Realty Income Corp (O) 2011 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen. Welcome to the Realty Income Third Quarter 2011 Earnings Conference Call. (Operator Instructions)

I would now like to turn the Conference over to Mr. Tom Lewis.

Thank you, Joe. Good afternoon, everyone, and welcome to our Conference Call, where we'll go through the operations and results for the third quarter and year-to-date.

With me in the room today, as usual, is Gary Malino, our President; Paul Meurer, our EVP and CFO; John Case, our EVP and Chief Investment Officer; and Mike Pfeiffer, our EVP and General Counsel.

As always, during this call, we will make certain statements that may be considered to be forward-looking statements under Federal Securities law. And the Company's actual future results may differ significantly from the matters discussed in any forward-looking statements. We will disclose in greater detail in the Company's Form 10-Q the factors that could cause the differences.

And per usual, Mr. Meurer will start with a review of the numbers.

Thanks, Tom.

As usual, let me go through the financial statement briefly and provide a few highlights of the financial results for the quarter, starting with the income statement.

Total revenue increased 23.6% to $107.3 million this quarter, versus $86.8 million during the third quarter of last year. This obviously reflected the significant amount of new acquisitions over the past year, but also positive change through our rent increases for the quarterly period of 1.8%.

On the expense side -- depreciation and amortization expense increased by $7.9 million in the comparative quarter. [Hence,] depreciation expense increases, obviously, as our property portfolio continues to grow.

Interest expense increased by just over $3.4 million. This increase was due primarily to the June issuance of $150 million of notes and the reopening of our 2035 bonds, but also because of a $96.6 million credit facility balance at quarter end. On a related note, our coverage ratios both remain strong. Interest coverage is now at 3.5 times, and fixed charge coverage now at 2.9 times.

General and administrative, or G&A, expenses in the third quarter were $7.1 million, representing 6.7% of total revenues; as compared to $6.2 million during the third quarter of last year, which represented 7.1% of total revenues at that time.

Our G&A expense has increased a bit, as our acquisition activity has increased and we have invested in some new personnel for future growth. This quarter's G&A was also impacted by the expensing of $233,000 worth of acquisition due diligence costs. Our current projection for G&A for 2011 is approximately $30 million, which will represent only about 7% of total revenues.

Property expenses decreased to just under $1.7 million 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. Our current estimate for all of 2011 is about $7.5 million. Income taxes consist of income taxes paid to various states by the Company, and they were $357,000 during the quarter.

Income from discontinued operations for the quarter totaled just over $3.1 million. This income was associated with our property sales activity during the quarter. Our Crest subsidiary did not acquire or sell any properties in the quarter. We did sell 12 properties from our core portfolio, resulting in a gain on sales of $3.1 million. And a reminder that these property sales gains are not included in our FFO or in our AFFO calculations.

Preferred stock cash dividends remained at $6.1 million, and net income available to common stockholders increased to approximately $34.7 million for the quarter. Funds from operations, or FFO, increased 32.6% to $63.4 million for the quarter. FFO per share increased 8.7% to $0.50 for the quarter.

Adjusted funds from operations, or AFFO, or the actual cash we have available for distribution as dividends, was higher, at $0.51 per share for the quarter. And our AFFO is usually higher than our FFO because our capital expenditures are fairly low, and we have minimal straight-line rent in the portfolio.

We increased our cash [multi] dividend again this quarter. We've increased the dividend 56 consecutive quarters, and 63 times overall, since we went public over 17 years ago this month. Our dividend payout ratio for the quarter was 87% of our FFO and 85% of our AFFO.

Briefly turning to the balance sheet -- we have continued to maintain a conservative and safe capital structure. In September, as you know, we raised just over $200 million of new capital in a common stock offering. Our current debt total market capitalization is only 28%, and our preferred stock outstanding represents just 5% of our capital structure. And as I mentioned, we have $96.6 million of borrowings on our $425 million credit facility.

We have no debt maturities until 2013. And so, in summary, we currently have excellent liquidity, and our overall balance sheet remains very healthy and safe.

Let me turn the call now back to Tom, who will give you a little bit more background on these results.

Thanks, Paul.

I'll start with the portfolio, which performed very well during the third quarter. Operations continued to improve across the portfolio.

At the end of the quarter, our largest 15 tenants accounted for 51.2% of our revenue. That's down a little bit from last quarter. And the average cash flow coverage at the store level for those 15 tenants remains fairly high, at 2.41 times during the quarter.

We ended the third quarter at 97.7% occupancy, and 59 properties available for lease out of the -- this is unusual, very even number -- number of properties -- 2,600 properties. And that's up about 40 balance sheet in occupancy from the second quarter and up about 130 basis points for the same period a year ago.

In the quarter, we had only six new vacancies, and then we leased or sold 15 properties, and obviously added to the portfolio. And that's the reason for the increase in the occupancy. But obviously very healthy, at 97.7%.

My sense is we should look for some moderation in occupancy in the fourth quarter. And that's primarily due to a number of lease rollovers that occurred at the beginning of the quarter. There were 18 that came off lease. And sometimes lease rollovers get a bit lumpy, and that was the case this quarter. And then the 15 Friendly's properties we got back -- our best estimate right now is about 97% for occupancy at the end of the fourth quarter. And then we'd anticipate, as we release those properties that came off the rollover and Friendly's, that that would go back up in the first quarter of next year. But a good guess is 97%.

Same-store rents on the core portfolio increased 1.8% during the third quarter -- that's same as the second quarter -- and 1.1% year-to-date. That's a very healthy number for us in net lease company. And if you wanted to look across the portfolio at kind of where the increases and decreases came from -- we had only four industries that had declining same-store rents during the quarter. That was office supplies, childcare, auto service and bookstores. But it was a very small decline of only about $50,000.

Two of the industries were flat, and then 23 had same-store rent increases, with the majority coming from motion picture theaters and convenience stores, and then, to kind of my surprise, casual dining restaurants and motor vehicle dealerships. But both of those as a function of -- during the recession, we had some rent reductions we did for those tenants, and those burned off. Their business has come back very nicely, and that's the reason that happened this quarter -- even though I think their fundamentals may not be representative -- that we did see the rent go up.

The balance of the industries had fairly small increases during the quarter. But the 23 industries together had increases of about $1.45 million, for a net gain of $1.4 million. And obviously, the occupancy gains and same-store rent increases over the last four quarters has been very healthy, and it continued in the third quarter.

Relative to diversification -- obviously, up to 2,600 properties at the end of the quarter. That's up 77 properties from last quarter, 38 different industries, 134 multiple-unit tenants in 49 states.

From an industry exposure standpoint, we continue to diversify with 38 industries. That's up six from the same period a year ago. And our major concentrations -- the top couple came down a bit. Convenience stores were 18.3% -- that's down about 70 basis points from last quarter. And then restaurants a little less than last quarter also, at 17.3%.

Theaters were up a bit -- 140 basis points, to 9.2% -- and that's a function of some recent acquisitions -- and then health and fitness, which is 6.1%. Then, the only other categories that are over 5% today is beverages at 5.6%, automotive tire stores, which have been, along with convenience stores, both at 5.2%. And those were much larger concentrations going back quite a ways. So pretty good shape by industry.

The largest tenant switch this quarter -- to AMC Theaters, at 5.4% -- and again, that's a function of some acquisitions -- Diageo second, at 5%, and then everything else is under 5%. I mentioned our 15 largest tenants are 52% of rent. When you get to the 15th largest tenant, as you can see in the release, it's about 2.2% and goes down from there. And when you get to the 20th largest tenant, you're at only about 1.1% of rent. So we continue to diversify the portfolio.

That's also true from a geographic standpoint, still in 49 states -- everywhere but Hawaii. Average remaining lease length in the portfolio, at 11.1 years, remains pretty healthy. So obviously, a good quarter for the portfolio.

As we look forward kind of into next year, we think expectations for economic growth notwithstanding -- higher-than-expected GDP numbers today -- have moderated over the last couple of quarters. And I think that will lead us to be a little more cautious about the portfolio going into 2012.

And if we look across the retail landscape, I think most of us have observed that the high end in retail is holding up well. We don't have a lot of [bath]. At the low end, it is tough in retail, but the dollar stores and the value retailers, club stores, seem to be doing pretty well serving that market.

And as we look out there, and in areas that might highlight some concern, I think it's really in the consumer discretionary area to the middle and lower class. And you can see their businesses being stretched a bit -- some of it margin compression as their costs go up. But if you look into areas like casual dining, consumer electronics, office supplies -- we think those are all worth watching.

Fortunately, most of our portfolio is in the basic needs type of businesses, with the tire stores, auto service, C-stores, that type of things, which are doing pretty well. But looking at the portfolio -- absent Friendly's, nothing has popped up that gives us concern from a tenant standpoint. But we adjusted our expectations a bit for the portfolio. And in the guidance for 2012 is our expected impact from the Friendly's filing.

As well, we also added into the estimate an expectation of additional filings of tenants equal to about 5% of revenue, with what has been our normal recovery rates over time. And while we don't know who it would be, we just think in an environment that's a little tough in retail, it was good for us to do that in our guidance.

We also in the guidance assume that none of the properties that come back from Friendly's or any other tenants would be leased during 2012. So I think that we've been conservative in our estimates relative to the portfolio.

[Pat] notwithstanding, we still think that our occupancy will remain very high in 2012, in the 97% range. And we'll have to see how that works out. But overall, we think we'll have high occupancy.

Moving on to property acquisitions -- obviously, a very strong quarter and year for acquisition. And I'll let John Case, our Chief Investment Officer, comment on kind of what we bought and what the environment is.

Thanks, Tom.

Our acquisitions activity continued to be robust in the third quarter. We acquired 89 properties for approximately $462 million, making the third quarter our second most active quarter for acquisitions in our company's history. The average initial lease yield on these investments was just a shade over 8.1%, and the average lease term was approximately 10 years.

Properties are diversified by geography, tenant, industry and property type. They're located in 15 states, are 100% leased to nine tenants in seven different industries, and represent three property types, with our traditional retail investments accounting for just over 88% of third quarter acquisitions volume.

The industries are automotive collision services, food processing, health and fitness, quick-service restaurants, theaters, transportation services and wholesale clubs. Of the $462 million that we acquired in the third quarter, $189 million was part of the $544 million diversified net lease portfolio acquisition we announced in the first quarter. As of third quarter end, we had closed $525 million of the $544 million acquisition during the first, second and third quarters. The final $19 million of this portfolio should close this quarter.

So for the first three quarters of 2011, then, we have acquired 125 properties for $826 million, with an average initial lease yield of approximately 8% and an average lease term of about 11 and a half years. The properties are leased to 20 commercial tenants in 15 different industry segments.

The $826 million in acquisitions we have completed in the first three quarters, the most we have completed in any previous full calendar year. For the entire year, we expect to complete just over $850 million in acquisitions at an average initial yield of about 8%. So we continue to be pleased with our acquisitions activity.

As we look forward, acquisitions transaction flow remains strong. With the high yield in CMBS markets cooling off since midyear, property owners continue to turn to the sale-leaseback market for liquidity. There continues to be significant competition for property portfolios from multiple sources with a good bit of capital. But we should continue to be competitive in the marketplace.

We are currently seeing opportunities in all of our property types and in a wide variety of industries and tenants. The majority of our current acquisition opportunities are in our traditional retail properties. Initial yields or cap rates seem to be holding steady for now, ranging from the mid-7% area for high-credit tenants to up to the low 9% range for some of the smaller noninvestment-grade tenant properties. We continue to believe that our initial yield on future acquisitions should average right around 8%.

Tom?

Thanks, John. I'd like the higher-credit tenants at 9%. Can you arrange that for us?

Yes, I'll do my best.

Okay.

As John mentioned, the pace of transactions [to] look at has been very good, and obviously we've gotten our fair share over the last 18 months or so. And that's led to a couple of years here of record acquisitions. But I'd also want to note that that level has been very heavily impacted by a few large transactions.

If you recall, Diageo -- we've done over $300 million. The ECM portfolio earlier in the year is $544 million, and then there were several others that equated to about $0.5 billion. And those transactions account pretty much for the majority of the acquisitions that we've done this year and last year. And so I just want to caution -- to extrapolate that out and assume the same thing happens in 2012 might be an aggressive assumption.

And we've said for many years, kind of being out there in the business, you do $25 million, $35 million a quarter by being in the business. And if you do a run rate, that works out to $100 million to $200 million a year. And then it's really a function of whether we grab zero, one, two, three, or a couple larger transactions. And while lately we've obviously gotten a bunch of them, each year it kind of unfolds. But the last two years, we've got, I think, more than our fair share.

So for our planning purposes and our guidance for acquisitions for next year, were assuming $350 million of acquisitions as what we're using in guidance, at an 8% cap rate. And obviously, it could be more. But that's, I think, a good number to start with, and we'll adjust as 2012 develops. But the transaction flow remains very robust currently.

As for the balance sheet and access to capital -- as Paul mentioned, we're in fairly good shape on that. We have only $96 million sitting on the $425 million line. So the vast majority of the acquisitions we've made this year have been permanently financed at fairly attractive rates. And with the balance sheet in great shape, with good metrics, that leaves us plenty of dry powder to execute on any acquisitions that come up.

Let me go back to guidance and kind of walk through that. Obviously, with acquisitions being strong and occupancy and same-store rent up, that's been very healthy for our FFO and AFFO numbers. And we think that'll continue to be the case the balance of this year and moving into next year.

We did a release a couple of weeks ago where we updated guidance and initiated -- for 2011 and initiated 2012. For this year, we are estimating FFO of $1.97 to $1.98, at [7.7%] to [8.2%] FFO growth, and then AFFO of 2.01% to 2.02%. And that's 8.1% to 8.6% AFFO growth.

And as usual, our AFFO -- Paul mentioned this, but I really want to highlight it -- is higher than our FFO. And lately that's been widening a bit, which is a function of a number of the acquisitions that we made this year who are on existing properties with existing leases. So we had to do a FAS 141 adjustment. And in net lease, generally that means that your reported cap rate will end up being slightly below the actual cash you receive on the leases. And that really is going to widen the gap again between FFO and AFFO, with AFFO being higher. We obviously paid dividends from cash, so the AFFO number will continue to be our primary focus.

For 2012 -- right now, you can see the estimate -- FFO is 2.07% to 2.11% -- that's about 4.5% to 7% FFO growth -- and AFFO of 2.11% to 2.16%, also about 4.5% to 7.5%. And with this growth rate, the dividend payout ratio is falling down into the kind of 85%, 86%, 87% rate. And were we to achieve the guidance, that would continue next year and really accelerate that. And generally, we want to keep our payout ratio in the 85% to 90% range. So we are optimistic about additional growth in the dividend and the amount to the growth looking into 2012. We think it could be a good time for dividend increases.

I'll take a second, since we just came out with 2012, to kind of walk through again the assumptions that are embedded in the 2012 guidance. As I mentioned, acquisitions of $350 million at an 8% cap rate. That's less than half this year and last year. But as I said, these were exceptional years driven by some large transactions. So we think it's prudent to keep expectations moderated for now.

Capital will depend on the timing of the acquisitions. Estimated property sales we've put in at $25 million. We have interest rates moving up modestly throughout the year, but still very low, so not a huge impact. We're putting occupancy kind of in the 96%, 97% range. And that is really where we're reflecting the Friendly's, plus any additional unidentified tenant issues that can come up. And again, we've built into the guidance the assumptions for Friendly's outcome as well as [these] 5%, and also the fact that we're just assuming conservatively that it takes through 2012 to lease any of them, which is a conservative assumption.

Same-store rent we modeled at about 1.5% growth, which would be pretty good; free cash flow at $50 million, and, as I mentioned, AFFO $0.04 to $0.05 above FFO. And that's what gets us to the 4.5% to 7.5% FFO and AFFO growth rates.

To the extent that tenant issues do not materialize -- that obviously would be great -- our acquisitions are ahead of $350 million -- that also would be very good -- I think we would probably take the opportunity to do some pairing to the portfolio and sell some properties, and move out maybe some of the tenants or properties that we think might have more exposure from an economic and interest rate standpoint going forward. That would likely burn off a little bit of FFO during the year. But really above a 4.5% to 7.5% rate, that would probably be prudent, and something we'd like to do in the next few years. So we think the assumptions we've made are pretty good assumptions.

Really, to summarize then -- obviously continued stability in the portfolio and a good quarter relative to occupancy and same-store rent increases. We remain very active in acquisitions, with good FFO and AFFO growth this year, and I think pointing into next year, which once again makes us somewhat optimistic [for] dividend growth.

With that, we will open it up for questions. So Joe, if you want to come back and remind everybody how to do that again, I'd appreciate it.

(Operator Instructions) Lindsay Schroll.

Tom, I know that you mentioned casual dining rents were up. But I was just wondering if you can discuss a little more the fundamentals of that segment, and if there are any other tenants that are kind of on your watch list in that segment.

Yes. If you look at casual dining -- they're a very good example. I was looking at some numbers yesterday relative to food prices this year that have been moving up pretty aggressively. And if you look at the grocers -- they've been able to pass a lot of that on, I think, with about 6% increases in food prices at grocery stores.

But if you look at restaurants, they haven't been able to pass it on. And consumers have been pretty tight with their wallets while [up to] the restaurants. So you're seeing their costs move up, and they're not able to pass it on. And I think it's really starting to wear on their margin. And so that's one area that's kind of up front for us. And I think other areas in consumer discretion that are impacted by commodity costs are similar.

The other ones -- and I also mentioned this -- if you just look at kind of the big box that tends to be discretionary purchase -- we look at them, and you continue to see the growth of Internet retailing. And that's kind of front-and-center right now as we move into the holidays. And we think their business could be a little weak.

But it's primarily consumer discretionary middle class, lower class. And I'd shine the light on restaurants. Normally, fast food does very well in a downturn. But I think even they're having trouble kind of passing at all along.

Okay.

Then, just turning to acquisitions -- what do you think, in the macro environment, can change that would potentially shut down some of the opportunities you're seeing, or decrease the flow?

I think it'd take a pretty good drop in the economy on one side. But John mentioned that the high-yield market -- while it's had a little bit of a resurgence in the last week or so -- has been weak, but still breathing. And CMBS has been very weak.

And a lot of times -- Paul's used the term, we like those markets breathing but not too robust.

Right.

Because it helps transactions to happen, and yet it makes our type of financing very attractive. And even though they've been very weak, we've found that people have really started turning to net lease. So if those markets came back very strong, it'd be a mixed bag. I think we'd see a lot more transaction activity out there, but the debt markets would be much more competitive. So that's one thing to watch. Or if we just get a big double dip, and the economy slows down.

But it's a fairly active environment for people viewing their real estate as a source of capital today. Very active.

Great. Thank you.

Joshua Barber.

Tom, Paul, John -- would you be able to comment a little bit further? In your press release a couple weeks ago -- and you alluded to it again today about the 5% of rents that you were looking at -- can you just talk about what sectors you've seen get the worst over the last six to nine months, and which ones would also have the tightest rent coverage today?

Yes. I think the tightest rent coverage -- you come back to casual dining and kind of the restaurant sector overall. And again, as I just said, that's where the margin compression is going on. So that's kind of front-and-center as we look at it

And as we put that in there, we have a couple decent-sized exposures. But then it really gets into a lot of little ones. And so that wasn't meant to be somebody at 5% -- it could be one at 5%, two at 2.5%. And we just thought it was time to be a little more conservative in that area.

But restaurants are kind of front-and-center. But when you get out of basic human needs, kind of the C-stores and the rest of it -- I think their business is weakening a little bit. And I was [boid] by seeing some higher GDP numbers, but I'm not sure if I really believe them. We'll see how they get revised.

Following on that -- would you say that most of the bankruptcies that we've seen year-to-date in casual dining have actually been okay for the landlords so far, or is that trend starting to worsen a little bit?

What two are you referring to?

Well, the Mexican dining with Boston Market -- not necessarily in the Realty Income.

Oh, yes, yes. Yes, there was Real Mex.

Real Mex.

Yes. Since that's, I think, El Torito, Acapulco, we didn't pay that much attention to it. But the kind of larger buildings like that would hurt a bit.

It's been a pretty good year. As we've said throughout the year, it was pretty quiet out there. But I think in the restaurant industry in particular, you can see some more. But so far, it's been pretty good for the landlords, and continued for us.

We keep a running toll of bankruptcies. And if you look at the fourth quarter, I've only got four on my list, and I've got five in the third quarter. And before that, there'd be eight or 10 or 12 in retail. So it's been a fairly short list. So not a lot to work with recently. We think we'll work out pretty well in the one we're working on. And generally, if you didn't overpay too much, it shouldn't be that bad.

But I don't want to ring a bell that everything's getting negative. It's just it's really been eerily quiet for about a year here in the portfolio. And it was nice to see the economy come back a bit, but it's not really running forward hard. And with some commodity price increases, we just are kind of saying somebody's got to be impacted by this if they're not able to pass through to the consumer, ultimately, those costs.

Well, I guess the fourth quarter's still young.

It's still young.

Thanks very much.

Michael Bilerman.

It's Greg Schweitzer here with Michael.

Tom, as you continue diversifying and increasing industry exposure to new areas, apart from some key new hires, is there anything new you are doing or investing in internally to better manage or handle the increase and improve core competency there?

Yes. We've hired people in research, and then we have hired people that have a background in those areas. And we continue to work very hard on all of that. And a lot of it is just expanding the corporate underwriting we've done for many years in retail. And fortunately, our people are credit people, bank-trained, and able to move outside of retail pretty good.

The other area that we will [have] down the road is portfolio management. But that's something that really comes later. We have 28 people in that department, which is up substantially in the last seven, eight years dealing with retail. So we'd anticipate, if you look four or five years down the road, we'll have to widen it there. But it's really three, four people in acquisitions who have some background in that, and then a couple of people in research.

Okay.

And anything new you could discuss related to the impact from Friendly's and the process going on there?

Really not that much. I think just for anybody -- I think most people are aware that Friendly's filed a couple of weeks ago. And we have 121 properties that are about 3.6% of rent. We bought, starting 10 years ago, 138, 140 of those units. We sold off a number of them, which got us down to the 121 today. They filed, rejected 15 properties, which equate to about $1.3 million of rent, which we will now have available to us, to go back and release.

But as is normal in these processes, I think this is the 24th filing we've had, since going public, of this type. And we've had fairly strong retention rates of rent, up in the 80%. And generally, we feel pretty good about these processes; we've done a lot of them. But now we have to just wait and let it work.

There are kind of two issues that go on. One is obviously, as we work through this process, there's some negotiation that goes on. So talking about what we would perceive as eventual outcome is not probably the best strategy there. And then we found it very useful to try and stay very involved in the process.

And our general counsel is co-chair of the Creditors Committee. And obviously that requires nondisclosure agreements as it goes through the process in the Court of Delaware. But as the court decides anything, that can be seen publicly. And then, over the next few quarters, as this works out, we'll fully report it. But we feel pretty good about the properties we own relative to their profitability about what we paid. And we are -- [expectation is] we'll do pretty well. And we did build that into the disclosure as well as some assumption that there'd be other ones next year.

Thank you.

Tayo Okusanya.

I have a quick question. If we're to come up with -- if 2012 ends up being a utopian world, where you don't see a lot of retail bankruptcies, and you were pick out this 5% of rent that you kind of put at risk in your 2012 guidance, by how much would guidance go up?

I think it'd probably go back up to where everybody pretty much has it before we first guided, which [is] lower. But as I said earlier, Tayo, as one analyst I know who has talked about capital recycling a lot, which is you, I think that's something that's coming up. And the level and the amount of capital recycling we can do, which I think does burn off some FFO -- if things are better and there isn't as much tenant activity, and if acquisitions are a little higher, I think we'd take the opportunity to do that, and then hopefully stay about where we are today.

So I think that's -- I could say it's slower, but that was the message we're trying to give.

So basically, [if] things were better on the retail side, you may take it as an opportunity to go direct to see more assets. So (inaudible) dilutions, net-net, you would still kind of -- you would kind of end up where you are?

That would be our expectation.

That's helpful. Appreciate it.

Thanks, Tayo.

R.J. Milligan.

Question for you on the $350 million for next year in terms of acquisitions, at least as a ballpark or the way to think about it -- how much of that, do you think, is going to be nonretail? Or can you tell us how you think about that?

John, you want to comment, relative to transaction flow, and what you're seeing?

Yes. I'll tell you sort of what we're currently seeing right now is predominantly retail. We are seeing a few investment-grade distribution centers. But we would expect -- I would think, based on what we're seeing now -- 80% of our acquisitions next year to be retail-oriented acquisitions in our traditional industries and property types. But that can change with one large, significant portfolio.

Yes.

(Inaudible).

Yes, if you look at this year, it's kind of interesting -- 55% of what we've acquired to date is retail, 21% distribution, 17% office, 6% manufacturing and 1% to 2% industrial. But the vast majority of that came through that one transaction with ECM.

And it's interesting to us over the last quarter or two. We thought we'd see a moderation in the number of traditional retail transactions come up, and they're actually accelerating a bit. So if we had to take just transaction flow right now and look forward, it'd be heavily retail with a smattering of some investment-grade in other areas. But as John said, one transaction can change that.

Is there a specific nonretail property type that's more attractive to you? Or is it just the credit quality?

It's very much credit quality when we move outside of retail. Because in retail, you can have the four-wall EBITDA cash flow coverage, which can give you a lot of protection, even when working with some weaker tenants. And when you get outside of retail, you can get it occasionally, but it's a little harder to tie down. So we think it's absolutely necessary to go up the curve.

And then, kind of our greatest comfort level to date relative to the other areas is in distribution. We've done -- with the Deagio, there's a fair amount of the agriculture that you see in there -- that 4.6% is pretty much all Deagio. That's very comfortable. That's the function of where it is and who the tenant is.

So I'd say tenant first, and going up the credit curve to investment-grade when we get outside of retail, and that's our intension. And distribution most comfortable out of that group, and probably manufacturing industrial after that -- probably office last.

Thank you, guys.

Todd [Zokostic].

Just a question -- is the plan still to get up to sort of 20% to 30% of the portfolio in nonretail over the medium term?

Yes. For us, that's a ballpark, four- to five-year feeling. And it's one of those things where once you're -- we're always asked what the objective -- and so 20% is a good initial number, when we're off to a good start. But it is so underwriting-specific that the number could freeze where it is if we weren't able to pull good investment-grade stuff in. But if we're able to pull investment-grade in, then higher would be okay, too.

Because there is a strong desire to do two things right now. One is, when working within retail, to have even higher cash flow coverages up above 2.5% -- where I think over the last years it's been in the 2.3% to 2.5% -- or go up the credit curve. And that's really a function of looking forward and understanding in the last 20 years that a lot of these less-than-investment-grade retailers had the wind at their back, as you were in a declining interest rate environment. And if you look forward, we're fairly close to 0% to date, interest rates.

And so the expectation that you might have higher interest rates in the future -- we're kind of undertaking a big project to look at the impact for all of our tenants if they had to refinance their balance sheets over a five- to 10-year period at 300 basis points higher in permanent financing costs and 600 basis points higher.

So to the extent that we're working in retail, we'd like higher coverages. And to the extent we can, we'd like to go up the credit curve, whether it's in or out of retail.

Okay. And as you get some of those higher-credit tenants in the portfolio, does that change your outlook on your use of leverage at all?

At the moment, not right now. I think we're okay to use leverage right now. We've been reducing it a bit, as you've seen debt fall from about 35% down to 27%, 28%. But we're more focused on the maturities of that. If you start, again, worrying about interest rates over five to 10 years, you look at your maturity schedule. So we're fine adding debt like we did earlier in the year, where we opened up $150 million of our 2035s. So we're comfortable with more leverage, a little bit more leverage. But if we're going to do it, we'd like the duration to be fairly lengthy, but don't want it to get too high.

Okay.

So in terms of sort of an average leverage that we could look at historically, it probably wouldn't increase much, even though you'll have higher-credit tenants on the roster?

Yes, we put -- the Board put a policy in in 1994, when we went public, 17 years ago, that we didn't want leverage debt over 35%, kind of gross assets market cap. And we didn't want preferred over 10, and we've stayed inside of that. And that hasn't changed.

Thanks. And Paul, we're looking forward to seeing you in Chicago in a couple of weeks -- the management behind the [mote capris].

Thank you. See you then.

Take care.

Richard Moore.

Following up on that for a second -- knowing how much you guys hate debt, should we think in terms of you guys clearing the acquisition line here, given that the market was up gigantic today -- it keeps going like this -- I mean, the clearing with common equity at some point? Or do you have to wait till it gets maybe [half full], something like that?

Yes. Generally, we'd like it to get up $150-plus million before we do something. And we just did a fair amount of equity. We've done kind of poor in the last year, at just under $1 billion. And while the prices were very good, and they a were very accretive transaction relative to the impact to cash flow, we're not in a hurry to rush into one right now. And so we'd like to do some additional acquisitions, build the line a bit; and then watch where things go. We took the opportunity this year to add to the equity base substantially.

Okay, thanks.

Then, I want to go back for a second to your comments, Tom, about getting rid of stuff if times get better. And it sounds like you'd look at different segments of what you have, maybe consumer discretionary or casual dining. As a whole group, [is it] something you might get rid of, maybe do a portfolio transaction that's a couple hundred properties? Is that how we should think about that?

My sense is, in this business, when you have a large portfolio and you're trying to put it out, and at the best price, you do that better on a one-off basis [as if] you go along one at a time. That was our experience we learned from Crest when we bought 30, 40 at a time, and put them out one at a time. And that's how we would probably want to do it.

But we've got, out of the tenant base, maybe 70 tenants of decent size. And we're going through and parsing them very carefully, given a lot of metrics, and refinance the balance sheet, and how we feel about the industry and our position with them, and how much debt, when it comes due -- a wide variety of metrics -- and then rating from top to bottom.

And if you put them into kind of four quartiles and looked at the bottom quartile, you'd say -- gee, wouldn't it be lovely if five to 10 years from now those weren't in the portfolio? And then you have to look at your growth rate, and making sure you deliver for the investors while you're doing it. And to the extent that acquisitions are good, the portfolio performs, you can do that at accelerated rate -- and that if it doesn't, maybe at a little slower rate.

So I think it'll be just picking out, really, a group of tenants in the lower quartile. And then there's a separate project we have to take all 2,600 properties and put a rating on them for the market they're in, for what we paid, for what the cash flow coverages are, how much we have less than lease. And when you marry those two together, ultimately it'll become a mix of tenant and property.

But over the coming years, we'd like to accelerate those sales. But it'll be a function of how much we can do and still maintain a decent growth rate and dividend growth.

Okay. But the lower quartile's about 650 properties. So we should think maybe, if you really get going on this, you could do 100 in a year? Is that what you're thinking?

I think it's possible, but I don't think that's in that cards at all for 2012, and that's probably aggressive for 2013. But it'll all depend on the growth rate. Because if you're adding a lot on the high-credit side, it gives you a lot of flexibility to still post pretty good numbers and accelerate it.

But there were years in Crest where I think we had $130 million of inventory in 2007, and we got it all out the door in about a year. And those were in [bite-size] properties of the $1 million to $2 million. So we've done it before, but I wouldn't look for it in '12. Because we're still crunching the numbers and in the middle of the analysis.

Thanks, guys.

Todd Stender.

Your assumptions for next year -- Tom, you're talking about interest rates ticking up. Does that mean initial lease yields edge up, too? Or is there a longer lag, maybe, that's more of a 2013 event? Just in your estimations?

Great question. I would assume, if I were you guys, a lag. Because that's almost always what happens. You'll start seeing your line costs rising. And it hasn't been happening, but we put, I think, 10 basis points in for it to go up on a regular basis. And so your line costs go first, your permanent financing costs go second. And the net lease cap rates tend to lag. That's true on the way up and the way down. So for modeling for us, or anybody in the business, that'd be our best guess. That's what we've seen over the years.

Thanks.

And the ECM deal that came with some secured debt -- do you have your fill with that right now? If you saw a portfolio with it, would that be a deal breaker? What are your comments on that?

I think -- Paul, is it $54 million or $58 million?

$67 million --

$67 million. There was $90 million we thought we'd be left with, but we've been able to pair that down. And so -- $67 million, you said?

Yes.

So we're about $67 million above where we'd like to be. But that doesn't mean we wouldn't -- if a portfolio came, and it had some secured debt, we'd take it. But as we did here, we'll do our best immediately to pay off everything that we can pay off without it being just a huge economic drain, and then paying off the balance as fast as we can.

So we don't want to say it'll preclude us from doing a portfolio. But at the same time, we're not looking to add it and would like to get rid of it as soon as we can. We like an unsecured balance sheet strategy.

As far as your underwriting new deals, are rent coverages being adjusted higher as well? And do you have less visibility on how the cash flows are going to look next 18, 24 months?

Yes. If you look at the cash flow coverages on our recent purchases, they've been 20, 30, 40 basis points higher than the last few years. So you're really looking up. In the very high 2s is where we're pointing; into the 3s if we can get it. And it changes from industry to industry. But we've been trying to really adjust that up, because that's the kind of less-than-investment-grade retail. And then obviously off in the other areas, we're looking for investment-grade credit.

Thanks, guys.

That concludes the question-and-answer session. I'd like to turn it back to Mr. Tom Lewis for any closing comments.

Thank you very much.

I know it's a busy earnings season, and we appreciate the time spent. And look forward to seeing many of you coming up at NAREIT and some other functions. Thank you very much. And thank you, Joe.

Thank you.

Ladies and gentlemen, this concludes the Realty Income Third Quarter 2001 Earnings Conference Call. If you'd like to listen to a replay of today's conference, please dial 1-800-406-7325, and enter the code 4480899.

We would like to thank you for your participation. You may now disconnect.