Realty Income - Earnings Call - Q3 2011

Transcript

Speaker 0

Welcome to the Realty Income third quarter 2011 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. If you have a question, please press the star followed by the one on your touch-tone phone. If you'd like to withdraw your question, please press the star followed by the two. If you're using speaker equipment, it may be necessary to pick up your handset before making your selection. I would now like to turn the conference over to Mr. Tom Lewis. Go ahead, sir.

Speaker 1

Thank you, Joe. Good afternoon, everyone, and welcome to our conference call where we'll go through the operations and results for the third quarter and year to date. With me in the room today, as usual, is Gary Molino, our President, Paul Meurer, our EVP and CFO, John Case, our EVP and Chief Investment Officer, and Mike Pfeiffer, our EVP and General Counsel. As always, during this call, we will make certain statements that may be considered to be forward-looking statements under Federal Securities Law, and the company's actual future results may differ significantly from the matters discussed in the forward-looking statements. We will disclose in greater detail in the company's Form 10-Q the factors that could cause the differences. Per usual, Mr. Meurer will start with a review of the numbers.

Speaker 7

Thanks, Tom. As usual, let me go through the financial statements briefly and provide a few highlights of the financial results for the quarter, starting with the income statement. Total revenue increased 23.6% to $107.3 million this quarter versus $86.8 million during the third quarter of last year. This obviously reflected the significant amount of new acquisitions over the past year, but also positive same-store rent increases for the quarterly period of 1.8%. On the expense side, depreciation and amortization expense increased by $7.9 million in the comparative quarter, as depreciation expense increases, obviously, as our property portfolio continues to grow. Interest expense increased by just over $3.4 million. This increase was due primarily to the June issuance of $150 million of notes in the reopening of our 2035 bond, but also because of the $96.6 million credit facility balance at quarter end.

On a related note, our coverage ratios both remain strong. Interest coverage is now at 3.5 times and fixed charge coverage now at 2.9 times. General and administrative or G&A expenses in the third quarter were $7.1 million, representing 6.7% of total revenues, as compared to $6.2 million during the third quarter of last year, which represented 7.1% of total revenues at that time. Our G&A expense has increased a bit as our acquisition activity has increased, and we have invested in some new personnel for future growth. This quarter's G&A was also impacted by the expensing of $233,000 worth of acquisition due diligence costs. Our current projection for G&A for 2011 is approximately $30 million, which will represent only about 7% of total revenues. Property expenses decreased, suggesting under $1.7 million for the quarter.

These expenses are primarily associated with the taxes, maintenance, and insurance expenses, which we are responsible for on properties available for lease. Our current estimate for all of 2011 is about $7.5 million. Income taxes consist of income taxes paid to various states by the company, and they were $367,000 during the quarter. Income from discontinued operations for the quarter totaled just over $3.1 million. This income is associated with our property sales activity during the quarter. Our credit subsidiary did not acquire or sell any properties in the quarter. We did sell 12 properties from our core portfolio, resulting in a gain on sales of $3.1 million. A reminder that these property sales gains are not included in our FFO or in our AFFO calculation. Preferred stock cash dividends remained at $6.1 million, and net income available to common stockholders increased to approximately $34.7 million for the quarter.

Funds from operations, or FFO, increased 32.6% to $63.4 million for the quarter. FFO per share increased 8.7% to $0.50 for the quarter. Adjusted funds from operations, or AFFO, or the actual cash we have available for distribution as dividends, was higher at $0.51 per share for the quarter. Our AFFO is usually higher than our FFO because our capital expenditures are fairly low and we have minimal straight-line rent in the portfolio. We increased our cash monthly dividend again this quarter. We have increased the dividend 56 consecutive quarters and 63 times overall since we went public over 17 years ago this month. Our dividend payout ratio for the quarter was 87% of our FFO and 85% of our AFFO. Briefly turning to the balance sheet, we have continued to maintain a conservative and safe capital structure.

In September, as you know, we raised just over $200 million of new capital in a common stock offering. Our current debt-to-total market capitalization is only 28%, and our preferred stock outstanding represents just 5% of our capital structure. As I mentioned, we have $96.6 million of borrowing on our $425 million credit facility. We have no debt maturity until 2013. In summary, we currently have excellent liquidity, and our overall balance sheet remains very healthy and safe. Let me turn the call now back to Tom, who will give you a little bit more background on these results.

Speaker 1

Thanks, Paul. I'll start with the portfolio, which performed very well during the third quarter. Operations continued to improve across the portfolio. At the end of the quarter, our largest 15 tenants accounted for 51.2% of our revenue. That's down a little bit from last quarter, and the average cash flow coverage at the store level for those 15 tenants remains fairly high at 2.41 times during the quarter. We ended the third quarter at 97.7% occupancy and 59 properties available for lease out of the, this is unusual, very even number and number of properties, 2,600 properties. That's up about 40 basis points in occupancy from the second quarter and up about 130 basis points for the same period a year ago.

In the quarter, we had only six new vacancies, and we leased or sold 15 properties and obviously added to the portfolio, and that's the reason for the increase in the occupancy, but obviously very healthy at 97.7%. My sense is we should look for some moderation in occupancy in the fourth quarter, and that's primarily due to a number of lease rollovers that occurred at the beginning of the quarter. There were 18 that came off lease, and sometimes lease rollovers get a bit lumpy, and that was the case this quarter. The 15 Friendly's properties we got back, our best estimate right now is about 97% for occupancy at the end of the fourth quarter. We'd anticipate as we release those properties that came off the rollover and Friendly's that that would go back up in the first quarter of next year. A good guess is 97%.

Same-store rents on the core portfolio increased 1.8% during the third quarter. That's the same as the second quarter and 1.5% year to date. That's a very healthy number for us and that lease company. If you wanted to look across the portfolio kind of where the increases and decreases came from, we had only four industries that had declining same-store rents during the quarter. That was office supplies, childcare, auto service, and bookstores, but it was a very small decline of only about $50,000. Two of the industries were flat, and 23 had same-store rent increases, with the majority coming from motion picture theaters and convenience stores and into kind of my supplies, casual dining restaurants, and motor vehicle dealerships. Both of those as a function of during the recession, we had some rent reductions we did for those tenants, and those burned off.

Their businesses come back very nicely, and that's the reason that happened this quarter, even though I think their fundamentals may not be representative of that. We did see the rent go up. The balance of the industries had fairly small increases during the quarter, but the 23 industries together had increases of about $1.45 million for a net gain of $1.4 million. Obviously, the occupancy gains and same-store rent increases over the last four quarters have been very healthy, and it continued in the third quarter. Relative to diversification, obviously up to 2,600 properties at the end of the quarter. That's up 77 properties from last quarter, 38 different industries, 134 multiple unit tenants in 49 states. From an industry exposure standpoint, we continue to diversify with 38 industries. That's up six from the same period a year ago. Our major concentrations, the top couple came down a bit.

Convenience stores were 18.3%. That's down about 70 basis points from last quarter. Restaurants a little less than last quarter also at 17.3%. Theaters were up a bit, 140 basis points to 9.2%, and that's a function of some recent acquisitions. Health and fitness, which is 6.1%. The only other categories that are over 5% today are beverages at 5.6%, automotive tire stores, which have been, along with convenience stores, both at 5.2%. Those were much larger concentrations going back quite a ways. Pretty good shape by industry. The largest tenant switched this quarter to AMC Theatres at 5.4%. That's a function of some acquisitions. Diageo second at 5%. Everything else is under 5%. I mentioned our 15 largest tenants are 52% of rent. When you get to the 15th largest tenant, as you can see in the release, it's about 2.2% and goes down from there.

When you get to the 20th largest tenant, you're at only about 1.5% of rent. We continue to diversify the portfolio. That's also true from a geographic standpoint, still in 49 states everywhere but Hawaii. Average remaining lease length in the portfolio at 11.1 years remains pretty healthy. Obviously a good quarter for the portfolio. As we look forward kind of in the next year, we think expectations for economic growth, notwithstanding higher than expected GDP numbers today, have moderated over the last couple of quarters. I think that will lead us to be a little more cautious about the portfolio going into 2012. If we look across the retail landscape, I think most of us have observed that the high end in retail is holding up well. We don't have a lot of that.

At the low end, it is tough in retail, but the dollar stores and the value retailers, club stores seem to be doing pretty well serving that market. As we look out there and in areas that might highlight some concern, I think it's really in the consumer discretionary area to the middle and lower class. You can see their businesses being stressed a bit. Some of it is margin compression as their costs go up. If you look into areas like casual dining, consumer electronics, office supplies, we think those are all worth watching. Fortunately, most of our portfolio is in the basic needs type of businesses with the tire stores, auto service, c-stores, that type of things, which are doing pretty well. Looking at the portfolio, absent Friendly's, nothing has popped up that gives us concern from a tenant standpoint.

We adjusted our expectations a bit for the portfolio. In the guidance for 2012 is our expected impact from the Friendly's filing. As well, we also added into the estimate an expectation of additional filings of tenants equal to about 5% of revenue with what has been our normal recovery rates over time. While we don't know who it would be, we just think in an environment that's a little tough in retail, it was good for us to do that in our guidance. We also in the guidance assume that none of the properties that came back from Friendly's or any other tenants would be leased during 2012. I think that we've been conservative in our estimates relative to the portfolio. That notwithstanding, we still think that our occupancy will remain very high in 2012 in the 97% range. We'll have to see how that works out.

Overall, we think we'll have high occupancy. Moving on to property acquisitions, obviously a very strong quarter and year for acquisitions. I'll let John Case, our Chief Investment Officer, comment on what we bought and what the environment is.

Speaker 5

Thanks, Tom. Our acquisitions activity continued to be robust in the third quarter. We acquired 89 properties for approximately $462 million, making the third quarter our second most active quarter for acquisitions in our company's history. The average initial lease yield on these investments was just a shade over 8.1% and the average lease term was approximately 10 years. Properties are diversified by geography, tenant, industry, and property type. They are located in 15 states, are 100% leased to non-tenants in seven different industries, and represent three property types, with our traditional retail investments accounting for just over 88% of third quarter acquisitions volume. The industries are automotive collision services, food processing, health and fitness, quick service restaurants, theaters, transportation services, and wholesale clubs.

Of the $462 million that we acquired in the third quarter, $189 million was part of the $544 million diversified net lease portfolio acquisition we announced in the first quarter. As the third quarter ends, we have closed $525 million of the $544 million acquisition during the first, second, and third quarters. The final $19 million of this portfolio should close this quarter. For the first three quarters of 2011, we have acquired 125 properties for $826 million with an average initial lease yield of approximately 8% and an average lease term of about 11.5 years. The properties are leased to 20 commercial tenants in 15 different industry segments. The $826 million in acquisitions we have completed in the first three quarters is the most we have completed in any previous full calendar year.

For the entire year, we expect to complete just over $850 million in acquisitions at an average initial yield of about 8%. We continue to be pleased with our acquisitions activity. As we look forward, acquisitions transaction flow remains strong. With the high yield in CMBS markets cooling off since mid-year, property owners continue to turn to the sale-leaseback market for liquidity. There continues to be significant competition for property portfolios from multiple sources with a good bit of capital, but we should continue to be competitive in the marketplace. We're currently seeing opportunities in all of our property types and in a wide variety of industries and tenants. The majority of our current acquisition opportunities are in our traditional retail properties.

Initial yields or cap rates seem to be holding steady for now, ranging from the mid-7% area for high credit tenants to up to the low 9% range for some of the smaller non-investment grade tenant properties. We continue to believe that our initial yield on future acquisitions should average right around 8%. Tom?

Speaker 1

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

Speaker 5

I'll do my best.

Speaker 1

Okay. As John mentioned, the pace of transactions to look at has been very good. Obviously, we've gotten our fair share over the last 18 months or so, and that's led to a couple of years here of record acquisitions. I'd also want to note that that level has been very heavily impacted by a few large transactions. If you recall Diageo, we've done over $300 million. The ECM portfolio earlier in the year is $544 million. There were several others that equated to about half a billion dollars. Those transactions account pretty much for the majority of the acquisitions that we've done this year and last year. I just want to caution to extrapolate that out and assume the same thing happens in 2012 might be an aggressive assumption.

We've said for many years, kind of being out there in the business, you do 25, 35 a quarter by being in the business. If you do a run rate, that works you up to $100 to $200 million a year. It's really a function of whether we grab zero, one, two, three, or a couple larger transactions. Lately we've obviously gotten a bunch of them. Each year it kind of unfolds because the last two years we've got, I think, more than our fair share. For our planning purposes and our guidance for some acquisitions for next year, we're assuming $350 million of acquisitions is what we're using in guidance at an 8% cap rate. Obviously, it could be more, but that's, I think, a good number to start with, and we'll adjust as 2012 develops. The transaction flow remains very robust currently.

As for the balance sheet and access to capital, as Paul mentioned, we're in fairly good shape on that. We have only $96 million sitting on the $425 million line. The vast majority of the acquisitions we made this year have been permanently financed at fairly attractive rates. With the balance sheet in great shape with good metrics, that leaves us plenty of dry powder to execute on any acquisitions that come up. Let me go back to guidance and kind of walk through that. Obviously, with acquisitions being strong and occupancy and same-store rent up, that's been very healthy for our FFO and AFFO numbers. We think that'll continue to be the case the balance of this year and moving into next year. We did a release a couple of weeks ago where we updated guidance and initiated for 2011 and initiated 2012.

For this year, we're estimating FFO of $1.97 to $1.98. That's 7.7% to 8.2% FFO growth. AFFO of $2.01 to $2.02. That is 8.1% to 8.6% AFFO growth. As usual, our AFFO, Paul mentioned this, but I really want to highlight it, is higher than our FFO. Lately, that has been widening a bit, which is a function of a number of the acquisitions that we made this year. We are on existing properties with existing leases, so we had to do a FAS 141 adjustment. In net lease, generally, that means that your reported cap rate will end up being slightly below the actual cash you receive on the leases. That really is going to widen the gap again between FFO and AFFO, with AFFO being higher. We obviously pay dividends from cash, so the AFFO number will continue to be our primary focus.

For 2012, right now, you can see the estimated FFO is $2.07 to $2.11. That is about 4.5% to 7% FFO growth. AFFO of $2.11 to $2.16, also about 4.5% to 7.5%. With this growth rate, the dividend payout ratio is falling down into the kind of 85%, 86%, 87% range. Where we would achieve the guidance, that would continue next year and really accelerate that. Generally, we want to keep our payout ratio in the 85% to 90% range. We are optimistic about additional growth in the dividend and the amount of the growth looking into 2012. I think it could be a good time for dividend increases. I'll take a second since we just came out with 2012, to kind of walk through again the assumptions that are embedded in the 2012 guidance.

As I mentioned, acquisitions of $350 million at an 8% cap rate. That is less than half this year and last year, but as I said, these were exceptional years driven by some large transactions. We think it is prudent to keep expectations moderated for now. Capital will depend on the timing of the acquisitions. Estimated property sales we put in at $25 million. We have interest rates moving up modestly throughout the year, but still very low, so not a huge impact. We are putting occupancy kind of in the 96% to 97% range. That is really where we are reflecting the Friendly's plus any additional unidentified tenant issues that can come up.

We have built into the guidance the assumptions for Friendly's outcome as well as these 5% and also the fact that we are just assuming conservatively that it takes through 2012 to lease any of them, which is a conservative assumption. Same-store rent, we modeled at about 1.5% growth, which would be pretty good. Free cash flow at $50 million. As I mentioned, AFFO of $0.04 to $0.05 above FFO. That is what gets us to the 1.5% to 7.5% FFO and AFFO growth rates. To the extent that tenant issues do not materialize, that obviously would be great. Our acquisitions are ahead of $350 million. That also would be very good.

I think we would probably take the opportunity to do some pairing to the portfolio and sell some properties and move out maybe some of the tenants with properties that we think might have more exposure from an economic and interest rate standpoint going forward. That would likely burn off a little bit of FFO during the year. Really, above a 4.5% to 7.5% rate, that would probably be prudent and something we'd like to do in the next few years. We think the assumptions we've made are pretty good assumptions. Really, to summarize, obviously continued stability in the portfolio and a good quarter relative to occupancy and same-store rent increases. We remain very active in acquisitions with good FFO and AFFO growth this year. I think pointing into next year, which once again makes us somewhat optimistic for dividend growth. With that, we will open it up for questions.

Joe, if you want to come back and remind everybody how to do that again, I'd appreciate it.

Speaker 0

Thank you, sir. We will now begin the question and answer session. As a reminder, if you have a question, please press the star followed by the one on your touch-tone phone. If you'd like to withdraw your question, please press the star followed by the two. If you're using speaker equipment, you may need to lift your hands before making your selection. One moment for our first question. Our first question comes from the line of Lindsay Skrull. Go ahead, please.

Speaker 6

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

Speaker 1

Yeah. If you look at casual dining, they're a very, very good example. I was looking at some numbers yesterday relative to food prices this year that have been moving up pretty aggressively. If you look at the grocers, they've been able to pass a lot of that on, I think with about 6% increases in food prices at grocery stores. If you look at restaurants, they haven't been able to pass it on, and consumers have been pretty tight with their wallets while it's for the restaurants. You're seeing their costs move up, and they're not able to pass it on. I think it's really starting to wear on their margin. That's one area that's kind of upfront for us. I think other areas in consumer discretion that are impacted by commodity costs are similar.

The other ones, I also mentioned this, if you just look at kind of the big box that tends to be discretionary purchase, we look at them, and you continue to see the growth of internet retailing, and that's kind of front and center. Right now, we move into the holidays, and we think their business could be a little weak. It's primarily consumer discretionary, middle class, lower class. I'd shine the light on restaurants. Normally, fast food does very well in a downturn, but I think even they're having trouble kind of passing it all along.

Speaker 6

Okay. Just turning to acquisitions, what do you think in the macro environment could change that would potentially shut down some of the opportunities you're seeing or decrease the flow?

Speaker 1

I think it'd take a pretty good drop in the economy on one side. John mentioned that the high yield market, while it's had a little bit of a resurgence in the last week or so, has been weak, but still breathing. CMBS has been very weak. A lot of times, Paul's used the term, we like those markets breathing, but not too robust because it helps transactions to happen. Yet, it makes our type of financing very attractive. Even though they've been very weak, we've found that people have really started turning to net lease. If those markets came back very strong, it'd be a mixed bag. I think we'd see a lot more transaction activity out there, but the debt markets would be much more competitive. That's one thing to watch.

If we just get a big double dip and the economy slows down, it's a fairly active environment for people viewing their real estate as a source of capital today. Very active.

Speaker 6

All right. Great, thank you.

Speaker 0

Thank you. Our next question comes from the line of Joshua Barber. Go ahead, please.

Speaker 8

Hi, good afternoon.

Speaker 0

Hey, Josh.

Speaker 8

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

Speaker 1

Yeah. I think the tightest rent coverage, you come back to casual dining and kind of the restaurant sector overall. Again, as I just said, that's where the margin compression is going on. That's kind of front and center as we look at it. As we put that in there, we have a couple of decent-sized exposures, but then it really gets into a lot of little ones. That wasn't meant to be somebody at 5%. It could be 1 at 5%, 2 at 2.5%. We just thought it was time to be a little more conservative in that area. You know, restaurants are kind of front and center. When you get out of basic human needs, kind of the C stores and the rest of it, I think their business is weakening a little bit.

I was buoyed by seeing some higher GDP numbers, but I'm not sure if I really believe them. We'll see how they get revised.

Speaker 8

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

Speaker 1

What two are you referring to?

Speaker 8

The Mexican dining with Baltimore, with some other, not necessarily in the Realty Income.

Speaker 1

Oh, yeah, yeah, yeah. You know, yeah, there was RealMex. Yeah. Since that's tough, that's, I think, El Corrido, Acapulco. We didn't pay that much attention to it, but the kind of the larger buildings like that would hurt a bit. It's been a pretty good year. As we've said throughout the year, it was pretty quiet out there. I think in the restaurant industry in particular, you could see some more. Right now, it's been pretty good for the landlords and continued for us. You know, we keep a running toll of bankruptcies. If you look at the fourth quarter, I've only got four on my list, and I've got five in the third quarter. Before that, there'd be 8 or 10 or 12 in retail. It's been a fairly, fairly short list. You know, not a lot to work with recently.

We think we'll work out pretty well on the one we're working on. Generally, if you didn't overpay too much, it shouldn't be that bad. I don't want to ring a bell that everything's getting negative. It's just, it's really been eerily quiet for about a year here in the portfolio. It was nice to see the economy come back a bit, but it's not really running forward hard and with some commodity price increases. We just are kind of saying somebody's got to be impacted by this if they're not able to pass through to the consumer or ultimately those costs.

Speaker 8

Right. I guess the fourth quarter is still young.

Speaker 1

It's still young.

Speaker 8

Thank you very much.

Speaker 1

You bet.

Speaker 8

Thank you. Our next question comes from the line of Michael Billerman. Go ahead, please.

Speaker 3

Hi. It's Greg McGinniss here with Michael. Tom, as you continue diversifying and increasing industry exposure to new areas, apart from some key new hires, is there anything new you are doing or investing in internally to better manage or handle the increase and improve core competencies there?

Speaker 1

Yeah. I mean, we've hired people in research, and we have hired people that have a background in those areas. We continue to work very hard on all of that. A lot of it is just expanding the corporate underwriting that we've done for many years in retail. Fortunately, our people are, you know, credit people, bank trained, and you know, able to move outside of retail pretty good. The other area that we will down the road is portfolio management, but that's something that really comes later. We have 28 people in that department, which is up substantially in the last seven, eight years dealing with retail. We'd anticipate if you look four or five years down the road, we'll have to widen it there. It's really three, four people in acquisitions who have some background in that, and then a couple of people in research.

Speaker 3

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

Speaker 1

Really not that much. I think just for anybody, I think most people are aware that Friendly's filed a couple of weeks ago, and we have 121 properties that are about 3.6% of rents. We bought starting 10 years ago, 138, 140 of those units. We sold off a number of them, which got us down to the 121 today. They filed, rejected 15 properties, which equates to about $1.3 million of rent, which we will now have available to us to go back and release. As is normal in these processes, I think this is the 24th filing we've had since going public of this type. We've had fairly strong retention rates of rent up in the 80%. Generally, we feel pretty good about these processes. We've done a lot of them. Now we have to just wait and let it work.

There are kind of two issues that go on. One is obviously, as we work through this process, there's some negotiation that goes on. Talking about what we would perceive as an eventual outcome is not probably the best strategy there. We found it very useful to try and stay very involved in the process. Our General Counsel is co-chair of the creditors committee. Obviously, that requires non-disclosure agreements as it goes through the process in the court of Delaware. As the court decides anything, that can be seen publicly. Over the next few quarters, as this works out, we'll fully report it. We feel pretty good about the properties we own relative to their profitability, about what we paid. We think our expectations will do pretty well. We did build that into the disclosure as well as some assumption that there'd be other ones next year.

Speaker 3

Okay. Great. Thank you.

Speaker 0

Thank you very much. Our next question comes from the line of Omotayo Okusanya. Go ahead, please.

Speaker 4

Hey, yes. Good evening. Tom, quick question. If we were to come up with, if 2012 ends up being a utopian world where you know, you don't see a lot of retail bankruptcies, and you were to take out this 5% of rent that you've kind of put at risk in your 2012 guidance, by how much would guidance go up?

Speaker 1

I think it'd probably go back up to where everybody pretty much had it before we first guided and wished to lower. As I said earlier, Teo, and as one analyst I know who has talked about capital recycling a lot, which is you, I think that's something that's coming up. The level and the amount of capital recycling we can do, which I think does burn off some FFO, if things are better and there isn't as much tenant activity, and if acquisitions are a little higher, I think we'd take the opportunity to do that and then hopefully stay about where we are today. I think that's, you know, I could say it's slower, but that was a message we're trying to give.

Speaker 4

Basically, if things were better on the retail side, we take it as an opportunity to just divest a few more assets. I'm not with some dilutions, but nothing that you would still kind of, you'll still kind of end up where you are.

Speaker 1

Perhaps that would be our expectation.

Speaker 4

Okay, that's helpful. Appreciate it.

Speaker 1

Okay. Thanks, Tim.

Speaker 0

Thank you very much. Our next question comes from the line of RJ Milligan. Please go ahead.

Speaker 2

Good afternoon, guys.

Speaker 1

Hey, RJ.

Speaker 2

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

Speaker 1

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

Speaker 2

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

Speaker 1

Yeah. If you look at this year, it's kind of interesting. You know, 55% of what we've acquired to date is retail, 21% distribution, 17% office, 6% manufacturing, and 1% to 2% industrial. The vast majority of that came through that one transaction with ECM. It's interesting to us over the last quarter or two. We thought we'd see a moderation in the number of kind of traditional retail transactions come up, and they're actually accelerating a bit. If we had to take just transaction flow right now and look forward, it'd be heavily retail with a smattering of some investment grade in other areas. As John said, one transaction can change that.

Speaker 0

Is there a specific non-retail property type that's more attractive to you, or is it just the credit quality?

Speaker 1

Oh, wow. It's very much credit quality when we move outside of retail because in retail, you can have the four-wall EBITDA cash flow coverage, which can give you a lot of protection even when working with some weaker tenant. When you get outside of retail, you can get it occasionally, but it's a little harder to tie down. We think it's absolutely necessary to go up the curve. Kind of our greatest comfort level to date relative to the other areas is in distribution. We've done, you know, with the Diageo, there's a fair amount of the agriculture that you see in there. That 4.6% is pretty much all Diageo. That's very comfortable. That's a function of where it is and who the tenant is. I'd say tenant first and going up the credit curve to investment grade when we get outside of retail, and that's our intention.

Distribution, most comfortable out of that group and probably manufacturing, industrial after that, and probably office last.

Speaker 0

Okay. Great. Thank you, guys. Thank you very much. Our next question comes from the line of Todd Pukowski. Go ahead, please.

Speaker 8

Hi. Good afternoon, guys.

Speaker 1

Hi. Hey, Todd.

Speaker 8

Just a question. Is the plan still to get up to sort of 20% to 30% of the portfolio in non-retail over the medium term?

Speaker 1

Yeah. You know, for us, that's a ballpark, you know, four to five year feeling. It's one of those things where we're always asked what the objective is. 20% is a good initial number when we're off to a good start. It is so underwriting specific that the number could freeze where it is if we weren't able to pull good investment grade stuff in. If we're able to pull investment grade in, then higher would be okay too because there is a strong desire to do two things right now. One is when working within retail to have even higher cash flow coverages up above 2.5, where I think over the last years, it's been in the 2.3 to 2.5, or go up the credit curve.

That's really a function of looking forward and understanding in the last 20 years that a lot of these less investment grade retailers had the wind at their back as you were in a declining interest rate environment. If you look forward, we're fairly close to zero today in interest rates. The expectation that you might have higher interest rates in the future, we're kind of undertaking a big project to look at the impact for all of our tenants if they had to refinance their balance sheets over a 5 to 10-year period at 300 basis points higher in permanent financing costs and 600 basis points higher. To the extent that we're working in retail, we'd like higher coverages. To the extent we can, we'd like to go up the credit curve, whether it's in or out of retail.

Speaker 8

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

Speaker 1

At the moment, not right now. I think we're okay to use leverage right now. We've been reducing it a bit, as you've seen debt fall from about 35% down to 27%, 28%. We're more focused on the maturities of that. If you start again worrying about interest rates over 5 to 10 years, you look at your maturity schedule. We're fine adding debt like we did earlier in the year, where we opened up $150 million of our 2035s. We're comfortable with more leverage, a little bit more leverage. If we're going to do it, we'd like the duration to be fairly lengthy, but don't want it to get too high.

Speaker 8

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

Speaker 1

Yeah. The board put a policy in in 1994 when we went public 17 years ago that we didn't want leverage debt over 35% kind of growth assets, market cap. We didn't want deferred over 10%, and we stayed inside of that, and that hasn't changed.

Speaker 8

Okay. Great, thanks. Paul, we're looking forward to seeing you in Chicago in a couple of weeks to get our management behind the Moat Conference.

Speaker 1

Thank you. See you then.

Speaker 8

Take care.

Speaker 0

Thank you. Our next question comes from the line of Richard Hightower. Please go ahead.

Speaker 8

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

Speaker 1

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

Speaker 8

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

Speaker 1

My sense is, in this business, when you have a large portfolio and you're trying to put it out at the best price, you do that better on a one-off basis, kind of as if you go along one at a time. That was our experience we learned from Crest when we bought 30, 40 at a time and put them out one at a time. That's how we would probably want to do it. We've got, you know, out of the tenant base, maybe 70 tenants of decent size, and we're going through and parsing them very carefully, given a lot of metrics and refinancing the balance sheet and how we feel about the industry and our position with them and how much debt when it comes to a wide variety of metrics. Then rating from top to bottom.

If you put them into kind of four quartiles and looked at the bottom quartile, you'd say, "Gee, wouldn't it be lovely if 5 to 10 years from now those weren't in the portfolio?" You have to look at your growth rate and making sure you deliver for the investors while you're doing it. To the extent that acquisitions are good, the portfolio performs, you can do that at an accelerated rate. If it doesn't, maybe at a little slower rate. I think it'll be just picking out really a group of tenants in the lower quartile. There's a separate project we have to take all 2,600 properties and put a rating on them for the market they're in, for what we paid, for what the cash flow coverages are, how much we have left in lease.

When you marry those two together, ultimately, it'll become a mix of tenant and property. Over the coming years, we'd like to accelerate those sales, but it'll be a function of how much we can do and still maintain a decent growth rate and dividend growth.

Speaker 8

Okay. The lower quartile is about 650 properties. We should think maybe if you really get going on this, you could do 100 in a year. Is that what you're thinking?

Speaker 1

I think it's possible, but I don't think that's in the cards at all for 2012, and that's probably aggressive for 2013. It'll all depend on the growth rate because if you're adding a lot, you know, on the high credit side, it gives you a lot of flexibility to still post pretty good numbers and accelerate it. There were years in Crest where I think we had $130 million of inventory in 2007, and we got it all out the door in about a year. Those were in bite-sized properties of the $1 million to $2 million. We've done it before, but I wouldn't look forward to 2012 because we're still crunching the numbers and in the middle of the analysis.

Speaker 8

Okay. Very good. Thanks, guys.

Speaker 0

Thank you, sir. Our next question comes from the line of Todd Fender. Go ahead, please.

Speaker 3

Hi, guys. Thanks. Your assumption is for next year, Tom, you're talking about interest rates picking up. Does that mean initial lease yields edge up too, or is there a longer lag? Maybe that's more of a 2013 event, just in your estimations?

Speaker 1

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

Speaker 3

Thanks. The ECM deal came with some secured debt. Do you have your fill with that right now? If you saw a portfolio with it, would that be a deal breaker? What's your comment on that?

Speaker 1

I think Paul's at $54 million or $58 million.

Speaker 8

57 million.

Speaker 1

There was $90 million we thought we'd be left with, but we've been able to pare that down. $67 million, you said? We're about $67 million above where we'd like to be. That doesn't mean we wouldn't, if a portfolio came in and had some secured debt, we'd take it. As we did here, we'll do our best immediately to pay off everything that we can pay off without it being just a huge economic drain and then paying off the balance as fast as we can. We don't want to say it'll preclude us from doing a portfolio, but at the same time, we're not looking to add it and would like to get rid of it as soon as we can. We like an unsecured balance sheet strategy.

Speaker 3

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

Speaker 1

Yeah. If you look at the cash flow coverages on our recent purchases, they've been 20, 30, 40 basis points higher than, you know, the last few years. You're really looking up in the very high twos, pointing into the threes if we can get it. It changes from industry to industry, but we've been trying to really adjust that up because that's the kind of less investment grade retail. Obviously, off in the other areas, we're looking for investment grade credit.

Speaker 3

Great. Thanks, guys.

Speaker 0

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

Speaker 1

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

Speaker 0

Thank you. Ladies and gentlemen, this concludes the Realty Income Third Quarter 2011 Earnings Conference Call. If you'd like to listen to a replay of today's conference, please dial 1-800-406-7325 and enter the code 4480899. Thank you for your participation. You may now disconnect.