Realty Income Corp (O) 2008 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Realty Income second quarter 2008 earnings conference call. During today's presentation all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions).

This conference is being recorded today, July 31st, 2008. Now I'd like to turn the conference over to Mr. Tom Lewis, CEO of Realty Income. Please go ahead, Sir.

Thank you very much and good afternoon, everyone. Welcome to our conference call where we will talk about the second quarter and a little bit about what is going in the balance of the year.

In the room with me today is Gary Malino, our President and Chief Operating Officer, and Paul Meurer, our Executive Vice President and Chief Financial Officer, [Mike Pfeiffer], our Executive Vice President and General Counsel; and as always, Tere Miller, our Vice President of Corporate Communication.

And as I am obligated to do on each call -- during this conference call we will make certain statements that may be considered to be 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 and we will disclose in greater detail on the Company's quarterly 10-Q the factors that may cause such differences.

And, Paul, if you want to go ahead and walk through the quarter, we will do that.

Thanks, Tom. As usual I am going to comment on our financial statements and provide a few key highlights of the financial results for the past quarter and start with the income statement.

Total revenue increased 17.2% for the second quarter as compared to the second quarter of 2007. Rental revenue increased to approximately $82.4 million in the quarter as a result, of course, of new property acquisitions. Same-store rental revenue increased 1.4% for the quarterly period. And other income was only $80,000 for the quarter.

On the expense side, interest expense increased by $10.9 million during the second quarter as compared to the second quarter of last year. And this increase, of course, is due to more bonds outstanding as compared to a year ago, specifically the $550 million of 2019 notes that we issued in September of 2007.

We had zero borrowings on our credit facility throughout the second quarter.

On a related note, our interest coverage ratio continues to be strong at 3.2 times while our fixed charge coverage ratio was 2.5 times. Depreciation and amortization expense increased by about $4.5 million in the comparative quarterly period as depreciation expense has increased, of course, as the portfolio continues to grow.

General and administrative expenses for the second quarter were about $5.9 million, representing only 7.2% of total revenues for the quarter. We continued to expect G&A expenses in 2008 to remain at or below 2007 levels.

Property expenses increased slightly on a comparative basis by $135,000 for the quarter. These expenses are primarily associated with the taxes, maintenance and insurance expenses which we are responsible for on properties available for lease. Income taxes consisted of income taxes paid to various states by the Company; and these taxes totaled $218,000 for the quarterly period.

Income from discontinued operations for the quarter was $4.7 million. Real estate acquired for resale refers to the operations of Crest Net Lease, our subsidiary that acquires and resells properties. Crest sold seven properties for $28.6 million during the quarter for a gain on sale of $1.7 million.

However, Crest also recorded an impairment of $953,000, on one Buffets property held for sale. You will recall that Crest holds three Buffets properties. We impaired two of those properties last quarter. This is the third Buffets property, and this impairment amount was already in our internal projections which we gave out last quarter when we updated earnings guidance at that time.

Overall for the quarter, Crest contributed income of $1,295,000.

Real estate held for investment refers to property sales by Realty Income from our existing core portfolio. We sold eight properties during the second quarter, resulting overall in income of $3.4 million. These property sales gains are not included in our funds from operations.

Preferred stock cash dividends remained at about $6.1 million for the quarter. Net income available to common stockholders was approximately $27 million for the quarter. Funds from operations or FFO was approximately $46.8 million for the quarter. FFO per share was $0.47 per share versus $0.49 per share a year ago. However our FFO before Crest contribution for the FFO from our core portfolio increased to $0.45 from $0.44 per share a year ago, an increase of 2.3% in earnings from our core portfolio.

When we file our 10-Q, we will again provide information you need to compute our adjusted funds from operations or AFFO for our actual cash available for distribution and dividends. Our AFFO or CAD is typically higher than our FFO as our capital expenditures are relatively low and we don't have a lot of straight line rent.

Our continued growth in core earnings allowed us to continue increase in our monthly dividend this quarter. In June we increased the dividend for the 43rd consecutive quarter and the 49th increase in the dividend overall since we went public over 13 years ago.

Our current monthly dividend is now $0.13.8 per share which equates to a current annualized amount of $1.656 per share.

Briefly turning to the balance sheet, we continue to maintain a very conservative capital structure. Our debt to total market capitalization is 33% and our preferred stock outstanding represents 8% from our capital structure.

In May, importantly, we recast our credit facility, increasing it in size to $355 million plus a $100 million accordion expansion feature. Initial term of this facility is three years plus two one-year extension options thereafter. We strongly felt that in this challenging market environment, recasting the new facility was a lot more prudent than simply exercising the one-year extension option, which we did have available to us on the prior facility.

We were very very pleased with the responsiveness of our bank relationships and the speed with which we were able to syndicate this new facility back in May. We continue to have zero borrowings on this facility, however, at this time.

Furthermore as noted on the balance sheet, we also have over $39 million of cash on hand. In November 2008, as many of you know, we have $100 million of bonds coming due and in January '09, another $20 million of bonds coming due. As we said previously we plan to reserve cash or credit facility capacity for this $120 million of upcoming obligations, so that we are not dependent on positive public capital market conditions at that time.

Thereafter our Net Debt maturity isn't until 2013. So we do not need to access any new capital for any upcoming financing obligations.

In summary, we currently have excellent liquidity and our overall balance sheet remains healthy and safe.

Now let me turn the call back over to Tom to give you more background on all of these results.

Thank you, Paul. Let me start with the portfolio. As you saw in the release, we ended the quarter with 96.8% occupancy and 75 properties available for lease out of the 2,367 we own. That is off about 60 basis points from last quarter in occupancy.

13 of the new vacancies were from credit default from a couple of small tenants this quarter. That is not a large number given we have almost 2400 properties. But it is an increase nevertheless, but is consistent with what we expected and actually what we included in the guidance that we gave last quarter. And then the balance was just normal leased rollover that is going on in the portfolio and ebbs and flows.

Our sense is occupancy should rise a bit from this level the balance of the year. We see good activity in the portfolio management department and releasing space, and don't have anything pending relative to additional vacancy that is not reflected in our guidance. So things look just about what we thought they would a few months ago and I would be a bit surprised if occupancy wasn't in the 96 to 97% range, the balance of the year absent anything material from what we see today.

You'll notice we announced in a press release a couple weeks ago an agreement with Buffets to continue to lease all of the 104 properties we had currently have leased to them in our core portfolio. And that the rent would be adjusted from $22.4 million to $19.4 million or about 87% of previous rents. That announcement was generated by filing at the court that we had reached an agreement with Buffets. And in response to a number of calls we got after that, we thought it was appropriate to put out that information of what the financial impact would be so people could see what that was.

We had planned, by the way to do that at the end of the third quarter when we could sit down and talk more about it which we can't do today. So that will be the extent of my comments on the Buffets situation. As I'd mention before, relative to that agreement specifically, we are under a confidentiality agreement. And then secondarily as their process is underway, the reorganization is quite active.

We are also on the Creditors Committee and have a confidentiality agreement subject to that as you would assume. And so, we anticipate no significant news out of that situation in the near future. I will say though that that agreement was consistent with what we were looking at last quarter and once again with guidance.

Relative to the balance of the portfolio, and I think as everybody knows out there listening into some other calls, the retail environment is weak overall. And it's obviously a very difficult environment, particularly in the last six to eight weeks for the consumer. We can see that in the operations of our tenants and the discussions we have with them. Also in the underwriting of new transactions which we continue to do.

And while we can see some stress in some very small positions we have with some retailers, we would really be surprised by some substantial additional vacancies coming in over the next quarter though. So nothing really new. We have nothing else significantly going on in our top 20 tenants.

We are currently reviewing those for a meeting we have with the Board every August. So we are in the midst of reunderwriting and talking to them. And quite frankly when you get down to below the top 20 tenants, you are looking at about 2% of rents.

Same-store rents on our corporate portfolio increased a little under 1.5% during the second quarter and for that year-to-date, looking forward to the balance of the year we see same-store rent increases probably at about that level, and so on a continued increase. If you look at the 30 different retail sectors that we have in the portfolio, there were two that had declining same-store rents, four had flat same-store rents and there were some increases in the balance of the 24 different industries.

But it was really concentrated on -- and I guess you'd expect this because there are larger industries with about half of the increases coming from restaurants, childcare, auto service, and C stores.

We continue to be well diversified in the portfolio. We had a decrease of about eight properties totally in the portfolio from quarter to quarter from 2,375 to 2,367. That is really coming from the sale of a number of properties out of the restaurant industry that we used to prune our position there and just slightly reduce overall and just acquiring one property during the quarter.

We continue to be in 30 different retail industries in the portfolio. We have 118 different retail chains and continue to be in 49 states. Relative to exposures to various industries, restaurant is our largest industry. At quarter's end it was at 21.7% of revenue, down from about 23.9% in the second quarter and from about 24.2% at the end of the fourth quarter. That is a reduction of a couple hundred basis points over the last 90 days or so.

And as we've said over the last couple of quarters, we are full in that industry, not making acquisitions. We are selling off a few properties and we are going to get that back down under 20%.

Convenience stores are about 16% of revenue. The next largest industry after that is [feeders] at 9 which is down a little bit from 10% and then childcare, which is at about 7.5% and from there it goes down pretty quickly. We continue to be mindful of diversification in the portfolio, one would like to keep it well diversified.

If you look from a tenant standpoint our largest tenant as we said in that past press release was Buffets, at about 5.9% of rent. The next largest tenant about 5.3% and every other tenant is below 5% of revenue. Our 15 largest tenants comprise about 54% of revenue today.

And just as a data point, when you get to No. 15, you are at about 2.2% of revenue. And to take it when you get to tenant No. 21, you are at about 1.4% and, again, it goes down very quickly after that. So we remain pretty well diversified.

The average remaining lease length in the portfolio continues to be a healthy 13 years. And that's really staying longer as a function of acquisitions over the last year so and then, secondarily, from releasing properties that are coming up and obviously having a longer lease than right before they expire.

I mentioned our top 15 tenants comprise about 54% of revenue. As always, our best metric for credit remains the cash flow coverage of rent at the store level or the individual stores cash flow to their retailer or the EBITDAR, if you will, divided by the rent he pays. And the average cash flow coverage for our largest 15 tenants on a store basis EBITDAR coverage of rent was 2.7 times at the end of the second quarter and ranged from a low of about 1.7 times up to about 455. That is off a bit from last quarter where it was 2.76 and ranged from 188 to 419. But at 2.7 times that's obviously very very healthy.

And we believe gives us an excellent margin of safety relative to the tenant's ability to pay his rent and that they own very profitable property. So we own their profitable properties.

Let me move onto property acquisitions. During the second quarter we only bought one property for $2.7 million. That was one we had really worked on over the -- at the -- in the fourth quarter of last year that crept into the second quarter of this year so, effectively, we really didn't buy anything in the second quarter which is what we had expected to do.

We continue to have $[250] million in acquisitions for the year for our guidance, but with $184 million done today certainly hitting the $250 million number for the year is doable. While we didn't buy anything during the second quarter, we continue to look at a lot of transactions. From time to time I will put these numbers out to give you a feel.

Year-to-date in Committee we've gone through just under about $2 billion worth of transactions that we've looked at and underwritten. About 61 separate transactions and, again, buying about [188] million in [eight] transactions we bought about 9% of what went through committee.

To put that into perspective for the same period a year ago, that is off a fair amount from what was coming through the committee as we see less transactions generally in the marketplace overall.

I think if you look at the acquisition environment today and you start really on the demand side, the number -- you start with a 1031 tax-deferred exchange size of the business that tends to the a fairly large part of the net lease market. And the number of those type of borrowers which has been very big, I think has declined quite a bit, as you see sales and other property categories declining which means there are less gains that need to be sheltered through a 1031.

And our people that kind of watch that area think the transaction volume is probably down about 50% in the 1031 market over the last 18 months, relative to net lease properties. Having generally buyers out there that are looking at that type of property are having a harder time finding financing, if they don't have a lot of equity to put into properties.

Obviously the CMBS market is quiet out there and then, secondarily, the regional banks that had built some of the lending gaps in recent years are running into their own [areas]. And I think financing is a little harder for them to get. We took a look recently at all of the properties from the 1031 people out there that were listed on the market for sale. And we just made notes that probably about 2/3 of them had been on the market for 90 days or longer.

So I think that the inventory is aging a bit and that 1031 market is slowing down.

Relative to the segment that we primarily play in, which is kind of the larger portfolio buyers, I think that's slowed down a bit too. I think most of the people who bought in bulk to then flip have exited the market, usually through capital issues having trouble accessing capital. I think that's a lot less other institutions out trying to buy today and a few like us are on the sidelines, waiting for cap rates to move higher.

From the supply side, obviously, there's less M&A related activity out there that would generate these. And that's brought the volume down overall.

Then I think just generically like a lot of real estate sectors, the big (inaudible) spread out in the net lease market between buyers and sellers is pretty large. And unless owners today are compelled to do a transaction they are trying to hold out for an improvement in the market at some point and hope cap rates will fall from where they are today.

From our perspective, I think prices are declining and cap rates are continuing the increase. I think on the larger transactions we've looked at, my sense is they're moving up into the high 8s, and maybe the low 9s, and continue to move up.

But there's really not a large volume of transactions being done out there right now. It is interesting relative to caps, it is kind of hard to know exactly where caps are in both transactions. Because if you look what was reported in second quarter numbers, that's pretty much looking back about 60 days or so into the marketplace. And as we've all same both at the general retail environment I think that's true in the property market cap rates that are 60, 90 days old are a bit stale.

And so it's hard to get a feel on the, but we definitely think that they are moving higher.

I also don't think that you are going to see transactions pick up very much for a while. I think there are a lot of people out there that don't have access to other forms of financing that do have real estate on their books. And at some point they are going to have to enter the market. I think they are hoping that the credit markets will open up and allow them to access other forms of capital and our sense that it will be difficult to do that.

However I think that most of that volume if it comes on the market will probably be late in the year or early into 2009 and that as that happens -- if it happens -- you are likely to see cap rates move up a fair amount. That will close the bid (inaudible) spread I would think and probably cause volumes to pick up.

I think for '08, though, we are going to stick with the $250 million number and subject to change depending on how cap rates and seeing what else is going on Out there.

As Paul mentioned, we are very liquid at the moment. There's no balance on the line. We have just about $40 million in cash sitting around and some property sales and free cash flow coming through. We are very liquid and I would like to stay that way and intend to stay that way for a while, until there is some definite movement upwards in cap rates and volumes. And then at that point we may put some of the money to work, but not until.

Let me move onto Crest Net Lease for moment. Most of you know that Crest is our business that we've had the last eight years that helps us buy large portfolios for the core portfolio where we will buy some, put them in Crest and then sell them so we can work down our concentration. It has been a moneymaker for us, but as we always say, obviously a very different quality of cash-flow. Because its cash flow is generated from property sales which is a lot more volatile.

And for perspective, Crest is made in any given year over the last eight years between $0.2 to $0.11 per share so it has been a fairly small part of our overall FFO, and remains so today. Last year we did $0.11 a share in Crest, which was a function of having a lot of inventory and a lot of sales last year.

Our inventory in Crest peaked last year at about $140 million and we have been paring inventory through the sales over the last year or so. We've bought nothing in Crest in five of the last six quarters and the last three quarters we've made no purchases at all and have really been trying to wind down that activity. Our current inventory at the end of the quarter was only eight properties for a little over $10 million.

Close to the end of the quarter we sold another property, have two more under contract which really leaves us with only five properties in the Crest portfolio with the inventory of about $6 million. Three (inaudible) year or so we haven't had to use Crest and our sense is at the current time that that is really where we see the risk of holding a lot of inventory in a rising cap rate environment and we are happy to effectively be out of that business today.

Moving onto dividends. As Paul mentioned we've continued to increase the dividend. I would anticipate and would look for dividend growth to continue here in 2008 and absent anything material also 2009. Relative to FFO, obviously, the number was $0.40 versus $0.49. Most of that had to do with closing Crest down, having $0.01 come out of Crest this quarter versus $0.04 a year ago.

On the core contribution pre Crest we grew from about $0.44 to $0.45 per share in core FFO which was up a little over 2%. Relative to guidance, there's no change to the guidance from last quarter and we will stay at $1.84 to to $1.90. That includes only $0.01 or $0.02 from Crest versus $0.11 a year ago. And then our expectation is that the core before Crest will grow at 2 to 5% this year.

You know as we start to think about 2009, I think looking into next year at the numbers we should have Crest washed out of those numbers. I think we should re-lease a fair part of what's on the vacancy list and I would anticipate to be positioned to have a pretty good 2009 relative to FFO growth. We will put out guidance for 2009 at the end of the third quarter. And is our -- as we are accustomed to doing at that point we will lay out all of the assumptions relative to the portfolio operations, Crest and acquisitions at that time.

To summarize then, I think the portfolio is in relatively good shape given the state of the overall markets. We are effectively out of Crest business. Being very patient with acquisitions and holding off here for higher cap rates, balance sheet is good. Liquidity is good and core operations continue to grow. And we think that will continue through the balance of the year.

All of which I can tell you I can live with in this type of market which is certainly interesting.

And I think that will wrap up our comments and I appreciate the patience to kind of go through everything. And, Operator, if at this time we could open up for questions, that would be good.

(Operator Instructions) Anthony Paolone with JPMorgan.

Good afternoon. With respect to the GO pipeline and hitting your acquisition target for the full year, just what's the visibility for what is remaining on the $250 million because it sounds like you are going to be pretty patient and wait for cap rates to move up?

Yes it will be interesting. I don't think we are going to buy much of anything here in the third quarter. We continue to underwrite transactions that is really [absent] something coming in where I think cap rates might be. As we get into next year will probably remained very patient.

And then it's a question of whether later in the year or not cap rates really rise. So my sense if we miss anything here this year it's really on the acquisitions, but those would have been later in the third quarter or fourth quarter, I think, from a model perspective and really have very little if any impact on '08.

And then we will update that relative to its impact on '09 as we do guidance for next year which we think will be positive. So it's really a hard to say at this point.

It would be very easy to pull the trigger. We had a number of transactions come through in the mid to high (technical difficulties) in the second quarter. And I think that will happen in the third and again unless something comes into the mid 9s or so, given effectively the nominal cost of capital is up around 8 unless you can get into the mid 9s I've -- in a bit of trouble trying to allocate that capital at an adequate spread.

So my sense is if we do it, it will be towards the end of the year and it wouldn't surprise me at all to do it or exceed it. But it wouldn't surprise me at all to be a little under it.

Is mid 9s kind of the spot that you think things should go to at this point or would reflect a fair price in your minds where you get a little more interested?

Yes, I think that's where it would be and maybe even a little higher. Obviously every transaction is specific, relative to the bump that you are getting on the leases, but that's probably into the range.

Is there any particular industry type that you are seeing more [GO flow] in at the moment or not?

It is pretty wide ranging. There's not a big theme which, normally, I think if you go back the past four or for five years I should say, we are seeing a lot of restaurants. C stores. We are really seeing a diverse group of things coming off.

And typically it's somebody who has got a decent sized piece on the balance sheet. They are becoming a little more rationalized relative to where the capital markets are and looking at where spreads have gone, credit spreads and they are saying, "I am going to need to do something for my balance sheet in late '08 or in '09," and have decided that the market may not get better and they are coming to market.

And I think because of that, it is less of an industry theme than it overall is a balance sheet theme. And I wouldn't be surprised if that continues.

Then with respect to your C store exposure, can you talk to how those properties are performing in light of just weaker consumer, relative to say, gas, and get their other sort of business?

Yes. We've been watching the C store and, obviously, that is a big story with gas prices. I know one of the public C store chains we know well reported and I think kind of the four or five takeaways from listening to their conference call say what we are hearing from pretty much everybody which is gallons are off probably about 5%, 4% to 5% over a year ago. Gas margins have come down $0.03 or $0.04 and are probably around $0.09 to $0.12 versus being $0.03 to $0.04 higher then that a year ago.

I think where most of them are getting pinched -- which is something you normally wouldn't look for -- is credit card fees. Because even if you maintain the number of cents, you are not maintaining your margin.

Yet, credit card fees obviously are a function of prices and with higher gas prices, they are getting pinched a little bit there. That's really been hitting their middle line. And so that, I think has been almost as hard on them as the reduction in gallonage.

Where they make their money inside, most of them are saying they are off maybe 2, 3, 4% inside sales, which is not as bad. And in this particular one today, the merchandise margin was relatively flat and in -- if you look at net income it was off probably about 20% quarter-over-quarter a year ago. But you can take that either way off 20% or maintaining 80% of it.

So while there is some stress in the slowdown which I can see -- I think you can see in a lot of retail today, that one is another one of the poster childs as a function of gas prices. But still not as bad as you might anticipate, just more talked about.

Last question. Do you have any sense as to maybe what percentage of your tenants or revenue base have a parent that's bankrupt at the moment? (inaudible) even though you have -- even though your stores are worked out the parents still bankrupt. Is there any way to gauge that?

You know, I haven't run that number but if I had to do that, I would say 7. If I had to guess and Buffets is [5.9] you know.

Yes, if you take away Buffets (multiple speakers) -- there's not much -- if you take away Buffets you are looking at less than 1%. Something like that.

Yes. There's really not much else in there at the moment.

Thank you.

Michael Bilerman with Citigroup.

This is [Anne B. Hill] with Michael. Could you put some color on the 13 credit default assets that you had? Were those tenants in any specific industries? And where are you really seeing those assets to?

Well, they've just come off-line and again there were only 13 and a few of them are restaurant and one was a general merchandise. But, again, you are looking 13 properties out of 2,367. So it is a very small number and we knew those were coming last quarter when we also put them in the guidance.

Then re-lease obviously is going to be restaurant and the other, I think it's 12 restaurants, small restaurants, and one box. And the box is near a mall and it could be released to just about anybody.

Have you found it more challenging to re-lease spaces, given softer restaurant operations?

You know, I really want to say yes but I can tell you also that we've had a pretty good flurry of activity recently here though. So I'm not sure that's the case, but I would certainly expect if it hasn't been in the last four to five weeks and it's been fairly strong, it will turn around and be worse.

Because as I said in the last call we really -- we normally use six months to release space and we've widened that to nine and I would still stick with that.

And then on the reset of the rents for Buffets, when does that hit?

That has not hit as of yet, but again I am going to demure from anything else beyond that that's pending, but I just wanted to get out there the agreement. From a modeling standpoint I think we are late enough in the year, and it's a small enough part of our rents where it won't be material.

Then on -- I'm not sure what you can say on this, but some of the lease terms were changed though -- they were cut down to (inaudible). When are we going to be able to get color on the changes in the lease structure for Buffets?

At some future date when they are through with their reorganization.

Then on the change in the coverages that you mentioned, is the drop-off on the bottom end, is that related to any specific industry or sector or any trends that you are seeing in your cash flow coverages?

No. That was with one particular tenant and I looked at that and, again, it's one out of, I think, 15 and that tenant was, I think, 1.2% of rent. And they had a rent coverage during the quarter go from 1.88 to 1.7 so it wasn't huge. There was I think in the previous quarter the top end was 4.88 and it came down to about 4.52.

So funny enough thankfully, most of the reduction we saw was at the upper end of the strata of the change that -- of the really strong [scores].

Jeff Donnelly. Wachovia Securities.

Paul, I guess picking up on an earlier question, I get the sense that you guys are of a mind that we are in the early innings I guess of a period of continued distress in retailing. Can you share with us, I guess, out of the two or three sectors that you think are going to bear the brunt of maybe future chapter 7 and 11 filings and conversely those that you might think come clean and avoid that?

I don't know who comes clean. I think restaurants, but I think they've already seen a lot of the stress. And so that's an obvious one people are talking about. The convenience store chains, while we've seen their numbers come off it's a basic human needs business and unless there's really -- they are heavily levered I think they are in okay shape for now.

And when you get beyond that I think the poster child is kind of the traditional hard and soft good retailers that you see out there. And I think one of the reasons we feel a little bit better about what we're doing is that is a very small part of our business. I think about 19% of our revenue comes from traditional hard and soft good retailers; and I think that is where you are going to see some of the stress out there.

But it's, as you know, pretty broad-based out there right now. And I think it's going to be more balance sheet-related than it's going to be industry-specific. I think to date it has been industry-specific looking at restaurants and seeing kind of the casual dining get hit as people traded down and fast food benefit, while the upper sit down dinner house did just fine. And I think now the more aspirational shopper, the guy out on the credit card that has a good job is starting to step back a bit.

And then I think it goes pretty broad-based and maybe moves a little bit more into the upper tier than it has been where it's been kind of the really low-end Wal-Mart consumer.

I think, Jeff, as Tom is saying when he is saying the hard soft good retailer is more than discretionary spending which, you know, is not kind of a new spin we are creating in this environment to talk about our portfolio but is always how we talked about; the stuff we are trying to buy where you had the consumer who really needs or enjoys the service that they otherwise can't get easily or can't make that discretionary decision on. So electronics stores.

Things that are a little bit more difficult to imagine in this environment, how people maybe waiting -- if not waiting a bit taking a year to buy the new refrigerator, what have you. And those are the kind of retailers we've always tried to avoid significantly in the portfolio and that's what's giving us pretty good comfort at the moment.

I mean, -- I was talking through this the other day and I just pulled something out of my book here that I have where we kind of went through and I misspoke. It is about 15.5% typical hard and soft goods. And I have a little thing in here that we talk about which is who is doing great, who is doing okay and who is weak.

I will just run through them in the typical hard and soft goods I have as great, nobody. I have as okay, you know drug, craft and novelty. And then I really have as kind of weak general merchandise, apparel, books, consumer, grocery, anything home-released, home furnishings, office supply, sporting goods. And that's a small part of our portfolio.

Relative to kind of hard and soft goods with services who is doing great -- auto parts is actually doing very well. Who is doing okay, tire stores, pet stores, kind of the business services at the low end. The weaker, obviously, are restaurants, motor vehicle, travel plazas, video, home improvement.

And that's there's really nothing imminent I see there, but that's it. And then up in services I would say great -- financial services, the small position we have there, those guys are doing really well. Health and fitness continues to do really well. Okay in theaters. They are slightly up in box office this year. Childcare, auto service and collision. And then the only thing I've got weak in services is equipment rental. So that is kind of our laundry list.

Actually if I could drill in there for a second. Auto just generally across all the categories has been steadily declining across, I think nearly all categories the last few years. Is there anything specific driving that?

Then I noticed I think it was in the last quarter you guys entered into an area called distribution/office. I was just curious exactly what that was?

Yes I'll do the first one second, second one third and the fourth 1/8. First part is relative and I forgot all three parts of the question so (multiple speakers) distribution and office.

As we've done larger transactions occasionally they have had a distribution facility or two that went with it. And in almost all most cases, what we've done is gone out and reached out to somebody else to one their own distribution and office.

And we own a couple distribution facilities that were part of a couple transactions that we thought were very well located and that they had to have. And then I think we own one office building which is the office of a retail tenant that we did a larger transaction with, but it is a fairly small part of revenue.

And then, auto, Jeff, I think is driven by obviously new auto sales. It's obvious why people may be slowing down their purchases there. Secondly maybe a little bit less driving, to try to conserve on gas.

But most of the stuff we are involved in is the auto parts, auto service, auto collision repair. Things that essentially you have to do if you've got to get to and from your job. And they would prefer to put a few dollars in to keep the old car running rather than go buy a new one. So that is kind of where our focus has been.

Yes. Parts is doing very well and I would just have to guess if you looked at tire and you looked at service and you looked at collision and if miles driven in May was off 3.7% which I think is what the [NTSB] said then maybe -- and I don't know you could assume that they would see a little bit of softness on the top line. But those are pretty steady businesses. And the decline in autos obviously [have] been kind of a dealership business.

So it's not so much that you guys have been selling out of those as it is that you have just been growing else where and they've lost share in your portfolio.

Yes. Exactly.

And not to monopolize the call but if I could just ask a few questions about the air cap rate assumption 8 to 9 you throw out. Was that on single asset deals or both portfolios?

That's both portfolios. You know, as I said the one's transactions we've gone this year we've been watching. And we've watched them go from the mid 8s to the high 8s; and then we are actually having some people say, you know we could go into the low 9s but either through cap rate, but also underwriting they didn't get there. So my sense is they are creeping up there.

If you look at the individual one-off, you know it's really -- as I think I talked about last quarter if you got a good brand, small price point, $1 million, and you are in a good market, you can probably creep in around 7 today, up from the high 6s. But that is even migrating up from there. I think those are 60 day ago comps. And those are moving up into the mid 7s.

But when you get into the secondary markets, secondary brands, when your price point gets up around $2 million, $3 million, $4 million I think you are starting to see those cap rates move. Price point really has to do with financing but I just think the market is thinning out and there's less buyers.

And I guess can you just tell us then, I guess my last question, what metrics are you going to look for to know that we've hit a bottom and it is safe for you guys to start trading in to the market again for acquisitions? And I guess related to that is why 8 to 9? I guess what are you looking at to derive that?

I don't think for us to step back in it's 8 to 9. That's just where I've been seeing in the high 8s, and low 9s is the stuff that's coming through.

But there's kind of two things going on. If it's in the high 8s, the low 9s and I think it is going to decline -- which I do, because I think there's -- we lived in Escondido here. And you know where that is and it's one of the ground zeroes for what happened in the housing market.

And when housing started to decline here obviously what happened is transaction volume just went away as the sellers didn't want to sell at a lower price and the buyers were demanding a lower. And so you went through this period of six to eight months where all of a sudden inventory started going up pretty dramatically. And then very slowly people who had to sell started selling and you saw prices go down and then over the next six to eight months that just cascaded.

And we saw that, clearly, here in the housing market. I can draw a parallel kind of in the net lease business because I really think there are a lot of people out there, generically in the capital markets, who have balance sheets that are going to need to be refinanced. And they are going to need to be refinanced at substantially higher rates.

And there are some people who I don't think are going to be able to get the financing they want and real estate is one of their alternatives, but I also think they're all -- there's a lot of people that are -- really just don't believe what is going on or hoping it will get better and they are sitting around and not moving and waiting until they have to.

And so my sense is if that happens and it is an if, but I think a reasonable possibility toward the end of the year and into next year you just -- at that point cap rates will really move because the guys that can step in with a large amount of capital I think are more limited. And I think there will be a larger transactions harder to underwrite and I don't think there will be a lot of players. But I think cap rates will move.

If not, if I'm wrong on that, my sense is we retain the very high degree of liquidity in an interesting credit market and we missed a couple of quarters of acquisitions. And life won't end.

Thank you.

David Fick with Stifel Nicolaus.

First of all congratulations on the financings. Most of my questions have been asked. One general question following up on your assumption that you are going to see better deals or hope to see better deals as people don't have financing alternatives.

I don't want to imply that you are saying you are a financier of last resort, but you are taking corporate credit in a declining economy. And I'm just wondering how separate from the cap rate conversation, what other disciplines are you using in the credit committee to make these kinds of calls?

That's the $1 million question. It's a great question. I think the first thing is is, obviously, what we've been really eyeing is cash flow coverages during this as we talk to our tenants on our own portfolio to gauge how quickly they are moving.

And while our number that I quote every quarter -- which is the top that's seen as the looking backward number -- what we've tried to do lately as we are doing underwriting maybe in the past we would have said, at this point in the year show me your '07 numbers, show me your '06 numbers and see if you can get me an update.

To underwrite that we are now saying, "Show me your last 12 months trailing and quite frankly I don't really care about unless there's big seasonal adjustments, the six months on the back end of that. I want to see your last eight weeks and what you're hearing from your stores."

I think we are really tightening up the numbers we are trying to use for cash flow coverages and then, if we were looking for a 2.5 in the past I would say we would be looking for a 2.75 and a 3 today. Because as always it's margin of safety.

And then it would be really trying to focus in on the real estate side of the risk and not get too far away from replacement costs. And they would just be mindful of their industry. You know if we're not doing any restaurant, but an example might be, if we were doing upper end restaurants and you looked at their trailing 12 months and the numbers looked just fantastic -- which some of them do -- I think if you look at the last six to eight weeks in their numbers, you would be looking at really declining and I would say that you may see see a decline quite a bit more.

So industry specifically I think we just, we would be careful. So in this we are going to have to have a higher cash flow coverage. We don't want to get away too far from replacement costs. And then we just want to think through carefully where they're going, but at this point not finding anything, we haven't had to do that.

You know, David, I would add to that on the credit analysis piece of it just as we mentioned that people needing to refinance things coming due on the liability side of their balance sheet, might be a driver for us of opportunities to invest. As a financier or choice for them that might the one of the last remaining choices for them.

Similar to that as we are looking at the balance sheets and underwriting the credit of these retailers, we are looking out over the next handful of years to see what other refinancing is going to happen in there. Because as there will be in corporate America in general, there's going to be a whole refinancing issue that is going to happen that is really going to strip a lot of earnings power out of a lot of balance sheets. And that's true for all of us, if you will, relative to how much low-priced debt is sitting in those balance sheets.

I assume you guys do the same kind of work yourselves as you are looking at the REIT. So that part of earn outs is kind of a new and interesting one as well. You know if you are looking at a retailer today, we actually kind of look at that 2010, 2011 maturity that is sitting there at 5.5%. We know it is not going to be 5.5% when it gets refinanced.

So we do a little rejiggering pro forma work. Just to kind of understand earnings we've got 20-year investments here. So it is something we take kind of a longer-term approach to.

Okay. We look forward to hearing more about Buffets' next quarter. Thanks.

[Eric Rothman]. (inaudible) Securities.

I was curious, given that most of your leases are tied to the (inaudible) and given the dramatic increase in the CPI over the last several quarters, why has your same-store rent not followed a similar trajectory? Basically where it has been forever. Should we expect to see higher same store NOI growth or same store rent growth -- excuse me, given dramatically higher CPI?

You know, I think down the line maybe a little bit -- I will back up in this and kind of give a history of leases. You go back years and years and years ago I mean late -- let me start with the '70s quickly.

Is basically you had a base rent and a percentage of sales and then you had a ton of inflation and the percentage of sales went through the roof. I can remember a couple of Taco Bells we had and you ended up with 100%.

The rent (inaudible) what you originally bought the thing for and the retailers all woke up and said, "Wait a minute, I want to put that breakpoint really high." And the leases written for the next five years had a percentage sales or something in them and they went flat.

So what happened is people started doing 1% to 2% increases but normally they even did it, 8 to 10% increases every five years. What we've always done is put in there the rent will go up but a couple of times CPI not to exceed 10 every five.

And we did that for a lot of years and then about three, four years ago we went to a thing that said it will go up at two times CPI not to exceed 2% every year.

So we are starting to see more annual increases in the portfolio so same store rent, I think, will rise a bit maybe the balance of this year but in the next year and the year after. But I don't think it's just going to be CPI because we did not have unrestricted CPI. We just have a CPI calculation in how we do the -- getting to the 2%.

Thank you very much. That's very helpful.

Philip Martin with Cantor Fitzgerald.

Just a couple of quick questions. First of all, to what extent are you having discussions with your tenants and then probably the stronger tenants in the portfolio on strategizing over the next 12 to 18 months, as an increasing number, hopefully, of opportunities come up? Are tenants coming to you wanting to talk about that strategy? Are you going to them or is there no discussion taking place?

That's a great question. You would think we would be out talking to everybody and they would be actively talking to us about how they are going to handle those. But I still am amazed at I think generically the people in denial about the credit situation we're in I think most people are saying, "Oh my gosh, look at this, when will it get back to the way it was?"

And we really view it, obviously there has been an end to an era here and credit is not going to be democratized as it has been in the past. There is likely to be have and have-nots. And generically without securitization out there and with people being more mindful that rates are likely to be higher, but I don't think most people out there are really seeing it that way.

I note talking to other REITs, a lot of REITs see the world that way, a few don't, but that's a function I think of REITs being companies that are very active in the capital markets. And if you have companies that aren't in it all the time, they are still either -- I think most people are somewhat aware but in denial. So there's not as many of those high level discussions going on as you think there might be and that would be rational to be had.

Lastly and I know you've touched upon it in some of the answers and your upfront comments, but are you seeing a higher percentage of late [pays] in the portfolio?

We are not seen a higher percentage of late pays in the portfolio.

Okay. Thank you.

Samit Harik with Banc of America Securities.

I'm here with Dustin Pizzo as well. Tom, even though you have close to $400 million of liquidity between cash and the line, how are you thinking about the equity market as a source of funding here, given the sub 8% (inaudible) implied cap rate at which your stock is trading. And the 9 to 9.5% cap rates you are targeting and on acquisitions especially as opportunities increase over the next few quarters?

Yes, for the moment we are not thinking of doing anything. I think, relative to the price of the stock, you want a decent price, but we really focus in and we will continue to focus in on getting an adequate spread of whatever capital that we issue because it increases our earnings.

So if you're sitting out there and you're equity cost you 8 on a nominal basis which is taking a forward FFO yield and divide it by the inverse of the cost to raise the capital; and you take that and if you can get 130, 140, 150 basis points above that, relative to yield, then it is going to be accretive to earnings to the parties involved.

We are less oriented to an [NAAV] discussion but we are mindful of equity shareholders and that we don't want to get anywhere near earnings dilutions. And that is why we focus on spread and also try to the mindful at what point people have entered the stock past in offerings.

Thanks.

[David Wiggington] with Merrill Lynch.

Just have a quick question, I think you typically don't lease to individual franchisee property. Just curious if you have seen a difference in the performance, say, of the franchisee portfolios that you lease to versus say some of the larger regional and national chains?

You know, if we ran something, we might even say at this point franchisees are doing better. But that is only because the franchisee we have in here have 600 or 800 or 1,000 units and are very big. And those few that we have are generally doing pretty well.

It was interesting that I was in a major restaurant chain the other night that is not in our portfolio. And in there is a guy I know who opens new stores for them and sees their numbers and they both have corporates and franchise. And it was interesting to note from his perspective, he had just been to a meeting and franchised stores were substantially outperforming the corporate. And I thought it was really interesting and he said that he heard that in a couple other chains. And he felt it was a function of a fair amount of management change and stress put on the corporate side to move people around to get performance versus a franchisee that had stable management.

And that is anecdotal in nature, but within our portfolio I don't think there is really much of a differential because we don't have much in franchise. But it was an interesting comment from this guy.

Thank you very much.

At this time we have no further questions. Mr. Lewis, please continue with any closing remarks.

All right. Thank you very much, everybody. I appreciate the participation and I know it is a busy season and it's an interesting world and we look forward to talking to you in the future. Take care.

Thank you, ladies and gentlemen. This concludes the Realty Income second quarter 2008 earnings conference call. We thank you for your participation and you may now disconnect.