Realty Income Corp (O) 2013 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Realty Income first quarter 2013 earnings conference call.

At this time all participants are in a listen-only mode.

Later we will be conducting a question-and-answer session and instructions will be given at that time.

(Operator Instructions).

I would now like to turn the conference over to our host, Mr. Tom Lewis, CEO of Realty Income.

Please go ahead, sir.

Thank you, Tega, and good afternoon, everyone.

Thank you for joining us on our call today to discuss the first quarter operations for Realty Income.

Before I start, in the room with me is Gary Malino, our President and Chief Operating Officer; John Case, our President and Chief Investment Officer; Paul Meurer, our EVP and Chief Financial Officer; and Mike Pfeiffer, our General Counsel.

And as always I must read and say that 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.

We will disclose in greater detail in the Company's Form 10-Q the factors that may cause such differences.

Also in the room with me today are some spring allergies, so if we go radio silent for a second or you hear a loud noise, I appreciate your understanding.

Paul, as we always do, if you will start by running through the numbers for everybody.

Thank you, Tom.

As usual I will comment on the financial statement, provide a few highlights of the financial results for the quarter, and start by just walking briefly through the income statement.

Total revenue increased 52.9% for the quarter.

Our current revenue on an annualized basis today at March 31 is approximately $718 million.

This increase reflects some positive same store rent of 1.5% in the portfolio, but more significantly it obviously reflects our growth from new acquisitions over the past year.

On the expense side, depreciation and amortization expense increased significantly to just under $70 million in the quarter.

Of course that depreciation expense increased with our portfolio growth.

Interest expense increased in the quarter to $41.5 million, and this increase was primarily due to the $800 million of bonds that were issued last October as well as some credit facility borrowings during the quarter.

On a related note, our coverage ratios both improved and remain strong, with interest coverage at 3.7 times and fixed charge coverage at 3.0 times.

General and administrative, or G&A, expenses in the quarter were approximately $11.6 million.

Our G&A expenses naturally increased this past year as our acquisition activity increased, and we added some new personnel to manage a larger portfolio.

Our employee base has grown from 86 employees a year ago to 92 employees at quarter end.

However, our total G&A as a percentage of total revenues has decreased to only 6.7%.

Historically our G&A had a run rate at about 7.5% to 8% of revenues.

Our current projections for G&A for all of 2013 is about $45 million.

Property expenses were just under $3.8 million for the quarter.

These expenses historically have been primarily our carry costs associated with properties available for lease.

However, as we noted last quarter, our 2013 property expense estimate is higher at about $15 million, as we have recently purchased a few double net properties where we are responsible for some of the property expenses.

Income taxes consist of income taxes paid to various states by the Company, and they were $671,000 for the quarter.

Merger related costs, obviously this line item refers to the costs associated with the ARCT acquisition.

During the quarter we expensed approximately $12 million of such costs.

Income from discontinued operations for the quarter totaled $39.5 million.

This income is associated with our property sales activity during the quarter.

We sold 17 properties during the quarter for $60 million, with a gain on sales of $38.6 million.

An important reminder that we do not include property sales gains in our FFO or in our AFFO.

Net income attributable to noncontrolling interest refers to the limited partners of the operating partnership we purchased which holds the ARCT properties.

These LPs own 0.7% of the equity of the OP.

All of the assets and operations of the OP are 100% consolidated into Realty Income.

Preferred stock cash dividends totaled approximately $10.5 million for the quarter, and net income available to common stockholders was about $61.3 million for the quarter.

Reminder that our normalized FFO simply adds back the ARCT merger related costs to FFO.

We believe normalized FFO is a more appropriate portrayal of our operating performance, and it is consistent with our public FFO earnings estimates and our first call FFO estimates that analysts have published on us.

Normalized funds from operations, or FFO per share, was $0.61 for the quarter, a 32.6% increase versus a year ago.

Adjusted funds from operations, or AFFO, or the actual cash that we have available for distribution as dividends, was $0.60 per share for the quarter, a 20% increase versus a year ago.

Also you will note that in our press released we continue to affirm our same earnings estimates for 2013.

As you know, we have also increased our cash monthly dividend significantly over the past year.

In addition to our regular quarterly increase, we did a $0.35 annualized dividend increase in January.

We have increased the dividend 62 consecutive quarters and 71 times overall since we went public 18.5 years ago.

Dividends paid per common share increased 17.6% this quarter versus the same quarterly period a year ago.

Our current monthly dividend now equates to a current annualized amount of $2.175 dollars per share.

Our AFFO dividend payout ratio for the quarter was 86%.

Briefly turning to the balance sheet, we've continued to maintain a very conservative and safe capital structure.

In March we raised $755 million of new capital with a very successful common equity offering.

We sincerely thank the 16 investment banks involved in the placement of our common shares with investors in their respective brokerage systems.

At quarter end our $1 billion unsecured acquisition credit facility had a balance of only $116.6 million.

Our credit facility also has a $500 million accordion expansion feature.

We did assume approximately $565 million of in-place mortgages during the quarter as part of our property acquisitions, primarily in the ARCT acquisition.

We now have 48 assumed mortgages on 185 properties totaling approximately $729 million.

In March we did repay at maturity $100 million of bonds which were placed back in 2003.

Our next bond maturity is only $150 million, and it is due in November of 2015.

Our overall current total debt to total market capitalization is 24.5%, and our preferred stock outstanding is only 4.5% of our capital structure.

So in summary, revenue growth this quarter was significant, and our expenses remain moderate, so our earnings growth was very positive.

And our overall balance sheet remains very healthy and safe, and we continue to enjoy excellent access to the public capital markets to fund our continued growth.

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

Thanks, Paul.

I will start with just the general comment that was in the release, which is obviously the first quarter was the best quarter I think operationally in the Company's history, and each facet of the business had solid results.

So we will keep the commentary here a little shorter than usual, because I think the results speak for themselves, but let me start with the portfolio, which continued to generate very consistent cash flow in the first quarter.

General comments, pretty much all of the tenants are reporting doing pretty well.

There are no issues that arose with any tenants during the quarter, and we believe that will be the case here in the second quarter, so very smooth.

At the end of the quarter our largest 15 tenants that are listed in the release accounted for 42.6% of our revenue.

That's down 680 basis points from the same period a year ago and down 450 basis points from the fourth quarter.

So the recent acquisition efforts continue to help us reduce any concentrations in the portfolio, and we've made continuous progress on this over time.

In 2008 the top 15 accounted for 54.3% of revenue, and we are now down to 42.6%.

We ended the quarter with 97.7% occupancy, and that is 81 properties available for lease out of the 3,525 that we own.

That's up 50 basis points from fourth quarter and 110 basis points from the same period a year ago.

And here in the second quarter we would anticipate occupancy remaining very strong, likely to be flat or up slightly again this quarter.

Very pleased with that.

I mentioned in the past there are three ways you can do occupancy.

The one we used in the released is to take the number of properties that are vacant, 81, divided by the 3,525, and that's how we get to 97.7%.

If you wanted to run it on a square footage basis, that would get you to occupancy of 98.6%.

The third way you could do it is take the previous rent on any vacant properties and divide that by the sum of that number and the rent on the occupied properties, and using that methodology occupancy is 98.8%.

And obviously any of three indicate high occupancy.

Same store rents on the core portfolio increased 1.5% during the first quarter.

As you recall, during last year same store rent was a small negative in the first three quarters and barely positive for the year, so getting to 1.5% is a good rate I think for a net lease portfolio, and it is good to get back to that number.

Diversification, really continued to widen substantially in the quarter.

As I mentioned before, 3,525 properties.

That is up 512 properties from last quarter.

In 46 different industries now, with 195 different tenants in 49 states and Puerto Rico.

And then the industry exposures also continue to climb substantially.

Our largest industry today, convenience stores, is at 12%.

That's down 290 basis points from last quarter and 500 basis points from a year ago.

Restaurants as you know is an area that we had targeted to reduce.

If you combine both the casual dining and quick service, it is now down to 10.5%.

And that is down 190 basis points from last quarter and 410 basis points over the same period a year ago.

I will just note we once I think had 22% of our revenue in that sector.

Theaters are at 6.7%.

That's down 200 basis points a quarter and 300 for a year.

And then you get to health and fitness and drugstores, both about 6%.

Health and fitness down a bit.

And then the three industries really that have been moving up, drug stores is at 6% now, up 270 basis points from last quarter.

The dollar stores is up about 5.6%.

And then transportation services at 5.2%.

And when you get below that, any other category is below 4%, so very good shape keeping industry concentrations reasonable.

Same thing on the tenant standpoint.

Our largest at 5.7% is FedEx.

That's up over the last year because of some acquisitions we made and also the RT portfolio.

LA Fitness is second at 4.5%, and that's down 60 basis points over the last quarter.

And then everything else is now down below 3.5% exposure in the portfolio.

And as I mentioned, the largest top 15 are down to 42.6%.

When you get to the 15th, you will notice you are at about 1.5% of revenue, so that just continues to widen on a tenant and also on an industry standpoint, and certainly the same could be said from a geographic standpoint.

Average lease length due to acquisitions has remained very healthy at 11.1 year, and as I mentioned the portfolio continues to generate very stable income with high occupancy.

Relative to property dispositions, we accelerated the asset disposition program a bit during the quarter with a focus on the intent of trying to further strengthen the credit quality of the overall portfolio.

And doing that by reducing exposures in certain industries and properties that we think might be particularly sensitive to any economic weakness.

Or a tenant whose balance sheet is levered, and if interest rates were to go up, we think that they might be somewhat at risk.

During the quarter we sold 17 properties for $60 million.

As you recall, we were looking in our guidance for a little over $100 million in dispositions for the year, and so getting $60 million of that done in the first quarter is very positive.

And we think that going forward that we will easily hit that 100 -- I think we said $75 million to $100 million, and we will easily hit that, and I would say well over $100 million for the year at this point.

Most of the sales for the quarter were in the restaurant and child daycare industry relative to the number of properties.

We also sold a multi-tenant industrial property that we had had in the portfolio for about 25 years that had 375 tenants.

And we think exposure to economic weakness might be substantially more than the balance of our portfolio, and so we moved that out with a sale.

I think it's safe to say the amount of sales, just like acquisitions, will vary quarter to quarter and be a bit lumpy, but they could accelerate a bit more as the year goes on.

Let me move on to property acquisitions.

As I've talked about for some time, acquisitions will vary quarter to quarter and they are a challenge to predict for any individual quarter.

But given really excellent transaction flow that we are seeing right now and what we did in the first quarter, which is a little more than we generally do, we are off to a very good start for the year.

The first quarter, as I mentioned, is a little slow.

If you recall, last year I think we did $1.2 billion, and I think we did $10 million in the first quarter, so at $128 million we view that as a positive.

I also think that transaction volume at this point tells us this should be another very good year for acquisitions.

We initially had in the guidance $550 million.

I can say now, and we are sitting in fairly early April, that that should not be an issue for us, and we should be able to meet that and exceed that, which is very much a positive for this time of the year.

Let me have John Case, our President and Chief Investment Officer, make some comments about what we did and kind of what we are seeing out there in the market place.

John?

Sure.

As Tom said, we remain active on the acquisitions front.

During the first quarter we made $128 million in property level investments and 27 properties at an average yield of 7.9%.

These properties had a weighted average lease term of just under 14 years, and 22% of these assets are leased to investment grade tenants.

The properties are leased to 14 different tenants in 11 different industries, so well diversified.

Two of the tenants are new to our portfolio, and the most significant industries represented were transportation services and health and fitness.

Properties are located in 16 states, and about 80% of the investments are comprised of our traditional retail properties.

Of course, this activity was in addition to our $3.2 billion acquisition of American Reality Capital Trust, which added 515 properties and closed in January.

So our combined total investment in real estate for the first quarter was just under $3.3 billion and 542 properties.

This was clearly our most active quarter in our Company's history by a significant margin.

Let me spend a moment here and talk about the market environment today, and I will start with transaction flow.

Tom just alluded to that.

We continue to be very busy.

So far in the first quarter we sourced $4.3 billion in acquisition opportunities, SO transaction flow continues to remain strong.

We continue to work on a number of these opportunities, and we are expecting another active year for transaction flow.

While investment opportunities are fairly abundant, competition for these acquisitions is also abundant.

There are plenty of well capitalized buyers in the market today, led by private and public net lease REITs, but we are also seeing some other private institutional buyers seeking yield in our space.

These buyers are using more leverage, with a CMBS market in our space that has gained strength here in the past quarter or two.

And that is helping all private buyers better compete.

But we expect to continue to close our fair share of these opportunities.

As far as pricing goes, cap rates remain low relative to historical standards.

Given the strong bid in the market today, they are coming under a bit more pressure.

Noninvestment grade properties are trading in the 7% to 8% cap rate range.

Investment grade assets are trading in the 6% to 7% cap rate range.

However, our overall cost of capital has also continued to decline, so our investment spreads remains very healthy relative to our historical averages.

In the current market, portfolios in the $50 million to $250 million range continue to trade at premium pricing relative to single assets.

The buyers are willing to pay a portfolio premium in order to deploy larger amounts of capital efficiently.

This is a trend we have been seeing for the last year or so, and we expect to see it continue.

So to recap our outlook, we do remain optimistic about achieving our previous acquisitions guidance of $550 million for this year.

We are still modeling a 7.25% initial yield on acquisitions for 2013, but that number will depend on our ultimate mix of investment grade and noninvestment grade acquisitions.

In the first quarter our property level acquisitions yield of 7.9% was really reflective of investment grade assets accounting for 22% of the total volume.

We would expect our near term quarterly average cap rates to be a bit closer to the 7.25% rate we have communicated to the market.

Tom?

Thanks, John.

John likes to use the term to get our fair share.

I would prefer us getting our disproportionate fair share.

Either way, we are pleased with the start for the year and very pleased where spreads are in the market place.

It is a very good time to acquire.

Obviously the recent acquisitions have certainly contributed to our revenue earnings and dividend growth, and that is very visible in the numbers here in the first quarter.

But the other thing we are doing they also and equally important have continued to help us adjust the makeup of our portfolio, where we are focused on moving the portfolio up the credit curve.

And obviously we've made very good progress on that front this quarter, with investment grade tenants now making up 35% of the portfolio.

As I talked a bit about last quarter, over the last 36 months or so we have now acquired about $6.2 billion of property, including RT.

About $3.7 billion of that is in retail and really pointed toward sectors that we think should continue to do well.

And what we anticipate is a somewhat more sluggish retail environment over the next 15, 20 years than it had been in the past.

And so we are really happy to get that invested and focused in the areas we want.

About $2.5 billion of what we acquired are in areas outside of retail that we think will do well for us, all with invest grade tenants.

And of that total $6.2 billion, about $3.9 billion or 63% of what we acquired in the last 36 months has been with investment grade tenants.

And what is interesting is a good measure of the rest of the tenants and acquisitions, while noninvestment grade, are also further up the credit curve than the average in the portfolio just a few years ago, and we are pleased with that.

It is kind of interesting to watch that move, and I will share some statistics with you.

If we go back and really look at having sat down and thought we should do this in 2008 and really started executing it in 2010, if you look in 2008, our top 15 tenants did 54.3% of our revenue.

Their average [dart] score, and the dart score is our credit score that approximates a credit score similar to what the rating agencies would do.

So the average dart score on our scale was about a 6.92, which would equate to a single B plus or BB minus credit rating.

And also, none of the top 15 tenants had investment grade ratings.

Having undertaken this project starting three years ago, today the top 15 are down to 42.6% of our revenue.

The average dart or credit score is up to 11.67.

That approximates to approximately a BBB minus credit rating for the tenants, and six of the top 15 carry investment grade ratings.

So really most of the work has been done in the last three years, but looking at it versus 2008, we have gone from 54.3% of revenue to 42.6%.

The dart score is 6.92 to 11.67, and we now up to where six of our top 15 tenants are investment grade.

And that is over really just about four years of activity, and we anticipate that trend will continue, and that's what we are trying to accomplish.

I think the other thing about -- that is important to us is how we paid for the acquisitions over the last three years.

We did issue about $1.2 billion in investment grade notes.

Most long-term at very good rates.

As Paul mentioned, we have assumed mortgages in the portfolios we have taken over that we intend to pay off as quickly as we can, and we have done about $162 million of property sales.

More important to us is issuing a little over $400 million in perpetual preferred.

And then we've issued equity in the last three years or so six times and generated about $3.7 billion in gross proceeds.

About $6.4 billion in capital overall, of which $4 billion was common and/or preferred.

And as we all live here in this very low interest rate environment, I think we want to remember that these rates, there is a possibility they won't persist forever and be mindful of where they could go, what funding costs could be, and what has to be rolled over.

So getting a lot of preferred in the equity done has been positive, and we intend to keep the balance sheet in really good shape and may even modestly delever from here on a bit to keep us in really good position.

Relative to capital, we are in very good shape.

As Paul mentioned, there is plenty of dry powder to execute on the acquisitions as they present themselves.

Raising a net $755 million in equity a few weeks ago was very helpful to make sure that the $1 billion credit line with the $500 million accordion was available, and so now we are in very good shape there.

Capital obviously is extremely attractively priced, and spreads are very wide, so I really think we are in great shape.

I would note that we are particularly pleased watching how the equity has performed here in recent weeks.

If you think about it, we put about $2.8 billion of equity into the market in the last 90 days between RT and the offering.

So for the equity to perform this way, I think it is fair to say the market seems to have absorbed it fairly well, and we have good access.

Earnings, as Paul mentioned, normalized FFO at $0.61, up 32%.

That's a percentage number we haven't seen before.

Same thing with FFO at $0.60, up 20%.

Relative to the guidance, we are staying with our previous guidance for now.

We think April at this point, we feel very good about all facets of the operations and very comfortable with the primary drivers to achieving the guidance, which is as John mentioned $550 million in acquisitions.

And we think it will easily hit that and likely exceed it.

But for now we will stay where we are and revisit the numbers over the next quarter or so as things unfold.

That puts normalized FFO for the year at $2.32 to $2.38, which is around 15% to 18% growth, and AFFO at $2.33 to $2.39, which is 13% to 16% growth.

I will finish with dividends.

We remain optimistic that we will be able to continue to increase the dividend.

Obviously we had nice movement in that in the first quarter, as Paul mentioned.

And we look forward to having additional increases over the year.

And with that, Tega, if you will come back and help us with questions, we'd appreciate it.

Thank you.

At this time we will begin our question question-and-answer session.

(Operator Instructions).

Our first question comes from the line of Emmanuel Korchman with Citi.

Please go ahead, sir.

Good afternoon, guys.

Hi, Manny.

John, if we can go back to your previous comment of I guess acquisitions this year being in that -- let's call it 7.25% range, what was the driver of such a higher cap rate in the first quarter?

It was primarily the percentage of noninvestment grade assets we closed.

We closed 22% in investment grade, which was a bit lower than we had been closing in the previous quarters, and certainly 64% in investment grade investments we did in 2012.

So that's the main driver, Manny.

Yes, there was one transaction we did in the first quarter with a tenant we liked a great deal, and it had a very attractive yield for what is a nonrated company, but if they were rated it would be considered investment grade.

We were able to secure a good deal there, and it just happened to be what came in this quarter versus what may come in next quarter.

Sure.

And then maybe, Tom, you could tell us a little more about how competition has been split between the investment grade product and maybe that stuff that is less -- looks less perfect on paper, but at the end of the day is still a good property.

You mean transaction flow that has come in the door?

And maybe just the competitors that are looking at both types of assets.

I will take that, Manny.

We are seeing a fairly broad group of competitors on both sides.

I would say there are a bit more on the traditional retail product, on the institutional larger buyers, than there are on the nonretail product.

On the investment grade side there is good competition out there, but primarily from the higher quality companies with lower capital costs that can pursue this type of product.

So it is probably not quite as extensive as on the noninvestment grade.

Is that what you are looking for?

Perfect.

And there is plenty of people looking to buy properties in both sectors, Manny.

Sure.

And maybe just digging a little deeper on what you are saying earlier, Tom, that -- it sounds like you have stuck to your guns in the retail space though I guess RT was the biggest mix of retail and nonretail.

What can we expect the rest of the year?

Are you guys kind of literally going to look at things just on what comes through, or is there a goal to diversify more?

We are willing to do either.

What we are really focused on is taking looking at the retailers and the consumers they serve.

And if it's discretionary goods and services are what they sell, then their target market better be the upper middle income or the upper income, because if it is lower middle or lower, we don't want to buy it.

So focus there.

And then on nondiscretionary type goods and services, if that is what the retailer is selling, then we are pretty good at the upper and middle income, but if it is lower we want to make sure there is a very deep value proposition, and that's why we have gotten into the club stores and dollar stores and others.

And that is a big focus when we are in retail.

And then generically moving up the credit curve, and in retail there are investment grade credits, but there is a limited number.

And so to get the portfolio up the credit curve, we are more than willing to look outside of retail, but it really has to be the Fortune 500, maybe Fortune 1,000, and investment grade, and what we think is property that they consider very, very important to their business itself.

Whether it comes in either basket, we don't really mind, and we are happy to have both sides expand a little more.

So if retail went up a little bit, it wouldn't bother us, as long as it was hit right where we wanted to go and generally up the curve.

But we would be happy if retail, which I think at end of the quarter was around 79%, and if that falls to 75% or 74% or 74% or 72%, that's fine too.

But I don't have a numerical target on either one of those.

It is really just those boxes we are trying to hit in terms of where we want to acquire and what we want to stay away from.

Perfect.

Thanks, guys.

Our next question comes from the line of Joshua Barber with Stifel Nicolaus.

Please go ahead.

Hi, guys.

Good afternoon.

Hey, Josh.

Quick like, can you tell us what the disposition cap rate was on your assets during the quarter?

That is a great question, and let me see if I have that sitting here in front of me.

Which I may or may not have.

Let's see.

Well for the year, Manny, our estimate for, call it $100 million plus, it's going to be about 8.75%, if that is helpful.

[Dean], do you know what it was in the quarter?

Disposition.

We've got it here.

I'm sorry.

It was a little actually lower than what we were planning for the year.

I do know that, because the one larger multi-tenant sale was substantially lower than that.

Do you remember the cap rate on the transaction?

It was like a 7.5%, and that was a big piece of it.

So I would guess it probably is closer to the 7%, 7.5% range, but we'll scratch around --

I think we will do better than the 8.75%.

We tend to model that conservatively.

Depends on what we choose to sell later in the year.

Okay.

And maybe this is a broader question, but you guys have been very clear over the last few years that you are trying to minimize retail and get more investment grade, get slightly different property types.

Is that a trend that you expect to continue, or do you think that there will be some other moves that you'd to make to really reshape the portfolio over the next couple of years?

I do think we will continue doing what we are doing, and as I said in the last question, we are happy to be in retail.

And we haven't moved away from it, and we are happy to buy.

We are just going to be more particular in terms of who the tenants are, who they serve, and what their balance sheet looks like.

So if we think they are investment grade or close, so there's not a big refinance risk when interest rates go up, happy to do it.

And as long as we are staying away from consumer discretionary to the lower income is who they market to, then we are happy to do it, and we would be just delighted if retail stays right where it is.

However, we are also focused on generically moving up the curve, and so if it is out to do that, we're happy to do it.

We don't have a target.

It is right now 78% or 79%.

21, 22 is the mix, and over the course of the year, if I had to guess, we will probably see a little more outside of retail, but we will probably end the year where retail is still over 70% of the portfolio.

Great.

Last question.

When you are looking at some larger scale acquisitions, given that you have significantly larger enterprise value than you have in the past, do you think have you a little bit more room today to take on secure debt from another -- company from another portfolio?

Would you have a little bit more ability to do that, or would that be something that you just don't want to risk the balance sheet on?

We have done that.

We've got over $700 million of secured debt and that's really come from buying portfolios, so we are willing to do it.

But when we do it, we try and payoff anything we can that doesn't have significant prepayment penalties and isn't uneconomic to pay off.

And then we will leave in place if there is one, two, three, four year debt and pay that off as soon as we can.

So it is our preference not to have any secured debt, but given size to buy portfolios, I think that that will be the case from time to time.

But it is going to remain a very small part of our balance sheet.

It is something we could consider, but as soon as we get it on the books the purpose is get it off.

All right.

Great.

Thanks very much.

Our next question comes from the line of Tom Lesnick with Robert W. Baird.

Please go ahead, sir.

Hi, guys.

Good afternoon.

I am just standing in for Paula.

I just wanted to follow-up on an earlier question about the competition.

I know you guys talked about competition across the credit spectrum already, but are you seeing increased competition in certain industries relative to other industries that you are looking at acquiring?

Not really.

There is pretty strong competition across the board.

And we're not really seeing it vary by the industry of the tenant.

Yes, there is enough people that are broad in terms of what they'll look at, whether it is investment grade or noninvestment grade, that I don't think there are any sectors that are just standing there with gaping holes with nobody investing in them.

We kind of look through all of the industries we are in.

We buy convenience stores; other people do.

We buy theaters; other people do.

And you can go right across it.

We are not buying casual dining sit down dinner house restaurants, but other people are, so the fact that we're out of that doesn't mean I think there's a gaping hole.

It is competitive throughout.

I mean, the performance of the net lease companies obviously has been relatively good for most of us for the last few years.

And with the demand for yield, both institutionally and at retail, given the yield characteristics in net lease, it's pretty much across the board everywhere.

We are fortunate that we have done this a long time.

We have the experience and size, and so the deal flow has been equally good.

But it is competitive all the way across.

Thanks.

And then secondly, I just wanted to hone in again on the disposition guidance.

I know you mentioned $100 million plus.

In your comments you said well over $100 million potentially, and it could accelerate through the year.

Could you ballpark that as maybe $100 million to $150 million, or $150 million to $200 million?

How much of a disposition pipeline or backlog do you guys have that you trying to get through?

I really -- that's a good question, and let me take a little time here and give some clarity how we look at it.

First the number.

I was saying $75 million to $100 million and that's up from the $50 million that was up from $25 million or so the year before.

So I now would be surprised if we didn't hit over $100 million.

But I don't have this backlog of stuff that I really feel I need to get out, because I am very much worried about it.

The objective is just generally sell if it will increase the cash flow, if it materially increases credit quality, or if it reduces concentration.

But the primary areas where we've gone through the portfolio, really parsed it, and seen where we see risk.

And that is where we are trying to sell.

We originally targeted -- if you recall, I spent some time on a previous call, and maybe it's a good time to talk a little about it now, focusing around what we are trying to do in changing the portfolio.

I think you know that I will do it quick.

And then relate it to -- because of that what we look at dispositions.

As I mentioned, we are trying to go up the credit curve and really trying to hit retailers that hit the consumers in a certain way and stay away from the rest of them.

And that's just a function of how we see the economy going forward and interest rates.

And a few years ago what we did is we sat down and re-underwrote the whole portfolio, and it was 67 tenants that do 83% of revenue.

And we rerated all the industries based on our views, and then the consumer they serve, and then there were 24 different metrics, which were a lot of debt, fixed charge coverage and margin.

And the big part of it though was saying if they had to refinance their whole balance sheet, and permanent financing costs were 300 basis points higher, what would it look like?

And then 600 basis points higher.

And then modeled the perfect storm, which is revenues down, margins tightened and then interest rates up by 600 basis points.

And when we finished we really dropped everything into four categories.

We had a kind of green color code, which is strong buy.

That was 23% of our revenues were generated by tenants who did that.

Yellow, which was buy, it was 21% of revenue.

Red, which was hold, was 16% of revenue.

And then kind of black, and this is for retailers who were in 23% of the revenue, and that is kind of sell.

So we looked at that and said, okay, we want to materially change the composition of the portfolio, and starting three years ago the easiest way to do that is acquisitions.

When you do it with acquisitions there is a side benefit, and that is it increases your earnings and your dividends materially.

So that really was the focus.

And so we dove in and said, as I talked about a couple times now, in a consumer nondiscretionary, devalue propositions, consumer discretionary, making sure it is low price point and ticket, and going up the credit curve and outside of retail.

And the result, we bought the $6.2 billion.

It's 120 different tenants, 41 industries.

60% of it was retail, 40% wasn't.

But 63% of everything we bought in the last three years was investment grade, and so that took investment grade from 0% to about 35%, and it really changed the portfolio.

The property sales program is the other way to do it.

If you take what was 23% of revenues that comes from retailers that rated black or sell, that's the first step.

But the second step is then -- we don't own their bonds and stock, we own their property.

So we need to look at the individual properties we own, and we want to look at their profitability to see how big the margin of safety is.

And that might cause us to want to keep a property even though we are not particularly enamored with that particular retail and the area they are in.

And then we want to look at if the rent on the property is above or below market.

And if it is above, see where the risk is, and if it is below, if there's an opportunity to capture rent if it came off lease.

And then we will want to probably keep the rest even though the retailer might be rated down in that area.

Initially we came up with a list of $190 million of property sales that we wanted to make that we thought would make a material dent in reducing the risk of our existing portfolio, coupled with a pretty large acquisition pipeline.

To date, we've sold $162 million of that $190 million, so I do have a list there.

And then we will move further into kind of the black or sell rated tenants, but with better properties.

And at that point we may just move into the red a little bit.

So I don't have this pressing, pressing need.

If you combine the sales and the acquisitions -- if you want to grab a pen, these might be interesting numbers.

In 2011 when we re-underwrote the portfolio, it was 67 tenants that did 83% of our revenue.

I mentioned a minute ago 22.8% were in the green, strong buy.

21.4% were in the yellow, buy.

15.9% were in the red, hold, and then we had 22.9% of our revenue came from people black, sell.

Roll forward to the end of the first quarter, and it is now 118 tenants that make up 87.2% of our revenue that are in these numbers.

And we now have in the strong buy, green category, 58 tenants that now do 42.7% of our revenues, so we're from -- in that category up from 22.8% of revenue to 42.7%.

In the yellow we have got 21 tenants that are 21.9% of revenue.

So that's up a bit.

In the red, or hold, we've moved to 25 tenants that are only 9.8% of revenue.

So we have gone from 15.9% to 9.8% there.

And in the black that was 22.9% of the portfolio, it's down to 12.8%, and it's only 14 tenants.

And I can think of one individual tenant that is chunky in the 12.8%, and in that one we went through and did an analysis at the property level and found that we had properties where the rents were above market and the cash flow coverages were okay, and we've sold those.

We had some where the rents were about at market and the cash flow coverages were just okay, and we've sold those.

But in that particular tenant there was a lot of properties where the cash flow coverage was modest, but the rent substantially below market, and we actually think there's a recapture there, so we won't sell those.

But that's kind of it.

We can make more progress on this on the acquisition side, and we also increased earnings and dividends, and we have done a lot of what we were really worried about on the sales.

So I'm going to plug it at $100 million to $125 million, and then if over the course of the year we decide to do a little more, we will communicate that.

I really appreciate the color.

Thanks, guys.

Our next question comes from the line of Todd Stender with Wells Fargo.

Please go ahead, sir.

Hi, thanks, guys.

The same store growth you highlighted was 1.5% in the quarter.

It has historically only been 1%, maybe a little bit better than that.

Is this kind of a rate we should expect the rest of the year, and what do you contribute this little bit above average growth to?

Yes, it is kind of funny.

I think it was a little above average.

If you want a run rate, I think 1% is a good one to use.

Interestingly enough, if you go back a few years ago in the recession, you recall we had a few tenants out of our very large group of tenants that went through some Chapter 11s.

And one of the things we did when we set some rents lower for them, we were also to build in some recapture if their business rebounded.

And their business has now rebounded, and so strangely enough, a good part comes from the restaurant industry.

And it comes from tenants that there was a problem, and their rent accelerated over the last few months as their business was better and our leases had been changed to capture part of that.

But we think going forward, and particularly with the RT coming into the numbers over time, I think 1% is a good run rate.

Okay.

And then you guided for 7.25% for 2013 acquisitions.

The average lease term was up around 14 years in the quarter.

What is a fair lease term average for the remainder of the year?

Do you think it will be that long, or closer to the in-place average of about 11?

I think it could range from 11 up to 15, 16, right in there.

It is hard to tell at this point, but they are all pretty much initial terms above 10.

You see some 20.

You see a fair amount of 15.

It just depends on how much you end up doing of each lease type.

And then it could be impacted if one of the larger transactions comes through, and that can change the cap rate up or down, depending on who the tenant is.

But those numbers John gave you are good ones that we're using for modeling.

And just to stay on that theme, if a good portfolio of assets was presented to you with an investment grade tenant roster at which you deemed an attractive price, what would be the shortest average lease term you would consider?

Interesting.

I would never say never.

I think that's smart to do.

But when you get inside of 10 years, it starts drawing some concern from us.

And you would have to be able to get in and establish that the rents were at or substantially below market before you want to go much inside 10 years I think.

And that's, in a chunky one or two tenant acquisition, something that can be done.

But in a broad M&A type situation it becomes a bit more challenging.

So on any granular acquisition, 10 years is kind of where we just draw the line.

If it was an M&A situation, we would like to think 10 years, subject to review of where rents are versus market.

That's helpful, Tom.

Paul, I assume you use the line to meet your March debt maturity?

That's correct.

Is that factored into guidance, and how long would you assume that that would sit there, and how long is that factored in, and I guess how much is factored into guidance?

That was factored into guidance.

We kind of just planned, since it was only $100 million, to do it on the line and then let the line balance run up a bit before we would consider a more permanent financing activity, in concert with the acquisition deal flow run rate and what happens there.

We sit here today in very good shape in terms of where the line balance is and no imminent capital needs.

But that will really at this point be dependent upon the acquisition deal flow and when that stuff closes.

We also, when we were looking at whatever financing we'd do next and plugging in what it would cost us, tried to use a rate substantially higher than where debt is sitting today.

And then that gives us the option of doing equity or preferred without materially moving the model.

And if we decided to do debt, it would have an impact.

Yes, so we basically modeled it where we could do anything if you will at that time; equity, preferred or debt.

Okay.

Thanks, guys.

Our next question comes from the line of Daniel Donlan with Ladenburg Thalmann.

Please go ahead, sir.

Thank you.

Real quick on the 7.9% acquisition cap rate, is that cash?

Yes.

So on a GAAP basis what would that be?

More.

It would be probably 8%, 10%, that area.

Okay.

And then what is the interest rate -- weighted average interest rate on the $700 million that you guys -- of the debt that is ARCT's?

That is part ARCT and part others we have taken.

Right, so the total portfolio of mortgage is $729 million, Dan, at the weighted average interest rate right now of 5.4%.

All right.

And then as we look at kind of the rent increases -- or decreases, I guess you could say -- on the subsequent expirations versus your initial lease expirations, how do we -- how should we look at that?

Would you expect to see higher rent growth on the initial expirations and then less on the subsequent?

Or does -- is --

We do better on the subsequent than we do the initial.

Traditionally, the subsequent has done very well and is up, and the initial is down.

Rollovers, this year so far in the ones we've done are up about 3.3%.

Modeling for the year, we're kind of just assuming they will be pretty much flat.

Traditionally, and this gets back very historical, we've had roll down.

And the roll down I think back in 2002 was about 24% in that peak.

One of the things that we did -- started seeing in the mid-1990s is that rent roll-down at the end of the lease was really starting to hit us.

This was the mid-1990s.

We dramatically changed how we acquire.

Previous to that, everything we acquired was a new store, and we didn't have cash flow coverages, and they were all less than investment grade.

And we found they did pretty well throughout the lease, but at the end of the lease, if we would had bought a bunch of new stores, about a third of them were below average, a third average, and a third above.

We totally changed our underwriting in retail to preselect those with high cash flow coverage and profits so we would not preselect the one-third that were underperformers.

So over the years what's happened is the burn that we get in lease rollover keeps declining pretty substantially, and yet the portfolio that is rolling over is stuff that was bought still quite a bit ago.

Particularly the subsequent.

So the last year there was a roll-down of about 4%.

So far this year it is up 3%, and we're thinking it will be closer to 0%.

And I think that is a good way to think of it.

Okay, appreciate that.

And then just two quick housekeeping items.

What is the amortization of net mortgage premiums that you guys recognized in the AFFO line?

And what is a run rate there?

I hadn't seen that before.

Obviously, that is associated with any portion of the mortgages that we assume that are above market.

The projection for the year is about $9.2 million.

You see the quarterly amount -- I am just trying to grab the AFFO page -- indicated in here, just under $2 million that occurred in the quarter.

But the projection for the year right now, based on the mortgages that we currently own, is about $9.2 million, and that is an amount that we reduce from AFFO in order to arrive at a real bottom line cash flow amount for us.

Okay.

And then capitalized interest in the quarter?

That's a pretty small number, so I don't really have that handy.

You don't mean capital expenditures?

No, just capitalized interest.

I was just curious if you guys were doing any funding of developments and what not.

I know you have done a little of that in the past.

We are, but -- and I don't know, John, if you have the number handy, but we have -- we definitely have some developments commitments underway, but it is a pretty small amount.

Total for the -- currently --

Why don't you give those numbers, John.

In the first quarter of our activity, $11 million of that was in development funding and funding of expansions on existing assets.

We have $21 million in funding remaining, so it is a pretty small number relative to our overall size.

And I don't have the capitalized interest associated with that.

For anybody who hears those numbers and is not looking for capitalized interest but thinking about development risk, all of those are on existing properties where a lease is in place, so there is no lease up-risk on that.

It is just expansions, or we bought the land and we are funding the development, but we have the lease in place from the tenant already.

Okay.

Thanks, guys.

Our next question comes from the line of Todd Lukasik with Morning News (sic).

Please go ahead, sir.

Hi, guys, this is Todd Lukasik with Morningstar.

Thanks for taking my questions.

Hey, Todd.

Thanks.

Just a quick one on the property type distribution.

I noticed health care is now on the roster at just under 2% of revenues.

Just wondering if you could explain a bit more about what that is, and then in general if you could talk about your attitude toward triple net lease health care and whether or not you expect that to be an area that grows in the portfolio?

Most of that came from the RT acquisition.

The tenants there are DaVita, which most people know, it's one of the largest in the dialysis area; and also Fresenius.

There is also a few Express Scripts properties, actually a few leased to GE Healthcare, and then like four MOBs, I believe they are, that are to St.

Joseph's.

It is fairly limited.

It is not an area we are targeting.

If it grows, it would surprise me as of now.

I guess it could a little bit, but those are mostly that came out of that area.

And I don't think I have a formal attitude toward it, outside that it's an area and an industry that is very well financed by some very smart folks.

If we find something at the margin, fine, but it is not anything we are pointing to.

Okay.

And just wanted to see if you could update us on rent escalators related to inflation across your portfolio.

I know a few years back you guys were trying to get more of those written into your leases.

I was wondering if you could tell us what percentage of the portfolio now has escalators specifically related to something like CPI, and whether or not you have better success today than you did in the past on new sale lease back transactions, getting something like that written into the initial leases?

Today the number is 15.61%.

Have real inflation, percent of sales, that type of stuff, building into it.

That's up substantially from a few years ago.

I would give us a C to D grade at best in getting that done.

It is extraordinarily difficult.

It is not the norm in the industry, and it is really an outlier, and it is probably one of the more frustrating things in the management of the business, and something that we really continue to work on.

As we drop back into a strategic planning mode, which we're going to do this year, that is something that we are really going to think about and where we could go to try and accomplish that.

But to date in the net lease business it's the Fountain of Youth that Ponce de Leon did that nobody ever finds.

I really think that is the case.

And you have to really parse how you ask the question, because if you say do you have CPI accelerators in your leases?

Well, yes, it would be a massive number for us, but they are capped.

So what they really is kind of fixed increases.

So it really does need to be asked that it is unrestricted, and that is about 15.6% for us, and very unusual to get.

Okay, got you.

Thanks for that.

And then just last question with regards to the assets for divestiture.

I know you had an industrial property in there.

I guess you said this quarter.

Going forward, is it reasonable to assume that those are going to be pretty much going to be all retail, or are any other property sectors that you guys have invested in more recently that have properties that are falling into that bucket for divestiture?

I think the bucket is going to be retail, and I think it is going to be the ones that have will fallen down in that black category and tenants that are very levered.

It will probably be dominated by restaurants, and there may be some convenience stores and then a smattering of other things.

Okay.

Thanks again, guys.

Our next question comes from the line of Rich Moore with RBC Capital Markets.

Please go ahead.

Hi, guys, Good afternoon.

Right now about a third of your portfolio is investment grade, and that is obviously up substantially over the last couple years.

As we listen to the call, Tom, I am wondering, the ultimate goal clearly isn't 100% investment grade, even though you keep moving up the investment grade curve.

During the quarter you didn't have -- you had below one-third investment grade tenants come in.

And I'm wondering, has the big move in investment grade change to the portfolio occurred and 35% is about right for the total, or is there much more to go from this point?

I hope it hasn't occurred, and I hope there is much more to go, because I would like that number to be substantially higher.

But I want to modify it in that it is not just buy investment grade to buy investment grade.

The reason we want to do it is over the last 30 years the ten years, quite frankly, just gone from 15% to 1.7% when I looked at it this morning.

And that has made a lot of very levered business strategies that involved a lot of financial engineering work, and should interest rates go up -- which were really low -- I want to focus on companies that would really have trouble refinancing their balance sheet.

Now that means generally investment grade companies are going to be less impacted.

There are tenants who are not investment grade who don't have a lot of debt, but they are not investment grade, or even a shadow rating might be less than investment grade because of their size.

But if their size, and they don't have big refinance risk exposure, and the customer they serve doesn't, then that still interests us very much even though they are not investment grade, because we are really looking for that lack of risk relative to refinance.

However, the bigger the entity, the lower the default rate.

The rating agencies will tell you, all our research tells us that.

I don't want to say always, but I would like it to continue to increase, but we are happy to have some of the tenants not be investment grade.

But even those that aren't, I'll tell you, have moved up the curve, where they're closer to investment grade substantially than they were a number of years ago.

Much less of the highly levered private equity M&A type stuff.

Good, I got you.

That makes sense.

And then on the disposition just for a moment, how much of the portfolio is double net, non-triple net, maybe multi-tenants, which I assume aren't as attractive, that fall in not so much into a tenant category, but fall into a type category that you would want to divest?

Is that part of the strategy as well?

Yes, the industrial property that we sold during the quarter, it was like 400,000 square feet with 375 small tenants.

So you start looking at a weak economic environment, you would worry there.

But we are kind of pretty much done with that.

We have sold most of what we had there.

The double net that we might have is actually more up the credit curve with people, and it is just that it is 2.5 net, or you may have some responsibilities with it.

But those aren't things that we are really looking to get out of.

We are looking at those when we underwrite them relative to the cap rate we get and trying to amortize some type of expense ratio for them even if the expenses are lumpy.

But I think -- go ahead?

I was going to say you didn't get multi-tenant assets from RT that you are trying to get rid of?

No.

In that portfolio it was almost all pretty straight net lease.

If we get a bunch of grocery anchor centers, we will think about selling them quick.

Thanks.

Yes, I got you.

And then on the G&A front it sounds like you are just annualizing this quarter pretty much for the year, which means that you have done the hiring and the additional infrastructure that you need to support things like RT.

Is that true?

So you are pretty much done with that aspect of the business?

Yes, that is part of the answer.

And then the other part is we did have some G&A reduction, because some of the employees who were associated with the large multi-tenant asset we sold affects that employee count, if you will.

So that kind of offset the number a little bit.

But go ahead and elaborate, Tom, (multiple speakers).

Yes, and I will tell you, one of the reasons I don't want to move the guidance right now -- we feel comfortable where it is -- is I think it could get better, but I also think we may do some more with G&A this year.

We are kind of doing a project in house and looking at if the Company was twice as large, what would it need to look like, how would reporting look, what would people be doing?

And then we've identified a number of areas where we want to add staff and expertise.

And there's probably a number of people in acquisitions where we are going to do that, a number of people in research, if we want to do that.

There has been some movement internally, so we need to do that portfolio management.

And we'll have a -- I think a pretty good increase in employee count during the course of this year.

We are in the midst of our recruiting in the undergrad out there, and we will probably do a much bigger class this year than we have done in the past.

So we have grown substantially, and I think we need to add a few people for that, even though this edition of the R2 is very efficient.

But we also want to plan for growth.

So we are going to need I think a couple more executives around here and a good group of professionals added in.

So there will be more.

Most of that won't affect the 2013 estimate too much, Rich.

But it will certainly increase the annualized run rate as we add in people over the course of the year on a go forward basis.

Okay, I got you.

So that's all in the $45 million.

So that sounds good.

The last thing, Paul, the other income line item was I think substantially higher.

What was that exactly?

Yes, that is always a mixed bag of interest income on cash, if we do a capital raise and the cash sits around for a few days or a week, if you will.

Interest income in that sense.

Also, easements and takings, which are a normal part of the portfolio management process.

So if you have a situation where there is an eminent domain on a portion of your parking lot.

Sometimes it doesn't even affect the viability of the asset itself.

It actually ends up being pretty positive proceeds that we receive in this kind of situation.

So that is all that $1.4 million is, is a mixed bag of those items, if you will.

Nothing different about the normal business.

Okay, so that goes back down, I assume, most likely in 2Q.

Correct.

I don't think $1.4 million is an appropriate run rate, no.

Got you.

Okay, good, thank you, guys.

Thanks.

This concludes the question and answer portion of Realty Income conference call.

I would now like to turn the conference over to Tom Lewis for concluding remarks.

Please go ahead, sir.

Thank you, Tega.

Thank you, everybody, for joining us for this.

I know it's a busy season and a particularly busy day and we appreciate the attention and I look forward to talking to you at one of the upcoming events.

Thank you.

Ladies and gentlemen, that does conclude our conference for today.

You may now disconnect.