Realty Income - Earnings Call - Q4 2011

Transcript

Speaker 2

Welcome to the Realty Income fourth 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 would like to withdraw your question, please press the star followed by the two. If you're using speaker equipment, please rest your hands before making your selection. This conference is being recorded today, February 9, 2012. It is now my pleasure to introduce our host for today, Mr. Tom Lewis, CEO of Realty Income. Please go ahead.

Speaker 0

Good afternoon, everyone. Thanks for joining us on the conference call, and we'll review our operations and results for the fourth quarter and full year for 2011. In the room with me, as usual, is Jerry Molina, our President and Chief Operating Officer, Paul Mueller, our EVP and Chief Financial Officer, John Case, our EVP and Chief Investment Officer, Mike Pfeiffer, our General Counsel, and Tere Miller, our Vice President of Corporate Communication. As always, during the call, we will make certain statements that may be considered to be forward-looking statements. Under Federal Securities Law, companies' actual future results may differ significantly from the matters discussed in any forward-looking statements, and we will disclose in greater detail on the company's Form 10-K the factors that could cause those differences. We'll start as we always do with the numbers, Paul.

Speaker 4

Thanks, Tom. As usual, I will provide some brief comments on our financial statements and provide some highlights of the financial results for both the quarter and the year. Starting with the income statement, total revenue increased 23.6% for the quarter and 22.6% for the year. Our revenue for the quarter was $114 million, or approximately $456 million on an annualized basis. This obviously reflects a significant amount of new acquisitions over the past year, and positive things for rent in our portfolio increased this for the year of 1.3%. On the expense side, depreciation and amortization expense increased by about $9.5 million in the comparative quarterly period, as depreciation expense increased, obviously, as our property portfolio continued to grow.

Interest expense increased by just under $3.9 million, and this increase was due primarily to the June issuance of $150 million of notes in the reopening of our 2035 bond, as well as the $237 million of credit facility borrowing, which we had at year-end. On a related note, our coverage ratios do remain strong, with interest coverage at 3.5 times and fixed charge coverage at 2.9 times. General and administrative or G&A expenses in the fourth quarter were $7.95 million, or 7% of total revenues. Our G&A expense has increased as our acquisition activity has increased, and we invested this past year in some new personnel for future growth. G&A was also impacted by the expensing of acquisition due diligence costs, $357,000 during the fourth quarter, and a total of $1.5 million to expend during the year.

Our current projection for G&A for 2012 is approximately $33 million, which will continue to represent only about 7% of total revenue. Property expenses were $2.3 million for the quarter and $7.4 million for the year. These, of course, were the expenses primarily associated with the taxes, maintenance, and insurance on properties where we were responsible for those expenses on properties available for lease. Our current estimate for 2012 is similar at about $7.5 million. Income taxes consist of income taxes paid to various states by the company. They were $367,000 during the quarter. Income from discontinued operations for the quarter totaled $1 million, and this income is associated with our property sales activity during the quarter. We did sell five properties, resulting in a gain on sales of $1.2 million during the quarter.

A reminder that we do not include these property sales gains in our FFO or in our AFFO. Preferred stock cash dividends remained at $6.1 million for the quarter, and net income available to common stockholders increased to approximately $34.9 million for the quarter. Funds from operations, or FFO, per share increased 8.5% to $0.51 for the quarter and 8.2% to $1.98 for the year. Adjusted funds from operations, or AFFO, or the actual cash we have available for distribution as dividends, was higher than FFO, and it increased 8.3% to $0.52 for the quarter and 8.1% to $2.01 per share for the year. Our AFFO will continue to be higher than our FFO, and the differential between our AFFO and FFO will continue to increase. Our capital expenditures are fairly low.

We have minimal straight-line rent adjustments in our portfolio, and we believe we will continue to have some FAS 141 non-cash reductions to FFO due to in-place leases that we acquire in large portfolio transactions that we do. In addition, in 2012, we will have a $3.7 million non-cash charge to FFO for the redemption of our preferred stock, representing approximately $0.027 per share in FFO. Our 2012 AFFO earnings projection is $2.07 to $2.12 per share, or an increase of 3% to 5.5% over our 2011 AFFO per share of $2.01. We increased our cash monthly dividend again this quarter. We've increased the dividend 57 consecutive quarters and 54 times overall since we went public over 17 years ago. As we announced this week, we have now declared 500 consecutive monthly dividends over the past 42 years.

Our dividend payout ratio for the quarter was 85% of our funds from operations and about 84% of our AFFO. Briefly turning to the balance sheet, we have continued to maintain a conservative and very safe capital structure. This week, we closed on our recent preferred stock offering, which raised over $373 million in gross proceeds, had a coupon rate of 6.58%. We were very pleased with the strong investor demand in the offering, and we very much appreciate the underwriters who supported us and did a terrific job on this offering. Use of proceeds will be to repay our outstanding 7.38% Class C preferred stock, which will save us $1 million in cash expense annually, and also to pay off all of our acquisition credit facility borrowings. Our balance sheet continues to be well-positioned to support our acquisition growth.

Our current debt-to-total market capitalization now is only 25%, and our preferred stock outstanding still represents only 8% of our capital structure. Our $425 million credit facility did have $237 million of borrowings at year-end, but as I mentioned, we used the preferred proceeds this week to pay off all of those borrowings on the facility. We had no debt maturity until 2013. In summary, we currently have excellent liquidity, and our overall balance sheet remains very healthy and safe. Now let me turn the call back over to Tom, who will give you a little bit more background on these results.

Speaker 0

Great. I'll start with the portfolio. During the fourth quarter, the portfolio continued to generate very consistent cash flow. At the end of the quarter, our largest 15 tenants accounted for about 49.8% of our revenue. That's down 480 basis points from the same period a year ago and 220 basis points from the third quarter. Our acquisition efforts continue to help us reduce our concentrations in the portfolio, getting that down to 49.8%. The average cash flow coverage at the store level for those top 15 tenants, which we mention each time, was right at 2.42 times, so very healthy. We ended the fourth quarter with 96.7% occupancy and 87 properties available for lease out of the 2,634 in the portfolio. That is down about 100 basis points from the third quarter and up about 10 basis points for the same period a year ago.

During the quarter, we had 43 new vacancies. 25 of those came from expirations at the end of the lease, and that is a little higher number than usual, but occasionally with the expirations, it gets a little bit lumpy, and that was the case in the quarter. We also had 18, which were defaults primarily related to Friendly’s. We also leased or sold 15 properties during the quarter and also added properties to the portfolio, which is how you get to the 96.7% number. If we look forward into the first quarter, I think with the Buffets filing and as we begin leasing the properties up that are on the vacancy list, we could see another 20 or 30 basis points decline in occupancy down to around 96.5% or 96.4% is the best estimate right now.

We would anticipate that we would see occupancy increasing from there over the next few quarters as we really generate some more leasing activity on these. Let me take a moment and kind of walk through how we calculate occupancy and then give you some color on it. For the last 18 years or so, we calculated occupancy by taking the number of vacant properties we have, which was 87, and dividing that by the number of buildings that we have in the portfolio, which was 2,634. That's a pretty simple methodology that gets us to 3.3% vacancy and 96.7% occupancy. For a number of years now, internally, we run occupancy a couple of other ways to size all the numbers.

Another way is to take it just on a square footage basis instead of property, where we take the vacant square footage and then divide it by the total square footage in the portfolio. Another way to do it is on a dollar basis, which is to take what was the previous rent on any properties that are vacant and divide that by the sum of that number and the rent on all the occupied properties, and then that gives it to you on a dollar basis. We've run all three methods for quite a while, and generally, they would be around the same number as historically. Our building sizes and kind of rents per property overall were pretty consistent.

However, in the last few years, as we bought some larger properties, that has skewed the numbers, and we also have about 4.5% of the portfolio now in agricultural land that have no buildings on it yet or under long-term leases. We're getting some variance in the three different methods of it. Somebody recently asked me rather than when I said occupancy, they said, "Asked if it was physical or economic." While we weren't quite sure what their version of economic occupancy was, we thought we'd go ahead and provide all three numbers. Again, the traditional way is 87 properties vacant, 2,634 total, and that's a 3.3% vacancy rate and a 96.7% occupancy rate. If you do by square footage, the total vacant square footage is 746,000 square feet.

If you divide that by the 27,369,000 square feet in the portfolio, that gives us a 2.7% vacancy and a 97.3% occupancy rate. The last way, if you take the former contractual rent in the fourth quarter for the vacant properties, that was about $2.48 million. If you combine that and the rent on the occupied properties of $113 million, you'll get $115.78 million. If you divide that back into the $2.48 million, that'll give you a vacancy of 2.1% and an occupancy of 97.9% on a dollar basis. You can pick your own number. We will, for historical continuity, continue to report it on the physical occupancy number, but what we'll now do is make those other numbers available, and we'll figure out how to get them into our reporting and then mention them on the calls or if anybody wants to know what they are.

Obviously, all three are fairly close and represent fairly high occupancy. Same-store rents on the portfolio increased 1.1% during the fourth quarter, which is in the kind of average range in our mind. For the year, same-store rents increased 3.3%. Taking a look at where those came from during the year, we had three of the industries that had declining same-store rents in the portfolio. Bookstores was one, automotive service, and quick service restaurants, which was fast food. It was a relatively modest decline of only about $492,000, so fairly small. Two industries had flat same-store rents. That was drugstores and transportation services, which was fairly new to the portfolio. Then 24 industries saw some same-store rent increases.

The majority of that, kind of going from highest to lowest, was in increases with movie theaters, motor vehicle dealerships, casual dining restaurants, convenience stores, sporting goods, automotive tire, and health and fitness. The balance were fairly small increases. In those numbers, casual dining restaurants and motor vehicle dealerships may seem surprising, relative to a contribution for the same-store rent increases. I would note we gave a few temporary rent reductions to a few of those tenants in those industries during the recession. Those expired, and that's what caused the increases in those two industries, and it's not a trend we would think is going to continue. Again, the balance of the industries was a fairly small increase. The 24 industries together had a total increase of about $4.7 million, and that gets to a net gain of the $4.25 million in same-store rent.

Diversification in the portfolio continues to widen. We're in 38 industries, that's up 6 from a year ago, and our concentrations in the industries continue to decline. Convenience stores is our largest at 17.2%. That's down 110 basis points from last quarter, and we think we will continue to bring that one down. Restaurants, if you combine both casual dining and the quick service, are a little less than last quarter, now at 16.4%. That's down 90 basis points from last quarter. Casual dining is now under 10% at 9.8%. It's down about 110 basis points from the last quarter. Quick service, fast food was up about 20 basis points to 6.6%. The next one is theaters, which rose to 9.8% as we made some acquisitions this year. Also, health and fitness was up 80 basis points to about 6.9%.

In both areas, we continue to like and will likely add to. The only other category that's over 5% now is beverages at 5.3%. I think we're in very good shape relative to industry concentrations. We'll keep them reasonable and try and continue to lower them. On a tenant basis, the largest individual tenant at 5.3% of rent is AMC Theaters. That's down 10 bps. Diageo is 5%, and then everything else in the portfolio is under 5%. When you put the 15 largest together, they're just under 50%, 49.8%. When you get to the 15th tenant, it's about 2.2% of rent. If you even went further to 20%, it gets down to about 1.5% of rent and then goes down pretty quickly after that. Fairly well diversified from a tenant standpoint. Geographically, we also remain well diversified. The average lease term remaining is 11.3 years.

That's up a little bit over the quarter with recent acquisitions. We announced a couple of weeks ago that Friendly’s is back out and operating, having completed their reorganization fairly quickly, and also announced Buffet's is in the process. We worked with their management, who we know well, very quickly to structure an agreement with them. As we said in that press release a few weeks ago, it is subject to court approval in the reorganization process, which is underway. Like in the Friendly’s situation with Buffet's, Mike Pfeiffer, our General Counsel, co-chairs the creditors' committee, and we're hopeful that a process can be completed expeditiously, which I think would benefit all parties involved, and we can move through that one fairly quickly. Relative to a theme with those two, I think it continues to be a difficult environment for retailers that sell discretionary goods to generally lower-income consumers.

I think tenants like these two in the casual dining area would generally fit into that category in our mind. As we've mentioned, we wouldn't be surprised to see a little more softness with another tenant in that area as the year goes on. Fortunately, our exposure to that area is modest and continues to decline, although we would prefer if more of that decline was generated from asset sales and investments in other areas as a way that it declines. The majority of the portfolio continues to do quite well, and occupancy, as I mentioned, is very high. We'll move on to acquisitions now. It's obviously a very strong year in that area, and I'll let John Case, our Chief Investment Officer, comment on activities there.

Speaker 3

All right, Tom. We remain quite active on the acquisitions front in the fourth quarter. We acquired 39 properties for approximately $190 million. The average initial lease yield on these investments was 7.5%. The average lease term was just under 20 years. Properties are diversified by geography, tenant, industry, and property type. They are located in seven states, 100% leased to four tenants and four different industries and represent three property types, with our traditional retail investments accounting for 86% of our funds invested during the fourth quarter. 80% of the acquisitions are leased to new tenants, which further diversifies our portfolio. In the fourth quarter, we closed the final $19 million of the $544 million diversified net lease portfolio or ECM transaction we announced in the first quarter of 2011. Our fourth quarter activity brought us to $1 billion.

Speaker 0

That's a billion?

Speaker 3

That's a billion with a B.

Speaker 0

Sorry.

Speaker 3

With a B, a billion dollars in property investments for 2011. The most we've ever completed in a single year in dollar terms. The billion for the year was comprised of 164 properties, had an average initial yield of 7.8%, and an average lease term of 13.4 years. The properties are leased to 22 separate tenants in 17 different industries. We continue to be pleased with our level of acquisition activity, which really helped us drive our FFO growth in 2011. Most of you have heard Tom describe our acquisition activity as lumpy before. It continues to be that way. $852 million of our 2011 acquisitions came from three large portfolio transactions. The remaining $148 million of acquisitions came from single property and smaller portfolio opportunities.

We generally see these from quarter to quarter, just seen in the marketplace, and these should lead to about $100 million to $150 million of acquisitions annually. Our success on the three large portfolios really drove our volume in 2011. On this year-end call, we usually give you an overview of the previous year's acquisition transaction flow and provide some additional perspective. I'm going to go slowly here because there are a lot of numbers I want to share with you. In 2011, we sourced $13 billion in total acquisition opportunities. This is everything that comes in the door. Not all of it makes sense for us. Of the $13 billion sourced, our acquisitions team analyzed about $8 billion in opportunities in 2011, an increase of about 70% versus 2010. Of this amount, just under $3 billion was taken through our investment committee.

The $3 billion represented 1,300 properties with 45 different tenants. Over the last 10 years, our investment committee has averaged working on about $3 billion in opportunities per year, ranging from a low of $1 billion to a high of $5 billion. The 2011 was right in line with our long-term average. The $1 billion we acquired represented 33% of what our investment committee worked on, and of course, it was a record year for acquisitions. Over the last 10 years, on average, we have acquired 15% of what our investment committee worked on. This year's 33% figure reflects our success in closing those three large portfolio transactions. Our initial yields or cap rates have averaged 8.9% during the last 10 years, with a high of 10.4% and a low this year of 7.8%.

Cap rates have declined over this period as interest rates have declined and as net lease properties have become more mainstream as more investors have entered the market. We have historically tracked our cap rates relative to 10-year Treasury yields. Since we went public in 1994, our cap rates have averaged about 475 basis points over the corresponding 10-year Treasury yield. The 2011 average 10-year Treasury yield was 2.8%. Our initial yield of 7.8% was 5% over the average 10-year this past year, a bit better than our long-term average. Obviously, now with the 10-year Treasury yield at 2%, our cap rates are closer to 5.75% over the 10-year. Another factor impacting our cap rates is our move up the tenant credit curve the last two years. In 2011, 41% of our acquisitions were with investment-grade tenants.

Our completion of these high credit tenant acquisitions reduced our overall initial yield by about 30 to 40 basis points in 2011. However, our investment spreads remain very attractive for our long-term average, and we improved our tenant credit profile. Over the last 17 years, our acquisition cap rate spread over our nominal cost of equity has averaged about 110 basis points. We calculate our nominal cost of equity by taking our forward FFO yield and grossing it up for issuance costs. Last year, that spread was approximately 107 basis points. As we had moved into 2012, our acquisitions transaction flow has continued to be quite active, consistent with the volume of opportunities we were seeing in 2011. Dollars were motivated by the significant liquidity in the net lease market. Continued private equity and M&A activity are also leading to sale-leaseback opportunities.

The flow is fairly evenly divided between investment-grade and non-investment-grade opportunity, and the majority of it is in our traditional retail properties, but we are seeing possibilities in all of our property types. There continues to be significant competition for property portfolios, but we should continue to be competitive in the marketplace. Cap rates are turning down slightly from where they were in the second half of 2011 as interest rates have declined a bit. Cap rates generally range from the low 7% area to the high 7% area for investment-grade tenants and from the high 7% area to the high 8% area for non-investment-grade tenants. We currently anticipate our initial yields on acquisitions for 2012 to average around 7.75%.

Speaker 0

Tom, John’s promised they’ll average 7.75%.

Speaker 4

Yeah.

Speaker 0

Okay. Thanks. Obviously, we're pleased with the results for 2011 in acquisitions, and I think as much by the pace of transactions that's coming in the door right now that'll drive what we're able to do this year. We think that'll continue to play a role in obviously growing the revenue in AFFO, which is what drives dividend increases. I think secondly, and equally important for us, is it'll also help us in adjusting the makeup of our portfolio, where we're trying to do a couple of things, which is move up the credit curve with the tenant base, and then also into areas both inside and outside of retail that we think we want to make up a larger piece of the portfolio going forward. If you look at the last 24 months or so, we bought about $1.7 billion of property.

$1 billion of it was in retail, and I think much in the sectors that we think will do well if we continue here with a tepid retail environment where lower-income consumers continue to struggle. $720 million of the properties we bought are into areas outside of retail, and we think will do well for us. Of the $1.7 billion total, about $770 million was done with investment-grade tenants, and a good measure of the rest of the acquisitions are also up the credit curve close to investment grade, and we're pleased with that. The other thing about it is how we've funded the acquisitions. Living in a very low-interest rate environment that's largely generated by monetary policy at the federal level, I think it's easy to get lulled into the assumption that rates will stay low, which they might.

However, we want to be mindful of where they could go in the future, particularly if they were to go up substantially. I think that's true not only for our tenants as they would refinance their balance sheet down the road, but I think also for our own balance sheet. One of the things we want to make sure we do as we're fairly active here in acquiring is that we don't materially add to our own levels or to our near-term maturities. If you look at the permanent financing that we've done or our funding of these acquisitions over the last 24 months or so, we did four equity offerings that generated gross proceeds of just over $1 billion. We did $150 million of debt that had a maturity of 2035. Last week, we did the perpetual preferred offering, which was $373 million.

That's about $1.5 billion in capital and with either no maturity or a small piece with maturity very far into the future. As we think about capital, we'll continue to keep in mind that the cost of capital could be materially higher in the future, and the cost of refinancing that could be an issue. We'll try and take care of that in terms of how we're funding acquisitions. Relative to the balance sheet and access to capital, we're in very good shape. As Paul mentioned, there's plenty of dry powder to continue to acquire. On earnings and guidance, obviously, the acquisitions, occupancy, and same-store rent increases the portfolio had in 2011 really drove the revenue, FFO, and AFFO, and that will benefit us, those acquisitions here in 2012.

In the release a couple of weeks ago, we adjusted our guidance for the preferred issuance to $2.01 to $2.05 on FFO, and that included that non-cash charge that Paul talked about. AFFO at $2.07 to $2.12, and that's 3% to 5.5% AFFO growth. That number will be our primary focus as Paul mentioned. It's the best we have for reoccurring cash flow right now. Finally, before we take questions, I'd be remiss if, like Paul, I didn't mention the press release yesterday announcing the 500th consecutive monthly dividend. That's over 41 years of monthly dividends. That's a long time. I think the company was at about its 108th consecutive dividend when I came in to do due diligence in the company and met the founders, Bill and Joan Clark. It was probably over 200 when I came to work here 25 years ago.

I called the Clarks, who are actively retired, to talk to them about getting to 500. I liked their comment, which is very typical for them, which was, "That's great, and I hope you guys are focused on the next 500," which we are. Anyway, a nice milestone for the company that they founded a long time ago. Operator, Diane will now open it up to questions.

Speaker 2

Thank you. We will now begin the question and answer session. As a reminder, if you have a question, please press star followed by the one on your touch-tone phone. If you would like to withdraw your question, please press star followed by the two. If you do think you need to see for equipment, it may be necessary to lift a handset before making your selection. One moment, please, for our first question. We have a question from the line of Lindsay Scholl from Bank of America Merrill Lynch. Please go ahead.

Speaker 1

Good afternoon. Can you guys please discuss the health of the casual dining sector overall, and whether the filings by Friendly’s and Buffet's are more retailer-specific issues or indicative of broader industry trends?

Speaker 0

Yeah, it's a good question. Happy to do that. We're not overly positive on the industry to say the least. I think a theme in almost everything we look at today is whether it's in casual dining or somewhere else is to try and look at the consumer that that individual retailer or here restaurant is targeting. Because if you look at kind of the upper-income consumer, they're spending both discretionary and nondiscretionary. The middle-market consumer, which seems to be a little smaller group today, is spending on nondiscretionary and is really looking for value when they're out doing discretionary spending, and that includes casual dining. When you get to the lower-end consumer, not only are they extraordinarily value-conscious on discretionary or nondiscretionary, they almost aren't spending on discretionary. Pick your casual dining and pick who their customer is.

I think for a lot of people, most of those chains are appealing to the middle and lower market, and it's a tough operating environment, and we think it'll continue to be so. The other things going on there over the last couple of years is also minimum wage has gone from, I think, $5.85 an hour up to over $7.25. They've seen some labor pressures, and at the same time, had some commodity costs move. We have the industry rather, relative to further investment, we're not going to do it. We'd like to continue to reduce it as part of the portfolio because it's an area that even though for short periods it can snap back, we are not overly positive with. I'd be remiss if I didn't note that ROAS and change are doing very well in that industry, and there are.

Casual dining for us, as we watch, it's an industry that we're not going to be doing additional acquisitions in.

Speaker 1

Okay, I think you've talked about wanting to dispose of your office assets. I'm just wondering what the demand is for those versus retail, if the cap rates are similar, if the buyer is the same. If you can just talk about that.

Speaker 0

Yeah, I don't think we're looking to dispose of it. We don't have much in that area, and they're tenants. I think it's more of a comment, but that's not something we're looking to aggressively add to the portfolio. In the ECM transaction, we had a couple of, few office buildings that came with that, but it's still a relatively small part of the portfolio. It's only about 2.6% of rent. I wouldn't see it increasing, but currently, we don't have plans to sell the assets.

Speaker 1

Okay, thank you.

Speaker 2

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

Speaker 5

Hi. Good afternoon. I certainly hope there's not going to be a quiz on all those numbers that you guys threw out.

Speaker 0

Sorry about that.

Speaker 5

That's okay. I just have a couple of quick questions. When you guys are talking about the eventual events from releasing the Buffet's and the Friendly’s deal, what's the time horizon that you're using for releasing those assets?

Speaker 0

It varies a little in the Friendly’s. I believe we assumed in our that we didn’t release anything until late in the year, early in the next year. We think we’ll do better with the Buffet’s. We had a little more aggressive move on it because we’ve had a little better luck as we’ve gone through this recently.

Speaker 5

Okay. Have any of them actually been released so far?

Speaker 4

There are LOIs in place and a handful. I think a best estimate is kind of 6 to 18 months. What that means is you'll have some outliers that happen sooner, and you'll have some outliers that happen later than that.

Speaker 5

Okay. Regarding, you know, casual dining, obviously, we've talked a lot about that. Could you talk about the sponsors of the casual diners, especially the ones that you have exposure to, and what their willingness to restructure or to keep those entities going rather than bankrupt them right now? What does owner posture tend to be today?

Speaker 0

Yeah. They tend not to be 7. They do tend to be 11. Certainly, that was the case in Friendly’s, and that’s the case in Buffet’s. When you think to sponsor, you kind of want to—there’s a couple of things. Obviously, these are levered entities. One of the strategies in the toolbox of these people has been to, if the chain starts to struggle and the debt trades to a discount, go into the market, buy the debt, and then they become both the debt and equity owner. That gives us some optionality to go through an 11, continue on the chain, and do some work on the contracts, other contracts of it. I think as long as they can see in the properties profitability and the chain overall, they’re obviously going to look for an 11.

That’ll either be through the debt holders becoming the owner or in the case that I mentioned where both have the same. If you look at Friendly’s and Buffet’s, both the rents are pretty low, which gives them the opportunity to do that. What we’ve tried to do in all of these, of course, is give some optionality for if the business recovers that we can get a piece of that. In most cases, they do want to operate. It’s a chain-by-chain basis. There’s been a fair amount of bankruptcy in that industry over the last four or five years, you know, 34 or 35 of them, and the vast majority have been 11s.

Speaker 5

Great. Thank you very much.

Speaker 2

Our next question comes from the line of Chris Lucas with Morningstar. Please go ahead.

Speaker 5

Hi. Good afternoon, guys.

Speaker 0

Hey, Todd.

Speaker 5

Just a quick question on the acquisitions. Do you guys have a preference right now for, you know, doing deals with the credit tenants and the 7s versus the non-credit tenants and the 8s, or still happy to do either category?

Speaker 0

We're happy to do either, and it really is, you know, investment grade, we'd like to take it up, take it up the credit curve when we can find them. It's a competitive world today, but like to do that. When they're not investment grade, we'd rather be moving, you know, kind of up the cusp with it. When you get to non-investment grade, if it again is kind of a tenant of a low-income consumer and discretionary, we really don't want to be investing there, even though yields can be very attractive. We're willing to do both today.

Speaker 5

Okay, the acquisition assumption that's currently embedded in your guidance?

Speaker 0

I think right now about $500 million is what I've got in there.

Speaker 5

Okay, in thinking about same-store rent growth, is 1% to 2% still a good long-term assumption for that?

Speaker 0

I would think I'd hang around the 1% level or closer to that through the first half of the year as we deal with some of these properties. That was the case a few years ago. I think it probably long-term, probably 1 to 1.5% is to consider average. When we get above 1.5%, that's high, just given the way lease structures work.

Speaker 5

Okay. You mentioned that, I guess a couple of the categories that contributed to the increase in the last quarter, the motor vehicles and the casual dining, that was from the expiration of rent reductions.

Speaker 0

Yeah.

Speaker 5

In this quarter, is that something that lasts then for 12 months in the same-store numbers, but that this time next year, that impact would drop off?

Speaker 0

Yes, I think that's the case. I also think we'll get some boost from leasing.

Speaker 5

Okay. Great.

Speaker 0

Thank you for taking my questions. Okay, you bet.

Speaker 2

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

Speaker 5

Hi, guys. Thanks. Tom, you were indicating the vacancies edge higher than expected in the fourth quarter. Other than the Friendly’s stuff, who was the tenant on the bulk of those?

Speaker 0

I'd have to go look. It's an automotive, but with service. What it was is we have vacant properties, and then we have a list, and there's generally 20 to 30 properties on it that are closed properties, but they're still under a long-term lease, and the tenant is healthy. What happened at the end of the third quarter, there was a bunch of properties that a tenant had closed about two years ago that were still under lease and still paying, and those all came off at once. We've gone back and we've looked at that list, which always exists, and there's very little of that this year, very little next year, but it was one little lump. I forgot, but it is an automotive service tenant, I believe, that was a bunch of them, and then there were just a couple of others.

Speaker 5

Okay, will they likely be teed up for sale?

Speaker 0

We will tee them up for release or sale, both.

Speaker 5

Okay. Just along those same lines, could you be seeing disposition volumes increase maybe ahead of schedule, maybe where you thought you'd be this time last year just to get out in front of some of these credit issues?

Speaker 0

That's exactly what our plan is in terms of property sales. We've typically sold $25 million, $30 million of properties a year, but that's mostly just working through lease rollover and occasional tenant issue, and that's just been kind of the average. We really do want to accelerate that kind of debt. If it's okay, I'll spend a second on it. Over the last year, we went back and undertook a very lengthy project that took about seven, eight months where we re-underwrote basically the majority of the portfolio. I think we picked the largest 67 tenants, and they combined at about 83% of our rents. We went through a rating of each industry.

We then went through our exposures relative to how many of their units we own, how many units we own, % of rent, and then went back through their credit ratings, ran their balance sheets, debt, maturity schedule, usage of line of credit, cash, debt after cash, liquidity, revenue, and then went after their trends and looked at the margin trends and revenue trends and fixed charge coverages. We literally remodeled each one of them once again and started running some stress tests where we would move their revenues and margins and then kind of refinance their whole balance sheet over the next five, seven years. We added on 300 basis points of higher financing costs up to 600 basis points. They did some mixing of that to get a perfect storm.

We took all of that, and that kind of guided us along with some themes we have relative to what would higher interest rates do, how retail is going to be different, that the lower-end consumer may have trouble coming back, that nondiscretionary is going to be difficult. In doing that, we kind of laid out a top to bottom in the portfolio. At the same time, we did the same thing with properties. When we got through, we merged that and basically came up with a group of the portfolio that over time, we would like to move out of and in combinations with acquisitions and sales kind of reorient the portfolio. Initially, we targeted a little over 100 properties, about $110 million or so, that we bought those at about $100 million of carrying value.

We've started a process to market them, and we've done some staffing here, done some systems, and we've just literally launched that over the last month or so. For this year, I think we can move that up to $50 million from the normal $25 to $35 million. That'd be just great. My sense is to do the whole $110 million we'll be moving in, through this year and early into next year. The plan right after that will then be to take the next on the list. We'd like to, over the next three, four, five years, be fairly active in recycling capital and moving into some new areas that we'd rather have in the portfolio.

Speaker 5

Okay. That's really helpful. Thanks, Tom. Just lastly, it looks like, did you add one agricultural property? Did I see that right?

Speaker 0

We did. We had one additional property with Diageo. It's in the Napa Valley. It's kind of wedged in between the other vineyards that we owned, and it is one that we had looked at doing a ways back, but there were a couple of complications operationally for them on it. We were able to do that, so it's a little addition to the Diageo portfolio.

Speaker 5

Any pricing on that? Any indication what the cap rate was?

Speaker 0

It's relatively similar to what we did two years ago.

Speaker 5

Okay, thanks, guys.

Speaker 2

Thank you. Our next question comes from the line of Anthony Paolone with JPMorgan. Please go ahead.

Speaker 5

Thanks. Good afternoon. Just following up on that, Tom, and thanks for, you know, laying out your thoughts on dispositions. Can you give us any sense of what that magnitude might look like, against the $500 million of acquisitions you're thinking about for 2012?

Speaker 0

Yeah. There's about, acquisitions for 2012. Again, our best guess this year is we'd like to do 50, and that probably adds in 25 to 30 of this new grouping of investment properties we'd like to sell. That's the number there. There's $110 million probably over the next 18 to 24 months. Behind that, as we went through and did the whole portfolio, it wasn't, "We need to sell these now," but it's, "These are areas we want to move out of." It was about 20% of the portfolio where we looked at and said over the next four or five years, that's what we'd want to recycle.

Speaker 5

When you say 20% of the portfolio, is that 20% of value or 20% of the buildings?

Speaker 0

Revenue.

Speaker 5

Revenue.

Speaker 0

Yeah.

Speaker 5

Does that suggest there's a lot, like a much bigger ramp in sales beyond 2012 and 2015 for that?

Speaker 0

No. If you think of about 20% to the 10, that's to the 4,500 properties. I think over three to five years, that's about 80 properties a year or something.

Speaker 5

To some extent, it's more art than science, Tony.

Speaker 0

Yeah.

Speaker 5

For example, if we, you know, buy $1 billion worth of real estate, it can do more than $50 million in sales this year. Who knows? We'll kind of manage that from an earnings run rate perspective as well.

Speaker 0

Yeah. It's a balancing act with acquisitions and all the other things going on in the portfolio and still hitting good numbers and raising the dividend. We think we can move a good part of the portfolio over the next few years.

Speaker 5

Okay. You talked a bit about same-store revenue. I was wondering if you can give a sense of same-store NOI, maybe net of things like $7.5 million of property expenses that you bear, the effect of Buffet's and Friendly’s this year, just some of the things, some of the vacancy picked up in the fourth quarter from some of those leases that burned off, and just how that rolled into a same-store NOI number for 2012.

Speaker 0

Okay. Let us work on that.

Speaker 5

Yeah. I mean, one thing we do, I think we do a pretty good job of giving you the specifics of how we approach same-store calculation in the 10-Qs and 10-Ks. We'll have that laid out to give you exactly what we put in it versus what's not in it because everyone does it a little bit differently. I think what you're generally going to find, and that's why Tom tries to give you some guidance on where we get some bumps in which industries and which ones were down, is that obviously the ones that we got bumps in probably have numbers slightly healthier than 1% to 1.5%.

Speaker 0

Yeah.

Speaker 5

The vacancies really dragged it down to that kind of overall run rate. When you're.

Speaker 0

In my head, Tony, but if you want to email what the piece of the puzzle is, let us take a look at it.

Speaker 5

Sure. What struck me is that, you know, I guess what struck me and where I was coming from was even between a 1% to 2% band, being towards the lower end of that, it just still seemed like not a whole lot of impact given what happened with Buffet's and Friendly’s and stuff. Is that impact all those things?

Speaker 0

Yeah, that's very fair. It definitely impacts. You know, when we talk about an 80% recovery rate, that is when we get those leased up. If you have an event happen for the next 12 months after that, the impact is certainly greater than the 20% that you don't recover because that's during the period where they're vacant. Aside from not gaining rent, there's also the triple net expenses. In a year, you know, like this, and it really spans a year between Friendly’s and Buffet's, that does have a pretty good impact. It may exceed the same-store rent for a period of time until you get those leased.

Speaker 5

Even with the impact on the top line of Friendly’s and Buffet’s, you still think you’ll come in in that low 1s?

Speaker 0

I'm only hesitating because I'm trying to make sure I understand what you're asking.

Speaker 5

Obviously, you understand why 2011 wasn't as effective because Friendly’s occurred late in the year and Buffet's had not occurred yet.

Speaker 0

Right.

Speaker 5

Fair enough. Your question is on the projection for 2012, and I think what we're saying is we were expecting same-store rent to be more like 1.5% plus next year, reasonably healthy from an overall historical perspective for us.

Speaker 0

Very healthy.

Speaker 5

The Buffet's and Friendly’s vacancies are what's dragging that down closer to a 1% number, certainly for the first nine months of the year or so.

Speaker 0

Okay. I just wanted to make sure that was in that low 1s. I would have actually guessed it to have had a greater negative impact than that.

Speaker 5

Great. Just the last thing, curious, as you've thought about your strategy and the push towards a little bit more, higher credit quality or their desire to go up the credit quality spectrum, how do you think about going higher credit quality versus perhaps maybe any other options, like staying where you are on the credit spectrum and focusing more on certain MSAs or just a different product category or something like that?

Speaker 0

Yeah. That's a very good question. I think rather than what we're doing, talking about why we're doing it, it's really important. Starting about four or five years ago as we were doing strategic planning, one of the things we did is say, "Okay, let's look back at the last 20 years and say, you know, it obviously went really well." Then say, "Okay, why did it go really well?" To try and differentiate between being in the right place at the right time and then secondarily what we did. There are kind of three themes in there that are driving it. One is looking at retail. In our business, if you look at the last 20 years, you had great domestic economic growth, personal income growth, the baby boomers were at peak earnings and spending years. The next one's very important. The consumer levered up.

Retail spending growth rates were really high. Retailers added a lot of new stores, and it was the right place to be at the right time, and we were. Then we said, "Okay, let's look forward." There's a bit of, you know, the new normal, the term goes around, debt to GDP is approaching, you know, up 90%, which takes something out of GDP growth and personal income growth. The baby boomers are aging. You got the baby bust behind them. The consumer is unlikely to lever up at the same rate because they can't and may even delever a bit. Maybe retail isn't as the growth rate isn't as high as it was in the past. You throw in kind of the impact of internet on retailing, and you say it's the difference between running downhill and the difference between running on flat ground or flat land.

The first step was to say, "Okay, industry and tenant selection will be more important in the future than in the past because it's just not as a great environment." Really going one step further and saying, "Let's take a look at the consumer." The low-end consumer did pretty well the last 15 to 20 years with all of the growth in construction and real estate and the building trades, home improvement. There was a fair part of what normally would be kind of the lower income that each business we have in which consumer it serves and assume it's not going to be as good as it could. The second thing, which is also really, really important, and I alluded to the taken that it is with interest rates.

The idea is the 10-year over the last 30 years go from 14% to 16% to 2%, and that's very much running downhill. That obviously made asset prices rise, but more importantly, it made leverage always work and refinance always work. There were a lot of what might have been marginal business models that worked because interest rates were falling so fast. There was a fair amount of our tenants that used a fair amount of leverage in an environment when interest rates were going down. With the 10-year at 2%, the chance of having a material declining interest rate environment is almost zero because if you go from 2 to 1, it's only 1%. That benefit won't be as robust. You say, "Okay, what if rates stay low?" That's generally because the economy is probably limping along and very tepid relative to economic growth.

In that environment over time, the possibility you could see credit spreads gap, which means refinance rates for those tenants would be higher. Moving out five to seven years, you take a look at those tenants and you say, "If they had to refinance their entire balance sheet, what would it do?" That's what started that project, which we did where we really know what it would do. Then you throw in, obviously, anybody that has impact by internet. When we got done with all of that, we said, "Okay, look, we want to go up the credit curve for five to seven years from now, interest rates are higher, and the tenants have to refinance their balance sheet and will fix cash flows, you know, really out of their." Second, in terms of the type of consumer they really serve.

Again, we want to stay away from more of the consumer discretionary. Third, where can we go outside of retail that should benefit? Good examples are FedEx and the impact it has for them with internet taking more and more of retail sales and other areas where we can also get investment-grade credit and then maybe even have some very large Fortune 1000 tenants that are benefiting from having a presence overseas where we are not, but as they're a tenant of ours, we would benefit. It was all of those kind of put together that we said, "Okay, in retail, up the curve, out of certain areas and into others, and then outside of retail, up the credit curve." We wake up five, seven, eight years down the road, and we've kind of remade the portfolio.

If it has been a slower retail environment and/or interest rates are materially higher, it won't have near the impact it might have because the last 20, 30 years and the track record, it was put together because of that as a function of the operating conditions to some extent, and it's unlikely that that will persist into the future. That was kind of the thought process.

Speaker 5

Okay, yeah. Thank you. Appreciate that.

Speaker 2

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

Speaker 5

Yeah. Hi. Good afternoon, guys. I was looking at the or thinking about the impact of Friendly’s, and I went back to the press release you guys had. Is that what you pretty much are seeing, what you put in the press release on January 18th? Is that still what you expect from the Friendly’s closures, and then how much you'll recover of what's left?

Speaker 0

Yes.

Speaker 5

Okay. At what point in the year did they stop? Did all of this take place? You said it was late in the year, but was it, you know, how much of that fourth quarter rent did we see?

Speaker 4

We received October rent. The impact is that for 15 of the 19 rejections, we did not receive November or December rent. For the other four rejections, we haven't received January rent.

Speaker 5

Okay.

Speaker 4

To give you a feel.

Speaker 5

Okay. Yeah, that does. As far as what you'll recover from the others, when did that start? You know, the reduction?

Speaker 4

All of that started November 1, basically, on the concessions and that sort of thing on any properties where we agreed to a lower rent level. October was a full rent.

Speaker 5

October was a full rent. I got you. For Buffet's, you're thinking, obviously, nothing has happened. Are you thinking the same that you have in the press release, the same sort of parameters that you mentioned in here?

Speaker 4

That'll all come back to January 3rd, basically.

Speaker 0

That's all, again,

Speaker 4

That's all loaded in our projection. Both Buffet's and Friendly’s, those recovery numbers, and, with the expectation, as mentioned, of, call it, a 6-month to 18-month general window, some earlier, some later than that in terms of releases on the rejected ones.

Speaker 5

Okay. With those parameters, Paul, as far as how much base rent you'll lose and what the concessions will be on your mandate, you still feel comfortable about that?

Speaker 0

Yes. We're at the same place we were with the press release a couple of weeks ago.

Speaker 4

Yeah. Absolutely.

Speaker 5

Okay, that all comes back to January 1st?

Speaker 0

Correct.

Speaker 5

Okay, I got you. I wanted to ask you guys, when you release some of these, you know, when you redo a Friendly’s role, do you have to put capital in in any way for the new tenant?

Speaker 0

Sometimes a little, but generally not.

Speaker 4

Generally not.

Speaker 0

Historically, whoever the new tenant was, that's part of the work he does on it. We agree to a long-term rental agreement. It's generally not, you also don't get two years free rent when you do it. Generally, we negotiate a rent and that's his responsibility. It's a marginal amount of CapEx that it adds in.

Speaker 5

Okay. Users for these.

Speaker 0

Thank you. We'll talk to you in about 90 days. Thank you, Diane.

Speaker 2

Ladies and gentlemen, that does conclude today's teleconference. Thank you for your participation. You may now disconnect.