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Executives

Tom Lewis – Vice Chairman and CEO

Paul Meurer – EVP, CFO and Treasurer

Gary Malino – President and COO

Analysts

Anthony Polini – JP Morgan

Justin Tissell [ph] – Banc of America

Jeff Donnelly – Wachovia Securities

Michael Bilerman – Citigroup

Greg Schweitzer – Citigroup

Tom Coleman – Kensico Capital Management

Rich Moore – RBC Capital Markets

Realty Income Corporation (O) Q4 2008 Earnings Call Transcript February 12, 2009 4:30 PM ET

Operator

Good afternoon, ladies and gentlemen. Thank you so for much for standing by and welcome to the Realty Income Fourth Quarter 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. (Operator instructions)

As a reminder, this conference is being recorded today on Thursday, February 12, 2009.

I will now turn the conference over to Mr. Tom Lewis, CEO of Realty Income. Please go ahead, sir.

Tom Lewis

Thank you very much, Michael and good afternoon, everyone. Thanks for joining us for our review of operations and results for the fourth quarter and 2008 overall.

In the room with me today is Paul Meurer, our Executive Vice President and Chief Financial Officer, Gary Malino, our President and Chief Operating Officer; Mike Pfeiffer, our Executive Vice President and General Counsel.

And as always, during this conference call, we will make certain statements that may be considered to be forward-looking statements under Federal Securities law. The company’s actual future results may differ significantly from the matters discussed in any forward-looking statements, and we will disclose in greater detail on the company’s quarterly and on Form 10-K the factors that may cause such differences.

Anyway, as we normally do, we will have Paul start with a review of the numbers and then we will come back trying to give some color for what went on in the fourth quarter.

Paul?

Paul Meurer

Thanks, Tom. As usual, let me comment on the financial statements, and provide some highlights of those financial results for the quarter, and starting with the income statement.

Total revenue increased 3.2% for the quarter and 12.2% for the year. Rental revenue for the quarter was approximately $82.6 million for an annualized run rate now of about $331 million. Same-store rental revenue increased only 0.4% for the quarterly period. However, excluding Buffets, same-store rental growth was healthier at 1.5% for the quarter. Other income was only $83,000 for the quarter.

On the expense side, interest expense remained flat for the quarter at around $22.7 million. We had zero borrowings on our credit facility throughout the entire year of 2008. On a related note, our interest coverage ratio finished the year strong at 3.2 times, while our fixed-charge coverage ratio was 2.6 times. Our coverage ratios will likely be even stronger in 2009 because of the recent retirement of the $120 million of bond which we paid off in the past two months.

Depreciation and amortization expense increased by just under $2 million in the comparative quarterly period, as depreciation expense naturally has increased as the portfolio has grown over time.

General and administrative expenses, or G&A, expenses for the fourth quarter were under $5.1 million, a reduction of over $400,000 from last year. For the year, G&A was down about $1.1 million. G&A represented only 6.1% of total revenues for the quarter and 6.5% for the year. We expect G&A expenses in 2009 to remain at only about 6.5% to 7% maximum of total revenues.

Property expenses increased by $855,000 for the quarter and by $2.3 million for the year. These expenses are primarily associated with the taxes, maintenance, and insurance expenses, which we are responsible for on properties available for lease. We expect property expenses to increase again a little bit in 2009, and our current estimate for 2009 is about $6.3 million.

Income taxes consist of income taxes paid to various states by the company, and these taxes totaled $307,000 for the quarterly period. Income from discontinued operations for the quarter was $4.3 million.

Real estate acquired for resale refers to the operations of Crest Net Lease, our subsidiary that acquires and resells properties. Crest however did not acquire or sell any properties in the fourth quarter.

Real estate held for investment refers to property sales by Realty Income from our existing core portfolio. We sold seven properties during the fourth quarter, resulting overall in income of $4.3 million. And a reminder, once again, these property sale 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 $28.3 million for the quarter.

Funds from operations or FFO, was approximately $47 million for the quarter. FFO per share was $0.46 per share for the quarter and $1.83 for the year. FFO before Crest contribution or the FFO from our core portfolio actually increased in 2008 by 2.2% to $1.82 from $1.78 in 2007.

When we file our 10-K, we will again provide information you need to compute adjusted funds from operations, or AFFO, or the actual cash available for distribution as dividend. Our AFFO, or cash available for distribution is typically higher than our FFO, and it was once again in 2008, as our capital expenditures remain relatively low, and we don’t have a lot of straight-line rent in the portfolio.

Our continued growth in core earnings allowed us to increase our monthly dividend again this quarter. We have increased the dividend 45 consecutive quarters and 52 times overall since we went public over 14 years ago. Our current monthly dividend is now $0.14175 per share, which equates to the current annualized amount of $1.701 per share.

Now let us turn to the balance sheet for a moment. We have continued to enhance our conservative and very safe capital structure. Our debt-to-total market cap is 33%, and our preferred stock outstanding represents just 8% of our capital structure. All of these liabilities are of course fixed-rate obligations.

We continue to have zero borrowings on our $355 million credit facility and 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.

As of 12/31, we had $46.8 million of cash on hand. We retired the $100 million of bonds which matured in November and the $20 million of bonds that matured last month in January. So now, 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 over the next four years.

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

Tom Lewis

Thanks, Paul. I will start with the portfolio.

Obviously, it is doing pretty well today, especially given the state of the world. I would like, before I go through the numbers to say with that said, obviously retail is a tough place today and all of our tenants operate in the same economy that everybody else does and certainly, it is challenging for some of them. We have worked with a few of them to get through this period. But to date, to be frank, we have dodged a lot of bullets relative to the filings that you have seen out there with retailers. And in a few cases where we have had tenants that have had to file, we either have had just a property or two or three or we loan them more profitable properties and so to date, we haven't had a meaningful impact on our occupancy or on the operations.

In all of our calls over the years, I think we have talked a lot about owning the more profitable properties or profitable stores of our tenants and that our high cash flow coverage of the rent repaid at store level is certainly our kind of margin of safety. If an industry or a tenant goes through a period where their revenues are dropping or their margins are impacted and I think that is just especially true today. Our 15 largest tenants today account for about 53.5% of our revenue and if you look at the average cash flow coverage, I know that we do this every quarter, for those of you who listen and on a regular basis. And last quarter, you will recall at the end of the third quarter, the cash flow coverage at the store level for the top 15, an average 2.79 times and ranged from about 1.7 to 4.55 times, which was very, very healthy.

Obviously, a lot happened in the fourth quarter in all areas of retail as we all know and we have been getting updated numbers from the tenants for year end and while they lag a little, I think we are pretty current with most of them. And at the end of the fourth quarter, the average cash flow coverage for the top 15 was 2.4 times and ranged from 1.22 to 3.75, so obviously very healthy still. However, you can see some erosion in that and that is not surprising at all, but the coverage is also doing pretty well. I think that is the reason the portfolio has held up pretty well and we had a pretty good margin of safety.

So we ended the fourth quarter at 97% occupancy, 70 properties available for lease out of the 2348, that is up 10 basis points from last quarter, which is great. It is a function, I think of some really effective leasing activity from the people on our portfolio management department. We are a little bit lucky here in that we built a fairly active portfolio management department to do our leasing in the last nine years, which is a little unusual sometimes at a net lease company. But given the age of our organization, we have now had in the last seven, eight, nine years over 900 properties where the leases have come to the end of the initial 15 years to 20 years lease and so we built that staff over the years. Really primarily they handle lease rollover and obviously if you get some vacancy today it is very, very helpful to have that staff up and operating to deal with any vacancy and I think it has served us pretty well. So it is 97% at the end of the quarter and it continues to collect pretty good operations.

Same-store rents, as Paul mentioned on the core portfolio were up 24% in the fourth quarter, 1.1% for the year. That growth in same-store rent is lower than in recent quarters and I think that will be the case over the next year or so. It does include the reductions from the Buffets properties we renegotiated last year, but at this point, given the economy and kind of how things look, I'm going to assume that really same-store rent growth will be muted this year. However, with that said, I like the fact that it is same-store rent growth that is muted rather than the opposite.

It is kind of instructive to see where the same-store rent declines and increases came over the year, but we have 30 retail industries in the portfolio. Five had declining same-store rents. The largest and the vast majority of the declines came where you would expect it, which is in restaurants. And when you consider that just under half of our exposure, restaurants are about 20% of the portfolio, is in fast food, which actually is doing very well. You can see in the casual dining segment and kind of the upper end segment, where we have very little, but that is where the declines would come from. The other four that were down were barely down at all.

Two of our industries had flat same-store rents and then there were 23 that had same-store rent increases, but there were some real concentrations where it came from. Childcare accounted for about 27% of all of the increases, convenience store 24% and then tire and automotive services were about 20%. The rest of them were very small. And obviously I think that is reflective of what is working out there in retail today, which is kind of basic goods and services that you buy on an ongoing basis that have low price points and that just seems to be the segment that is – I do not know if it is growing but it has held up much better than the other more consumer discretionary and durable goods type of retail.

If you look at the portfolio today, about two thirds of our revenue comes from those type of operators and those type I mean that the childcare, c-stores kind of fast food, anything from auto parts, tire, provision, which tends to be pretty stable throughout a period like this and then if you add in some grocery and drug and theater and health and fitness, I think that is the reason that most of those people revenues are holding up pretty good in this environment.

We continue to be pretty well diversified. As I mentioned earlier, there are 2,348 properties in the portfolio. We have 30 different industries and 119 different chains in the portfolio and we are pretty well spread out throughout the country in 49 states, Hawaii being the only place that we are not to date.

From an industry standpoint, (inaudible) restaurants is our largest industry. I mentioned it is at 20.8% at the end of the quarter, which is down from 24.2% the same quarter a year ago and as we have said for the last few quarters, we will pull there and we will be reducing that back below 20% over the next several quarters.

Convenience stores at 16.4%, and as we look through the difference, other categories that we are in, it really goes down from there with theaters and childcare, theater is at about 9.1%, childcare about 7.5%. So, pretty good from an industry standpoint.

At year end, our two largest tenants were only about 6% of rent, the next one is 5%. It goes on very quickly from there. And the top 10 comprise about 42% of rent, top 15 about 53% of rent, and when you get down to the fifteenth largest tenant, you are looking at only about 2% of revenue.

Average remaining lease term in the portfolio, which is very nice today, is about 11.9 years and that has kept up there pretty well, really based on acquisitions over the last few years and releasing anything that came up under lease rollover.

Overall then, with the portfolio, I have to tell you that given what we saw in the fourth quarter in retail and notwithstanding that a lot of what we own was kind of basic human needs low price points, we are pretty pleased that the portfolio held up and we are at 97% and have same-store rent growth.

Relative to property acquisitions, we have continued to remain inactive pretty much ever since last February. During the fourth quarter, you saw in the press release, there was a very small addition in acquisitions but as it has been in the last few quarters those are primarily just some additional expenditures on some properties that we were developing and most of those I think we started in the fourth quarter of last year, first quarter this year and except for maybe a couple of hundred thousand, we are pretty much through with any development that the company had going on and out of that area.

For the year, then that gave us $189 million in acquisitions, 108 properties, average cap rate was 8.7% with an average lease length of about 20 years and I think that is within a million or so of what we guessed last quarter. And again, we have intensely been not buying any property or kind of staying out of the acquisition market. We have believed for some time that obviously cap rates are rising and anything we could buy would probably be cheaper later. And given that, why not wait and I think that that has served us pretty well. As we speak and we kind of watch transaction flow out there and there's not a lot of transactions being completed. However, there are transactions being introduced into the market and cap rates are rising and we are seeing a few people trying to come to market with transactions and while they have adjusted cap rates up, I think not really enough and so I think that most of those transactions under a lot of them will probably just stall until you see a pretty good move up in cap rates. And you know, we continue to believe there are a lot of people out there with real estate on their books, they may have limited access to other forms of financing today. So at some point, we think we will see the cap rates move up further and more transactions in the marketplace. And we will wait until that happens, whenever that is.

The other issue in acquisitions today, I will just bring up obviously is cost of capital in the market today. I think for us and almost everybody. And as you look at acquisitions and where cap rates are, I could probably go out and do things in the mid-9s today and approaching 10, but obviously if you look at your sources of capital, you have your credit line. That is not permanent capital, so I don’t think it makes sense to price it over your credit line. In the lease today, even if you're looking at BBB investment-grade senior unsecured, those are traded up over the other BBBs out there in the marketplace and you're probably looking at 12% plus. The preferred market has been heavily impacted by the financial institutions coming to market with a lot of paper in the fall and over the summer, so that market would be up beyond substantially the senior unsecured and really not attractive capital.

So I really think if you're going to look today at acquisitions and you're going to look at permanent financing you have to be looking at your common and if you took our company for instance and used 20 a share is a round number and kind of mid ranged at guidance at $1.86 you would be looking at about a 9.3% FFO yield. If you gross that up for offering costs, you are probably up around 9.8% and since in the net lease business you really want to make sure you are securing a substantial spread upfront when you bite, I think you would have to be looking up at the 11% cap range today before it makes sense to go out and be buying anything and have inadequate spread over your cost to capital, notwithstanding that you would also want the underwriting to be pretty solid.

So I think while things could change based on where we see the spread of our permanent capital right now, I do not anticipate that we will be buying anything in the first quarter or until the cap rates rise a fair amount or the cost of permanent capital comes down a bit. Cap rates may rise, I mentioned this last quarter but for myself I have to keep looking at it to keep it in my thinking. Next Tuesday is the 40th anniversary of Realty Income and I can go back over 40 years and look at where cap rates were every year and it is kind of interesting and if you take the last four years, 2005 to 2009, and look at our acquisitions, it was over $1.5 billion, cap rates ran at about 8.4% to 8.7% on the properties that we bought. In 2003 and 2004, the couple of years before that, they averaged 9.5% and then, going back from 2003 all the way back to 1994, cap rates every year were in the range of 10.3% to about 11.3%. And then I went back and dug out kind of previous to 1994, when we went public and in each year that the company bought from 1969 to 1994, cap rates were at 11% or slightly above. So I think all of us have been kind of sensitized in the last few years to 7% and 8% caps and like a lot of assets in many other areas, I think that we are really (inaudible) historically cheap financing rates and moving up over 10% again seems probably appropriate given what has happened in the credit markets. And I wouldn't be surprised if it happened and we will wait for a while until we see that.

The other side of it obviously in this environment, which is fairly dynamic, to say the least, having cash and liquidity is a position that is a fairly attractive one I think for us and a lot of people right now.

Let me just talk about Crest quickly. For those of you that are uninitiated, that is our subsidiary that we have operated for the last nine years or so that we buy in and subsequently sell property. We used it to buy big portfolios and then pair down our exposure to really maintain some diversification. And it has been a regular part of our business. Since we started it, it has made somewhere between $0.02 to $0.11 a share in FFO. So while it has been a fairly small part of our FFO, it has been in there. We did earn $0.11 in Crest in 2007, only a penny in 2008 as we closed it down and if you factor out our assets in Crest, our core FFO was up for the year and during 2007, the inventory peaked at about $140 million and we have been pairing it down the last 24 months basically not buying in Crest.

As we have said in the release, we are down to five properties for $6 million. That is static from the third quarter. We're kind of just letting the properties sit there and they're available for sale if anybody wants them but not actively marketing in this market and effectively we are kind of out of that business. We think it is kind of risky business today and while we don't like the $0.10 differential in FFO as we closed Crest between 2007 and 2008, I think if we had not closed it down and got substantial inventory we would feel a lot worse about it. So in future calls, I probably won't say much about Crest at all, because we effectively have it closed down now.

Let me comment on dividends for a moment, which seemed to be a pretty good area for a lot of people. As you all know, dividends are very much the priority here at the monthly dividend company. We will pay dividend in cash, I think that is no surprise to most folks, as most of our investors, some 70,000 rely on it to pay their bills or so they tell us. And cash is the priority as it has been for the last 40 years. I would anticipate at this point that the dividend will be higher this year than last year. How much will be dependent on operations. And I also would hopefully say that it is our goal to have it higher in 2010 than 2009. Dividends are really why we are here and it is a focus for the company.

Paul commented on the balance sheet, paying off the $100 million of 8.25% notes and the $20 million of 8% notes with cash on hand. We were glad to get that done and so we are out till 2013 before any debt comes due. I think it is just the $100 million in 13, not in 14. So we're in pretty good shape there and as Paul said, we have good cash on hand and no balance on the line. So as we sit here today, the balance sheet is pretty simple, there are no JBs or developments going and nothing off balance sheet, so the business is pretty straightforward.

The last area is on guidance. We tweaked our estimate to $1.83 to $1.90 this quarter. That is flat FFO growth to 3.8% and as I spent a lot of time talking about in the third quarter call, our estimates that we put out initially for 2009, we put out the low end at no acquisitions for the year, since that has traditionally been a pretty good driver of FFO growth and then on the top end, it was $500 million or about $125 million a quarter. As I mentioned a little earlier, we do not anticipate buying anything in the first quarter so our guidance this time really runs from no acquisitions on the low side and then we backed off the $500 million to $375 million. And taking that $125 million of acquisitions out in the first quarter, obviously that would have been the acquisitions for the year that contributed to the revenue side primarily and backing that out had an impact and then secondarily, what we also did, given our stance on acquisition right now, for the $125 million in the second quarter, we made the assumption that all of that would come in at the end of the quarter and that gets us then from zero acquisitions to 375.

On the low end or both ends really we have also assumed some additional vacancy or lower same-store rent growth for 2009 given the economy. We have built anything that we can see now in the portfolio with our retailers into that number, and to be frank, we also just added in another penny or two assuming that something else would come down the line that we can’t see right now, but I think where we sit right now, that is a pretty good estimate, absent any material changes, and I will leave it to everybody listening to figure out where the economy goes and then we will all have a better picture. Obviously, it is challenging that visibility for almost anybody out there today with long term leases and pretty good occupancy number, it is a little easier, but it is a dynamic environment.

To kind of summarize and given the circumstances, we are pleased, particularly with occupancy and where the portfolio sits. It will be interesting to see how the year progresses and we all look forward to as I am sure you do to the economy getting better, whenever that is.

And with that, Michael, if you will, we will go ahead and open it up to questions and if anybody would like to chat a bit, we will do that.

Question-and-Answer Session

Operator

So we will begin the question-and-answer session at this time. (Operator instructions) Our first question is from the line of Michael Bilerman with Citigroup. Please go ahead.

Michael Bilerman – Citigroup

Hi there.

Tom Lewis

I’m sorry.

Operator

I’m sorry, Mr. Bilerman.

Operator

Did you have a question?

Tom Lewis

Maybe we’ll move on with it. We’ll move on. If Michael wants to get any, he can queue back up. Sorry about that.

Operator

Anthony Polini with JP Morgan. Please go ahead.

Anthony Polini – JP Morgan

Okay, thanks. Good afternoon.

Paul Meurer

Hi.

Anthony Polini – JP Morgan

All right. I was looking – if I look at your annualized revenues divided by the occupied number of stores, about $140,000 a year per store it seems. Can you give us a sense as to – if a store goes dark, obviously, you lose the $140,000 but how much expenses would you be on the hope for?

Tom Lewis

Yes. It obviously varies, which I’m sure you know, but our kind of ballpark around the shop, if you lose a buck of rent, you probably want to add on $0.20 or so in expenses. And that’s a pretty good rule of thumb and then it just depends on the property and age, and what is going on in the part of the country it is in and whether it is a theater or a convenience store. But that is a good ballpark, if you lose a buck of rent you probably want to add on another $0.20 in expenses.

Anthony Polini – JP Morgan

Okay, great. And then, I was wondering if you could put some parameters around your auto dealership exposure in terms of maybe brands or domestics versus imports, things like that.

Tom Lewis

Sure. Obviously, we don’t get into great GPL relative to the individual tenants, but the dealership is primarily one tenant, so it is a good-sized guy. He’s kind one of the largest, most successful in his business. Fortunately, he’s got a fairly strong service business and fair retail running off that because sales throughout the dealership industry whether it is cars, boat, RVs, almost anything, any durable goods is just really severely impacted. So that is the one if you look, at in the third quarter, where I said the range from cash flow coverages was 1.77 to the mid-fours, that’s the one that’s down at 1.22. The good news, if you can call it good news, is the 1.22, I think that’s pretty much assuming no sales, and all of the revenue coming from the other sides of the business. But that’s an impacted one. We’re also fortunate that it’s also somebody who has an extraordinarily good balance sheet.

Anthony Polini – JP Morgan

Okay. And then just last question, along the same lines, just movie theaters and how you are feeling about those and their performance these days.

Tom Lewis

Yes, we feel very good about movie theaters. That has turned out to be as – it’s been speculated sometimes to be cheap entertainment and while people are doing a lot of whatever is required spending in basic human need, low price point, people don’t stop entertaining themselves. And so, I think if you look at people cocooning a little more, but they’re also getting out and when they get out, they’re staying away from very expensive stuff. But the theaters are doing pretty good. If you look last year, I think, they were off a little bit relative to traffic but up in price, and it has been a pretty good slide of movies out there and content always drives the box office. So the numbers we’re getting from our theaters are pretty good and we also had a group of theaters that have particularly high coverage, so I don’t think we have any issues there, Tony.

Anthony Polini – JP Morgan

Okay. Thank you.

Operator

Thank you. Our next question is from the line if Justin Tissell [ph] of Banc of America. Please go ahead.

Justin Tissell – Banc of America

Hi, thanks. Good afternoon, guys.

Paul Meurer

Hi, Justin.

Justin Tissell – Banc of America

Tom, can you just maybe put some numbers around that vacancy loss assumption that you guys have in the guidance for us? And in the last quarter, you mentioned I think 100 basis points. Does that still sound about right or –?

Tom Lewis

Yes, we widened it out a little bit.

Paul Meurer

It is a full 1% and really up to 2%, so it is kind of a 1% to 2% bandwidth. You know, when we go to the 2% in kind of our model, if you will, that may assume a few acquisitions on the back end. So if you look at zero acquisitions, then we are looking at kind of 1% to 1.5% occupancy loss. Does that make sense?

Justin Tissell – Banc of America

If you look at zero, you’re looking at 1% and 1.5%. Okay, I’m just trying to figure out if you take – to get to the guidance stage, if you take the run rate from this quarter and you annualize it, you essentially get to the low end of the guidance range. So with no acquisitions and vacancy loss, I’m just trying to figure it out.

Paul Meurer

We have some vacancy lost. We have some, thanks to our rent growth. We have less interest expense, etc.

Tom Lewis

Our numbers internally at – with zero – get us a little higher.

Justin Tissell – Banc of America

Okay. And then when you look at those coverages that you mentioned earlier on, I mean, at what point – when you look at the, I guess, the midpoint of that, that two four in the low end, I mean it looks like the midpoint was down about 15% in the low end, 30%. I mean, at what point do you guys start to get concerned about potentially tenants coming back to try and – either renegotiate leases or on the low end, bankruptcy-type scenarios, I mean have you had increase in levels of concern there, any increasing conversations with your tenants recently?

Tom Lewis

I don’t know that they’re increasing. We had a lot of discussions with them last year too. But I – it’s interesting, I mentioned earlier, we’ve done 900 lease rollovers and that’s when you get to the end of the lease and the tenants has got to put on the property. So we’ve got a big data base and almost all of the time, if it was less than a 1 to 1, we got it back. If it was a 1 to 1.25, they’re going to want a rent cut or we’re getting it back. At about 1.35, they start going, I’d really need a rent cut. I’d really like one. Gee, this is my put opportunity. But that’s when they start going. I just don’t want to give up that EBITDA because it’s positive. And at 1.5, you’re feeling okay. That can give you a huge margin of safety on the downside, but you’re feeling okay. So sitting up at 2.4 today, and we’ve done a bunch of sensitivities, we took the cash flow coverage in the top 15 that averages 2.4. And then, add the research part and say, “If you took a full another turn of 10% drop in revenue out.”

And by the way, a 10% drop in revenue impacts each industry dramatically different. In some, a 10% drop of revenue can take a 2.0 to 1.2. In another industry, a 10% drop takes a 2.0 to 1.8. But if you average it all out, if after the first quarter you had another in 10% drop of revenue, the 2.4 goes to about a 2.0. And it’s really – at 2.0, we’re still very comfortable. And the reason we’ve never underwritten the 2.0 and we wanted it higher is to give us the margin of safety, and now we are using it. But as long as we’re up around 2.0 then I’m comfortable. It gets below that, I get a little more uncomfortable. But at a 1.5, the majority of the stores, somebody is not going to walk away from. What happens though, obviously, is all of these you have a bell curve. And if your bell curve is a 2.4 at the peak, and a 3.77 on the right and a 1.22 on the left, when you do sit out with a retailer, the ones on the left side of the bell curve, you’re going to be talking about a handful of properties with somebody. And that’s been absolutely typical over the years. But at 2.4, we’re still really high.

Justin Tissell – Banc of America

Okay. Thank you.

Operator

Thank you. Your next question is from the line of Jeff Donnelly with Wachovia Securities. Please go ahead.

Jeff Donnelly – Wachovia Securities

Good afternoon, guys.

Tom Lewis

Hey, Jeff.

Jeff Donnelly – Wachovia Securities

I guess continuing that line of questioning, it used to be that you couldn’t help try to avoid retailers or financial institutions that (inaudible) lead counter was on the stores should be attractive not a little economic. But then it go – and what we’re hearing from other landlords, not necessarily just net lease landlords, is that retailers these days seem to be much more arbitrary around their decisions for closing stores because it’s more of a credit than liquidity for them. I’m not sure that’s inventory driven or just balance sheet capacity driven, but is that in your experience of late, have you found it to be less orderly?

Tom Lewis

You know, it has been a little less orderly and strangely enough, the law of unintended consequences, the new bankruptcy law really tightened up the time they have to make those decisions. So, on the margin, as the time gets close, where they used to sit around and really hem and hob about properties and you’d get there at some point now, they do have to make a decision, and it does cause them maybe to let a few go away where they had before. And we’ve seen a few of those in our numbers.

The other thing, Jeff, that comes up today is obviously – and it kind of come in two phases. First which a lot of people filed, and then what happen is the DIP financing or debtor in possession market went away. You went from about 14 lenders out there to two or three, and there had been a couple of cases you’ve seen out there where people couldn’t get DIP financing and went right to chapter seven. What happened now is that has eased up a little and then you’ve had some, I’d say more aggressive individuals enter that market and kind of DIP to own so that has eased up a bit. But it is been a little bit less orderly than it might have been in the past. There are probably a few or some profitable properties went away because somebody couldn’t get financing. But, generally, absent closing a region where you’ll get a few, it still is high casual coverage and you end up in pretty good shape. But you’re making a good point. It is a little more messy today than it has been in the past years.

Jeff Donnelly – Wachovia Securities

And I’m curious much of you are able to do this. But if you have to guess where industry wide occupancy was, I guess, for the net lease business, say at year-end 2008, where do you guess, staying where we are today, where do you guess that goes at year-end ’09 and say year-end 2010?

Tom Lewis

That’s a pretty good guess and calls for a big macro call on the economy, which I don’t have. Fourth quarter was absolute mess, which we all know, albeit really centered around those more consumer durable and non-discretionary. First quarter, actually, January to date, I think things haven’t gotten materially worse, but they haven’t gotten better. And so, then it is your macro call. And I really – I would say it’s almost impossible for me to tell. If you see the economy really start moving soft, again, another round of job cuts takes it in the opposite direction, then you are probably going to see that down at around – I would say our (inaudible) is higher than the industry in general. If it were at 97, I’d put the industry profit around 93, 92 and I’m guessing here. And if you have another good couple of bad turns in the economy, and then I think the whole market might be around 93, 92 and 91. And I would assume we will be a couple of points or something higher.

Jeff Donnelly – Wachovia Securities

But I guess what I generally mean – do you think that it’s possible for the industry to shed 300 or 400 basis points for occupancy in a year or just that seems dramatic to you?

Tom Lewis

The answer is the generic industry, yes. Okay? I think its income is down. This underwriting to cash flow coverage is fairly unusual, although it may not seem to those who follow the rates because it’s talked about. We started doing it about 13, 14 years, 15 years ago. And to my knowledge, the guys at FFCA Spirit did it very effectively, and then a couple of other people in the last few years. But I would say probably 90% of all of the net leases that are in existence, the landlord does not have the ability to look through and understand what the profitability of the unit is, so it’s rather unusual. We’ve underwritten to it, which has been very helpful. So I could very much see another 200 to 300, 400 basis points generically, but I think it would bifurcate off if you knew upfront when you’re underwriting how profitable the properties are and you ought to do a little better.

Jeff Donnelly – Wachovia Securities

Are you willing to share at this point, maybe, what’s happened with its income to occupancy in the first 45 days of the year?

Tom Lewis

No, we report at the end of the quarter, as always. Quite frankly, I thought it might tick down 10 basis points last quarter. We had nine properties go vacant last quarter and much to my surprise, our leasing people had a very active quarter and leased 12 and therein lies the difference between 96.9 and 97. So, I wouldn’t be surprised to see it tick down a bit, but nothing dramatic as of this point. And again, I’m very pleased with the efforts of the people in our Leasing Department over the last few months in this market and I think I’ll continue to be. It is making a huge difference. Again, on our part when we put together, basically, deal with lease rollover, I’m glad that we have it.

Jeff Donnelly – Wachovia Securities

So, one last question and maybe this is just looking down the road, which I don’t know how long it is. Clearly, I know we’re not through this predicament yet in the economy and hopefully, there are another side to this chasm, but when we get to that point, are there operating or financing lessons that you guys have gleaned right now from your experiences thus far that maybe incorporate it at that future view?

Tom Lewis

Yes. It is just for being a little bit shell-shocked through a hundred-year flood, you don’t have some lessons that you’ll hang on to, you’re probably not human. So, while we’ve always thought we wanted high cash flow coverages, I’d think that I’d want them equal or higher; but on the low end, we would do deals in kind of at the 1.75 closeout at the low end for just a few properties that we really like them and I probably wouldn’t do that again, but that’s minor in nature. We’ve always really concentrated on the unsecured underwriting. If we thought that they did get in trouble from balance sheet perspective, then it’d definitely be an 11 and not a 7, and I’d probably look at that even a little bit harder as we’ve seen what’s happened this time with those. Also, you sit there and you say we do basic human needs and low price points and that’s a vast majority of everything we do, and then you always have two or three transactions you did in the seven-year period were outworking. And to be perfectly frank, there’s one that kind of didn’t fit the mold, but we had a good reason and the good reason held up and then there are two where we now sit there and hit ourselves in the forehead and go, “Wait a minute. Didn’t this have two things against if and somehow, because of one property, we bought his one and somehow we did it again.” And so you just – I think if we just go back and be even more strict than what we did, then overall, I’d say I’m pretty pleased thus far in how well it has held up.

Jeff Donnelly – Wachovia Securities

Aside from credit, any buys and towards geography or even by industry like restaurants or Hawaii?

Tom Lewis

I have a definite prejudice for Hawaii and I think it’ll take some due diligence on a senior level in a short-term basis like Maui. But geographically, it’s funny we both stayed a little bit of concentration in the south, in the west, in the east, because you get economic growth and it bails you out of some dumb decisions, and then you get a housing crisis in the area that you were looking at that had the economic growth has the reverse of it and you’re glad that you stayed very well-diversified all the way around. And as long as you’re stating a basic human need, there are people up in the mid west and that’s actually the most stable part of the portfolio right now. As we’ve identified, we continue to see. You don’t want to get too rural, I guess, unless you’re in a convenient on two state routes, so staying close to SMAs, those are all little lessons of the margin stuff we knew, but maybe you could be a little more disciplined in the future then you were in the past.

Jeff Donnelly – Wachovia Securities

Okay. Thank you, guys.

Operator

All right. Thank you, Michael. Michael Bilerman with Citigroup. Please go ahead.

Michael Bilerman – Citigroup

My phone working now?

Tom Lewis

There we go.

Michael Bilerman – Citigroup

There we go.

Paul Meurer

We can hear you.

Michael Bilerman – Citigroup

Greg Schweitzer is on with me as well. Tom, when you look at the expiries this year, you have a much bigger percentage of guys who are on their subsequent expiration that had never renewed in the past versus the initial. Can you drill down a little bit in looking at your expirations this year and time that with 100, 150 basis points and occupancy for those coming up with report the.

Tom Lewis

Thank God that the two-thirds are of more second rolls in this market. The second roll has always been better. These are properties that have been launched and they wanted them because they make them a lot of money, and we think that’s the case. We just went through this in portfolio management. We think it’s breakeven. There may be down a point. We think we’re going to retain the vast majority and we don’t look at that as really where the occupancy change might come. I think if it comes, it’s going to be under rollover and we feel very good about rollover.

Michael Bilerman – Citigroup

And then, and so this is 4% of – how much of square footage does that actually represent?

Tom Lewis

It’s probably a little less than that.

Michael Bilerman – Citigroup

Less than 4% square footage, so they’re above market rate?

Tom Lewis

No, no. They’re just smaller buildings.

Greg Schweitzer – Citigroup

Is it the kind of way to look at them?

Michael Bilerman – Citigroup

Yes, I think Greg has some questions also.

Tom Lewis

Sure.

Greg Schweitzer – Citigroup

I know you guys all keep talking about tenant specifics, but just touching on (inaudible), there’s a lot going on in Australia right now with ABC Learning. About 25% of the assets are – their (inaudible) are looking at non-binding office to buy out those properties. Could you just provide a bit of color on what’s happening with the US assets and maybe, specifically, your exposure?

Tom Lewis

Yes. As we went through in some detail last year when ABC went up, there was a lot of misconceptions relative to what was going there in the US. The US units that we own are fairly strong. I don’t have a concern about them. And last year, ABC sold the majority interest in the US Company, so they are no longer the owner of it, they are a minority owner.

Greg Schweitzer – Citigroup

And any color that you can provide on how your assets are performing, maybe cash flow coverages?

Tom Lewis

We don’t give them out for individual tenants, but they’re performing adequately. They’ve been in the portfolio now for, in most cases, for over 20 years; so, those were properties that were purchased at very low prices many years ago.

Gary, do you remember what the average cost of those is?

Gary Malino

Yes, the average cost of our units – this is really important, it was about $400,000, $500,000, where replacement cost today for a newer unit, you’d be looking at $1 million, $1.2 million, $1.3 million. So, even with some rent increases, you’re really looking at those being on the very low end of the rents they pay and amazingly enough, there’s pretty good correlation between profitability and low rent. So, I can just tell you that coverages are probably not up to our average, but they’re very comfortable.

Greg Schweitzer – Citigroup

Okay, thanks. And just one more, any tenant that you put on the watch list that you’re a little bit concerned about?

Tom Lewis

Well, we have a couple of tenants on the watch list, but nobody eminent. And what we’ve done, although we don’t know if there’s going to be an impact, we put what we thought what would be the impact in guidance and then added some more in; but nobody eminent that I’m aware of today that would have a meaningful impact on us outside of what we’ve got in guidance.

Greg Schweitzer – Citigroup

Okay, thanks.

Operator

All right, thank you. Our next question is from the line of Scott Coleman with Conseco Capital Management. Please go ahead.

Scott Coleman – Conseco Capital Management

Asked and answered. Thank you.

Operator

All right, thank you. (Operator instructions) Tom Coleman with Kensico Capital Management. Please go ahead.

Tom Coleman – Kensico Capital Management

All the properties you have for sale in Crest, are they all vacant?

Tom Lewis

No. We only have five. We’ve had up to 120. Three of them are former Buffets. They’re vacant, but for those of you who will recall, a couple of quarters ago, we impaired them by over 50% in value. So, those are vacant, but we wrote them down by half. The other two are fully occupied, paying rents, and pretty good properties; so, there are only five.

Tom Coleman – Kensico Capital Management

And then the properties that you offer for sale that are vacant that aren’t in Crest. What does that mean? They’re just on the balance sheet – how are they presented differently in the financial statements?

Tom Lewis

They are just properties in the portfolio.

Paul Meurer

Yes. You would find them just in our real estate portfolio on the balance sheet because in actuality, they are consistently marketed for sale or for lease with a preference towards lease. We’d like to generate income to pay our dividends. So when you look at our balance sheet, you’re not going to find them in the for sale category. That’s going to be the Crest up at the moment. There might be one or two from the lease where it’s clear. That’s what it is, a for sale property. Maybe, there’s an LLI place we’re moving forward with and it would fall into that, but otherwise, you’re going to find the lease vacant properties in the real estate held for investment.

Tom Lewis

Yes. If you look at the 12 that – you see, there were 12 that went out of the vacant category, and nine were released and three were sold. And if you look in the sales last year, the majority was not vacant properties. They were occupied properties.

Tom Coleman – Kensico Capital Management

And the prices that you have, the prices that you’re offering those at, do they relate in any way to the GAAP value of that property?

Paul Meurer

We have tended to sell the properties at a GAAP gain and that has been the case this year too.

Tom Lewis

Yes.

Tom Coleman – Kensico Capital Management

Okay. Thank you.

Operator

All right, thank you. And our next question is from the line of Rich Moore with RBC Capital Markets. Please go ahead.

Rich Moore – RBC Capital Markets

Hi, guys. Good afternoon. I’m curious on this, the credit market has come roaring back suddenly or cap rates shoot was higher, how quickly do you actually begin closing on things? Are you actively reviewing a lot of portfolios or how is that working right now?

Tom Lewis

Realistically or probably, it could be inside but I would say I think 60 to 90. We have transactions that are coming over the trends. We have things downstairs we’re looking at right now. They get reviewed, so it’s merely a decision to say, “Here’s the cap rate and yes, we’re buying,” and we would be at the right price. But last year, as an example, we stopped buying in the second quarter and we bought $189 million. We still had $5 billion go through the committee last year, so the number of transactions reviewed last year was roughly equivalent to what it was the year before when we bought $533 million. So, we keep the flow going through. What we do is we cut it off about halfway through because we don’t want people to think that we’re going to close when we’re not, but we are actively reviewing. If the prices were right, would we actively go? But I think if I said today, “Boy, look at where cap rate’s got and we’d want to go,” I think you’d be looking at 60 to 90 days as a good guess.

Rich Moore – RBC Capital Markets

Okay. And then you mentioned that maybe nine to ten is what you’re seeing at the moment and I assume that’s some kind of average. Are you seeing anything at all that’s attractive in the 11% range or is there nothing up there yet?

Tom Lewis

No. How was that?

Rich Moore – RBC Capital Markets

Yes, that’s fair. That’s very fair. And I certainly know where interest rates are and financing cost, so anyway, great. Thank you guys very much.

Operator

All right, thank you. Mr. Lewis, there are no further questions at this time. Please continue with any closing comments.

Tom Lewis

Okay. Well, thank you everybody. I think, again, with reports from this quarter, we’ll all watch the economy and we operate the same way as everyone else. We manage portfolio and see how we sit next quarter. It’s a dynamic environment. Thank you all very much.

Operator

Thank you. Ladies and gentlemen, this concludes the Realty Income fourth quarter earnings conference call. You may now disconnect. Have a very pleasant rest of your day.

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Source: Realty Income Corporation Q4 2008 Earnings Call Transcript
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