Realty Income Corp (O) 2017 Q2 法說會逐字稿

Good day, and welcome to the Realty Income Second Quarter 2017 Earnings Call.

Today's conference is being recorded.

At this time, I'd like to turn the conference over to Ms. Janeen Bedard, Vice President.

Please go ahead, ma'am.

Thank you all for joining us today for Realty Income's Second Quarter 2017 Operating Results Conference Call.

Discussing our results will be John Case, Chief Executive Officer; Paul Meurer, Chief Financial Officer and Treasurer; and Sumit Roy, President and Chief Operating Officer.

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 the factors that may cause such differences in the company's Form 10-Q.

(Operator Instructions)

I will now turn the call over to our CEO, John Case.

Thanks, Janeen, and welcome to our call today.

Our business continued to perform well in the second quarter with healthy AFFO per share growth of 7%.

During the quarter, we completed $321 million in high-quality acquisitions and increased portfolio occupancy to 98.5%, while maintaining our conservative balance sheet.

Given the confidence we have in our business, we are increasing our 2017 acquisition's guidance from $1 billion to $1.5 billion.

We're also increasing our 2017 AFFO per share guidance, as we now expect 2017 AFFO per share to be $3.03 to $3.07, which represents annual growth of 5.2% to 6.6%.

Let me hand it over to Paul now to provide additional detail on our financial results.

Paul?

Thanks, John.

I'll provide highlights for a few items in our financial results for the quarter, starting with the income statement.

Interest expense increased in the quarter by $6.3 million to $63.7 million.

This increase was primarily due to a higher outstanding debt balance in the second quarter following our March issuance of $700 million of long-term unsecured bonds.

Our G&A as a percentage of total rental and other revenues was 5.5% for the quarter and 5.1% year-to-date.

We are still projecting approximately 5% for the year, and we continue to have the lowest G&A ratio in the net lease sector.

Our nonreimbursable property expenses as a percentage of total rental and other revenues were 1.6% in the quarter.

Our guidance remains 1.5% to 2% for all of 2017.

Funds from operations, or FFO per share, was $0.75 for the quarter versus $0.70 a year ago.

We are revising our 2017 FFO guidance to a range of $2.96 to $3.01 per share.

Our reported FFO follows the NAREIT-defined FFO definition, which includes various noncash items such as quarterly interest rate swap, gains or losses, amortization of lease intangibles and the $0.05 charge incurred in connection with the redemption of our Series F preferred stock in April.

This $0.05 preferred stock redemption charge is the primary difference in our FFO and AFFO guidance.

Adjusted funds from operations, or AFFO, or the actual cash we have available for distribution as dividends, was $0.76 per share for the quarter, representing a 7% increase over the year ago period.

Briefly turning to the balance sheet.

We've continued to maintain our conservative capital structure.

During the quarter, we raised $55.1 million in equity, primarily through our ATM program.

Our senior unsecured bonds have a weighted average remaining maturity of 7.9 years, and our fixed charge coverage ratio is 4.4x.

Other than our credit facility, the only variable rate debt exposure we have is on just $23 million of mortgage debt.

And our overall debt maturity schedule remains in very good shape with only $213 million of debt coming due in the remainder of this year, and our maturity schedule is well laddered thereafter.

And finally, our overall leverage remains modest with our debt-to-EBITDA ratio standing at approximately 5.6x.

In summary, we continue to have low leverage, excellent liquidity and continued access to attractively priced equity and debt capital.

Now let me turn the call back over to John to give you more background on our results.

Thanks, Paul.

I'll begin with an overview of the portfolio, which continues to perform well.

Occupancy based on the number of properties was 98.5%, the highest occupancy we have achieved in 10 years.

We continue to expect occupancy to be approximately 98% in 2017.

During the quarter, we re-leased 53 properties to existing and new tenants, recapturing approximately 113% of expiring rent, which is well above our long-term average.

This quarter was the fourth consecutive quarter of leasing recapture rates above 100%.

For the first half of 2017, we re-leased 102 properties to existing and new tenants, recapturing approximately 109% of expiring rent.

Since our listing in 1994, we have re-leased or sold over 2,400 properties with leases expiring, recapturing over 99% of rent on those properties that were re-leased.

This compares favorably to the companies in our sector who also report this metric.

Our same-store rent increased 0.4% during the quarter, primarily due to the timing of percentage rent increases on a year-over-year basis.

For the first half of the year, our same-store rent increased by 1%, which is consistent with our projected run rate for 2017.

Our portfolio continues to be diversified by tenant, industry and geography and, to a certain extent, property type, which contributes to the stability of our cash flow.

At the end of the quarter, our properties were leased to 250 commercial tenants in 47 different industries located in 49 states and Puerto Rico.

80% of our rental revenue is from our traditional retail properties.

The largest component outside of retail is industrial properties at about 13% of rental revenue.

Walgreens remains our largest tenant at 6.7% of rental revenue, and drug stores remain our largest industry at 11% of rental revenue.

As you all know, due to regulatory concerns, Walgreens terminated its agreement to purchase Rite Aid and instead plans to purchase about 2,200 Rite Aid stores.

While the proposal must still clear regulatory approval, the completion of the transaction would have benefits for both companies.

Walgreens would fill in gaps in its geographic footprint and achieve additional financial and operational synergies.

And Rite Aid has stated it would delever its balance sheet, and it would remain the third largest player in the industry, while gaining access to Walgreens' purchasing network.

Within our retail portfolio, over 90% of our rent comes from tenants with a service, nondiscretionary and/or low price point component to their business.

We believe these characteristics allow our tenants to compete more effectively with e-commerce and operate in a variety of economic environments.

These factors have been particularly relevant in today's retail climate, where the vast majority of U.S. retailer bankruptcies this year have been in industries that do not share these characteristics.

We continue to have excellent credit quality in the portfolio with 46% of our annualized rental revenue generated from investment-grade-rated tenants.

The store-level performance of our retail tenants also remained sound.

Our weighted average rent coverage ratio for our retail properties remains 2.8x on a four-wall basis, and the median remains 2.7x.

Our watch list has declined by approximately 15 basis points and remains in the low 1% range as a percentage of rent, which is consistent with our levels of the last few years.

Moving on to acquisitions.

We completed $321 million in acquisitions during the quarter at attractive investment spreads.

We continue to see a steady flow of opportunities that meet our investment parameters.

We remain selective in our investment strategy, acquiring less than 4% of the amount we source.

Our low cost of capital allows us to simultaneously acquire the highest-quality properties that provide favorable long-term returns, while also creating meaningful near-term earnings growth.

Given the continued strength in the investment pipeline, we are increasing our acquisitions guidance for 2017.

We now expect to complete approximately $1.5 billion of acquisitions, an increase from our prior estimate of $1 billion.

This estimate does not account for any unidentified large-scale transactions.

Now let me hand it over to Sumit to discuss our acquisitions and dispositions.

Thank you, John.

During the second quarter of 2017, we invested $321 million in 73 properties located in 27 states at an average initial cash cap rate of 6.6% and with a weighted average lease term of 13 years.

On a revenue basis, approximately 33% of total acquisitions are from investment-grade tenants.

91% of the revenues are generated from retail and 9% are from industrial.

These assets are leased to 23 different tenants in 16 industries.

Some of the most significant industries represented are health and fitness, quick-service restaurants and theaters.

We closed 26 discrete transactions in the second quarter.

Year-to-date 2017, we invested $692 million in 126 properties located in 30 states at an average initial cash cap rate of 6.3% and with a weighted average lease term of 14.8 years.

On a revenue basis, 51% of total acquisitions are from investment-grade tenants.

95% of the revenues are generated from retail and 5% are from industrial.

These assets are leased to 34 different tenants in 20 industries.

Some of the most significant industries represented are grocery stores, automotive services and health and fitness.

Of the 37 independent transactions closed year-to-date, 2 transactions were above $50 million.

Transaction flow continues to remain healthy.

We sourced approximately $7 billion in the second quarter.

Year-to-date, we have sourced approximately $18 billion in potential transaction opportunities.

Of these opportunities, 46% of the volumes sourced were portfolios; and 54%, or approximately $10 billion, were one-off assets.

Investment-grade opportunities represented 35% for the second quarter.

Of the $321 million in acquisitions closed in the second quarter, 72% were one-off transactions.

We continue to capitalize on our extensive industry relationships developed over 48 years of operating history.

As to pricing, cap rates continued to remain flat in the second quarter with investment-grade properties trading from around 5% to high 6% cap rate range and noninvestment-grade properties trading from high 5% to low 8% cap rate range.

Our investment spreads relative to our weighted average cost of capital remained healthy, averaging 221 basis points in the second quarter, which were well above our historical average spreads.

We define investment spreads as initial cash yield less our nominal first year weighted average cost of capital.

Regarding dispositions.

During the second quarter, we sold 14 properties for net proceeds of $12.3 million at a net cash cap rate of 6.6% and realized an unlevered IRR of 9.5%.

This brings us to 28 properties sold year-to-date for $43.5 million at a net cash cap rate of 7.9% and realized an unlevered IRR of 9.7%.

In conclusion, we remain confident in reaching our 2017 acquisition target of approximately $1.5 billion and disposition volume between $75 million and $100 million.

With that, I'd like to hand it back to John.

Thanks, Sumit.

Last month, we increased the dividend for the 92nd time in the company's history.

The current annualized dividend represents a 6% increase over the year ago period.

We have increased our dividend every year since the company's listing in 1994, growing the dividend at a compound average annual rate of just under 5%.

We're proud to be 1 of only 5 REITs in the S&P High Yield Dividend Aristocrats Index.

Our dividend represents an AFFO payout ratio of approximately 83% based on the midpoint of our 2017 guidance.

To wrap it up, we are pleased with our company's operating performance and remain confident in our outlook.

Our real estate portfolio is performing well, our acquisition pipeline is robust, and our balance sheet is conservatively capitalized.

Our cost of capital remains a competitive advantage in the net lease industry, which we believe allows us to continue generating favorable risk-adjusted returns for our shareholders.

At this time, I'd like to open it up for questions.

Operator?

(Operator Instructions) We'll take our first question from Joshua Dennerlein with Bank of America Merrill Lynch.

So I saw on Page 24 there's an additional invested capital line, a bit higher than normal this quarter.

Could you walk us through that line item, how we should think about it?

Yes, 24 of the supplement, I think, is what you're referring to.

Virtually all of that was related to an expansion of an existing industrial distribution property where we double the size of it and extended the lease term with an investment-grade credit by 10 years.

Our incremental yield on that investment capital was 7.5%, which is about 150 basis points above where our acquisition yield would be on this type of property.

So the value creation exercise for the company and its shareholder.

So we were pleased with that.

Great.

And do you think this will become more common for your business on a go-forward basis?

Or is this -- this is kind of a one-off here?

We hope so.

I mean, these expansion opportunities are quite attractive for us and deliver attractive risk-adjusted returns and returns beyond what the acquisitions typically yield the company.

So I think as we move forward, we'll see that number grow a bit.

And we'd like to see it grow a bit.

Right now, overall, we have $90 million under development, of which we have $16 million to fund.

We'd like to see that number pick up.

That does include expansions and redevelopments.

We'll take our next question from Ryan Meliker with Canaccord Genuity.

I guess, just -- I wanted to talk a little bit acquisitions.

You obviously increased your guidance for the year by a pretty lofty $500 million.

Can you just give us some color on what you guys are seeing out there?

Is it larger portfolios that seem to be coming to market?

I know there's been a lot of expectations that maybe volumes might slow this year or next year.

It sounds like you guys aren't seeing that.

Just any color would be helpful.

Sure.

We're not seeing buying slow.

Year-to-date, we've sourced $18 billion in investment opportunities, and we're still remaining quite selective in what we're investing in.

Year-to-date, 4% of what we've sourced we've actually closed on.

When we look forward, we're seeing a combination of some larger portfolios but also strong activity in our aggregation program where we're looking at assets on a more granular basis or small portfolios.

So the increase is predicated on both types of acquisitions, smaller portfolios as well as a couple of large sale-leaseback opportunities we're working on and would expect -- we would hope to hit those as well.

So again, not seeing any sign whatsoever of the transaction opportunities slowing, Ryan.

Great.

That's helpful.

This is a quick follow-up.

Are you changing any of your underwriting standards, driven by what's going on in the retail environment and some of the uncertainties surrounding some retailers with regards to e-commerce?

Well, on the retail side, we continue to focus on service, nondiscretionary and/or low price point businesses which we have done now for nearly 10 years.

And we do that because those types of tenants have been much more resistant to the impact of e-commerce.

So we've not changed our investment parameters on the retail front or on the industrial front.

We continue to adhere to those investment parameters.

And when you look at the selectivity, as I said just a moment ago, we're not increasing the percentage of opportunities we see in terms of what we're closing on.

Over the last few years, it's averaged probably 8%, and this year we're running at 4%.

So again, I think that selectivity metric is something the market can look at and be comfortable that we're not changing our investment parameters.

We'll take our next question from Vikram Malhotra with Morgan Stanley.

Just on the pipeline -- or sorry, the watch list.

You mentioned some -- that watch list declined.

Can you maybe give us some color what actually fell off the watch list?

And has the composition changed in any way?

Well, the overall watch list declined by 15 basis points.

It's still in the low 1% area.

And that's a combination of some sales we made and also some improving financial metrics on some properties that were in that watch list that we took out given the improvement in the financial metrics for those particular properties.

So Vikram, that's a fluid concept.

That's changing almost on a daily basis based on conversations we're having with our tenants and the information we're receiving in our research and credit group.

But it is trending down.

And I would add to that, that our credit watch list has been running around 6%.

But this past quarter, it was less than 5%.

So we're seeing the credit profile within the portfolio improve as well.

Okay.

That's helpful.

And then just as a quick follow-up.

In your expirations over the next 2 years, are any of your top 10 or 15 tenants, are any of them in there?

Anything sizeable we should be aware of?

No.

Nothing sizable in our top tenants rolling within the next 1 to 2 years.

We'll take our next question from Collin Mings with Raymond James.

Just, first one from me.

Can you guys just update us on how you're thinking about capital markets activity over the remainder of the year with about $650 million or so on the line at the end of June?

Just remind us how much you're comfortable carrying on that and how you see the back half playing out from a capital markets perspective.

Well, our line of credit has a base amount of $2 billion with an accordion feature at our option of another $1 billion and has 2 years remaining in terms of term, plus a 1-year extension option at our -- in -- at our option.

So we are seeing -- we have plenty of liquidity today.

As we look forward, what we'll do with regard to financing is we'll look at all of the markets, the unsecured market, the debt market, the hybrid markets and at the appropriate time pick the right form of capital to term out our line balance.

So as we sit here today, we don't have any specific plans in terms of what we want to issue.

But as that line balance grows, we're comfortable with it, up into the billions, but we want to be opportunistic in excess capital at the appropriate time and certainly the right types of capital.

Okay.

And then maybe just switching gears.

As far as the entry of NPC International into the top 20 tenant roster, any color you can provide on that?

Yes.

NPC has been a relationship and a tenant for us for probably 20 years now, and they are the largest Pizza Hut franchisee in the U.S, and they are the largest Wendy's franchisee in the U.S. And we did a Wendy's portfolio last quarter that brought them back into our top 20.

They've been in our top 20 before, but it's a result of a portfolio acquisition of Wendy's.

We'll take our next question from Nick Joseph with Citi.

We'll take our next question from Michael Carroll with RBC Capital Markets

Yes.

John, can you provide some color on the health of the leapy market versus the historical trends?

It looks like companies have been driving much higher recapture rates over the past few years?

Is this a trend?

And if so, what's driving it?

Well, it's been a trend.

We've had, over the last 5 quarters, strong numbers on that front.

And I think it just speaks to the portfolio, the health of the tenants, the quality of the properties and, specifically, those tenants' operations at those specific properties.

So we've been pleased with it.

Over the life of the company, we have had recapture rates right at about 100%, just a hair below, I think it's 99.4%.

So realizing these recapture rates in the 113% range, very healthy.

And I think it speaks to the quality and health of the portfolio.

I'll tell you, we have a tremendous team in our portfolio management group that is working these properties, in some cases, years in advance, negotiating with our tenants to retain them in those assets, and it makes sense for their business but also for our business.

So it's been a real focus of ours over the last several years and one which we continue to have.

And we hope it'll yield similar results.

It'll vary from quarter-to-quarter, but the trend certainly has been positive for us.

Okay.

And then I might be nitpicking here a little bit, but given your success you had in the first half of '17, why was it necessary to remove the top end of the same-store rank guidance range this quarter?

Yes.

We went out with same-store rent guidance at the beginning of the year of 1% to 1.2% growth.

So as we're here at the midyear point, we've got more visibility in what the same-store pull is going to look like for the remainder of the year.

And it looks like it's going to be in -- closer to 1%.

And this is the time of the year typically that we update our guidance numbers.

And we thought it'd be appropriate to move back to 1%.

It's not related to any tenant credit issues.

As I've said, our credit watch list as well as our overall watch list have continued to decline.

It's just fine-tuning at the midyear point.

Really nothing to read into that.

(Operator Instructions) And we'll take our next question from Dan Donlan with Ladenburg Thalmann.

Just 2 questions from me.

John, curious if you could comment on what portion of the portfolio is baked in but still paying rent?

And then kind of how do you manage that down, especially if you have a lot of lease term left.

How do you guys kind of look at that?

Okay.

Well, we have, Dan, about 0.75% of rent that is current but on vacant assets, and that's in line with where our company has been for a while now a number of years.

The average lease term remaining on those properties -- it's about 60 properties, it's 6 years.

61% of those closed current, as we refer to them, are investment-grade rated tenants.

And we remain in close communications with those tenants in terms of re-leasing or subleasing.

And we're not re-leasing those primary tenants from their rental obligations.

We're spending more time working on those properties expected to roll in the near term, so within the next 3 years, of course, than we are properties that may not roll for 6, 7, 8, 9 years and have an investment-grade tenant paying rent.

So, yes, that's part of the business and has been for a long time.

Okay.

And then just curious on Gander Mountain what the thought process is there?

I think if I look at the list, say, maybe 1 of your 9 properties is going to be kept.

If you look at the new build list that they've put out, it seems like maybe 3 of 9. So just kind of curious how your discussions are going there and do you have any replacement tenants lined up?

Any additional commentary would be helpful.

Sure.

Well, Gander is interested in the majority of our properties, and they're being purchased by Camping World.

So we know FreedomRoads, Camping World very well.

They've been a tenant of hours for a long time.

We're in discussions with them.

The list that are being put out there, I'd say, aren't always completely accurate.

But in some cases, Gander may want to stay but not at a rent level that makes sense for us.

So we're having conversations with other tenants beyond Gander for those properties that may yield a better result than what Gander's staying would be.

So clearly, they'll stay in a handful, and we'll see what happens to the others.

We've been -- we're current on Gander rent through the month of July.

And we have factored, I think fairly conservatively, our expectations of the impact of Gander into our guidance for this year.

And so we're not expecting any surprises from that standpoint.

And collectively, on an annualized basis, Gander is less than 0.5% of our rent.

So that's not completely insignificant, but it's not a large material issue for us.

And we think the locations that we have are attractive, in major metropolitan areas.

And again, we're seeing good interest from other tenants in those locations.

So I think we're going to be fine there.

(Operator Instructions) And we'll take our next question from Karin Ford with MUFG Securities.

Have you seen any change in the tone of your discussions with any of your retail tenants?

Are they, say, more wary of extension plans, less likely to renew?

Anything like that?

No.

Our renewal rates are up, more are considering expansions.

In our conversations with them, Karin, they're optimistic about their business.

The portfolio overall is in very good health.

And I'd say, we're not experiencing any more tenant credit issues than we have in any year in the last 4 or 5 years of this cycle.

So this year has been pretty much business as usual.

The largest issue we just talked about, and that's Gander, that's not that material for us.

And then once you get beyond that, there are a few moms and pops that have had some credit issues.

But even on a collective basis, they're not material for our company.

Okay.

And my second question is, given that success and the fact that your credit has held up so well with your service, nondiscretionary low price point tenant in the retail -- on the retail side, are you seeing more competition for those assets?

Are people starting to chase them more?

Are you seeing a widening of the gap in cap rates between those types of retailers and deals with other types of retailers?

Well, I think retailers that are e-commerce resistant and have proven to be to this point and are well-capitalized, high credit, well-managed businesses are going to trade at cap rates that are more aggressive.

And fortunately for us, we've got, overall the lowest cost of capital in the business.

We have the greatest access to capital, and we have the ability to do larger-scale transactions with these larger companies without creating tenant revenue concentration issues for the company.

So we're really in an advantageous position.

We've developed great relationships with these -- those tenants tend to be larger.

And those relationships are resulting in some opportunities on the acquisitions front that are being done on a purely negotiated basis.

So we're happy with that.

We'll take our next question from Michael Knott with Green Street Advisors.

Just a quick question on just more generally what's happening with yields in the investment marketplace.

Your yield that you achieved on acquisitions this quarter was higher than it had been for the last couple of quarters.

So I just wanted to get your thoughts on what you're seeing and what you expect to happen over the balance of the year in that marketplace?

Yes.

Michael, the yields vary from quarter-to-quarter.

The yield this quarter was 6.6%.

In the first quarter, it was 6.1%.

Year-to-date, it was 6.3%.

That fluctuating yield is really a -- between the first and second quarter the function of 2 items.

One is we did more investment grade in the first quarter than we did in the second quarter, and that's really a function of the opportunities available to invest in, in the market.

And then the lease terms were slightly longer in the first quarter than the 13-year term that we had in the second quarter.

And hence, you had a bit of a pricing differential on cap rate.

But year-to-date, the leasing terms of 15 years.

And over the course of the last 3 or 4 years, our lease terms by quarter vary quite a bit.

Sometime they'd been as low as 10 years and as high as 17 years.

So coming in at 15 year-to-date is fine.

And the cap rate, we're still guiding to something for the year in the low 6s.

And what'll impact that is just simply -- the quality of the properties in both quarters were very strong.

And when you do get investment grade on top of strong real estate location with strong operating metrics, you are going -- that is going to be reflected in a more aggressive cap rate.

And then, can we get your views on traffic and trends in the restaurant space?

Maybe more specifically on QSRs, I guess, because that's where your focus is more so.

And then also with my last question, can I get you to make any comments on your view of grocery changes potentially with Amazon entering into Whole Foods?

Sure.

I'll start with Amazon on the grocery front.

Obviously, there's been a lot in the news about that.

Our grocery exposure is just under 5%.

Virtually all of that is with 2 of the leading grocers in the marketplace, that's Walmart Neighborhood Markets and Kroger, which have both developed successful online businesses, omnichannel businesses and continue to expand those businesses and incorporate their real estate locations, which are favorable.

They're also very well-capitalized companies who have the ability to continue to invest in their e-commerce initiatives, and they've shown with their results to date in terms of their investments in those initiatives good growth and good results.

So they're well positioned to compete with the Amazon-Whole Foods.

And I think we'll see how this plays out.

But we have very strong grocery stores there, and we have the ones we want.

I think the ones that are going to be impacted are the ones that are smaller, regional, don't have an omnichannel presence and don't have the capital strength to invest in that business.

On QSR traffic, Sumit, you want to take that?

Yes, sure.

So we continue to invest in QSRs.

And we feel that this particular subsector in the restaurant space has continued to improve.

Our specific portfolio has coverages in the high 2s in this particular area.

The fact that John alluded to a Wendy's portfolio that we just closed on, this is an area that we feel very good about and will continue to invest in.

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

I will now turn the call over to John Case for concluding remarks.

Thank you, Casey, and thanks everyone for joining us today.

We look forward to speaking with all of you as we head into the fall and conference season.

Have a good afternoon and a great remainder to your summer.

That concludes today's call.

Thank you for your participation.

You may now disconnect.