Realty Income Corp (O) 2012 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Realty Income Second Quarter 2012 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 26, 2012.

I would now like to turn the conference over to Tom Lewis, CEO of Realty Income. Please go ahead, sir.

Thank you, Liz, and good afternoon, everyone. Welcome to our conference call where we will discuss the operations activity of the second quarter and for 6 months of this year.

In the room with me today is Gary Malino, our President and Chief Operating Officer; Mike Pfeiffer, our Executive Vice President and General Counsel; and as always, Tere Miller, our Vice President of Corporate Communications. And then on the call with me today will be Paul Meurer, our EVP and Chief Financial Officer, and John Case, our EVP and CIO.

And again, during this conference call, we will likely 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. But we'll discuss in greater detail in the company's Form 10-Q the factors that may cause such differences.

And as our custom, we'll start with Paul and you can do an overview of the numbers.

Thanks, Tom.

As usual, I'll just comment on the income statement first and -- providing a few highlights and then moving on to the balance sheet.

Total revenue increased 13.8% for the quarter. Our revenue for the quarter was just over $115 million, or just over $460 million on an annualized basis. This obviously reflects a significant amount of new acquisitions over the past year.

On the expense side, depreciation and amortization expense increased by about $6.8 million in the comparative quarterly period, as that expense increases as our property portfolio, of course, continues to grow.

Interest expense increased by almost $3.2 million. This increase was due to our credit facility borrowings during the quarter, as well as the June 2011 issuance of $150 million of notes and the reopening of our 2035 bonds, some of which appears in this quarter and not all of which appeared in the comparative quarter last year.

On a related note, our coverage ratios both remain strong with interest coverage at 3.6 times and fixed charge coverage at 2.7 times.

General and administrative expenses in the second quarter were approximately $9.3 million, as compared to about $8 million a year ago. Part of this increase is due to higher unexpected costs related to our proxy process this year -- about $550,000 more than we expected.

Our G&A expense has also increased as our acquisition activity has increased and because we've added new personnel as we continue to grow the portfolio. We spent $392,000 of acquisition due diligence costs during the quarter, and our employee base has grown from 78 employees a year ago to 89 employees today. However, our current projection for total G&A for all of 2012 is approximately $35 million, which will still represent only about 7.5% of total revenues projected for the year.

Property expenses were just under $2.1 million for the quarter. These are the expenses primarily associated properties available for lease. Our current estimate for property expenses for all of 2012 is about $9 million.

Income taxes consist of income taxes paid to various states by the company, and they were just over $400,000 during the quarter.

Income from discontinued operations for the quarter totaled $3.8 million. This income is associated with our property sales activity during the quarter. We sold 14 properties during the quarter for $15 million, and a reminder again that we do not include property sales gains in our FFO or in our AFFO.

Preferred stock cash dividends totaled approximately $10.5 million for the quarter, and this number obviously increased because of the issuance of our preferred F stock earlier this year. Excess of redemption value over carrying value of preferred shares redeemed -- a reminder again -- refers to the $3.7-million non-cash redemption charge stemming from the repayment of our outstanding 7.375% preferred B stock with some of the proceeds from our preferred F offering earlier this year. Replacement of this preferred B stock in our capital structure did save us about $1 million cash annually, obviously due to the lower coupon of the newly-issued preferred.

Net income available to common stockholders was $32.95 million for the quarter. Funds from operations, or FFO per share, was $0.49 for the quarter, a 2.1% increase versus a year ago. It was $0.95 for the first 6 months of the year, but a reminder that excluding the $3.7-million preferred stock redemption charge, our FFO year to date would have been $0.98 per share.

Adjusted funds from operations, or AFFO, or the actual cash that we have available for distribution as dividends, was higher again, at $0.50 per share for the quarter, a 2% increase versus a year ago.

As we mentioned recently in the last couple calls, our AFFO -- we think -- will continue to be higher than our FFO, and we believe this differential between our FFO and a higher AFFO will continue to increase a bit. Because our capital expenditures still remain fairly low, we have minimal straight-line rent adjustments overall in the portfolio. We'll continue to have some FAS-141 non-cash reductions to FFO for in-place leases when we acquire them in large portfolio transactions. And of course, this year in 2012, we have that $3.7-million non-cash preferred redemption charge.

Our 2012 AFFO earnings projection is $2.06 to $2.11 per share, or an increase of 2.5% to 5% over our 2011 AFFO per share of $2.01.

We increased our cash monthly dividend again this quarter. We've increased the dividend 59consecutive quarters and 66times overall since we went public over 17.5 years ago. Our AAFO dividend payout ratio for the quarter and year to date was 87%.

Briefly turning to the balance sheet, we've continued to maintain our conservative and safe capital structure. In May, we were very pleased to enter into a new $1-billion unsecured acquisition credit facility to replace our existing $425-million facility. This facility has a 4-year initial term plus a fifth year within our control. It also has a $500-million accordion expansion feature, and the pricing is very attractive at only 125 basis points over LIBOR. We are very appreciative of the 15 bank lenders who participated in this expanded credit line which gives us tremendous flexibility with our acquisition and financing efforts.

The credit facility had only $184 million of borrowings at quarter-end.

Our current total debt to total market capitalization is only 24%, and our preferred stock outstanding still is only 8% of our capital structure. And our only debt maturity in the next 3 years is a $100-million bond maturity in March of next year.

In summary, we currently have excellent liquidity and our overall balance sheet remains very safe and well-positioned to support our continued growth.

Now let me turn the call now back over to Tom who will give you more background.

Thanks, Paul.

Let me kind of run through each piece of the business and I'll start with the portfolio.

The portfolio continued to generate very consistent cash flow during the second quarter. Generally, the tenants are doing well. There were no issues that arose with any of the tenants during the quarter, and I think at this point we'd look for that to continue herein the third quarter. So pretty much steady as she goes for portfolio operations.

At the end of the quarter, our largest 15 tenants represented about 48.5% of revenue. That's down 350 basis points from the same period a year ago and about 90 basis points from the first quarter. So this kind of accelerated acquisition activity we've had the last couple of years continues to help us reduce concentrations in the portfolio.

Generally very healthy from an operational standpoint, too. The average cash flow coverage at the store level for those top 15 tenants stayed just under 2.5 times. So very, very healthy relative to the operations there.

From an occupancy standpoint, we ended the second quarter at 97.3% -- you saw in the release -- with 75 properties that -- available for lease out of the now 2,762 we own. That's up about 70 basis points from the first quarter and just about flat unchanged from a year ago.

During the quarter, we had only 6 new vacancies in the portfolio. We leased or sold 21 vacant properties during the quarter. And I really have to say our portfolio management department and the leasing people did an outstanding job and have kind of gotten ahead what we've asked them to do this year, which is quite positive. In addition to that, we acquired 145 properties and that's the reason for the change in the numbers. I mentioned last quarter I thought we'd see a, I think, 30-basis-point jump in occupancy for the quarter, and very pleased that it came in higher than that.

I've mentioned this the last couple quarters and now I'll do it much quicker than I used to, but there are three ways to calculate occupancy. The first is physical, which is taking the number of vacant properties -- 75 -- and divide it by the 2,762 total, and that's the one we publish in the press release that gets us to 2.7% vacancy and 97.3% in occupancy. A second way is to take the vacant square footage in the portfolio and divide it by total square footage. If you run it that way, we get 2.3% vacancy and 97.7% occupancy -- a little higher. And then the third way to do it is pretty much economic, which is take the previous rent on vacant properties and you can divide that by the sum of that number and the rent paid on the occupied properties and then you can run it in dollar terms. And if you use that methodology, vacancy is only about 2% and occupancy at 98%. Obviously, any of the three represent high occupancy and we'll mention each as we do these quarterly calls in the future.

Same-store rents on the portfolio decreased 1.1% during the second quarter and also year to date, excluding the impact of some rent reductions which was done in the reorganizations of Buffet's and Friendly's. It was a same-store rent increase of about 1.1%, so you can see the impact and where that came from during the quarter. It's likely the impact from both of those tenants will probably stay in the same-store rent number through the end of the year and then we'll have been through the 4 quarters since that was undertaken, and it's likely then same-store rent will turn positive as we get early in the next year.

If you look where same-store rent and declines came from, 6 industries had declining same-store rent, which would be auto service, auto tire, bookstores -- I think of which we have 1 -- craft and novelties and office supplies. But really, the vast majority of it came from casual dining, which is where we have Buffet's and Friendly's, and that was about $1.9 million.

There were 3 industries that had flat same-store rents -- equipment services, shoe stores and transportation -- and then 22 of our industries saw same-store rent increases, with only a couple that have larger numbers -- sporting goods, health and fitness and quick-service restaurant, and then the balance was really spread out amongst a lot of different industries. And if you put the 22 industries together, they had an increase of about $1 million for a net decline between all 3 of down 1. And the percentages, as I said earlier, are pretty much the same whether you're looking at the quarterly or year to date.

We remain well-diversified, being up to 2,762 properties. That's up 131 properties from last quarter. And they're in 38 different industries with 136 significant tenants in 49 states.

We continue to work down our industry exposures. Convenience stores, our largest industry, is down to 16.9%, down a little from last quarter and a couple hundred basis points from a year ago. And then restaurants -- if you combine both casual and quick-services, is down at -- now down to 13.8%. It was at one time over 20%, and that's down 80 basis points from the last quarter and just under 4% -- 370 basis points from a year ago.

Then it falls pretty quick to theaters, which is under 10% at 9.6%. And health and fitness (inaudible) down at 6.9%. And while those continue to be industries we like a lot and we'll probably do some additional acquisitions there, we think we'll be able to keep those in pretty good shape.

The only other one over 5% is beverages. So we think industry standpoint in fairly good shape. And the same on a tenant standpoint. You can see in the release, AMC is our largest at 5.2%, LA Fitness at 5%, and then everything else is under 5% today. And again, the top 15 about 48%. And when you get down to the fifteenth-largest tenant, about 2.2% of revenue is what they represent, and when you get twentieth, it gets down -- which is not on that list -- but it gets down about 1.8% and falls fairly quickly. So well-diversified there, and we think also from a geographic standpoint.

Average remaining lease term on the portfolio remains healthy at 11.1 years. And as I started, the portfolio continues to generate very consistent revenue.

Let me move on to property acquisitions, and I'll start with an update on where we are and kind of where we see volumes going for the year. As those of you who follow us know, we normally report our acquisitions on a quarterly basis after they have closed and don't report what is under contract since, from time to time, what is under contract doesn't close and falls out during the due diligence process. If you recall, in our first-quarter call we mentioned that, first of all, that we thought we would acquire around $650 million in acquisitions this year, given what market conditions looked like and what we were seeing in volume. And then secondly, we said we had previously disclosed in an offering document that we did earlier this year for a preferred offering that we had $514 million under contract for acquisitions at that time. And the reason we disclosed what was under contract -- the $514 million -- was really twofold. Primary was it's a fairly large number and we thought, secondarily, in light of doing the preferred offering, that that was good disclosure, but not our normal disclosure.

During the second quarter, we closed on $198 million of that $514 million. and another $13 million or so for total acquisitions of just over $210 million. The remaining $316 million in acquisitions under contract -- we terminated during the due diligence process and will not close, and that puts us at $221 million in acquisitions as of the end of the second quarter. So we wish more of it had closed, but $221 million is where we ended at the end of the quarter.

Relative to where we see things going from here, we remain very active on the acquisition front and continue to believe we will be still meet the $650 million in acquisitions for the year and that there is a very good chance we'll end up exceeding that number. And obviously, most of that will now close in the third quarter -- where we are today -- and in the fourth quarter, and while it'll be very helpful for our 2013 numbers, the impact on 2012 AFFO will be modest. And that was the reason for the $0.02 adjustment to our FFO and AFFO guidance. I still think we'll acquire $650 million or maybe even better now for the year, but obviously, the timing of when we do that is what impacts the 2012 numbers.

Interestingly, had we closed on the $316 million, we would likely be guiding to around a billion again this year in acquisitions, and I only point that out to say that as I've talked about for a long time when working on these larger transactions which we tend to do, it can cause acquisitions to be very lumpy and hard to predict on a quarter-over-quarter or year-over-year basis.

And anyway, John, why don't you spend some time and make some comments relative to the activity we did and kind of what you're seeing out there.

Sure. The second quarter was fairly active for acquisitions. As Tom said, we acquired 145 properties for approximately $211 million at an average cap rate of 7.1% and an average lease term of 15 years. The credit profile of the tenants we added was pretty attractive. 98% of the acquisitions or leased -- tenants with investment-grade credit ratings. The acquisitions were leased to 5 tenants in 5 separate industries. Four of the 5 tenants were existing tenants of ours. These tenants operate predominantly in the general merchandise, drug store and transportation services industries. The acquisitions were geographically diversified, located in 28 states, and 95% of our acquisitions activity was comprised of our traditional retail assets.

That brings us to 147 properties acquired for $222 million for the first two quarters of the year at an average cap rate of 7.2% and an average lease term of 15 years.

Let me spend a second talking about acquisition yields and investment spreads. Acquisition yields have continued to come down a bit, and there are two principal reasons for this. The first is cap rates are coming down as interest rates and investment yields in general continue to decline. A second reason is we've acquired a much higher percentage of our properties with investment-grade tenants which offer lower yields than we have previously. 90% of the assets we have acquired during the first and second quarters are leased to investment-grade tenants. So we have continued to improve the credit profile of our tenant base, but we have sacrificed some yield to do so. However, our investment spreads -- the spread between our initial yields and our nominal cost of equity, defined as our FFO yield adjusted for issuance cost -- have continued to be very attractive relative to where they have been historically. Our year-to-date average cap rate of 7.2% represents more than a 200-basis-point spread to our nominal cost of equity at the end of the second quarter. This compares favorably to our average spread of 110 basis points over the previous 17 years, especially when you factor in that we acquired assets leased to investment-grade tenants in only 2 of those years -- 2010 and 2011. Our 2011 investment spread was 170 basis points when 40% of our acquisitions were with investment-grade tenants. So we have been able to improve our investment spreads while moving up the credit curve this year, with 90% of our acquisitions leased to investment-grade tenants. When compared to our current weighted average cost of capital, factoring in the cost of our debt, our investment spreads are, of course, a bit higher -- 230 basis points this year above our weighted average cost of capital.

As you know, we also track our cap rates relative to the 10-year treasury yields, and since our IPO -- you've heard me say this before -- since our IPO in 1994, our cap rates have averaged 475 basis points over the corresponding 10-year treasury yields. In 2011, our cap rates averaged 500 basis points over the 10-year treasury yield. This year, our cap rates have averaged approximately 575 basis points over the 10-year treasury yield. So we believe this is a great time for us to acquire at very attractive spreads while enhancing the credit profile of our tenant base.

Transaction flow continues to be strong. We remain comfortable, as Tom said, with our acquisitions guidance of $650 million for 2012. We've sourced $8 billion in acquisition opportunities through the end of the second quarter this year, and as you recall, we sourced $13 billion in acquisition opportunities in 2011 and ended up closing a billion of those acquisitions. Retail and distribution properties continue to account for the majority of what we're seeing, and approximately 50% of these sourced acquisitions have been properties leased to investment-grade tenants. We are continuing to pursue a number of these opportunities and anticipate an active second half of the year as far as acquisitions goes.

We're still seeing competition from property portfolios from multiple sources with a lot of capital. This is not new. We should remain competitive in the marketplace, though. This competition should continue to put some pressure on investment yields, though. In our last call, you may recall we stated that we expected cap rates to average 7.5% -- 7.75% for the year. We now expect our initial yields or cap rates for 2012 to average just a shade less than 7.5%. Of course, this will ultimately be a function of the mix between investment-grade and non-investment-grade properties we acquire for the balance of the year. So we believe our investment spreads will continue to hold up well in this environment and should exceed the spreads we have achieved historically, even as we acquire properties leased to higher-credit tenants.

Tom?

Thank you. Obviously, it's very nice to see large transaction flow and continue to think that we'll acquire what our targets have been or more, but do wish that all of the properties under contract would have closed.

We think acquisitions is going to continue to play a big role, obviously, first in continuing to grow our revenue in AFFO which is what really drives our dividend increases, and then secondly and equally important to us right now in adjusting really the make-up of the portfolio where we're trying to more sharply define where we want to be when we're in retail, and then also as we move outside of retail and, importantly, as John mentioned, up the credit curve.

Let me move on. Relative to the balance sheet, just quickly, with access to capital we're in very good shape, as Paul mentioned. Plenty of dry powder to execute on the acquisitions and the new $1-billion credit facility is very helpful in that light. Looking at permanent capital, obviously where our share price is trading is attractive, as is -- the debt markets are very attractive and as is preferred, and as we acquire additional properties and the balance builds on the facility, we look to enter the capital markets and take advantage of that at some time. But for now, only about 18% of that facility is drawn.

On earnings and guidance, we're looking -- as the release says -- for $2.00 to $2.04 per share and FFO that includes the $0.03 of non-cash charge from the preferred. And then AFFO of $2.06 to $2.11, and that's 2.5% to 5% growth. And that number really is our primary focus as it best really represents the recurring cash flow that we use to pay dividends.

And speaking of dividends, we do remain optimistic that our activities will support continued dividend increases. As most of you know, we've historically raised the dividend in fairly equal amount each quarter and then looked in our August board meeting to see if a fifth larger increase in the dividend is warranted to keep our payout ratio kind of in the 85% to 87% range, which is where we're comfortable, of AFFO. And our AFFO payout ratio is in that range now and continues to grow, and the board will have that discussion on an additional larger dividend increase in our board meeting next month.

And I think that pretty much does it, and why don't we -- Liz, if we could open the questions at this time, that'd be great.

Thank you. We will now begin the question-and-answer session. (OPERATOR INSTRUCTIONS.) And our first question comes from the line of R.J. Milligan with Raymond James & Associates. Please go ahead.

Good afternoon, guys. Tom, you often run through the acquisition funnel in terms of deals that come in through the door versus the number that you actually close on. And I know we don't often hear about deals that are under contract that get terminated. I'm just wondering what percentage of the deals that do get under contract end up getting terminated through the due diligence process.

It's very spotty and most of the properties that we put under contract generally do close but occasionally fall out. And it's hard just to put a percentage on it. This obviously was one large one, but it does happen and kind of trickles through the year. And usually what it is is you'll go through the approval of the tenant, you do the site checks, you do most of the work, and then what happens as you put it under contract and do a lot of the final work -- if it falls out, it's usually either title issues or something with the property condition. Occasionally you can find out that there's some planned condemnations or there's some termination rights or something in a rider on the lease. Obviously environmental -- that happens from time to time. And then a few times for us over the years -- since we do a lot of work in larger transactions where the real estate is just one piece of the financing package for an acquisition of an entity, it can fall out by one or more pieces of that doing it. And if you look at a typical year, it'll be a few properties here and there, and with this one, it was a larger transaction that we worked on with a number of parties and everybody was moving forward and then the decision was made to pull it pretty late in the diligence. So it's hard to see, "Gee, the number under contract is 100 and generally close 92.6." It'll be -- we'll close it all one year, close it all the next year, close 95 one year and then in a situation like this, in a big chunk, it's hard to tell.

And of the 316 that was terminated, does that -- is that mostly an existing tenant or is this a new tenant?

It was an existing tenant, I believe, but we had a small position with them.

Okay. Thanks, guys.

Thank you. Our next question comes from the line of Joshua Barber with Stifel Nicolaus. Please go ahead.

Hi. Good afternoon.

(Inaudible.)

Tom, you mentioned the growth outlook for the back half of the year. You're still pretty confident to get to $600 million to $650 million of acquisitions. I'm just wondering how much of that is dependent on, I guess, an LBO or an M&A sort of outlook, or is that just people who are trying to modify existing real estate today?

It's pretty granular. Isn't it, John?

Yes. It's a little of both, but it's well-diversified. As usual, the ultimate number will depend on our success on some of the larger portfolios. But I would say there's some emanating from private equity-generated acquisition opportunities, some we're working on directly with private developers, and some we're working directly on with tenants. So it's really -- when I look at the pipeline, it's not concentrated in one single area. Does that help?

Yes. Last year, as you recall -- and John, you can help me with the numbers -- we bought a billion and there were 3 large transactions that, if you totaled them up, they were --

Yes. $850 million --

Yes. And so --

(Inaudible) three large portfolio transactions.

It was very concentrated last year. And as I look down the list of what we're looking at, it seems to be in a lot more transactions than it was last year, although some (inaudible) decent size.

Okay. Tom, you mentioned before about some of the releasing gains that were done in the quarter. What's roughly the split in occupancy gains between releasing and acquisition?

Gosh, I'm sorry. I'd have to sit down and do the math. But I think if you look at this, we leased or sold -- I think it was --

20-plus.

20-plus and --

And then we bought 140 --

140, but that's on a base of 2,600 already. So I would think -- and this is top of my head. I'd have to grab a calculator. Maybe two-thirds really came from leasing.

Okay. That sounds fair. Last question. You guys were mentioning your typical spread on cap rates versus your cost of capital. How do you think about your equity cost of capital today, I guess, given the dividend yield and given the fantastic run the shares have had over the last 5 years?

Yes. As we always say when we discuss equity cost of capital, we realize it's as much a philosophical and religious discussion as it is a financial one. But what we try and do, first of all, is -- we're in a business kind of like a bank where you're working on spread and you need to make it up front, and so we kind of focus on a forward AFFO yield, which is obviously FFO divided by stock price and then we'll gross it up for issuance, and then say, "Okay. Where are we coming in over that to begin?" And we really start with equity, and that's the number where historically it's been about 110 basis points, and at the end of the second quarter it was about 200. And then what we do is we'll throw in the other type of capital, which is debt, which has huge spreads today and obviously is very attractive, and then preferred, which we issued at the beginning of the year. So as I said, there's only about 18% of the line drawn right now, but as some of these get closed in the third and fourth quarter, we'll start thinking about which way we want to go. We'll watch the markets at that time. But let me tell you, spreads are very large all over and we have, as you know well -- I think we've issued equity 20 times since we became public in '94 and that's been at a stock price of 19 bucks to 34 bucks to fund accretive acquisitions, so that's worked out pretty well for the shareholders. And we've kept debt -- today I think it's 23.8% or 23.9% on the balance sheet so there's a lot of room there, too. So we think that's all very attractive right now, given where spreads are.

Sounds good. Thanks very much.

Thank you. And our next question comes from the line of Rich Moore with RBC Capital Markets. Please go ahead.

Hi. Good afternoon, guys. With your bigger line, Tom, do you plan to clear it as often, I guess, from an equity issuance standpoint or will you maybe play a bit of the "I think interest rates are going to stay low" game?

Yes. We've historically, as you know, not been one to play that game. The reason for getting the bigger line is we're working on bigger transactions. And with that said, though, it is efficient, particularly when you look at the debt markets when you issue to make sure it's index-eligible, and so you need to do in size. I think it's 250-plus. And also, with equity, I think we'd rather go out if we're -- even if we're buying a lot and funding a lot -- not do small offerings 5 times a year. It's a little easier for, I think, the equity side of the street if you fund when you do it in bigger chunks. So we'll probably leave a little more on the line, but that is a function of not really making a call on interest rates, but a little more comfort and availability to do transactions out there when you have a little bit on the line.

Okay. Alright. Good. Thank you. And then on the disposition front, you guys accelerated a bit in the second quarter and you had talked about how you were going to do that. You had laid out quarterly for us kind of what you were thinking. But now I'm curious. As you have slowed the acquisitions a bit -- because, as you said, you might have been close to a billion dollars of acquisitions -- as you slow that a bit, do you also slow the disposition process or are they really unrelated?

Yes. Those are levers we could certainly pull because you really want to start and making sure you have some good AFFO growth to grow the dividend. But with that said, it is a priority for us and we think we'll close what we probably would have last quarter, but it'll just be later in the year. But we haven't slowed disposition. We did the 5 properties for $3.6 million in the first quarter and then 14 for, I think, $15 million in the second. And the third quarter, I think we will do more than we did in the second and I'd like to do another $50 million or so the balance of the year. I think that'd get us to around $70 million for the year and, most important, the run rate up a little bit. And then in the beginning of the year, we can kind of polish off the first $100 million that we put out there. And then we're likely just going to grab another $100 million and start off again next year. But if we could get the run rate $50 million to $100 million a year and then we can take a look at all the other levers and all the other variables and looking at the company's cash flows and work off that. But we're very active. There's -- right now we're at a point where there's 10 to 15 that are in some property -- some type of closing, whether you're just putting them under [LLI] or whether you're -- they've gone non-contingent. And then I think we've got 28 properties out on the market and then a good-sized group of properties behind that can go out and that's on the $100 million. So we do intend to be active, but if I can get to a run rate of $50 million to $100 million a year at the end of the quarter and kind of next year get into -- or at the end of the year and next year get it up around $100 million, we'd be happy.

Okay. Good. Thank you. And then is Crest officially gone now or is it just irrelevant? You didn't mention it for the first time that I can remember in the press release so -- and I'm assuming the properties are gone. So is it -- have you done away with it?

No. It's still just hanging out there and I think it's got 3 properties in it and then 2 mortgages that we took back, so it's generating some income. It just didn't have any activity so we kind of left it out there. But actually, with the acquisition that was under contract and didn't close, we did plan to put some properties in there and use it. It wasn't going to be a huge number, but we will use it if we think it helps us from a diversification standpoint in doing something, but we don't look at -- for it to become active over the next quarter or so.

Okay. And then Friendly's and Buffet's -- are we run rate at this point on those two?

Yes. I think we are on those. The leasing -- I think we said that we thought the Friendly's -- we would recover about 80% and I looked this morning and we've updated that number. We think it'll be a little higher -- around 82%. And then Buffet's -- yes, I think we had said about a 65% recovery. That's also looking a little better just by a couple hundred basis points or so. And then the leasing in Friendly's -- we had in the model not to really lease anything this year and it's gone faster than that. That was part of what this quarter was. And similar on Buffet's. So I'd say run rate and just moving through and maybe a little bit above what we thought recoveries would be.

Okay. Very good. Thank you, guys.

Thank you. Our next question comes from the line of [Emanuel Porchman] with Citi. Please go ahead.

Hi, guys. Good afternoon.

Good afternoon.

Just had a -- with the properties that you ultimately terminated the contracts on, was that purely a property characteristic or a title characteristic or the (inaudible) you talked about earlier -- was there pricing involved, too? (Inaudible.)

It wasn't -- yes. It wasn't pricing and it wasn't one of those others; it was the overall transaction moving away from of which we part of. And I apologize. Beyond that, I can't say much. There were a number of parties involved and our confidentiality agreement was only cleared to discuss when it closed, and since it didn't close we're still under it, and since we plan to do future transactions with those parties -- perhaps not on these assets -- I really can't go much further. But it was the transaction itself that went away.

Understood. And then on last quarter's call, you had discussed about a third of what you look at being investment-grade, and obviously you're closing a hyper-percentage of stuff as investment-grade tenants. Is that (inaudible) sort of a consistent run rate or was that simply the portfolio you were looking at at the time, and how much of the 650 for the year -- how much of it is going to end up being 650 as investment-grade, I guess is my question.

Great. Of course, it's subject to what closes and doesn't, but John, maybe you'd take a run at that.

Right. The 90% we've closed year to date that's investment-grade is high. I would expect it to come down a bit based on what's in the pipeline and what we're working on, but it is dependent upon some of these larger portfolios -- some of which are not investment-grade, some of which are investment-grade. But I would expect it to be a little higher than where it was last year at the end of the year if I had to guess, and last year --

(Inaudible) half, ballpark.

Yes. 50% or so.

It's hard to tell, but it is, as I said, one of the things we're trying to do. And above and beyond just investment-grade, I would say even when you get below investment-grade, it tends to be, on average, a little higher credit than it might have been in the past. And that's intentional, too. But --

Perfect. Thank you, guys.

Thank you. Our next question comes from the line of Paul Lukasik with Morningstar. Please go ahead.

Hi. Good afternoon, guys. Just to follow up on the investment-grade question. I guess sort of in an ideal world, 5 to 10 years down the road, what percentage of the portfolio would you guys like to have in the investment-grade category?

Yes. We haven't been as exactly specific, but we'd like to move that up. And again, I'll allude to what I just said, which is some of the things that aren't investment-grade will be (inaudible), and if they have very high cash flows, we'll be happy with that. But right now -- we've gone from 0 to close to 20% -- in between 15% to 20% today -- and in just a couple of years, and we'd be very happy 5, 6 years down the line if that was 50% to 60%. And we think that that's something that we'll be very happy about down the road. There will come a point -- likely -- that interest rates do get higher, although they could stay low for some time, and so we are really working for 5, 6, 7 years down the road, and if it could be 50%, 60%, 70%, that'd be just fine.

Okay. Thanks. And then just curious about the timing of the acquisitions that did close in the quarter. Were there early? Late? Middle?

Virtually all of them were at the end of the quarter.

Okay. Great. Thanks for taking my questions, guys.

Thank you. Our next question comes from the line of Todd Stender with Wells Fargo Securities. Please go ahead.

Hi. Thanks, guys. Just looking at the average of investment per property in the second quarter. It looks around 1.5-million range. Is this a reflection of the type of deals you're looking at right now or am I looking too much into that?

Yes. It's just what actually closed. And as John said, the vast majority this quarter was in retail and, traditionally, those are smaller and these were a little smaller, too. So I don't think it's really anything targeted. There was just a cluster of retail with smaller stores this quarter. That's likely to increase over the next quarter -- a few quarters -- and be a larger number per property.

Have you guys talked about the tenants? Have you disclosed who the tenants are and specifically what industries within retail?

John, you talked about the industries, I think, a little earlier in the call, which was general merchandise, drug store --

And transportation services.

And then I think there was a little QSR.

Yes. A little QSR.

And so those were the industries. But we didn't do the tenants individually, but if you look into the top 15, you'll see that there were some increases in some names and some that popped in for the first time.

Okay. Thanks. And John, the blended cap rate was 7.1. If some of these properties were going to go individually, are they going for higher or is there a portfolio premium that we should look at?

I think there is a portfolio premium today in that $100 million to $200 million range. Buyers are trying to get capital efficiently invested. When you get above $200 million, that premium goes away because there's just a limited number of players who can execute transactions in excess of $200 million without financing contingencies. So there is a bit of a portfolio premium at that level -- $150 million.

Yes. Todd, I think one's talking cap rates, one's talking price. I think when you do a portfolio in the $100 million to $200 million range today, it actually -- you may pay a tiny bit more than you would on a one-off. Above that number, you would pay less than a one-off, and it's not a huge spread but it is a little bit of a spread, given the number of people out trying to put capital out in bulk.

Okay. That's helpful. Thanks, Tom. And really, who -- back to the disposition discussion -- who are the buyers to support the volumes that go in excess of $50 million? If you say you're going to shoot for $50 million to $100 million, what kind of buyers are you looking at?

To date, it has been all individual buyers. The numbers, in terms of property size, is fairly small, as you can see by how many we sold and what the value were. And there is a 1031 market again today, to some extent, because with the declining cap rates, there are some gains out there in commercial property. So some have been there. And -- but that was the majority of kind of one-offs years ago. Today, it's maybe a third 1031 and the other two-thirds are just people looking for yield. They are yield-starved out in the marketplace, and so when something comes out and has a name on it and has an attractive yield, the prices are -- the cap rates are lower than we had anticipated when we started doing this. We were thinking on some of these it'd be up in the 9 and 10s and it's down into the 8s and 7s. So they're individuals. One of the things we may do as we move along here, given that there are some people out there trying to look to put away money in little -- larger pieces is we may package some up and work through a few people and look for a little more quasi-institutional buyer for some of the assets. But today it's been all individual.

Okay. That's helpful. And just lastly, I'll just ask Paul a question. There doesn't seem to be much change expected in the second half of the year with your property operating expense guidance. Is it fair to say you're not expecting any new vacancies? And if that's the case, how long a lead time do you generally get for tenants (inaudible) notice when they're moving out?

Well, as a general comment on that area, the estimate did go down. I think last quarter I estimated $9.2 million for the year. Now that estimate is closer to $9 million. The increase that we've had has really not been a bad debt expense; it's been more some costs on vacant properties -- insurance, legal fees, things like that. The down time -- historically, we used to say 6 to 9 months. I'd say over the past handful of years that widened. It became more 9 to 12 months or sometimes more. And that has started to tighten a bit back to the more normalized run rate, which -- let's call it 9 months, to kind of answer your question. So it did widen even further than that, but I think it's been getting better and the folks in portfolio management have been able to release things a little quicker than they were, say, 18 months ago.

On the how much lead time do we get when a tenant has a problem, we have a few properties in the portfolio that it's a one-man show where we released and then it's generally the rent doesn't show up. But in the vast majority of the cases, we have large tenants and so we're trying to do some job of monitoring their situation. And we normally do get a lead time -- not always, but normally we'll know 90 days ahead of time or so, and sometimes 5, 6 months that mom's on the roof or something's going on. And today, that -- as I said earlier, there was nothing that came up during the second quarter and we don't anticipate anything in the third quarter.

Okay. That's helpful. And actually I did have one last question. If you could just address the development piece of the new properties that you purchased in the second quarter?

Yes. Of that total, about $3 million was development-oriented investments. So very little of it.

These are new construction. They're pre-leased. They're just not cash-flowing yet?

That's correct.

Yes. And I'll just comment on that right now. We have 5 properties under development and it's not a huge amount of money, and then 3 re-developments, and in those, if you look at it, the total cost will be about $31 million and we've already funded $21 million. So there's only about $9.8 million to be funded. And in each case, it's a situation where we have the tenant and there is somebody building the building and we were able to go in and buy it during the construction period and it's going to get built when the lease is already in place. So you're not taking lease (inaudible).

Okay. Thanks, guys.

Thank you. Our next question comes from the line of Tom Lesnick with Robert W. Baird. Please go ahead.

Hi, guys. Just standing in real quick for Paula Poskon. Most of the other questions we had have been answered at this point, but just a quick one. How much of that occupancy increase was due to vacant properties being reclassified as held for sale?

None.

None. Okay. That's helpful. That's all I got.

Okay. Thanks.

Thank you. This concludes the Q&A portion of the Realty Income conference call. I will now turn the call back to Tom Lewis for closing remarks.

I'd like to thank everybody for joining us and thank you for your time. I know it's a busy earnings season. And if not before, we'll talk to you at the next quarter. Thank you again, Liz.

Ladies and gentlemen, this concludes the Realty Income Second Quarter 2012 Earnings Conference Call. If you would like to listen to a replay of today's conference, please dial 1-800-406-7325 or 303-590-3030 and enter access code 4552149 followed by the # sign. We'd like to thank you for your participation and you may now disconnect.