rate debt of $1.6 billion remains modest at only 6.3% of total debt principal at quarter end, and our liquidity remains solid with access to approximately $3.8 billion of capital. At the end of the second quarter, inclusive of cash on hand, availability under our $4.25 billion revolving credit facility and our outstanding ATM forward equity. We remain comfortable with the liability side of the balance sheet and believe we are well-positioned to act on larger investment opportunities should they present themselves. As Sumit mentioned earlier, we view our credit investments as a natural hedge to the inherent interest rate risk associated with debt maturities we have on our balance sheet. That end, the six-year £300 million sterling senior secured loan we invested in during the quarter provides us with an attractive 8.1% yield secured by the solid credit of a U.K. grocery store operator, while reducing the rate sensitivity on the value of sterling debt we have on the balance sheet maturing in 2030, which currently totals £540 million. From a 2024 earnings guidance perspective, we are reiterating our full-year investments at $3 billion in our AFFO per share guidance of $4.15 to $4.21, representing 4.5% annual per share growth, assuming the midpoint. We increased our guidance on June 4, which included the expectation of collecting the $16 million of lease termination fees recognized in the second quarter. Offsetting a portion of AFFO tailwinds with termination fees was the recognition of approximately $6.2 million of AR reserves from one of our clients in the convenience store industry. Lease termination fees are excluded and are same-store rental revenue calculations, while AR reserves are included. Thus, the $6.2 million of reserves we recognized on one client in the quarter, alongside impacts from our theater portfolio, held back our second-quarter same-store rent growth by approximately 60 basis points, resulting in overall same-store growth of 0.2% for the quarter. Including this reserve, we continue to expect our full-year same-store rental revenue growth to recover to close to the 1% level for 2024. With that, I would like to hand the call back to Sumit for closing remarks.

Thank you, Jonathan. To conclude our prepared remarks, the year is progressing largely in line with expectations, perhaps even slightly ahead. There are signs the transaction market is beginning to normalize as we find more opportunities to deploy capital into high-quality investments that meet our minimum return requirements. Adjusted free cash flow and dispositions continue to be accretive sources of capital we can use to support future growth. Combined with the stability of our solidly performing client base and the strength of our balance sheet, we believe we are well-positioned to deliver attractive risk-adjusted returns to shareholders in a variety of economic environments. I'd like to now open it up for questions. Operator?

Good afternoon. Thanks a lot for taking my question. The largest component of your investment volume this quarter was the investment in the Asda notes. How should we think about the different investment buckets that you have when it comes to expectations for the back half of the year? Thanks.

Thank you, Michael. That's correct. We did have a $377 million investment in the Asda loan, which was very opportunistic. We've already highlighted the reasons why we did that. For the balance of the year, we expect that the majority, if not all, of our investments will be in our more traditional investment asset-level, portfolio-level real estate direct investment.

Got it. Then as a follow-up, can you talk a little bit about the opportunities you're seeing in the U.S. versus European markets? Outside the loan, you leaned a little bit more to the U.S. in the second quarter or a reversal from the first quarter. Can you talk a little bit about what you're seeing in these markets and the spreads in the U.S. versus Europe? Thanks.

Yes. During the first quarter, we observed some green shoots here in the U.S. where sellers were starting to realize the higher cap rate environment was here to stay. That obviously resulted in an increase in volume in terms of investments here in the U.S. in the second quarter. We expect that to continue into the remainder of the year. The volume increase that we saw with regards to sourcing supports that observation. I think with the backdrop that we are seeing on the cost of capital side, I do think that there will be more transactions that will materialize in the next half, especially here in the U.S. The markets in Europe have been fairly stable. The expectations of the interest rate cuts were well understood, and what we saw in the first quarter appeared to be beneficial transactions undertaken by opportunistic sellers. Similar transactions took place in the second quarter, and we feel confident that trend will continue for the remainder of the year. You should see an increase in volume coming from the U.S. and more of the same in markets outside the U.S.

Yes hey guys. Maybe just going back to the Asda loan. I think you've done some other loans in the past that were pretty sizable. How do you think about the duration risk and when you're taking an equity stake and doing a real estate loan, you'd assume that real estate forever, but for a loan, it's limited duration. How does that factor into your underwriting? Is there a limit on exposure you want to have for lending?

Yes. So Joshua, we've been clear with the market that the credit investment side of the business is an addendum to what we are offering our clients. We believe that opportunistically, it makes sense for us to continue to be a partner to our clients, such as Asda. When looking at the investment we made of $377 million at an 8.1% yield over six years, and overlaying our maturing debt close to £600 million coming due in about the same time frame, this is one of the reasons we pursued this loan. If we were to go out today and try to do a sale-leaseback on Asda real estate, it would probably be in the mid-6% range. Therefore, achieving an additional spread of 160 to 170 basis points over six years made a lot of sense for us. Additionally, we've continued to share our mission of being long-term partners to some of our clients; we are willing to do 20-year sale-leasebacks on their real estate. We like the credit, and if we can enhance our relationship by participating higher up on the capital stack, that is favorable for us. Credit investments serve as a natural hedge to some of the higher interest rate impacts we're experiencing. Having said all this, we clarify that credit investments will be used opportunistically and won't be available in every environment.

Okay. And then maybe just one other question. You mentioned the expansions into data centers and gaming. Are there any other verticals you're looking at, or where you think you can achieve a higher internal growth rate?

Yes. The areas that contribute to our higher internal growth largely include those you mentioned and the international market. While this is not a new vertical for us, the industrial sector also tends to yield higher internal growth. The combination of our investments in these areas has shifted our internal growth profile from approximately 1% to 1.5%. We are very comfortable with the total addressable market based on the verticals currently articulated to the market, and there's much to be done in these fields. Therefore, we are content to continue operating within those specified verticals.

Hi, thank you. The amount of investment-grade tenants as a percentage of acquisitions was 10%, which is lower since the third quarter of 2017. How should we think about that and your appetite to move down the risk curve to generate yields here?

Yes. I don't necessarily agree with your perspective on the investment grade representing 10% of our investments in the second quarter. We have been clear in the market that we do not target investment-grade as a criterion for investment. Instead, we seek to generate the right yield for the credit risk and real estate risk we are taking. The actual ratings of the client are a by-product of underwriting an appropriate risk-adjusted return. If we happen to have clients that are rated investment-grade, that's wonderful, but it's not a specific target of ours. For instance, in our current portfolio, many names in our top 20 happen to be non-rated, and if they went through a rating process, they would be considered investment-grade. Companies like Sainsbury's, Treasury Wine Estate, and we have grocers like Public and Trader Joe's that are also non-rated yet could be rated investment-grade.

Understood. And could you share where your bad debt number stands today and if there's potential upside to your guidance?

Yes. Looking at what we disclosed in the footnotes of the income statement on the earnings press release or the supplement, we've recognized around $9 million year-to-date in bad debt expense, which is approximately 70 basis points of revenue. Historically, we've been around the 35 basis point range as a percentage of revenue for bad debt expense, and closer to 23 basis points when excluding the pandemic. We're currently higher than those averages, primarily due to this $6 million reserve we took on one convenience store operator, but we don't expect that magnitude to carry forward into the back half. There is still some conservatism, and while we feel good about many of these credits, we expect that in the back half of the year, you can assume something close to what we recognized in the first half.

Hey, I guess first question, just a follow-up on the Asda loan. Are there any purchase options or agreements attached to the loans? I'm assuming these are assets you wouldn't mind owning at some point. Should we not anticipate you pursuing more loan deals in the second half of the year?

So Haendel, yes, your last comment is accurate. We do not plan to pursue any credit investments in the second half; however, credit investments remain an opportunistic tool for us. It's a secured bond offering; we are comfortable with the credit and operators involved. This positions us well for future sale-leaseback discussions should Asda consider that route.

Got it. And you mentioned transaction activity improving, but do you see any new competitors or private equity firms reentering the landscape due to a lower cost of capital?

Good question, Haendel. It may be too early to tell, but if interest rates begin to decrease, private equity could re-enter the market, which we've not seen extensively in recent transactions. We are currently observing institutional capital entering the market and becoming slightly more aggressive. However, private equity's presence is not yet prevalent. If interest rates continue to decline, we should anticipate private equity to become a competitor. While our cost of capital has improved, we remain disciplined and aim to pursue meaningful opportunities fitting our portfolio when they arise, rather than increasing our acquisition guidance exclusively based on capital costs.

Hi, thanks. Regarding the transaction activity pipeline, do you see more larger portfolio deals, or is it more smaller one-off transaction opportunities since your last quarterly call?

Smedes, there are some large transactions expected in the second half, involving existing clients we are in discussions with. Whether we are successful in securing those transactions remains uncertain, but we are starting to see these discussions take place, indicating an improving market. Our pipeline is aligning with what we've achieved organically, and though no $1 billion portfolios are currently in our pipeline, I remain optimistic.

I also wanted to ask whether the termination fees received were related to one particular client or multiple clients?

Yes, Smedes, those fees were related to one particular tenant reflecting an agreement reached for a handful of assets.

Hey, hope you're doing well. I was just hoping to get color on identifying assets for disposition, whether you consider tenant credit, renewal risks, geography, etc.

Sure, Greg. The analysis is opportunistic and conducted deeply by the asset management team, assessing assets of existing clients that may not have the right return profile due to changing markets or location viability. There are several factors for assets entering our disposition list, including credit quality. We utilize predictive analytic tools to monitor our 15,000 assets continuously, rating them based on location risk, low fungibility, etc. The asset management team evaluates these assets quantitatively, comparing the economic outcomes to determine if selling now or keeping them is more profitable. This proactive analysis has led to our expected disposition of $400 million to $500 million worth of assets that may not have a long-term future in our portfolio.

Thanks. Regarding acquisitions, how should we view your perspective on investment spreads with improved capital costs vs. what's currently seen in the market? U.S. cap rates were up 70 basis points quarter-over-quarter. Is that a fair target area, or could we see it start to pull back?

Greg, I don't see cap rates moving out from current levels; in fact, they may begin to tighten. We're hopeful to maintain the spreads achieved so far, despite potentially lower cap rates. However, we will remain selective in our pursuits, which is why we haven't increased acquisition guidance. It will be important to navigate the current volatility as we approach upcoming elections and geopolitics. Our aim is to maintain the spreads we've achieved thus far.

Great. Thanks for taking my question. Could you clarify your reasoning for providing guidance on dispositions now? Is it due to improved visibility or a shift in strategy? You noted an intention to be more active on that front than before.

Yes. You should expect at least half of our disposals to be occupied assets and half vacant. The trend in the first half leaned towards vacant asset sales, which is expected to shift moving forward. This guidance reflects a slight strategic shift, driven by two large M&A deals over the last 2.5 years. We are proactively disposing of unreimbursed assets from the acquired portfolio due to their long-term unsuitability for our strategy. It's crucial to clarify to the market that this source of capital helps reduce our dependency on equity.

You mentioned the transaction market moving toward normalization. What do you mean by that? Is it related to volume, cap rates, investment spreads, seller sentiment, competition?

The sentiment among sellers has changed. Many were sidelined anticipating cap rates would move, but sellers can't wait indefinitely. We're beginning to witness that change, with sellers starting to re-enter the market after a certain period. There’s greater clarity regarding the future of interest rates, which may help REITs transact. This shift among buyers and sellers indicates the market should facilitate more transactions in the second half than in the first.

Hi. Regarding the 1% same-store revenue growth this year. What does it look like for next year, assuming your portfolio's stabilized internal growth rate is 1.5%?

Yes. Linda, regarding this year's guidance of approximately 1% on same-store, the year-over-year comp is challenging due to reserve reversals and deferment payments from last year. Last year, we had 1.9%, and this year, averaging about 1% gives you a ~1.5% growth. Next year, we expect easing of the difficult comps but will frame guidance close to the 1.5% contractual rent growth basis expected to continue.

Thanks. If we assume an 84% recapture rate through year-end 2026, the mentioned $0.02 of AFFO per share is at risk. Could this indicate your bad debt outlook in 2025 is stable or even less than this year?

Linda, we start the year with a projected percentage for bad debt expense. Some years we meet or beat that, while other years, like the pandemic year, we exceed expectations. Last year’s outcome was positive and not in line with expectations. This year seems to be aligning more closely with our original anticipation. We believe there's potential upside but won't overstate it. We generally do not discuss years far ahead, but Realty Income's past experiences suggest a stable or consistent outlook.

Hi, thanks for taking my question. Can you readdress the litigation regarding that C-store client? Do you have that space back? Is there already a replacement tenant for that asset?

We don't yet, Alex, due to ongoing litigation. The current expectation is this will be a resolution year, and once we gain those assets back, we are confident in finding alternative tenants for those C-store locations, presenting further upside.

Got it. What are your thoughts on future debt issuances? What currency seems most attractive, and what rates can you issue it at?

If we were to estimate current indicative rates for 10-year unsecured paper, it's likely around the very low 5s for U.S. dollars and sterling, and low 4s for the Eurozone. A level of flexibility is important for us, and given how sterling has traded relative to the dollar, we've leaned more toward dollar issuances. The optionality is present for us to access sterling market as well, especially as currency rates trade near parity.

Perhaps just one final question regarding the transaction market. Can you share where you're seeing the largest bid-ask spreads across property types or industries?

In the first half of the year, the largest bid-ask spreads were observed in the U.S. Thus, our volume was much lower than historical figures. We see this spread beginning to compress, leading us to believe the U.S. market will become favorable for us moving forward.

Just two quick questions for me. First, regarding interest costs, can you remind us how much of the FFO growth guidance this year is affected by higher interest expenses? And how are you approaching maturities in 2025?

This year, interest costs didn't significantly impact our FFO growth. We did a debt offering in January at just above 5%, so year-over-year differences are minor. Moving into 2025, we face $1.8 billion to $1.9 billion maturing, centering around 4.2%. There's perhaps 100 basis points of dilution potential when utilizing sterling and dollars based on today's rates resulting in a maximum impact of 50 basis points to earnings. Overall, we seek to manage costs more adeptly than in previous years.

For future growth verticals, specifically in data centers and gaming, have there been any lessons learned or adjustments in structuring future deals?

On the gaming side, we've seen great investments from our assets and structured favorable leases that serve both operator and investor. There's not much we would change; it reaffirmed our modeling approach. In terms of data centers, we are just entering that sector with one significant investment, and we remain optimistic about developing relationships with partners. The hyperscale business caters to enterprise needs, presenting a massive opportunity. We'll be thoughtfully constructing this pipeline.

Hello, thanks for taking my follow-up. You mentioned an 84% recapture rate. How much does that number fluctuate over the years? Could this actually decrease next year if you have a longer run rate for knowing store closures?

The 84% recapture rate is our historical benchmark during bankruptcy processes. There is variability: some clients yield 65%, while others reach 100%. We've historically maintained an average of 84%, and while it may fluctuate year-over-year, we aim to keep it stable based on our long-term experiences. Thank you all for joining us today. We look forward to speaking soon and seeing you at conferences in the coming months.