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Realty Income Corp. (NYSE:O)

Q3 2008 Earnings Call Transcript

October 30, 2008, 4:30 pm ET

Executives

Tom Lewis – Vice Chairman and CEO

Paul Meurer – EVP, CFO and Treasurer

Analysts

Greg Schweitzer – Citigroup

Michael Bilerman – Citigroup

Todd Lukasik – Morningstar

Suneet Parikh [ph] – Banc of America Securities

Steve Redona – BB&T Capital Markets

Craig Kucera – BB&T Capital Markets

Jeff Donnelly – Wachovia Securities

Ryan Levinson [ph] – Private Fund [ph]

Philip Martin – Cantor Fitzgerald

Operator

Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the Realty Income third quarter 2008 earnings conference call. (Operator instructions)

At this time, I would like to turn the Conference over to the Chief Executive Officer of Realty Income, Tom Lewis. Please go ahead, sir.

Tom Lewis

Thank you, Andrew. Good afternoon, everybody, and welcome to our conference call, where we’ll run through the third quarter and nine months, and then see if we can give some color or additional information on the balance of the year.

In the room with me today is Gary Malino, our President and Chief Operating Officer; Paul Meurer, our Executive Vice President and CFO; Mike Pfeiffer, our Executive Vice President, General Counsel; and Tere Miller, as always, our Vice President, Corporate Communications.

And as I am oriented to do on all of these is to say during this conference call, we will make certain statements that may be considered to be forward-looking statements under Federal Securities law.

The company’s actual future results may differ significantly from the matters disclosed in any forward-looking statements, and we will disclose in greater detail on the company’s quarterly 10-Q the factors that may cause such differences.

And Paul, if you want to start up by going through the numbers, that’ll be great.

Paul Meurer

Thanks, Tom. As usual, I’m going to comment on our financial statements, provide a few highlights of our financial results for the third quarter, starting with the income statement.

Total revenue increased 12.2% for the third quarter as compared to the third quarter of 2007. Rental revenue increased to approximately $82.2 million in the quarter as a result of new property acquisitions. Same-store rental revenue increased 1.1% for the quarterly period, and other income was $322,000 for the quarter.

On the expense side, interest expense increased by about $7.8 million during the third quarter as compared to the third quarter of last year and this increase is due to more bonds outstanding as compared to a year ago, the $550 million of 2019 notes that we issued in September of 2007.

We had zero borrowings on our credit facility throughout the third quarter. On a related note, our interest coverage ratio continues to be strong, at 3.2 times, while our fixed-charge coverage ratio was 2.5 times.

Depreciation and amortization expense increased by about $3.4 million in the comparative quarterly period, as depreciation expense has increased as our portfolio continues to grow.

General and administrative expenses, or G&A expenses, for the third quarter were about $5.1 million, a reduction of almost $1.2 million from last year. G&A represents only 6.2% of total revenues for the quarter. We expect G&A expenses in 2008 to remain below 2007 levels.

Property expenses increased by $963,000 for the quarter and these are the expenses primarily associated with the taxes, maintenance, and insurance expenses, which we are responsible for on properties that are available for lease or sale.

Income taxes consist of income taxes paid to various states by the company, and these taxes total $308,000 for the quarterly period. Income from discontinued operations for the quarter was $6.1 million.

Real estate acquired for resale refers to the operations of Crest Net Lease, our subsidiary that acquires and resells properties. Crest sold three properties for $4.6 million for the quarter, for a gain on sale of $199,000 and overall for the quarter, Crest contributed income of $238,000.

Real estate held for investment refers to property sales by Realty Income from our existing core portfolio. We sold 13 properties during the third quarter, resulting overall in income of $5.9 million. These property sales gains are not included in our funds from operations.

Preferred stock cash dividends remained at $6.1 million for the quarter, and net income available to common stockholders was $28.6 million for the quarter. Funds from operations, or FFO, were approximately $45.7 million for the quarter. FFO per share was $0.46 for the quarter versus $0.47 per share for the same quarter a year ago. However, our FFO before Crest contribution, or the FFO from our core portfolio, remained at $0.45 per share for the comparative quarterly period.

For the nine-month period year-to-date, our FFO before Crest contribution increased to $1.37 per share, versus $1.34 per share a year ago, or an increase of 2.2% in earnings year-to-date from our core portfolio.

When we file our 10-Q, we will again provide information you need to compute our adjusted funds from operations, or AFFO, or our cash available for distribution as dividends. Our AFFO, or CAD, is typically higher than our FFO, as our capital expenditures are generally relatively low, and we don’t have a great deal of straight-line rent in the portfolio.

Our continued growth in core earnings allowed us to increase our monthly dividend twice this quarter. We have increased the dividend 44 consecutive quarters and 51 times overall since we went public over 14 years ago. Our current monthly dividend is now $0.141125 per share, which equates to a current annualized amount of $1.6935 per share.

Now let’s turn to the balance sheet for a moment. We’ve continued to enhance our conservative and safe capital structure. Our debt-to-total market capitalization is 33%, and our preferred stock outstanding represents just 8% of our capital structure and all of these liabilities are fixed-rate obligations.

We continue to have zero borrowings on our new $355 million credit facility. This facility also has $100 million accordion expansion feature. The initial term of this facility runs until May 2011, plus two one year extension options thereafter.

In September, we were very pleased to raise $75 million in a common equity offering. As noted on the balance sheet, we now have $113 million of cash on hand. We will use this cash and other cash being generated by our portfolio to repay our $100 million of bonds maturing next month and the $20 million of bonds maturing in January 2009 and thereafter, our next debt maturity isn’t until 2013.

In summary, we currently have excellent liquidity, and our overall balance sheet remains healthy and safe. We have no exposure to variable-rate debt, and we have no need to raise capital for any balance sheet maturities for almost five years.

Now let me turn the call back over to Tom, who will give you more background on these results.

Tom Lewis

Thank you, Paul and as is our custom, I’ll just run through the various areas of the Business and I’ll start with the portfolio.

We ended the third quarter with 96.9% occupancy in 73 properties available for lease. That’s out of the 2,355 we own. That’s up 10 BPs from last quarter and I’ll tell you, I never thought I would get excited about occupancy going up 10 BPs, but I am, given this environment, and we’ll certainly take that.

We had 14 new vacancies for the quarter. We re-leased 12 of those, and we sold four property which gets us to the increase in occupancy. Only four of the 14 new vacancies came from credit default, from a couple of smaller tenants this quarter. That’s obviously not a large number, given the 2,300 properties and the other 10, the balance, really came through the normal lease rollover that’s going on in the portfolio at all times, which ebbs and flows, so pretty good there.

Our sense, looking forward for the fourth quarter as of right now, is occupancy should remain strong. We’re not seeing a lot of default reflected in the portfolio at the moment, but obviously, the retail environment is very tough, and things could change.

I think we have a good handle on the lease rollover, and we’re making decent progress on the leasing that comes up. So our expectations as of right now would be once again very high; 96% to 97% occupancy at the end of the fourth quarter, so fairly stable.

Same-store rents, as you saw in the release, on the core portfolio, increased 1.1% during the third quarter, 1.3% for the year. Most of you know we have 30 retail industries in the portfolio. Two had declining same-store rents, three were flat, and then most of the portfolio, different industries, had some type of increasing rent, with about half the overall increases coming from three industries, which is childcare, interestingly enough, restaurant; and convenience stores.

I think we continue to be very well-diversified with the portfolio. Relative to the total number of properties, we had a decrease of 12 properties in the portfolio during the quarter from 2,367 to 2,355 and that really was generated by the sale of a few restaurant properties out of the portfolio, where we pruned some units to reduce concentration and we are keeping that money in cash and have not invested it through a 1031 back into property.

As I mentioned, there are 30 retail industries in the portfolio, 118 chains in 49 states and I think the industry exposure remains fairly well diversified. Restaurants are our largest industry, at 21.4% for the quarter. That’s down from 21.7% last quarter and 23.7% in the first quarter and then 24.2% at the end of the fourth quarter last year. So we continue to make a little progress in terms of reducing the concentration. We’ve said in previous calls that we’re full in that sector and want to reduce that back down under 20%, and we’re doing that.

Convenience stores are the second-largest industry at 16.3%. It then goes to theaters at 9.1%. Childcare is down to about 7.7%, which was once our largest. So we continue to be mindful of diversification.

On a tenant basis, our largest tenant is 5.9% of rents, next one’s 5.4%. Everybody else in the portfolio is below 5% of rents and if you put the top 15 tenants together, they comprise about 53.7% of our revenue, which is down a bit from last quarter.

By the way, when you get to the 15th-largest tenant, that’s only about 2.2% of revenue and when you get to the 21st, you’re down to 1%. So the vast majority of all of the tenants in the portfolio, even the larger ones, are a fairly small percentage of revenue and we’re pretty well diversified.

The average lease length in the portfolio remains long, at 12.1 years and relative to the overall health of the portfolio, again, our 15 largest tenants are about 53.7%. Our best metric that we watch for credit in our portfolio is the cash flow coverage at the store level for the rent that’s being paid. That’s the individual store’s cash flow to the retailer EBITDA divided by the rent and that shows us how much we’re really covering rent on a store and unit basis, which is our best method of credit and profitability.

The average cash flow coverage for our largest 15 tenants for the quarter was 2.79 times. That ranged from a low on a tenant basis of 1.7 times to 4.55 times, which is very, very healthy. That compares last quarter to 2.7 times, so actually up a bit, and a range of 1.77 to 4.55 and we continue to believe that’ll give us a really good margin of safety and is really the primary thing that are going to allow the tenants to pay in this environment.

I do want to make a couple comments on those numbers. As always, they’re not real-time. We get the reports from our larger tenants quarterly on some, annually on others, so they do tend to lag and we like to make sure everybody knows that and I think the number probably would have dropped a little bit this quarter if it had been real-time, obviously, because of the slowdown that we saw in retail going back to September, where I think retail sales were up about 1.2% throughout the country and I think you would have seen it in our portfolio, too.

The other thing in there is that the rent concessions that we gave to Buffets at the end of the fourth quarter really reset their cash flow coverage’s up to higher numbers, higher coverage and that obviously helped the number, but I would also note that generally, we like our cash flow coverage numbers to increase through the store’s EBITDA going up, and not through the rent going down. So while we’re pleased that it’s high coverage generally, it’s preferable if it happens through the tenants doing a little better.

However, the cash flow coverage do remain very high, and we think that’s what gives us our best margin of safety and that’s important to us in this environment, and I think continues to be why the portfolio does very well.

I’ll move on to property acquisitions. During the third quarter, we invested a whopping $400,000 in one property at a 10.1 cap. That was a convenience store. It was another $3.9 million completing a couple of development properties. The development properties were all transactions started late last year or at the end of the first quarter, and that pretty much complete any development that we have in the portfolio. Those are all now paying rent and we won’t have a lot of funds going out for development, as we’ve just moved away from that in this market environment.

We’ve been using for acquisitions $250 million for the year. For the nine months, we’re at $188 million and we’re now assuming that we do not buy really anything else in the fourth quarter, and that that $188 million is our estimate for guidance. That obviously could change if we saw some motivated sellers willing to go with higher cap rates, but for now, we’re going to assume no acquisitions in the quarter, which is what we’ve been doing for the last couple of quarters.

It’s been an act of volition, really intentional, for us not to be out buying properties. We thought prices would decline and cap rates rise and generally, anything that we would have bought in the last few quarters we could have bought at a better, higher cap rate today or in future quarters and we continue to believe that’s the case. So I think that’s served us pretty well.

I will say, though, that I think cap rates are definitely rising, while transaction volume’s gone down quite a bit. We’re starting to see a fair number of people, or a good number, coming to market, trying to use their real estate to raise some capital and in most cases, I think they’ve adjusted cap rates upwards, but in our view not enough. So I think the transactions we’re seeing, a number of them won’t get done until cap rates rise enough to interest some of the buyers like ourselves sitting out there, but we are seeing that movement.

We continue to believe that there are a lot of people out there that have real estate on their books that don’t have great access to other forms of capital, and that they’re really going to have some capital needs that are coming up on them and have thought that probably next year, if the capital markets don’t come back, they’re going to need to bring those to market and that likely will be the impetus to move cap rates and probably close the bid-ask spread that you see there out in the market, that has really caused declining number of acquisitions.

As I mentioned, we’re starting to see that. I think caps are going to have to move up into the 10% range to really start things moving. I can tell you that 10 caps have creped into the discussions that we’ve had with several tenants over the last month or so and while they’re not there yet, I do believe that they’re moving in that direction and it wouldn’t surprise me at all to see a few acquisitions go off at above that price for people who need the capital.

It’s interesting, when we talk about 10 caps to people, that it seems very high to them, but on a historical basis, it really isn’t. Obviously, we’ve been in this business for 39 years and I went back and looked at the cap rates that we did in each of the years that we’ve been in business and the last three years, kind of 2005 through 2008, our cap rates have run from 8.42% as a low up to the 8.7% that we’re doing this year and we’ve done about $1.5 billion in acquisitions at that price.

And then look back at 2003 and 2004, and cap rates were over 9%, really closer to a mid-9% range, in those years. 1994 to 2003, which is really when we came public, up until just a few years ago, cap rates ranged from 10.35% to 11.3% and previous to 1994, as I went back, cap rates were right around 11% in each year that I looked back, going back into the early ‘70s.

So I think the 7% and 8% caps that we’ve seen out in the 1031 market in the last few years, like a lot of pricing at other asset classes, are really a function of what was some historically cheap financing and moving up over 10% probably seems appropriate and really not that surprising, particularly if we look at what we’ve compared things against in the last few years, which were credit spreads, which have obviously gapped out in the debt markets and so it’s probably appropriate that it happen in net leases, too.

I think we’ll wait a bit to go higher. I think we will make some acquisitions next year and it really doesn’t bother us to be patient right now. Obviously in this environment, a little liquidity is not a bad idea, either. So we really don’t mind having some cash on hand and no balance on the line.

I’ll move on to Crest for a moment. That’s obviously our subsidiary that acquires and then sells properties. We’ve been in that business about eight years and it’s a business where we booked FFO, but obviously, unlike our core revenue from long-term leases, its contribution is based primarily on property sales and because of that; its cash flow is very volatile.

We started that business in 2002 and going through kind of 2002 through 2006, it made anywhere from $0.02 to $0.10 in FFO per year. Last year, in ‘07, it was $0.11 and this year, we’re looking at a penny and that last year’s $0.11 was obviously a function of starting the year with a lot of inventory and a high level of sales.

That inventory peaked at $140 million last year and since the beginning of last year, we’ve been pairing inventory through sales, really for about 20 months now. We bought nothing in Crest six of the last seven quarters, and nothing for the last four quarters and we plan no acquisitions in Crest as of right now.

Inventory held for sale there is down to five properties for $6 million. So effectively, we are out of that business, really until market conditions change substantially, or we feel we need to use Crest and market conditions change for acquisitions.

We’ve thought for some time that cap rates would be moving up and prices down, and really thought holding inventory for sale would really give us some risk to the operation because of the mark-to-mark component of that business for pricing, if your cap rate that you bought at moves through the cap rate that you’re selling at and so, while it’s cost us about $0.10 a share in FFO; we’ve had less FFO this year versus last year to get out of that business; we think it has been prudent, and that’s where we’re going to stay.

Moving on to dividends, as Paul said, we’ve been increasing the dividends. I would anticipate we’d look for dividend growth to continue in 2009. I think it’ll likely be at a moderate pace that will match probably our FFO growth over the next year or so.

I wanted to just cover one more time, as Paul did, the balance sheet, which is in great shape and obviously with the retained earnings, a few property sales and the capital from the equity offering we did, we’ll have cash on hand to pay off the $100 million at 8.25% 10-year paper that we had, and the other $20 million coming due in January.

And post that, given that we just recast the $355 million credit line, we’ll have no maturities, as Paul said, to 2013 and no balance on the line. So, sitting here with no mortgages on any of the properties, and no need for capital and a strong balance sheet, feels very good right now for the business.

As to guidance, we revised our estimates for 2008 to $1.82 to $1.84 and that revision really reflects having the additional number of common shares outstanding after the recent equity offering. Also, the assumption in there that there were a couple of remaining Crest properties that we thought might sell at the end of the year, and we now think those will move into next year, and also that we’re not going to acquire additional acquisitions for the balance of this year.

And while it’s minor, I think it’ll show up that since we have sold some properties out of the portfolio, and we’re keeping the cash from those properties rather than reinvesting, that’s pretty much how we get to that number. By the way, I think that means that our FFO for the year will be down a bit. Our core FFO before Crest will be up a bit for the year.

For 2009, we really talked at length about guidance internally and posted $1.86 to $1.96, which would be 1.1% to 7.7% FFO growth. For next year, we will have lost Crest out of the numbers, so really looking at zero probably, to a penny at best in Crest, so almost everything in the guidance coming from the core portfolio.

It’s obviously one of the more interesting times that we’ve had trying to think about guidance for 2009, with everything going on in the economy and while we’re in great shape from a balance sheet standpoint, trying to estimate, I think, first acquisition to this point or the movement of the portfolio is difficult.

So as we put the guidance together, the $1.86 in 2009 estimates no acquisitions in the portfolio whatsoever. I think we’ll do some, but I think it’s good to put that down as a marker, the $1.96. About $500 million or so in acquisitions and to put that in perspective, in the last five years, I think we’ve bought obviously $188 million this year, but as high as $770 million. So we thought that was a pretty good range.

It, I think, also assumes a conservative re-lease schedule on the 3.1% of the assets that are not leased right now. Also on lease rollover is only about 3% of the portfolios rolling over next year. However, two thirds of those rolls are a second-time roll, where the existing tenant, at a very profitable store, stayed in the first time the lease rolled and typically those tend to be pretty easy. So we don’t foresee a significant problem there.

Anyway, that’s our best estimate, I think, for the moment, which I hope is helpful for everybody’s modeling. We’ll obviously see what unfolds in 2009 and watch the portfolio.

To summarize, then our portfolio’s in relatively decent shape. We think that’ll continue through the fourth quarter. We’re being patient with acquisitions. We have the balance sheet to buy, and obviously nothing to deal with on that front.

And our core FFO continues to grow, albeit slowly and we anticipate that that will be the case into the future, although it is certainly a very challenging market out there in retail, and we’re well aware of that.

So with those comments, we will open it up to questions at this time and if anybody would like to ask us something, we’d be happy to do that. Andrew, if you can handle that for us?

Question-and Answer Session

Operator

Thank you, sir. (Operator instructions) We’ll take the first question from the line of Michael Bilerman with Citigroup. Please go ahead.

Greg Schweitzer – Citigroup

Hi, it’s Greg Schweitzer, I’m here with Michael. This one’s probably for Paul. What occupancy expectation for the full year are you baking into the ‘09 guidance range?

Paul Meurer

We do take into consideration that there might be some additional stress, if you will, in the portfolio. As kind of a general comment, I’d say about 1% occupancy down is something that’s already in those numbers and those assumptions.

Greg Schweitzer – Citigroup

How would that compare to when you were at this point last year; deciding on ‘08 occupancy and when you made the ‘08 plan were you sort of also baking in sort of a decline there?

Paul Meurer

Something similar, maybe a little bit less, maybe half of a percentage point, or that sort of thing, at that point, but there’s always something like that baked in just as a more of a conservative view in the model and at this point in time, it seems prudent certainly to have something in there as part of the viewpoint for how the portfolio might perform and that would mean, what, 96% occupancy or similar. What have you, instead of 97%?

Greg Schweitzer – Citigroup

Right.

Tom Lewis

It may not be as conservative as it has been in previous year, given the market we’re talking about.

Paul Meurer

No and then of course, if it’s a little bit more than that, but yet we do some acquisitions, then obviously, we’re still in that range in terms of earnings performance.

Greg Schweitzer – Citigroup

Okay and then Tom, just touching on Buffets to get your thoughts, we had disappointing September sales clearly and the default on the loan. How shall we think about the situation?

Tom Lewis

It’s an interesting one. I’m not overly concerned. I’ll mention we’re on the Creditors Committee and subject to confidentiality agreements and the reorganization is likely not to be completed till early next year. So I’ll give you some color on it, but relative to parsing that while it’s still going on and we’re in committee is something we can’t do.

They filed last January. We had 116 properties; we got 12 back. They were about 7.6% of rents in our largest tenant and we took the 12 back and went off on those, and really started focusing on the 104 properties that we own.

And as we mentioned three months ago now or so, or four months, the agreement we put together with Buffets is to lease all of the 104 properties and adjust the rent from a little over $22 million to a little over $19 million, or about 87% of previous rent.

That agreement was signed by all parties; it was approved by the court and we’re operating under that in the fourth quarter and I think it was pretty consistent with what we thought and it’s also what we had in the guidance, so that really didn’t change guidance.

Our thought on Buffets, as we worked through, even though their EBITDA declined substantially post their merger, there was still a lot of EBITDA in the chain, and it was going to be a reorganization.

And while we had some properties that had been, I think, substantially weakened in their operations, we had mostly profitable properties and we knew that they would want those profitable properties and we felt, given the level of EBITDA, that they would go forward, and we continue to think that today.

It’s interesting, as we looked at it. One of the goals we had, as we look at a case like this and it changes from market conditions, and certainly we have interesting market conditions today is that what’s going to cause us to continue to get paid rent, like we’re getting paid the majority of it today, is that they have high EBITDA cash flow coverage of the rent.

We also are focused in working on this that we wanted to keep the vast majority of the properties occupied. We don’t always do that, but given what we were seeing coming through the year with market conditions, we thought that was a good idea.

So we broke the portfolio down for us into the current profitability, and then tried to adjust the rents on the weaker units and we did that in return for shortening some lease lengths on it and basically, what it did for us is it got the cash flow coverages on the units we owned back up into a very comfortable level that we normally like to underwrite at, and left them in a situation where the properties we had were profitable.

So I think there are some things they have to go through here in completing the reorganization. Our belief is they’ll come out, our belief is there’s enough EBITDA where the company will be out and operating and I think now, if you look at our properties all the way up and down the portfolio, we have good operations in them.

So my sense is obviously, we prefer not to go through one of these, particularly since it was our largest tenant and it was a rather large integration of M&A that didn’t work.

I’ll also tell you that I think their customer was kind of a poster child for what’s been going on in the economy, and also the middle line was hit with some increasing costs.

But if we can go through that and maintain over the vast majority, 80%-plus of the rent we had in, and then end up back with cash flow coverages. For those of you that follow us we are in very attractive levels, and come out of it with the stores occupied, we’re pretty pleased with that and my sense is we’ll move forward with that and that we won’t have a lot of issues in the future.

Greg Schweitzer – Citigroup

How much could sales come down for the cash flow coverage range to be at the point where you start to get concerned, on the properties in the portfolio?

Tom Lewis

In the confidentiality agreements, the only thing I could speak to was rent levels and terms, but saying that we want the cash flow coverages in levels we’re comfortable with – for those of you that watched the underwriting in recent years, I think you know where those levels are and obviously that would take a substantial decrease.

Greg Schweitzer – Citigroup

Okay and then just finally, are you able to provide some color on the revised lease lengths?

Tom Lewis

Yes, sure. They vary. We cut the portfolio up into pieces with them and on that, I’ll give it to you exactly, here we go.

Paul Meurer

And by the way, before he answers, Greg, just so you know, the expiration schedule that’s currently in our press release now and will be in our 10-Q, and of course on a go-forward basis, does reflect all of these changes that were made to the Buffets lease plan.

Michael Bilerman – Citigroup

And Paul, it's Michael Bilerman, that takes effect as of October 1 or at what point in the fourth quarter?

Paul Meurer

It’s September 15.

Tom Lewis

We reflected that in the numbers at the end of the quarter relative to cash flow coverages, and also the lease rollover.

Anyway, of the 104, we had 15 of them where we cut the rents pretty substantially and went to a three-year lease, but again, putting the cash flow coverages up into a very comfortable range didn’t bother us that much.

We had 11 that we did at five-year, we had 34 at seven-year, we had 10 we did 10-year leases, and we had 34 where we did 13-year leases and again, the focus for us is – if you get the cash flow coverage very high, then lease length is not your issue.

Greg Schweitzer – Citigroup

Right, thank you.

Operator

Thank you. We’ll move to our next question from the line of Todd Lukasik with Morningstar. Please go ahead.

Todd Lukasik – Morningstar

Hi, thanks for taking my questions.

Tom Lewis

Hey, Todd.

Paul Meurer

Hey, Todd.

Todd Lukasik – Morningstar

Hi. Just seems like you guys have some dry powder to potentially take advantage of some good deals in the acquisition space. Can you just speak a little bit about what metrics you all will use to know when cap rates have gone high enough?

Tom Lewis

That’s a great question and like most decisions, rather than rely on one thing, there are a number of things, but I think, given what I talked about in historical cap rates, I think we’re really going to need them up over 10, so that’s one.

Second, at the same time that they need to be up over 10, I think that it’d be smart for us to be a little more stringent with our cash flow coverages. So if you’re raising the rent a bit, the properties have to be more profitable to be up at 2.5 to three times cash flow coverage. So I think it’s really a mix of cap, and as well as a price adjustment in a seller’s mind, relative to where prices have to be, but my sense is 10-plus.

The other part of this is in net lease. While our leases do grow, we have to make a good spread right up front. So I think if you look at your cap rate, and then you start looking at cost of capital, I think it shows you that cap rates do need to be high before it makes sense to make accretive acquisitions.

If you look at debt costs for us today, BBB spreads have gapped out. In the REIT world, I think you’re over 10%. If you look at preferred, obviously that market’s been beaten up pretty bad, so you’re looking at 12%.

So you kind of look for permanent financing in the common equity area and I think if you take the guidance we have for 2008 as an example, and you did $1.82 to $1.84, and you divided that by the price of the stock at $21, a price of the equity around there on a nominal basis, if you then mark it up for underwriting costs, you’re going to be looking at 9% or so as a cost of equity.

And so I think you really have to be looking at a spread of 100 basis points before it makes sense to add accretive acquisitions. So it’s one, the market relative to cap, which I think has to be 10-plus. I think it’s then secondarily making sure that in this environment, which will be volatile for a few years and a tough financing market for people for a few years – we make sure that cash flow coverages are even higher than they were before and then it’ll be a look just personally at our company, and I think for anybody else in the business, at what point is it accretive enough on a nominal basis over your cost of capital where it makes sense.

Todd Lukasik – Morningstar

Okay and can you talk a little bit about the process that you go through internally? Do you guys proactively go out and look for attractive property portfolios and approach the current owners or is it mainly reactive, where people are coming to you with opportunities?

Tom Lewis

It’s a mix of the two, but if it’s reactive, it’s because we have a list of close to 1,000 retailers, and a lot of owners and our people are out really acting like investment bankers and calling on those people, and talking to them about their portfolio, first of all, but also talking to them about their business plans and their balance sheets and their sources of capital and the majority of the transactions really come from those discussions, either through, gee, that’s interesting, let’s take a look at it; or, after having talked to the guy for five years, he wakes up and says, gee, the debt market’s no good, I’m going to need to use my real estate to get some capital, and we get that call.

So I would say it’s almost all a function of being fairly proactive, calling on people and we’ve tried to be knowledgeable in terms of who’s asset-rich and who has portfolios. We’ve also tried to be proactive relative to understanding people’s debt maturities that are coming up.

In our industry, there was a lot of net lease financing that was done in the CMBS market over the last five to seven years and a lot of those were five-year floaters. So they’re going to be coming up in ‘09, ‘10 and ‘11 and I think, unless the capital markets change dramatically relative to access and even if they do, they probably won’t get back to the pricing of a few years ago that sale leaseback may end up being more attractive to them than the spreads they’re going to experience as they see in the CMBS market.

So we’ve been proactive calling on people. That’s where it comes from, but I think a lot of it’ll come from refinance in the next few years, versus M&A, where it came the last few years.

Todd Lukasik – Morningstar

Okay and it sounds like you may even expect more opportunities than sort of the $0.5 billion that you’ve said might be available next year. Do you have a sense, from your own balance sheet, what other funding opportunities might be available to you all to take advantage of even more potential acquisitions?

Tom Lewis

There’ve been a lot of things used in the last few years in the REIT business to fund capital for growth and I think one of the things that has served us better than anything is keeping a very uncomplicated balance sheet and so I think it’s primarily going to be through some asset recycling and it would be through issuance of additional securities, where it’s accretive to do so.

The credit facility, the $355 million, has no balance on it, and we don’t anticipate it’s going to have a balance on it in the near future. So that’s available to buy properties, but I think before you put a lot on a credit line today, it would be very wise to know what your takeout’s going to be and I think that’s going to be asset recycling and issuance of new securities, if they’re profitable.

Paul Meurer

And Todd, just to be clear, in terms of opportunity our historic track record has been more in the 10% to 15% range, in terms of what we purchase, of opportunities, not only that we hear about but really look at and underwrite, so that those are opportunities that are looked at internally through our Investment Committee, where we do the real estate work, the credit work, the cash flow coverage work.

So when we say $500 million next year, to do that, we’d end up having to look at a whole lot more than that. Because we continue to be pretty stringent on opportunities we close on and make the final decision on relative to purchase.

Activity levels and opportunities, I would say, has slowed down a bit, but it is still strong, and we are still looking at lots of opportunities. We clearly have seen cap rate movement, but we don’t think the volume, as Tom mentioned, will really tick back up again until people kind of get over the sticker shock, if you will, and realize that the alternatives available to them, from a refinancing or recapitalization perspective, are quite limited.

And while the debt product historically was our big competitor whether that be CMBS, high-yield debt, leveraged loan or bank credit facilities. That competitor has largely completely disappeared for the BB retailer. Or if it’s there, it’s very, very expensive.

So equity sale leaseback capital will be attractive to them and make a lot of sense and when you start talking 10%, 11% equity sale leaseback capital to a BB retailer who doesn’t have a lot of other alternatives relative to their balance sheet, it’s still a very attractive alternative to them.

Once they get over that hump, start realizing that they’re not quite there yet, but once they do, we think we’ll have a lot of activity to look at.

Tom Lewis

I’ll just make one more comment. I would assume on the low side of the range and until we see that movement and then, we’ll guide up in future quarters if it should be. So if I was doing what you’re doing, I’d assume right in the midline, and understand it could be lower than that.

Todd Lukasik – Morningstar

Right, okay, that’s very helpful. Thanks again for taking my questions.

Operator

Thank you. Our next question will come from the line of Suneet Parikh [ph], Banc of America Securities.

Suneet Parikh – Banc of America Securities

Hi, I’m here with Dustin as well. The question is given that you’re partially in the business of helping to extract real estate value from retailers then, there’s been some talk in the market about trying to do that with one large public big-box retailer in particular.

Could you provide maybe your thoughts on this type of strategy to create liquidity for a retailer in an environment when underlying real estate values are so much in question?

Tom Lewis

That’s a great question, and I’ll speak generically. I’m aware of the one you’re thinking of, but my sense is, is the move to extract value out of the retailer to give further value to the equity holders and to do so by forming a REIT today is something that I think was talked about a lot a few years ago, and done, and a piece of financial engineering in a very well-capitalized market that might make sense.

In this market, if you’re going to extract "value" out of the real estate portfolio in this environment, if I was running a retailer, it would be to make sure I’m solving a problem relative to my balance sheet, and stay as liquid and with the biggest margins I can, because it’s certainly a tough market out there.

And then the second part is how that would be valued in the market, obviously, as it was discussed in the press, would be a decent structure, but it would be only one tenant and even if you look at REITs today and you’re doing this every day, and look at the valuations they’re getting perhaps the value extraction might not be as high as somebody thinks, but for a retailer who’s got a financing problem, I think that’s where you step up to it today, or you want to build cash, unless you’ve got something compelling to do with the business.

But I think in most businesses, it’s probably not a period when huge CapEx investments are going to generate a lot of incremental revenue. It’s a better time to take care of your balance sheet.

Suneet Parikh – Banc of America Securities

Sure and then, I guess, then just as a follow-up on that. Where do you think, I guess, a ground lease for a well-capitalized big-box retailer would trade right now?

Tom Lewis

You know, I could have probably given you a really good answer six months ago or 12 months ago, and I think it would have been down in the sixes, but today, it could be substantially higher and I think if you just take a look at our yield and look at the balance sheet, and kind of run through the implied cap rate there, you’d maybe take 100 basis points off for it and then understand your standard deviation on that guess may be 200 basis points. I apologize for not being that helpful in this market.

Suneet Parikh – Banc of America Securities

No, that’s fine and I guess, lastly I guess your troubled-tenant watch list – has there been any changes? Has your watch list maybe increased? And I’m sure you look at rent coverage ratios for your troubled tenants. How’s that been going? Have they gone down?

Tom Lewis

It’s interesting; the watch list today has a couple of retailers on it. They’re not huge positions for us; they’re small and there’s nothing imminent and like all of you, I know it’s a difficult market out there, and it’s difficult for the retailers, particularly those that have a lot of debt and I think for those, their primary problem is their debt; it’s not their real estate and so some of them may well have to deal with that.

But it’s not expanded as fast as I thought it would. It’s not large and if I go back six or eight months ago, it looks about the same as it did then.

And I think cash flow coverages again in the portfolio are like 2.7, and they range from 1.7 to 4.55. So you can assume that if we have somebody that’s on the watch list, my sense is they’d probably be at the 1.7 to 2.1 at the lower end of that range.

Paul Meurer

We try to make some pretty affirmative statements on these calls every quarter, as a good form of disclosure, relative to our tenant base. Because we recognize that we don’t disclose specific tenant names for competitive business reasons.

So let me just say a couple more things beyond what Tom said in his call remarks at the beginning. That is, in our top 20, we don’t have any other retailers in bankruptcy. So when you get down beyond our top 20 tenants, now you’re getting down to about 1% of rent. So that’s just kind of an affirmative statement that might be helpful to a lot of folks out there wondering about our portfolio.

Tom Lewis

I’ll also just want to say, so people know we know. Obviously, the economic position is not positive out there. There’s a lack of credit available, you’ve got an over-levered, worried consumer, who’s worrying about his house and equity portfolio declines. Consumer debt’s high, credit cards are tough; while gas price and food inflation has come off at bit, which is certainly helpful. That’s really offset by a low consumer confidence level.

So I think for a lot of retailers, you need to dig in your heels and operate well, and watch your CapEx and your balance sheet and retail sales were up about 1.2% September. I think it’ll be worse in October, and then we’ll have to see.

So with that said, though, with high cash flow coverages, we hear noise and complaints from tenants, but there’s nothing that I can say today, gee, I think in the second quarter, X is going to happen, or Y, but it’s a market also where we know that things can change, but for right now, not bad.

Suneet Parikh – Banc of America Securities

All right, that’s it from me, thanks.

Operator

Thank you, our next question comes from the line of Craig Kucera with BB&T Capital Markets. Please go ahead.

Steve Redona – BB&T Capital Markets

Yeah hi, good afternoon. This is actually –

Paul Meurer

Hey, Craig.

Steve Redona – BB&T Capital Markets

This is Steve Redona, for Craig. On the C-store acquisition, albeit it was a small one, is that pricing, the 10/1, is that indicative of what you’re seeing now or was this more or less a distress situation?

Tom Lewis

That’s what we’re telling them it’s going to take and so this was a situation, actually, with an existing tenant, who had another property they wanted to get done and we had done business with them and we said, look, that’s the new rate and it’s just a poster child.

We just say, look at the spread on our 10-year, and look at how much it’s moved and so the fact that we’re moving you up 130 basis points is really still pretty much of a bargain and if you don’t need to do it, and you think things will get better, then hang out and wait, but our advice is that cap rates will go up before they go down and again, it’s really anecdotal, because it was a one-off, but they felt that was the easiest thing to do for the one property.

We’ve had a couple other three people come in the door and the discussions have been up in that range, or maybe even higher, but I think it has been to date some challenged credits, where even at a higher rate, it didn’t meet some of the other pieces of the puzzle, but that’s where we’re quoting.

Craig Kucera – BB&T Capital Markets

Okay and then on the sales, the 13 sales in the quarter, do you have kind of a blended cap rate on those?

Tom Lewis

Yes. It was 7.9%.

Craig Kucera – BB&T Capital Markets

7.9%.

Tom Lewis

Obviously lower than you’ve seen on sales in the past, but it was lightening up on what were some attractive properties, smaller price point, in good markets, which I think over the last quarter there was still a pretty good market in that and I think I would look for higher cap rates on sale and not put that in your model.

Craig Kucera – BB&T Capital Markets

Okay.

And then just broadly, what industries are you seeing the best risk-adjusted returns right now? Are you still taking a look at any banks, sale leasebacks there and if you can just talk sort of through your major industries there?

Paul Meurer

You could send us a list of which banks you think are perfectly safe, and get a look at that sector.

Paul Meurer

As Tom’s grabbing his notes here, let me just make a comment on this, which is that banks or not banks, but it’s really going to be balance sheet-driven as opposed to industry-driven, relative to where the opportunities are. So we’re kind of seeing a mix, if you will, come in the door.

Tom Lewis

What Paul’s saying is I don’t think there’s an industry theme that we’re going to see. I think it’s going to be looking at each of our industries and having a view of how we feel about their business and their future, and how much they’re impacted right now by the consumer; i.e., are they are a low-price point basic human need or value that seems to be holding up?

Or are they a consumer discretionary that’s not holding up, or anything home-related that’s not holding up? And we’ll start with kind of that view of whether we like them or not, but I think, to get to the cap rates we want in this environment, when these guys really aren’t trying to grow, it’s going to be balance sheet-related, and them really doing some liquidity.

We’ve looked at banks. Banks are something we’ll continue to look at. About three years ago, we took one of our people and had him spend a year on banks – talked to everybody in the business, underwrite the industry, go through it and what we found out is there wasn’t a bank in America that needed any money that we could find, that was a bank in America, not the Bank of America.

As such, we spent a year and didn’t do any business, but put the files away thinking there are points, albeit far between, where banks need capital and now that we’re in that, we’re starting to see portfolios come across in banks and it’s a very careful underwriting process. So I’m not particularly optimistic relative to doing large volumes there.

The other challenge is if cash flow coverage at the unit level is our best metric for credit, that’s something that’s a lot more difficult to do in a bank branch than it is in other type of retail, and just from the standpoint of identifying what those are.

Then more importantly, can they migrate down the street if a bank has two branches? And we believe it can migrate. So it really has to fall so heavily on the overall credit of the bank, that’s a difficult one today and then secondarily, the real estate and secondary use, which is a little better in the newer de novo type branches, but it may be a challenge to do a lot there, but we’re seeing them, and we’re looking at them.

Craig Kucera – BB&T Capital Markets

Great, thanks.

Operator

Thank you. We’ll take the next question from the line of Jeff Donnelly with Wachovia Securities. Please go ahead.

Jeff Donnelly – Wachovia Securities

Good afternoon. Paul, in light of the fact, I think two-thirds of the people on the call work for a bank alright, (inaudible) talking here somewhere, but frankly it alludes me.

Paul Meurer

Hey, I did not mean it in that light.

Paul Meurer

Don’t write bad things about the company now because of it, please.

Jeff Donnelly – Wachovia Securities

Of course not. Actually, the question is historically, you guys have used an internal credit-scoring system. I guess it’s the DARTH score, I believe to score deals and determine somewhat of a baseline, I think, for an appropriate cap rate.

However, with the debt markets blown out, I guess, how valuable are the conclusions there from a pricing standpoint? And I guess as a follow-up, where does your portfolio-wide DARTH score fall today on the S&P credit scale? And what sort of yield would that imply for your portfolio?

Tom Lewis

Yes. The last part of that I’m not quite sure I can answer, Jeff. It’s our DARF score that gets us to where we really think in it. I think the DARTH scores generally have held up to date. They’re higher than they were a few years ago.

However, I anticipate they’re going to decline and I will tell you, of the three credit metrics we use – which is an unsecured underwriting, which is what you’re talking about – versus the real estate and cash flow coverage at a unit level, it’s the one we assign the less, I think, credence to relative to underwriting.

Where that goes with yield – I mean, if you’re trying to take a cap rate to their debt spreads, obviously it’d be significantly higher. So I’m kind of struggling with a good answer here for you.

Paul Meurer

Well, let me just say this, Jeff. Similar to what you guys are doing to the REIT space, and really, I think, most investors or analysts are trying to do to any companies out there – our credit analysis has adapted to the current environment and when we’re looking at credit, what’s the first thing we do? The balance sheet.

What do the debt maturities look like for the next two to three years, and are we comfortable with that? If the use of proceeds for the sale leaseback we’re talking about solve some of that problem, great, but are there additional problems beyond that in the balance sheet?

And then we look at cash flow metrics. In our case, in our industry, it’s going to be payout ratio, if you will, but say, in a general corporate underwriting, it might be a fixed-charge coverage ratio type calculation.

So we’re – it’s reordered, if you will, in terms of what the priority is of what we look at, whereas in the past, we might have been less concerned, if you will, about a debt maturity coming up in their balance sheet a year from now. Like sure, they’ll have access to the capital to repay that. Well, guess what? As we know, that’s not always the case and so – and certainly not the case today, and certainly not the case for a BB retailer.

So I’d say that the analysis and approach we go through has naturally adapted to the current times, but in terms of the actual scoring system, it hasn’t really changed. They’re hanging in there. As Tom said, they’ll probably go down, I would guess, but in terms of our approach to credit underwriting, it’s certainly adapted to the current times.

Tom Lewis

Yes, I’d throw in BB minus as kind of the unsecured debt scoring – obviously we own the real estate and don’t own their equity debt converts, credit default swaps, or whatever securities out there.

Jeff Donnelly – Wachovia Securities

And then, I’m curious – I guess it’s a follow-up to an earlier question on banks. You know 12 to 24 months ago, banks were sort of maybe the hot tenant, if you will. The margin that – they were paying top-dollar rents, and there’s top-dollar pricing for their assets.

I’m curious where that has gone. Because you said a year or two ago, none of the banks really wanted or needed money. Could you argue that now, in this environment, they definitely want capital?

And has TARP effectively provided some degree of a government backstop or cushion that you could argue that this is an industry that’s sort of back on its heels, or a group of creditors that are back on their heels a little bit, but at the end of the day, their credit’s actually better than it appears?

Tom Lewis

Maybe. With the regional banks – or the ones that have been coming in the door are the local banks and I’ll tell you, we’ve looked at a number of them and a part of our underwriting requires that we get into their portfolio, and we get into the portfolio, and we start looking at the real estate and the real estate development loans, and backing residential homebuilders and the rest of us – quite frankly, in a number of them, we just threw up our hands in the middle of the underwriting and said we’re not smart enough to do this at this juncture.

And the people that are not in that situation and are really backed by TARP and the bigger banks – it just would have to be a decision to build liquidity, but I don’t think the cap rate’s going to be in a range where we would do it right now.

Jeff Donnelly – Wachovia Securities

Okay and I guess, just last question – point of clarification – the low end of your $1.86 guidance next year – that includes the $0.05 of investment sale gains, correct?

Paul Meurer

No. We’ve never included property gains – sales gains in our –

Tom Lewis

No.

Paul Meurer

– numbers.

Jeff Donnelly – Wachovia Securities

Okay. I wasn’t sure. Just, when I was reading through your –

Paul Meurer

No, just Crest and Crest essentially is estimated, to be honest, at 0 next year.

Jeff Donnelly – Wachovia Securities

Okay.

Paul Meurer

We say 0 to 1, just put something in there, but its 0.

Jeff Donnelly – Wachovia Securities

Okay.

And then, I’m curious – how plausible is it that you could actually face a year-over-year decline in FFO? Or maybe, what sort of magnitude of occupancy decline would you need to make that a reality?

Tom Lewis

Well, there’s a lot of moving parts to it, and no acquisitions and we have 1% growth in the portfolio. I’m just doing the math in my head. Then it would take a – and we’ve built about 100 BPs decline in occupancy into the model.

Unidentified Speaker

Already.

Tom Lewis

So I would say, why don’t you start at a couple hundred BPs, 300, to see some decline, but –

Paul Meurer

I think at that point, Jeff – if I could say this – and I don’t mean it cavalierly – Realty Income might not be the company you’re going to be worried about under that scenario. It’s going to be a pretty significant issue in the economy and I tend to think, on a relative basis, we’ll still be hanging in there pretty well.

Tom Lewis

Yes, but I think you just take – you take the bottom end of the range and understand we got a 100 BP decline in there, and you see the number it gets it – and it’s all core; there’s no crest. So it’s easy to do and then you can start working some numbers.

Jeff Donnelly – Wachovia Securities

Okay, and thanks. Oh, sorry, before I meant $0.01, not $0.05. Thanks, guys.

Tom Lewis

Thank you.

Operator

Thank you. We’ll move to the next question from the line of Ryan Levinson [ph] with Private Fund [ph]. Please go ahead.

Ryan Levinson – Private Fund

Thanks for taking my question.

My first one is, I think you just said these numbers, but I was busy talking to somebody and missed them. The kind of the portfolio leverage numbers that you used that range of EBITDA to lease coverage?

Tom Lewis

Yes.

Ryan Levinson – Private Fund

Just repeat that?

Tom Lewis

Yes, sure, I will. When we’re in the portfolio for the quarter, the top 15 tenants – and this is EBITDAR, the "R" being rent – to rent was 2.79 times on average on the stores we own in our top tenants, top 15 tenants. The lowest tenant was a 1.7, the highest, 4.55.

And typically, I think if you look back over the last five, six, seven years, we’re a company that has liked a 2.5 times coverage and it would really vary industry to industry, but when you get down to 1.5, we’re getting uncomfortable. So it’s really like a 2-plus is what we’re looking for.

And then obviously, the higher the coverage, better and that goes up as, hopefully, EBITDAR goes up over time. So we’re really looking at about 2.5, and when we go and do an acquire and in the past, I would say there were a few transactions where there’d be a couple properties that might get down to a 1.6, 1.7 – I would say and something we’re doing today, we’d be a lot less patient with having a cash flow coverage under 2 at all and we’d want the transaction overall to be 2.5 to 3 times, I would think.

Ryan Levinson – Private Fund

Okay and so that’s just EBITDAR to rent.

Tom Lewis

Right.

Ryan Levinson – Private Fund

Given that you’re dealing with all less-than-investment-grade credits, they’re all leveraged – what is EBITDAR to rent plus interest?

Tom Lewis

The EBITDAR to rent is what we look at on a unit basis. When we do our underwriting for the tenant, we do a full unsecured underwriting and there are many, many metrics, of which that’s one and primarily, what we’re looking for somebody is that we think – we just start by saying that we’ve got a business that is a low-price point basic human needs and it’s something that their product’s going to be used over a long period of time, that there’s a lot of EBITDAR.

So if they ever had a problem by overleveraging the balance sheet – that it’ll be a Chapter 11, and not a Chapter 7 and then we really go and focus on cash flow coverage at the unit level to survive that type of event, and real estate prices, so if we ever get a unit back, then we’d have a decent chance of leasing it.

But then it ranges all over the board, and I’ll give you an example. In 2000, when all the theater companies were having a significant problem, we walked into one that we knew was going to do a Chapter 11 in about three months, and really structured a transaction where we looked at a group of their movie theaters that were very profitable, and then we bought the land under them at very high cash flow coverages and so we were happy, knowing we had a tenant who might do an 11, to go in and underwrite that.

Conversely, we’ve been in situations with a tenant that we think has a business that’s a little more volatile and we’ve required that just their balance sheet would be in better shape.

But I’ll give you our lessons of 39 years and that is we own properties for 10 to 20 years – we don’t own securities and during that 10 to 20 years, it has been our experience the balance sheet will change, management will change, that industry will go through a downturn, it will go through an upturn.

And while we do all of that work, it’s really centered around that it’s a business that we think has a large amount of sustainable EBITDAR over a long period of time, but we are not underwriting to a corporate credit to make sure we get paid. It’s more centered on the individual units we own, the real estate price, and then the assumption if they ever have a problem, it’s an 11.

The other caveat I’ll put on that on EBITDAR is it various dramatically, from tenant to tenant, to industry and industry. Because obviously, different tenants have different margins and different industries have very different fixed costs. So if you’re taking a look at a movie theater, and you have a two-times coverage, it would take close to a 40% decline in revenue to take it to a one-to-one coverage.

If you were looking at a department store when we underwrote a Boscov’s or a Gottschalks but didn’t do anything, our sense was a 2.0 coverage only took about a 9.8% drop in revenue to get to a one-to-one coverage. So it varies dramatically from industry to industry and tenant to tenant.

Ryan Levinson – Private Fund

And I understand that. I guess what I’m just trying to understand is – across the portfolio, and this is the EBITDAR-to-rent number, I think, tells only part of the picture and I’m just interested –

Paul Meurer

We stand in front of the interest expense in a bankruptcy scenario. So we’re in front of the debt-holders, if you will. If we have a positive cash flow EBITDAR-to-rent property that’s cash flow-positive, they need to accept the leases to keep those properties, to generate cash flow to pay the debt-holders. So we stand in front of that.

So we, on some level, really don’t care, meaning yes, we look at how leveraged a credit might be, and don’t want them, in a best-case scenario, to go into bankruptcy, but, if you will, at the same time, you should assume most of the BB retailers we do business with are generally going to be leveraged. I mean, they’ve been leveraged for 39 years. They’re hitting a pretty bad cycle right now, over the past couple years, combined with some operating metric downturns.

But in terms of the leverage element, that’s nothing new and so that’s why we don’t kind of add that into our calculation. Now we do – as Tom said, when we do credit underwriting, to make sure, from a fixed-charge coverage ratio, that they’re cash flow-positive. We certainly don’t want them to be not being able to pay their interest expense and make money as an entity.

But we also assume that over the course of a 10-year, 15-year, 20-year lease, they’ll probably take on more leverage than even what we’re looking at upfront in our underwriting.

Ryan Levinson – Private Fund

I’m just a little perplexed by something. How do your leases – is there a provision written that some sort of document that works with your creditors, with your tenants’ creditors as well, that puts the leases ahead?

Or are you just saying, kind of notionally, that if they want to stay in the building that they have to accept the terms of your lease? I don’t – because I think the mechanics of it –

Paul Meurer

It's your latter comment.

Ryan Levinson – Private Fund

Okay.

Tom Lewis

That is –

Paul Meurer

Chapter 11, right.

Tom Lewis

What happens – in an 11, obviously the equity-holders typically get wiped out. The debt-holders have their position markedly changed and very often, they end up the equity-holders primarily and that happens in a Chapter 11.

You then go to what happens to the real estate – and it’s pretty simple – is they either want to keep the unit, or they don’t want to keep the unit and that is going to be based on their profitability and the way we measure that is EBITDAR divided by rent.

So if it’s 2.5 times, that means for every buck of rent, they’re making $2.50 EBITDAR, and their choice is pretty clear. They can A, reject the lease, in which case we get the building back. We have our asset and our risk as what we can rent to somebody else versus them – or they can accept it.

If they accept it, then we have had no credit event. So if you have a substantially cash flow-positive property, that is what happens to it because they have to have the stores to sell their goods to generate their EBITDA and they can’t have it without paying rent.

And I think if you look at Buffets, that was a very good example. Here’s a tenant that had an M&A that they struggled through their top line, really got hit, their middle line really got hit; all of those three things happened at once. It was our largest tenant. We had 116 properties.

We got 12 back immediately that we’re out re-renting and then on the balance, the majority of them had no rent change whatsoever and overall, we maintained 87% of the rent on that portfolio. So that’s kind of how it works.

Ryan Levinson – Private Fund

Okay.

Let me just switch gears, if I could. I’m just curious. On the guidance, the $1.86 to $1.96, there’s nothing for Crest, but where does the growth come from? I know you have some modest escalations built into some of the leases, but if you have 100 BPs of a decline in occupancy, what’s more than offsetting that?

Tom Lewis

Well, we have lower G&A, which you saw in this quarter and we anticipate will continue. That’s primarily a function of compensation of the lower level of activity and outside of that, and maybe something else –

Paul Meurer

We had same-store rent growth, we had free cash flow.

Tom Lewis

If you’re 40% levered, which I guess if you add debt and preferred, and you have one –

Paul Meurer

Our interest expense is going to go down pretty significantly –

Tom Lewis

– 1.1% to 1.3% growth, then that gets up around 2%.

Paul Meurer

Our interest expense is going to go down pretty significantly after we pay off the bonds.

Tom Lewis

And the balance is acquisitions.

Ryan Levinson – Private Fund

Okay. So – pardon me – and so acquisitions gets you to the $1.96; no acquisitions gets you the $1.86?

Paul Meurer

Correct.

Tom Lewis

Correct.

Ryan Levinson – Private Fund

Okay. All right, thanks a lot.

Tom Lewis

Thanks, Ryan.

Paul Meurer

You bet.

Operator

Thank you. Our next question comes from the line of Philip Martin with Cantor Fitzgerald.

Philip Martin – Cantor Fitzgerald

Good afternoon.

Paul Meurer

Hey, Philip.

Philip Martin – Cantor Fitzgerald

I guess my only question – a lot of them have been answered – but how will Crest impact your ability to go after and take advantage of opportunities, I guess, along the risk curve in 2009?

I mean, for example, an opportunity may present itself that may combine a higher-risk, less desirable – or that may contain higher-risk or less desirable assets, but this might occur before Crest’s business really comes back. So, I guess how do you manage that and balance that?

Tom Lewis

I can answer that, Philip. If you go back two years ago, when we were – last eight years, when we were using Crest a lot, I’ll make a blanket comment that cash was a commodity, and property was valuable.

And as such, the person selling the property to a number of people who had cash in a competitive environment was able to put into a number of properties that may not have hit where you wanted to underwrite to, or secondarily, it may be a large enough portfolio where you needed out of diversification by selling off.

Today, that has completely flip-flopped, where I think properties are a bit of a commodity and cash is what’s valuable. For somebody looking for cash, it’s a very different market.

We competed primarily with a 1031 tax-deferred exchange market that really bought the bulk of all net lease properties out there and that market has just shut down; it’s just really declining extraordinarily fast, as the people in that market, A, either don’t need a 1031, because they’re not selling properties at profit; or B, can’t get their financing.

And then secondarily, because other forms of financing have been dramatically impacted because the spread expansion in the debt markets, or the shutdown of the CMBS – I think we’re in a situation today where there’s a dearth of buyers who have cash and there are a number of sellers out there and I think next year that there’s going to be a dramatic number of sellers and not a lot of buyers.

So the answer is, if we had to use Crest, it’d be no. If they want to put in some properties we don’t want to buy, we’d take them out and it’s just a very different market.

Philip Martin – Cantor Fitzgerald

Then you just have the negotiating leverage, obviously, to do that in this market with – okay. Okay.

Tom Lewis

And that’s what I – and that’s what it is and I anticipate, but don’t know for sure that we’re going to kind of sit back here in the fourth quarter. We’re looking at transactions and if we find the right one, we’ll do it.

But my sense is it’s going to be coming in the next year, when the reality for a lot of folks – who are just hoping with all their might that the credit markets come back – capital markets come back – that reality will impede, and there’ll be a lot of properties out there.

If – look, if credit comes running back in, and the world is just great, and interest rates go low, and equities go high, then you’re back into a situation where you could probably use Crest again, and I guess we would, but I’d be amazed if that happens.

Philip Martin – Cantor Fitzgerald

If that happens, okay. Okay, thank you.

Operator

Thank you, sir. Management, at this time, I’d like to turn the conference to you for any closing remarks.

Tom Lewis

Thank you. Thank you very much, everybody. As always, it’s a busy earnings season, and there’s a lot of complicated things going on and we appreciate the coverage and the support and appreciate your attention. Thank you very much.

Operator

Thank you. Ladies and gentlemen, at this time, we will conclude today’s teleconference. We do thank you for your participation and for using ACT Teleconferencing. You may now disconnect, and please have a pleasant afternoon.

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