Realty Income Corp (O) — Q3 2024 Earnings Call Transcript

Thank you all for joining us today for Realty Income's third-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-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 CEO, Sumit Roy.

Thank you, Kelsey. Welcome, everyone. Realty Income's third-quarter results highlight our continued momentum, disciplined execution, and the benefits of our global investment and operating platform. Our value proposition to investors is simple: we are a real estate partner to the world's leading companies. We've created a defensive and diversified real estate portfolio consisting of top-tier clients to drive stable and predictable cash flow. As a result, we've delivered positive total operational returns each year since becoming a public company 30 years ago, successfully navigating a variety of economic environments. Importantly, as we move through an improving external backdrop helped by a recent rate cut in the U.S., we've started to see a more attractive transaction landscape. Given this, we are pleased to increase our 2024 investment volume guidance to approximately $3.5 billion, underpinned by strong investment activity year-to-date as well as a robust pipeline for the fourth quarter. Concurrently, we are raising the low end of our AFFO per share guidance for the year to a range of $4.17 to $4.21. Despite some recent volatility driven by external factors, we remain confident in our strategic vision and the opportunity ahead. Our investment strategy offers significant opportunities for growth across multiple verticals, including our core of retail and industrial and newer verticals such as data centers and gaming. At the same time, we are making progress towards the establishment of a private capital fund, which I'll touch on later in this call. Turning to the details of the third quarter. We delivered AFFO per share of $1.05, representing a 2.9% growth compared to last year. We invested $740 million into high-quality opportunities at a blended 7.4% initial cash yield or a 7.8% straight-line yield assuming CPI growth of 2%. Of this, $378 million of volume was invested in the U.S. at a 7.4% initial cash yield with a balance of $362 million invested in Europe at a 7.3% initial cash yield. We've seen meaningful improvements in both the U.S. and Europe. Our international markets continue to contribute a greater share of volume relative to prior years with healthy investment activity year-to-date, exemplifying the benefits we achieved by cultivating multiple avenues for growth. In total, we completed 70 discrete transactions, including four transactions over $50 million, which represented nearly 60% of our investment volume, highlighting the breadth of our platform. As I noted, the momentum we are seeing in the transaction market supports an increase in this year's investment volume guidance to $3.5 billion. In the third quarter, our organic acquisition activity, which excludes credit investments as well as development spending largely negotiated in prior quarters totaled $594 million or more than double the second quarter's volume. We expect further momentum through the balance of the year, with an implied fourth quarter outlook of approximately $1.3 billion in investments, which is fully funded as we are vigilantly focused on deploying capital into high-quality opportunities that meet our risk-adjusted return requirements. Capital deployed in the third quarter yielded an investment spread of 243 basis points, above our historical average spread of 150 basis points. This spread was supported by $165 million of adjusted free cash flow available after dividend payments to fund investments. These spreads are based on our short-term nominal cost of capital that measures the year one dilution from utilizing external capital and excess free cash flow on a leverage-neutral basis to fund our investment volume. As a reminder, our ultimate investment decisions are based on our long-term weighted average cost of capital, which burdens every dollar of equity with the same cost of equity. Underpinning our increased investment activity, external capital improved by approximately 65 basis points in the third quarter. This compares to the decline in our weighted average initial cash yield of approximately 50 basis points during the quarter. Turning to portfolio operations. We've created a diversified portfolio of more than 15,400 properties with high-quality clients that have proven resilient through various economic cycles and continue to deliver stable returns. In addition, our vast data availability, proprietary predictive analytic tools, and insights from our asset management and research teams enhance our ability to anticipate future trends. We finished the quarter with 98.7% occupancy, a 10-basis point decrease from the prior quarter. Our rent recapture rate on the 170 leases we renewed was 105% and totaled approximately $38 million in new annualized cash rent, thanks to the diligent efforts of our team. Separately, we are continuing to lean into dispositions as an additional source of capital. In the third quarter, we sold 92 properties for total net proceeds of $249 million, of which $87 million was related to vacant properties. This brings our year-to-date total to $451 million. For the year, we now expect proceeds of $550 million to $600 million in asset sales. With that, I'd like to turn it over to Jonathan to discuss our third-quarter financial results in more detail.

Thank you, Sumit. We are pleased to deliver another strong quarter while increasing our investment and AFFO guidance for the year, reflecting continued momentum. Consistent with our investment strategy, we remain disciplined in our balance sheet management. Our strong balance sheet, underscored by A3/A- credit ratings and deep access to capital globally, continues to represent significant competitive advantages, fueling the opportunity to grow earnings through multiple channels. Our leverage, as measured by net debt to annualized pro forma adjusted EBITDA, was a healthy 5.4x, well within our target ratio of 5.2x, including $969 million of unsettled forward equity outstanding as of today. Our fixed charge coverage ratio of 4.6x remains in line with the 4.5 to 4.7x range. We have delivered consistently over the last seven quarters. A focus on derisking our future funding needs was a catalyst behind our two bond offerings during the third quarter, which consisted of a $500 million 30-year U.S. dollar bond offering with an effective semiannual yield to maturity of 5.49% and a dual-tranche sterling bond offering that raised £700 million at a weighted average tenor of 11.1 years and a weighted average annual yield maturity of 5.4%. These offerings illustrate the diversity of debt products available to us and the intentionality of our capital diversification philosophy. Our 30-year offering was our first 30-year issuance since 2017, and our public sterling offering was our fifth non-U.S. public bond offering in approximately three years, bringing our foreign-denominated outstanding unsecured debt to over $8 billion. We are grateful for the loyal support we have received from the fixed income community as we continue to expand our credit presence globally. At the quarter's end, we held $5.2 billion of liquidity, including unsettled forward equity, in addition to retaining almost full capacity, net of cash available on our $4.25 billion revolving credit facility. Only 3.4% of our outstanding debt at the end of the quarter was variable rate in nature, illustrating the financing flexibility we have heading into the end of the year. Access to capital is paramount to the success of our company, and our portfolio size, scale, diversification, and our trading liquidity in the public markets, have consistently afforded us well-priced capital to grow with large-scale, high-quality investment opportunities. With that said, we strive to demonstrate a proactive forward-looking mindset as we plan, position, and evolve our financing strategy for future growth. Over the last few years, we have evaluated additional sources of equity capital beyond the public markets and have recently begun in earnest to build a private capital infrastructure that we believe, over time, will leverage our strengths and expand the breadth of our capital allocation opportunities globally. I would like to hand it back to Sumit to provide additional color.

Thank you, Jonathan. As we mentioned last year, a natural step in our evolution is to diversify and enlarge our access to equity capital through private markets. We see multiple strategic benefits of entering the private capital business. First, the amount of equity available from private sources far exceeds that which is available through the public markets we have traditionally accessed. The size of the U.S. private real estate market is approximately $18.8 trillion, ten times larger than the $1.9 trillion of assets owned by public REITs. Thus, private capital controls more than 90% of the U.S. commercial real estate market based on research from the National Association of Real Estate Investment Trusts. Creation of a private capital investment platform is expected to provide us with access to a deep pool of institutional capital from investors who may otherwise lack the mandate or ability to invest in real estate securities. Second, access to the alternative source of equity with generally less pricing volatility will give us the opportunity to accelerate the monetization of the scalable and proven investment and operating platform we have built, which in turn supports our ability to continue delivering value to shareholders. Third, a powerful element of the fund management strategy is the incremental capital-light fee earnings it's anticipated to offer. Base management income earned by managing third-party capital represents a source of recurring and potentially high-growth revenue, which we observed as receiving a premium multiple from the investment community. The vast majority of fees earned would be recurring in nature and generated through open-end perpetual life funds rather than performance-based or transaction-oriented fees. Fourth, the capability of our differentiated business model will allow us to advance this initiative with limited incremental investment while leveraging the collective talent and experience of our top-tier team and platform. We have a long history of underwriting, operating, and maximizing the value of our real estate holdings, dating back to our founding in 1969. Leveraging that history, we have harnessed an impressive quantum of property-level data to develop our proprietary predictive analytics model to support decision-making. With additional size and scale, these data-driven insights will become increasingly robust and accurate. Together with the expertise of our team, we believe we provide a compelling co-investing platform for investors. Finally, we believe private capital will enable us to source, acquire, and manage a large percentage of available market opportunities that we currently acquire for the public vehicle. Overall, our intent is to create and operate an evergreen open-end fund that will manage private capital on behalf of institutional investors, such as pension funds, sovereign wealth funds, endowments, foundations, and large insurance companies. To be clear, this structure will be distinct from a typical private equity style closed-end fund that may have a fixed duration or a narrower opportunity set. Importantly, this fund will be designated to target institutional investors. It will not be structured as a non-traded REIT, and we do not intend to market to high-net-worth or retail investors. Our fund business is expected to follow the same balance sheet and prudent leverage philosophy that Realty Income describes today. We do not anticipate an adverse impact on our balance sheet strength or credit ratings. Rather, it will enhance our financial flexibility. Realty Income intends to be a meaningful co-investor in the fund while receiving management and potentially incentive fees generated by the operation of the fund. These additional earnings would bolster Realty Income's return on investment while ensuring incentives between public and private investors are aligned. This approach also reinforces our commitment to transparency and shared objectives. In summary, we believe this private capital platform will be complementary and additive to our existing business. We intend to take a thoughtful approach to allocating investment opportunities between Realty Income and the fund to maximize the returns for our public shareholders, benefiting both our shareholders and private investors. We expect this initiative to enhance our ability to grow our earnings and dividend, expand our addressable market for investments, and reduce our reliance on public equity across market cycles when strategically advantageous. We look forward to sharing more information as we progress on launching the fund. In closing, our year-to-date performance has exceeded our expectations, propelled by momentum on the investment front and supported by the stability of our portfolio, consisting of leading clients across the globe. Looking forward, I'm optimistic about the multiple verticals for growth we have cultivated for capital deployment. Importantly, pairing these growth verticals with alternative sources of capital will further accelerate the maturation of our platform. I would now like to open it up for questions.

Could you provide some insights on the acquisition numbers for the third quarter and the guidance for the fourth quarter? I noticed there has been significant cap rate compression, and I'm interested in the current state of the acquisition market. Also, regarding the increased acquisition volumes, could you discuss the possibility of a transaction related to the large 7-Eleven deal? If that is on the table, considering the cap rates we've discussed for that deal, would it be beneficial to your long-term weighted average cost of capital?

You've raised a lot of questions, John. Let me address them one by one. The $740 million we recorded in the third quarter at a 7.4% cap rate is indeed 50 basis points lower than the 7.9% cap we achieved in the second quarter, but this reflects the cost of capital as well. Our cost of capital actually improved during the third quarter compared to earlier this year, with about a 65 basis point enhancement. So, despite the 50 basis points of cash yield compression, the improvement in our cost of capital makes the transactions we executed in the third quarter more favorable than those in the first half. Focusing on cap rate or cost of capital individually could lead to incorrect conclusions, so I suggest considering both factors together to understand the true spread from these investments. Regarding your second question about the approximately $1.3 billion we expect to close in the fourth quarter, we do have a robust pipeline, primarily built from the conditions we faced throughout most of the third quarter, although we've seen more volatility in the last week to a week and a half concerning cost of capital. This volatility has helped us enhance our pipeline, and we have essentially forward funded to support our fourth-quarter goals. We always factor in cost of capital fluctuations when assessing potential transactions, ensuring that we maintain adequate margin of safety in every deal we pursue, which is vital for our investment strategy. Long term, it’s crucial that our hurdle rates on long-term cost of capital exceed the necessary margin. I won’t detail the specific transactions for the fourth quarter, but I want to clarify some comments about the differences between acquiring large portfolios versus one-off deals. We actively participate in the one-off market every day. For context, there have been 35 transactions completed in 2024 so far with similar lease terms, trading at cap rates between 5% to 9%. When we pursue portfolio deals, including the four large ones we accomplished in the third quarter, we ensure they are priced lower than what we see in the one-off market. This is evident from the $740 million of investments, which are priced 6% below market and 26% below replacement costs. This underpins our confidence that the transactions we're engaged in will deliver long-term value for our investors.

Sumit, although you mentioned an improving acquisition environment benefiting full-year investments based on this foray into private capital market equity raising, it seems like saying the limiting factor on acquisition volume this year has been capital raising and not lack of sourcing investments at widened spreads. Do you expect the cost of equity in the fund business to be lower? And how will investment philosophies between the fund and core business differ to avoid any potential conflicts of interest when determining where an investment should be placed?

That's a very good question, Greg. The biggest difference between the private markets and public markets that I can point to is this focus on first-year spread versus a focus on long-term IRR. When we are looking at a particular transaction that is inside of our historical spreads, which has been 150 basis points, we hesitate to pursue that transaction because it is not in line with what we can generate in the first year. And as you know, better than most, we are valued off of that initial spread that we are able to capture, which then translates into AFFO per share growth. But that does not allow us to pursue transactions that have a similar, potentially even a higher total return profile given the inherent growth, etc., that they might have despite having a much lower initial cash cap rate. That is where we feel like being able to access private capital that has similar expectations on the long-term horizon, the return horizon that we focus on even as a standalone public entity, but not with that short-term focus, as acutely as the public entity does, will allow us to expand our sandbox and make investments alongside this private capital business, to take advantage of much higher growth rate opportunities, but potentially at a lower initial yield. So, we think of this as truly complementary to our business.

Yes. I just was hoping you might be able to give us maybe some examples as to types of investments or tenants that you guys have had to pass up on because of current structure versus what this new type of equity capital will allow you to pursue?

Sure. Industrial is a perfect example. We've looked at opportunities with a 5.5% cap rate, but we cannot pursue them right now due to our cost of capital, alongside 3% growth and 20-year leases. If you do the math, the return profile aligns with our long-term goals, but we have to pass on that specific transaction because of the initial non-spread effect. Data centers are another example of an asset type that falls into this category, and we may not be able to pursue them currently due to our cost of capital. This is an area of the business we believe can contribute to earnings growth for the public entity in the coming years.

Yes. So, it sounds like really the target for the fund would be just a lower cap rate opportunity set. I'm curious, do you expect that there would be any overlap in the investment profiles between the two vehicles?

Of course, we are going to continue to be a very large equity holder in the fund. So, our interests are going to be perfectly aligned. So, there will be a lot of opportunities that we are going to be looking at, which actually works for both entities long-term, but potentially in the short term does not work for the standalone public entity. But this is also going to be a function of the capital raising. We are not going to be buying things into the fund that we would never have touched even taking the long-term return profile into account as a public entity. So, this is truly to enhance the box and to pursue transactions, assuming our capital raising is successful, and participate together through the fund structure. That is how we would like to deploy capital.

Okay. And then, do you have any sort of target in mind for a size where it makes sense, given just the added complication?

I hope it's going to be very simple. What causes added complication? Well, it's a different pocket of capital, but unlike pockets of capital that have finite life, this is a perpetual vehicle. And we are going to be very large co-investors in this perpetual vehicle. And for all intents and purposes, it will be fully consolidated with our financial statements. So, you will have perfect visibility. The fact that we have scale and the fact that we have a platform that we are very proud of, unfortunately, does not get valued at points in time by the public markets. And this is a way for us to monetize this platform and, therefore, incur very little incremental cost to stand up this vehicle. That, too, is a value that our current platform is going to bring. And I might go so far as to say that given our size and scale, which we have talked about being such a massive advantage, this is one of the ways that we can show that to the market.

I wanted to ask a little bit about the $63 million charge in the quarter related to the convenience store client. Is that related to the same client where you took some smaller charges in the first half of the year? And could you maybe just talk a little bit more about kind of what the outcome would be there? I guess you can't name the client, but maybe just a little more color around what's going on there?

First of all, I'd say we absolutely expect a fair recovery. We've talked historically about situations where we've had credit issues in the portfolio, and we've recouped over 80% of rent that's been impacted. As it relates to the accounting that drove the $64 million charge, it's non-cash first and foremost. It really has to do with the fact that upon the allocation of the original purchase price, you've got land, you've got a building, and then you've got the intangible, which is meant to account for the future cash flows inherent in the lease. And so, the reserve that you see, which rolls into impairment, is classified because these were originally sale-leasebacks as a financing receivable. And that's really just a difference in nomenclature, and that's why it's excluded from AFFO as non-cash. We've already accounted for all of the lost rent for the entirety of 2024 that's built into our guidance.

And I'll just add to that just because we're talking about credit. Let me just share a bit more. I mean these are assets that we really want control over. And we are doing everything in our power to get control of this asset. It is essentially a client who's decided not to pay rent while operating these assets. And given the work that the asset management team has done, we already have a tremendous amount of interest in these assets, which are primarily located in Texas. And so, we feel very confident about being able to replace the rent, which is not significant in this case, the actual cash rent that is very quickly once we gain control. So that's this convenience store operator. But while we are on the topic of credit, I want to walk you through some of what has dominated the conversations over the last few quarters. Red Lobster has emerged from bankruptcy and just hired a CEO. They've hired a Chief Marketing Officer, and they've got a new CFO. Let me close the storyline on that. We had 216 assets pre-bankruptcy. Nine assets were rejected through bankruptcy. We had a 91% recapture rate on that particular name. Rite Aid: we have 29 locations today; we had an 88% recapture rate on Rite Aid, which has now emerged from bankruptcy and is an ongoing concern. Regal, where we have 35 assets today, and an 85% recapture rate, has emerged from bankruptcy. So those are the story lines that have dominated multiple quarters of conversations, and this is the end result of all of those discussions. Let's talk about Walgreens. Everybody is concerned about what used to be 2,000 store closings, which has now been reduced to 1,500. Year-to-date, we've had 13 Walgreens come up for renewal. They had lease maturity. All 13 were renewed by Walgreens. In our history of 55 renewals with Walgreens, we've had a recapture rate of over 100%. Let's throw CVS in that mix. We've had 40 leases renew with CVS in our history at over 102% renewal. Let's talk about Family Dollar, Dollar Tree. We've had 135 lease renewals with Family Dollar, Dollar Tree in our history at over 108% renewal rate. Dollar General is a similar story. So, I just asked that what we see in the headlines doesn't necessarily translate to what is happening on the ground for our portfolio. And that's the emphasis I want to make is that we are very selective, and the data proves that out to be the case. Go ahead, Smedes. Sorry, I cut you off.

I appreciate the detail provided. However, given the headlines we see, we need to address those topics. I wanted to revisit the fund for a moment. I believe this was asked earlier, but I'm unsure if I heard the answer. Do you have an idea of what the fund's scope would be? Are we considering starting at around $1 billion, or could it be several billions? How do you see the initial size of the fund, and how might it expand over time?

Yes. It's too early to tell. We obviously believe in our pieces. We believe in what we are doing. We believe that the benefits of what we are doing are going to accrue to our public shareholders, but it is too early for me to opine on how big this could potentially become.

I was wondering if you can comment on kind of the opportunities that you're currently seeing in Europe? And as you see things today, are you looking into exploring new territories, and do you expect that acquisition opportunity in Europe to continue to outpace the U.S.?

That's a great question, Jay, and it's a valid one considering our performance in recent quarters. While 56% of our year-to-date activities have been in Europe, we see this as an advantage. This is exactly why we established various growth verticals—to capitalize on the best opportunities available. Europe has shown to be a strong area for us during the first three quarters, and I expect that momentum will persist. We are uncovering significant opportunities in Europe, and we are also actively exploring the possibility of expanding beyond our current locations within Europe, looking for the right opportunities and clients in countries where we are not yet present. Regarding the future, I want to touch on the expected $1.3 billion for the fourth quarter. The momentum I mentioned earlier pertains to what we are experiencing here in the U.S. While we have seen consistent momentum in Europe from the start of the year, we anticipate that in the fourth quarter, the dynamics will shift back to more traditional patterns between the U.S. and international markets.

Sumit, I wanted to go back to the fund one more time. There appears to be a long list of benefits that you mentioned already, but I'm also thinking that there could be a long-term benefit of allowing you at some point to potentially generate mid-single-digit AFFO growth, your long-term kind of core growth target without the need for sizable annual equity raises when you think about your existing rent bumps and the reinvestment of your free cash flow. So, I guess, first, is that fair? And then maybe some color on if you'd look to fund it with existing assets within your portfolio and what that mix could look like?

That's a very good question, Haendel. Thank you. And you're right. The idea here is we get into this business to expand the investable universe for ourselves and for the fund while making sure that we adhere to the return expectations of all parties concerned. Look, it's a mathematical fact that it's not an issue today, but 10 years from now, at the rate we are growing, if we continue to rely on just the public markets to finance our growth, we're going to run up against capacity issues. I don't believe that the public markets, especially the fund business in the public markets, are growing at the same level that we have expectations of growing as a public entity. And so, it is not a dearth of opportunities that is driving this desire to get into the fund business. It is making sure that this complementary source of equity capital will help us monetize our platform and create a business that will then allow us to continue the momentum that we have shown over the last 55 years, 30 of which has been as a public entity. That is the goal of what we are trying to do. And outside of the initial seating of this fund, which, by the way, that portfolio will look and feel very similar to what Realty Income looks like. And at the appropriate time, all of that will get disclosed, is a way to attract capital and start our business. But subsequently, it will be new transactions that they participate in, either alongside us or it will be on balance sheet for the public entity. That's how the business is going to function.

No, that's incremental. I appreciate that. And one more, and I'm not sure if you answered it, but I didn't quite catch if the pipeline for the fourth quarter, if you expect the cap rates to be comparable or lower? And then just thinking about the uptick in volume into the fourth quarter, if that's an appropriate run rate to think about into next year?

Yes. Haendel, I'm not going to opine on cap rates, etc., because things can move around quite a bit. But what I will tell you is that the spread that we are going to make will continue to be healthy and will continue to be north of our historical spreads. That you can take a fair amount of confidence in. And the other piece I'll leave you with, Haendel, is we have already prefunded our need for the fourth quarter. So, there is no reliance on the public markets to help fund this $1.3 billion that we are planning on doing in the fourth quarter. Hopefully, that helps.

One more on the private fund. Can you maybe just talk about how time will be spent in underwriting deals and opportunities for the team in general, but also for you, Sumit? And then I know you commented on economies of scale around our data and data analytics. But just curious if you foresee any changes to headcount or to the investment process just in the early stages of that launch?

That's an excellent question, Spenser, because it really highlights the essence of our ability to leverage our current scale to tackle costs that would be overwhelming for a startup in this business. We have 465 employees and a fully staffed investment team both in the U.S. and internationally in the U.K. and Amsterdam, so we don't anticipate needing additional personnel for investments. The first benefit of our scale is that we can remain flexible about how assets are managed, whether in a fund—where the public entity will have a significant interest—or on our balance sheet. Our asset management team, which has excelled in managing public assets in the U.S. and London, will continue to oversee these assets. The second benefit is that we have the established team for any asset disposals or related tasks, as well as a substantial legal team that will support us. We're proud that we perform most of our legal work in-house and will continue to rely on them for transaction and lease negotiations. The third benefit is that our existing setup allows us to avoid hiring new personnel for operational tasks related to our investment arm. While we will incur some incremental costs for a fund manager and reporting functions tailored to specific private investors, all accounting and financial tasks will utilize our current framework. Therefore, I believe the additional costs to establish this business will be relatively low.

Very helpful. And then just last one, can you talk about how the competitive landscape is changing? Or if there's been any changes in the U.S. and Europe right now as it relates to the transaction market?

Yes, Spenser, the competitive landscape is quite dynamic. Private firms are increasingly becoming significant players in the transactions we are targeting. Additionally, several companies in the net lease sector have gone public recently. However, we don't typically encounter most of these firms due to the specific types of transactions we focus on. It is indeed a competitive environment in the U.S. As for the international market, it remains one of our key advantages. While we are facing more competition now compared to a year or two ago, the intensity is still not as high as in the U.S. Most of the competition internationally comes from private capital. This outlines our competitive landscape both in the U.S. and internationally.

Sumit, you talked about the momentum in the transaction market, but I wanted to kind of get a sense on how buyers and sellers have really reacted to that 50 basis points rate cut, and with another 25 basis points cut likely this week and then with the 10-year really driving higher about 65 basis points since the last Fed rate cuts. So, I want to get a good sense on that.

Yes, I believe much of the current volatility is tied to today's events, which are the main external factor influencing the curve's future position. We have less exposure to the short end of the curve compared to the long end. What occurs on the long end affects our cost of capital, as it serves as a lasting source of financing and influences our transaction capabilities. This is tied to inflation expectations for the future. If new policies lead to significantly higher inflation expectations than what has been experienced historically, it will affect where the tenure settles, impacting our permanent cost of capital for the net lease business, either positively or negatively. These developments are primarily driven by policy. Various proposals have emerged that could influence these inflation expectations, so it's still too early to predict the outcome. The situation has led to considerable volatility, and we are optimistic that once there is more clarity on the curve, we can proceed with our usual business activities.

Great. That was helpful. And then last one for me. Going back to the private capital fund. I know you've already listed a bunch of benefits there. But I wanted to get your sense on why now and why this makes sense in today's economic environment. I know you mentioned capacity could be an issue in the future, but is there anything else that you may have been dealing with that was creating some friction on your end?

Upal, we aren't noticing any issues on the credit side. I've shared a detailed overview indicating that we feel confident in this area. Our credit watch list has actually decreased by 10 basis points to 4.2% compared to the last quarter, reinforcing our positive outlook. We believe the market is healthy enough to support transactions, despite recent events, which we expect will pass. The focus is on executing this correctly, which is our common goal. We want to approach this gradually and thoughtfully, as it will take time for this to mature into a successful business. Looking at one of our peers with a prosperous open-ended fund business, Prologis, which has taken over 20 years to develop, illustrates this point. We anticipate that in a decade, as we face potential limits on accessing our current capital sources, the need to invest now will become more pressing. This is why we’re starting today, when we don’t urgently need additional capital, to build our fund business for the benefit of our public shareholders. Regardless of when we might have initiated this, the importance lies in beginning now to mitigate future constraints.

Just a few quick ones. Can you give us an update on where 2024 bad debt year-to-date has trended? And what's your outlook for '25?

Yes. So, Linda, if you look at the earnings release, first nine months of this year, we've incurred about $6 million in bad debt expense. That's around 40 basis points of our rental revenue. When you take out this one C-store operator that we referenced earlier, you're really looking at sub-20 basis points on 18 basis points. We've talked historically about how when you exclude the pandemic, we've been right there around 25 basis points of credit loss in a given year as a percentage of revenue. So, to be at 18 outside of these one-time unusual events, we think is pretty indicative of a very constructive and healthy portfolio.

And I think we, as Sumit alluded to earlier, the credit loss was at 4.2%. There's really not a lot out there that we're really monitoring that meaningful. There are no 1-plus percent exposure tenants on there. We feel as though those that are on the watch list, we've been monitoring for quite some time. In some cases, we have very good visibility into the cash flow coverage on these assets. And so, we'll get into all of the assumptions that we're baking in for 2025 come February when we release our guidance.

And then in terms of the C-store write-down in the quarter, what's the potential AFFO impact on earnings? And then what do you think is the recapture rate?

So, in terms of this one C-store operator, it's really, I call it $1 million a month or so. And all of that is built in. All of that is built into our guidance. And we'll see where we trend out to in terms of recovery. But as we referenced earlier, we do feel like there could be quite a bit of interest in these assets. So, I think the default response that we have to offer up is you look at our historical precedents and being able to get 84%, 85% or recapture of any rent that's been impacted by a bank or credit event.

Just two quick ones back to the fund. I think you talked about some of the investments that the fund would be interested in, where the public equity couldn't do it. I guess my other question is just, is there any other differences in terms of dividend policy in terms of geography like in the fund go anywhere? And in your mind, is that investor that's going into the fund, is that a completely different investor base that would contemplate the stock? Or is there some overlap?

Yes. Ron, we haven't really done any work on the investor profile, but the comments I made about how much bigger this investable universe is of potential investors to look to invest in real estate through a fund structure is what's so compelling. Is it possible that you have some of these funds that have ambit to invest in public securities and they have a mandate to invest in private direct investments? I'm sure that may be the case. But even those investors will tell you that what they have to invest through a fund structure directly into real estate is multiples of what they have on the security side. So, I can't give you a more precise answer than that, but the vast majority, I believe, are going to be investors who don't have the ability to invest in public securities but would like to utilize our platform, work with us, and invest in the product that we invest in. And outside of that, the strategy is one that I've already touched on. There's not going to be anything new that the fund business is going to be doing that we won't do on balance sheet. Keep in mind that the goal is we will be a massive co-investor in this fund. And so, our interests are going to be perfectly aligned in terms of what it is that we pursue.

Great. And then my second quick one is just an update on sort of the data center sort of initiatives. Obviously, there's been a lot of data points about demand ramping? Just how are you guys sort of seeing the pipeline in that vertical evolving?

Yes. So, I won't talk about pipelines, Ronald, but what you've referenced in terms of the demand, we're seeing that in space. We've been very lucky to be speaking with multiple operators in this space. We see it in terms of what they're showing us regarding the pipeline that they've created. We are trying to craft a value proposition that is compelling to these operators. And we are very optimistic about where this particular business could go for Realty Income going forward. We feel like we can be a solution that helps meet some of the demand and the capital needs to execute on what is a once-in-a-cycle type situation. And at the end of the day, we have capital allocators. If we can allocate capital exposed to S&P 10, S&P 20 clients for 20 years, that's our core business. And so, we are excited, but it's too early to tell in terms of how this is all going to play out.

So, I wanted to ask a couple more questions on the funds. Given those examples of some of the transactions that might be more appropriate there, has been helpful. And I wanted to be clear, do you expect the fund to invest in properties that might not necessarily have triple-net leases and therefore, have better internal growth or more structured investments, development loans? So, I'm just trying to get an idea of what the mix is or if it's going to be pure triple-net.

R.J., what I'll share with you is you should think of these investments in terms of flow-through, rental income flowing through to NOI to be very similar to what we've done on balance sheet, right? The idea is not to go and start executing on businesses that have a 40% NOI margin. That's not what we do. And so, when we talk about data centers, we are not going to be going out there and buying colocation sites where the flow-through is very different versus hyperscale single-tenant 20-year leases that may not be precisely triple-net, but the flow-through is still incredibly high, i.e., mimicking what a triple-net asset should generate. That's really what we are going to be doing.

Okay. And then two quick follow-ups, and I may have missed the answers. But number one, do you expect the cost of equity to be higher or lower than Realty's?

The long-term return expectations for both businesses should be quite comparable, but the emphasis is on the long-term return rate rather than immediate gains. That’s the key distinction. As a publicly traded company, we currently cannot achieve our goals of generating returns in the first year while also meeting long-term return requirements. Both criteria must be fulfilled for us to engage in public market transactions, and we appreciate that this is the framework we operate within. However, we are foregoing opportunities for high-quality assets that can satisfy long-term return expectations, even though they may have lower initial returns. I believe our fund structure will allow us to improve our co-investment through the ongoing asset management fee revenue, which effectively monetizes our platform for the advantage of our public shareholders. This is how we intend to proceed.

Okay. And one last follow-up is, will Realty Income be contributing properties to the fund?

There will be a seed portfolio that will allow us to have conversations with potential investors. But thereafter, it will be new investments that we pursue. That's how we're thinking about it today. So outside of that initial seed portfolio, everything else will be new transactions that we'll be pursuing.

Sumit, I want to follow up on your last point. You mentioned Prologis, which relates to the contribution question. Can you envision increasing investment in developments that you might not have typically underwritten, which could then be included in the platform? Or would you prefer to handle those developments within the platform itself?

Greg, that's a very good question because when we pursue development, we do have certain accounting elements that we have to adhere to. And there are times where we are unable to recognize the full cash impact, the positive cash yield that we are able to generate on dollars that we are investing in a development scenario, just given the lease accounting that we have. That's certainly not going to be a prohibitive factor in doing it through the fund structure. And so, could we do more of those? Yes. In the fund, the answer is yes. But again, it needs to meet and exceed the overall return hurdles that we would need to address. So, there are a lot of things that this alternative source of financing could allow us to do, which we have done as a public entity, but only in a limited way because of some of the inherent limitations that we have either in terms of how we can report stuff, etc. So, I do think that this will give us the flexibility and thus, the comment I made about expanding the sandbox of the types of transactions that we would be able to pursue by having this alternative source of capital available to us.

And do you already have kind of first investors in mind or conversations that you've had on this front?

We have none of that in mind. We have, and I think I've talked about this, what the profile of this investor would look like. We certainly have that, and we are working with our advisers who have shared with us what the details are around that, but we haven't had any conversations today.

Okay. And just final follow-up for Jonathan. Is there anything specific to point to in the slight increase in the midpoint to the expense leakage guidance?

Yes. It's a combination of a few things. Greg, first of all, there's been some deferred expenses we brought forward, some that were carried forward from last year. We're just trying to get ahead of spending and trying to catch up in some cases. So, there is a little bit of heavier load this quarter. I would also say for this year, I would also say that there are some carry costs that we are incurring with a few vacant assets that do comprise a bit of an increase on a year-over-year basis from a margin perspective. And then also, I think when comparing to the 1.1% leakage that we experienced last year, keep in mind we did bring in a $9 billion portfolio in January with the Spirit portfolio. That did have slightly more leakage as well just on a run rate basis. So, I would really attribute it to those factors as what's driving the slight increase going from 1.1% and now to a midpoint of 1.35%.

I just want to have a question on the development pipeline. When do you expect the non-retail to lease up? Are you holding back leasing on that right now?

Yes, that's a great question, Wes. Look, it's a very small portion of the overall development. I think it's like 15% plus/minus in that ZIP code. Even though the quantum that we have identified for this particular type of development, we really don't spend until we get clarity on the leases coming through. And so, we feel very confident. We are partnering with one of the best developers in Panattoni, and we feel very confident that some of these are going to get leased up in the near term. Keep in mind, we won't make the big capital investment without having line of sight on potential clients being able to step in and take over those leases.

Maybe just a quick follow-up on that since it's more spec in nature. Are you going to get a little bit more incremental yield?

Yes, absolutely. In fact, in situations where we've had two buildings, one leased and the other not, we have expectations for the lease rates. More often than not, our expected lease rates have been exceeded by the actual results. This builds considerable confidence in both our partners and our team's ability to evaluate these types of transactions.

Thank you all for joining us today. We look forward to speaking soon and seeing you at a conference in the coming weeks. Thank you, guys.