Realty Income's CEO Discusses Q1 2013 Results - Earnings Call Transcript

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Realty Income Corporation (NYSE:O)

Q1 2013 Earnings Call

April 25, 2013 4:30 p.m. ET

Executives

Thomas Lewis - Vice Chairman of the Board, Chief Executive Officer

Paul Meurer - Chief Financial Officer, Executive Vice President, Treasurer

John Case - Executive Vice President, Chief Investment Officer

Michael Pfeiffer - Executive Vice President, General Counsel, Secretary

Analysts

Joshua Barber - Stifel Nicolaus

Emmanuel Korchman - Citigroup

Tom Lesnick - Robert W. Baird & Co.

Todd Stender - Wells Fargo Securities

Todd Lukasik - Morningstar

Richard Moore - RBC Capital Markets

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Realty Income first quarter 2013 earnings conference call. At this time all participants are in a listen-only mode. Later we’ll be conducting a question-and-answer session and instructions will be given at that time. (Operator Instructions)

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

Thomas Lewis

Thank you, Tager and good afternoon everyone. Thank you for joining us on our call today to discuss the first quarter operations for Realty Income. Before I start, in the room with me is Gary Malino, our President and Chief Operating Officer; John Case, our President and Chief Investment Officer; Paul Meurer, our EVP and Chief Financial Officer; and Mike Pfeiffer, our General Counsel.

As always I must read and say that during this conference call we will make certain statements that may be considered to be forward-looking statements under Federal Securities Law and the company's actual future results may differ significantly from the matters discussed in any forward-looking statements. We will disclose in greater detail on the company's Form 10-K the factors that may cause such differences.

Also in the room with me today are some spring allergies so if we go radio silent for a second or you hear a loud noise I would appreciate your understanding. Paul, as we always do, if you’ll start by running through the numbers for everybody.

Paul Meurer

Thank you, Tom. As usual, I will comment on the financial statements, provide a few highlights of the financial results for the quarter and start by just walking briefly through the income statement.

Total revenue increased 52.9% for the quarter. Our current revenue on an annualized basis today at 3, 31 is approximately $718 million. This increase reflects some positive same-store rent of 1.5% in the portfolio, but more significantly it obviously reflects our growth from new acquisitions over the past year.

On the expense side, depreciation and amortization expense increased significantly to just under $70 million in the quarter. Of course that depreciation expense increased with our portfolio growth.

Interest expense increased in the quarter to $41.5 million and this increase was primarily due to the $800 million of bond that were issued last October as well as some credit facility borrowing during the quarter. On a related note, our coverage ratios both improved and remain strong, with interest coverage at 3.7 times and fixed charge coverage at 3.0 times.

General and administrative or G&A expenses in the quarter were approximately $11.6 million dollars. Our G&A expenses naturally increased this past year as our acquisition activity increased and we added some new personal to manage a larger portfolio. Our employee base has grown from 86 employees a year ago to 92 employees at quarter end. However, our total G&A as a percentage of total revenues has decreased to only 6.7%. Historically our G&A had a run rate at about 7.5% to 8% of revenue.

Our current projections for G&A for all of 2013 is about $45 million. Property expenses were just $3.8 million for the quarter, these expenses historically have been primarily our carry cost associated with properties available for lease. However, as we noted last quarter, our 2013 property expense estimate is higher at about $15 million, as we have recently purchased a few double properties where we are responsible for some of the property expenses.

Income taxes consist of income taxes paid to various states by the company and they were $671,000 for the quarter. Merger related costs, obviously this line items refers to the cost associated with the ARCT acquisition. During the quarter we expensed approximately $12 million of such costs. Income from discontinued operations for the quarter totaled $39.5 million. This income is associated with our property sales activity during the quarter. We sold 17 properties during the quarter for $60 million with a gain on sales of $38.6 million. An important reminder that we do not include property sales gains in our FFO or in our AFFO.

Net income attributable to non-controlling interest refers to the limited partners of the operating partnership we purchased which holds the ARCT property. These LPs own 0.7% of the equity of the OP. All of the assets and operations of the OP are 100% consolidated into realty income. Preferred stock cash dividend totaled approximately $10.5 million for the quarter and net income available to common stock holders was about $61.3 million for the quarter. Reminder that our normalized FFOs simply add back the ARCT merger related costs to FFO. We believe normalized FFO is a more appropriate portrayal of our operating performance and it's consistent with our public FFO earnings estimates and our first call FFO estimates that analysts have published on us.

Normalized funds from operations or FFO per share was $0.51 for the quarter, a 32.6% increase versus a year ago. Adjusted funds from operations or AFFO, or the actual cash that we have available for distribution as dividends, was $0.60 per share for the quarter, a 20% increase versus a year ago. Also you will note that in our press release we continue to affirm our same earnings estimates for 2013. As you know, we have also increased our cash monthly dividend significantly over the past year. In addition to our regular quarterly increase, we did a $0.35 annualized dividend increase in January. We have increased the dividend 62 consecutive quarters and 71 times overall since we went public 18.5 years ago. Dividends paid per common share increased 17.6% this quarter versus the same quarterly period a year ago. Our current monthly dividend now equates to a current annualized amount of $2.175 per share. Our AFFO dividend payout ratio for the quarter was 86%.

Briefly turning to the balance sheet. We have continued to maintain a very conservative and safe capital structure. In March, we raised $755 million of new capital with a very successful common equity offering. We sincerely thank the 16 investment banks involved in the placement of our common shares with investors and their respected brokerage system. At quarter end, our $1 billion unsecured acquisition credit facility had a balance of only $116.6 million. Our credit facility also has a $500 million accordion expansion feature. We did assume approximately $565 million of in place mortgages during the quarter as part of our property acquisition, primarily in the ARCT acquisition.

We now have 48 assumed mortgages on 185 properties, totaling approximately $729 million. In March, we did repay at maturity $100 million of bonds which were placed back in 2003. Our next bond maturity is only $150 million and it is due in November of 2015.

Our overall current total debt to total market capitalization is 24.5% and our preferred stock outstanding is only 4.5% of our capital structure.

So in summary, revenue growth this quarter was significant and our expenses remain moderate so our earnings growth was very positive. And our overall balance sheet remains very healthy and safe and we continue to enjoy excellent access to the public capital markets to fund our continued growth.

Now let me turn the call back over to Tom who’ll give a little bit more background.

Thomas Lewis

Thanks Paul. I’ll start with just the general comment that was in the release which is obviously the first quarter was the best quarter I think operationally in the company’s history and each facet of the business had solid results. So we’ll keep the commentary here a little shorter than usual because I think the results speak for themselves. But let me start with the portfolio which continued to generate very consistent cash flow in the first quarter and general accounts pretty much all of the tenants are reporting doing pretty well. There are no issues that arose with any tenants during the quarter and we believe that will be the case here in the second quarter. So very smooth.

At the end of the quarter, our largest 15 tenants that are listed in the release accounted for 42.6% of our revenue. That’s down 680 basis points from the same period a year ago and down 450 basis points from the fourth quarter. So the recent acquisition efforts continue to help us reduce any concentrations in the portfolio. And we made continuous progress on this over time. In 2008 the top 15 accounted for 54.3% of revenue and we’re now down to 42.6%.

We ended the quarter with 97.7% occupancy and that’s 81 properties available for lease out of the 3,525 that we own. That’s up 50 basis points from the fourth quarter and 110 basis points from the same period a year ago. And here in the second quarter we would anticipate occupancy remaining very strong, likely to be flat or up slightly again this quarter and very pleased with that.

I mentioned in the past there are three ways you can do occupancy. The one we use in the release is to take just the number of properties that are vacant, 81, divided by the 3,525 and that’s how we get to 97.7%. If you wanted to run it on a square footage basis that would get you to occupancy of 98.6%. The third way you could do it is take the previous rents on any vacant properties and divide that by the sum of that number and the rent on the occupied properties and using that methodology occupancy is 98.8% and obviously any of the three indicated higher occupancy.

Same store rents on the core portfolio increased 1.5% during the first quarter. As you recall during last year’s same-store rent was a small negative in the first three quarters and barely positive for the year. So getting to 1.5% is a good rate I think for a net lease portfolio and it’s good to get back to that number.

Diversification really continued to widen substantially in the quarter. As I mentioned before 3,525 properties. That’s up 512 properties from last quarter in 46 different industries now with 195 different tenants in 49 states and Puerto Rico. And then the industry exposures also continue to climb substantially. Our largest industry today convenience stores is at 12%. That’s down 290 basis points from last quarter and up 500 basis points from a year ago. Restaurants as you know is an area that we had targeted to reduce. If you combine both the casual dining and quick service is now down to 10.5% and that’s down 190 basis points from last quarter and 410 basis points over the same period a year ago. I’ll just note we once I think had 22% of our revenue in that sector.

Theatres are at 6.7. That’s down 200 basis points quarter and 300 for year. And then you get to health and fitness and drug stores, both about 6%. Health and fitness down a bit and then the three industries really that have been moving up, drug stores is at 6% now, up 270 basis points from last quarter. The dollar stores is up to about 5.6% and then transportation services at 5.2%, when you get below that, any other category is below 4% and a very good shape keeping industry concentrations reasonable.

Same thing on the tenant standpoint. Our largest at 5.7% is FedEx, that’s up over the last year because of some acquisitions we made and the ARCT portfolio. L.A. Fitness is second at 4.5%, that’s down 60 basis points from the last quarter. And then everything else is now down below 3.5% exposure in the portfolio. And as I mentioned, the largest top 15 are down 42.6%. And when you get to the 15s, you will notice you are about 1.5% of revenue, so that this continues to widen on our tenant and also on an industry standpoint and certainly the same could be said from a geographic standpoint. [Average leasing] due to acquisitions has remained very healthy at 11.1 year and as I mentioned, the portfolio continues to generate very stable income with high occupancy.

Relative to property dispositions, we accelerated the asset disposition program a bit during the quarter with a focus on the intent of trying to further strengthen the credit quality of the overall portfolio, and doing that by reducing exposures in certain industries and properties that we think might be particularly sensitive to any economic weakness or a tenant whose balance sheet is levered, and if interest rates were to go up, we think that they might be somewhat at risk. During the quarter we sold 17 properties for $60 million. As you recall, we were looking in our guidance for a little over $100 million in dispositions for the year, and so getting $60 million of that done in the first quarter is very positive. And we think that going forward that we will easily hit that 100. I think we said 75 million to 100 million, we believe we hit that and I would say well over 100 for the year at this point.

Most of the sales for the quarter were in the restaurant and (inaudible) industry relative to number of properties. We also sold a multitenant investor property that we had had in the portfolio for about 25 years that had 375 tenants that we think exposure to economic weakness might be substantially more than the balance of our portfolio, and so we moved that out with a sale. I think it's safe to say the amount of sales just like acquisitions will vary quarter-to-quarter and be a bit lumpy, but they could accelerate a bit more as the year goes on.

Let me move on to property acquisitions. As I have talked about for some time, acquisitions will vary quarter-to-quarter and they are a challenge to predict for any individual quarter. But given really excellent transaction flow that we are seeing right now and what we did in the first quarter, which is a little more than we generally do, we are off to a very good start for the year. The first quarter as I mentioned, is a little slow. If you recall, last year I think we did $1.2 billion and I think we did $10 million in the first quarter. So at $128 million, we view that as a positive.

I also think that transaction volume at that this point tells us, this should be another very good year for acquisitions. We initially had in the guidance, $550 million. I can say now, and we are sitting in fairly early April but that should not be an issue for us. And we should be able to meet that and exceed that which is very much a positive at this time of the year. Let me have John Case, our President and Chief Investment Officer make some comments about what we did and kind of what we are seeing out there in the marketplace. John?

John Case

As Tom said, we remain active on the acquisitions front. During the first quarter we made $128 million in property level investments in 27 properties at an average yield of 7.9%. These properties had a weighted average lease term of just under 14 years and 22% of these assets are leased to investment grade tenants. The properties are leased to 14 different tenants and 11 different industries, so well diversified. Two of the tenants are new to our portfolio and the most significant industries represented were transportation services and [health] business.

Properties are located in 16 states and about 80% of the investments are comprised of our traditional retail properties. Of course this activity was in addition to our $3.2 billion acquisition of American realty capital trust which added 515 properties and closed in January. So our combined total investment in real estate for the first quarter was just under $3.3 billion and 542 properties. This was clearly our most active quarter in our company's history by a significant margin.

Let me spend a moment here and talk about the market environment today. I’ll start with transaction flow. Tom just alluded to that. We continue to be very busy. So far in the first quarter we sourced $4.3 billion in acquisition opportunities. So transaction flow continues to remain strong. We continue to work on a number of these opportunities and we’re expecting another active year for transaction flow.

While investment opportunities are fairly abundant, competition for these acquisitions is also abundant. There are plenty of well capitalized buyers in the market today led by private and public lease REITS, but we’re also seeing some other private institutional buyers seeking yield in our space. These buyers are using more leverage with the CMBS market in our space that has gained strength here in the past quarter or two. And that’s helping our private buyers better compete. But we expect to continue to close on a fair share of these opportunities.

As far as pricing goes, cap rates remain low relative to historical standards. Given the strong bid in the market today they’re coming under a bit more pressure. Non-investment grade properties are trading in the 7% to 8% cap rate range. Investment grade assets are trading in the 6% to 7% cap rate range. However, our overall cost of capital has also continued to decline. So our investment spreads remain very healthy relative to our historical averages.

The current market portfolios in the $50 to $250 million range continue to trade at premium pricing relative to single assets. So buyers are willing to pay a portfolio premium in order to deploy larger amounts of capital efficiently. This is the trend we’ve been seeing for the last year or so and we expect to see it continuing.

So to recap our outlook, we do remain optimistic about achieving our previous acquisitions guidance of $550 million for this year. We are still modeling a 7.25% initial yield on acquisitions for 2013. But that number will depend on our ultimate mix of investment grade and non-investment grade acquisitions. In the first quarter, our property level acquisitions yielded 7.9%, it's really reflective of investment grade assets accounting for 22% of the total volume. We would expect our near-term quarterly average cap rates to be a bit closer to the 7.25% rates we have communicated to the market.

Thomas Lewis

Thanks, John. John likes to use the term to get our fair share. I would prefer us giving our disproportionate fair share. Either way, we are pleased with the start here for the year and very pleased where spreads are in the marketplace. It's a very good time due to acquire. Obviously, the recent acquisitions have certainly contributed to our revenue earnings and dividend growth, and that is very visible in the numbers here in the first quarter. But the other thing we are doing, they also and equally important to have, continued to help us adjust the makeup of our portfolio where we are focused on moving the portfolio up the credit curve and obviously we have made very good progress on that throughout this quarter, with investment grade tenants now making up around 35% of the portfolio.

As I talked to it bit about last quarter, over the last 36 months or so, we have now acquired about $6.2 billion of property including RT. About $3.7 billion of that is in retail and really pointed towards sectors that we think should continue to do well in what we anticipate is a somewhat more sluggish retail environment over the next 15-20 years than it had been in the past. And so we are really happy to get that invested and focused in the areas we want.

About $2.5 billion of what we acquired are in areas outside of retail that we think will do well for us, all with investment grade tenants. And of that total $6.2 billion, about $3.9 billion or 63% of what we acquired over the last 36 months have been with investment grade tenants. And what's interesting is a good measure of the rest of the tenants and acquisitions while not investment grade, are also further up the credit curve than the average in the portfolio just a few years ago and we are pleased with that. It's kind of interesting to watch that move and I will share some statistics with you.

If we go back and really look at having set out and thought that we should do this from 2008 and really started executing it in 2010. If you look in 2008, our top 15 tenants did 54.3% of our revenue. Their average [DAR] score, and the [DAR] score is our credit score, that approximated credit score similar to what the rating agencies would do. So the average [DAR] score on our scale is about 6.92, which would equate to a single B plus or Double B minus credit rating. And also none of the top 15 tenants had investment grade ratings.

Having undertaken this project starting three years ago, today the top 15 are down to 42.6% of our revenue. The average [DAR] credit score is up to 11.67. That approximates to approximately to a triple B minus credit rating for the tenants and six of the top 15 carry investment grade rating. So, really most of the work has been done in the last three years. But looking out, it was 2008 we have gone from 54.3% of revenue to 42.6%. The DAR score is 6.92 to 11.67 and we are now up to where six of our top 15 tenants are investment grade. And that’s over really just about four years of activity. And we anticipate that trend will continue in that what we are trying to accomplish.

I think the other thing about, that’s important to us is, how we paid for the acquisitions over the last three years. We did issue about $1.2 billion investment grade notes, most long-term at very good rates. As Paul mentioned, we have assumed some mortgages in the portfolio as we have taken over that we intend to pay off as quickly as we can. And we have done in that period about $162 million of property sales. More important to us is issuing a little over $400 million in perpetual preferred. And then we have issued equity in the last three years or so, six times and generated about $3.7 billion in gross proceeds. So about $6.24 billion in capital overall, of which $4 billion was common and/or preferred. And as we all live here in this very low interest rate environment, I think we want to remember that these rates there’s a possibility they won’t persist for ever and be mindful of where they could go, what funding costs could be and what has to be rolled over. So getting a lot of preferred in the equity done has been very positive and we intend to keep the balance sheet in really good shape that may even modestly delever from here on a bit to keep us in really good position.

Relative to capital, we’re in very good shape. As Paul mentioned, there’s plenty of dry powder to execute on the acquisitions as they present themselves. Raising a net $755 million in equity a few weeks ago was very helpful to make sure the $1 billion credit line with the $500 million [quoting] was available. And so now we’re in very good shape there.

Capital obviously is extremely attractively priced and spreads are very wide. So I really think that we’re in great shape. I would note that we’re particularly pleased watching how the equity has performed here in recent weeks. If you think about it, we’ve put about $2.8 billion of equity into the market in the last 90 days between our T and the offering. And so for the equity to perform this way I think it’s fair to say the market seems to have absorbed it fairly well and we have good access.

Earnings as Paul mentioned, normalized FFO at $0.61, up 32%. That’s a percentage number we haven’t seen before. Same thing with FFO at $0.60, up 20%. Relative to the guidance, we are staying with our previous guidance for now. We think April at this point we feel very good about all facets of the operations and very comfortable with the primary drivers to achieving the guidance which is as John mentioned $550 million in acquisitions and we think it will easily hit that and likely exceed it. But for now we’ll stay where we are and revisit the numbers over the next quarter. So things on hold. That puts normalized FFO for the year at $2.32 to $2.38 which is around 15% to 28% growth and AFFO at $2.33 to $2.39 which is 13% to 16% growth.

I’ll finish with dividends. We remain optimistic that we’ll be able to continue to increase the dividend. Obviously had nice movement in that in the first quarter as Paul mentioned and we look forward to have additional increases over the year.

And with that, Tager, if you’ll come back and help us with questions we’d appreciate it. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Emmanuel Korchman with Citi. Please come ahead, sir.

Emmanuel Korchman - Citigroup

John, if we can go back to your previous comment of I guess acquisitions [since] you’re hanging that, let’s call it 7.25% range. What was the driver of such a higher cap rate in the first quarter?

John Case

Yeah. It was primarily the percentage of non-investment grade assets we closed. We closed 22% in investment grade which was a bit lower than we had been closing in the previous quarters and certainly 64% in investment grade investments we did in 2012. So that’s the main driver, Manny.

Thomas Lewis

Yeah. There was one transaction we did in the first quarter with a tenant we like a great deal and it had a very attractive yield for what is a non-rated company. But if they were rated it would certainly be considered investment grade. So we were able to secure a good deal there and it just happened to be where what came in this quarter versus what may come in next quarter.

Emmanuel Korchman - Citigroup

And then maybe Tom you could tell us a little bit more about how competition has been split between the investment grade product and maybe the stuff that looks less perfect on paper but at the end of the day is all good property.

Thomas Lewis

You mean the transaction flow that’s come in the door?

Emmanuel Korchman - Citigroup

And maybe just the competitors that are looking at those types of assets.

John Case

I’ll take that Manny. We’re seeing a fairly broad group of competitors on both sides. I would say there are a bit more on the traditional retail product on the institutional larger buyers than there are on the non-retail product. And on the investment grade side, there’s good competition out there, but primarily from the higher quality companies with lower capital cost that can pursue this type of product. So it's probably not quite as extensive as on the non-investment grade. Is that what you were looking for?

Emmanuel Korchman - Citigroup

Yeah, perfect.

John Case

And there is plenty of people looking to buy properties in both sectors, Manny.

Emmanuel Korchman - Citigroup

And maybe just to dig in a little bit deeper on what you were saying earlier, Tom, that it sounds like you have kind of stuck to you guns in the retail space, though I guess [RT] was the biggest mix of retail and non-retail. What can we expect for the rest of the year? Are you guys kind of literally going to look at things just on what comes through or is there a goal to diversify more out of retail?

Thomas Lewis

You know it's, we are willing to do either, what we are really focused on is taking a look at the retailers and the consumer they serve. And it's discretionary goods and services or what they sell and there target markets better be the upper middle income or the upper income, because it it's lower middle or lower, we don’t want to buy it. So focus there. And then on the non-discretionary type goods and services, if that’s what the retailer is selling then we are pretty good at the upper and middle income, but if it's lower we want to make sure that there is very deep value proposition and that’s why we have gotten into the Club Stores and Dollar Stores and others. And that is a big focus when we are in retail.

And then generically moving up the credit curve, and in retail there are investment grade credits but there is a limited number. And so to get the portfolio up to credit curve, we are more than willing to look outside of retail. But it really has to be the Fortune 500, maybe Fortune 1000 and investment grade and what we think is property that they would consider it very very important to their business. So whether it comes in an either basket, we don’t really mind. And we are happy to have both sides expand a little more so if retail went up a little bit, it wouldn’t bother us as long as it was hit right where we wanted to go and generally up the curve. But we would be happy if retail, which I think in the quarter was around 79, if that falls to 75 or 4, or 3 or 2, that’s fine too. But I don’t have a numerical target on either one of those. It's really just those boxed we are trying to hit in terms of what we want to acquire and what we want to stay away from.

Operator

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

Joshua Barber - Stifel Nicolaus

Quick one, can you tell us what the disposition cap rate was on your assets during the quarter?

John Case

That is a great question and let me see if I have that sitting here in front of me, which I may or may not have. Well, for the year, Manny, our estimate for call it a 100 million plus, it's going to be 8.75%, if that’s okay.

Joshua Barber - Stifel Nicolaus

Do you know what it was in the quarter?

Thomas Lewis

Disposition cap. No, we have got it here, I am sorry. It was a little, actually lower than what we were planning for the year. I do know that because the one larger multi-tenant sale was substantially lower than that. Do you remember the cap rate on the transaction? Yeah, it was like a 7.5, and that was a big piece of it. So I would guess it is probably is closer to the 7-7.5 range but we will try to....

Paul Meurer

I think we will do better than the 7.5, we tend to model that conservatively depending on what we chose to sell later in the year.

Joshua Barber - Stifel Nicolaus

Okay. Maybe there is a broader question, but you guys have been very clear over the last few that you are trying to minimize the retail and get more investment grade, get slightly different property types. Is that a trend that you expect to [give in] or do you think that there will be some other move that you would like to make to really reshape the portfolio over the next couple of years?

Thomas Lewis

Yeah, I do think we will continue doing what we are doing. And as I said in the last question, we were happy to be in retail and we haven’t moved away from it and we are happy to buy. We are just going to be more particular in terms of who the tenants are, who they serve and what their balance sheet looks like. And so if we think they are investment grade or close so there is not a big refinance risk when interest rates go up, we are happy to do it. And as long as we are staying away from consumer discretionary to just kind of lower income is who they market to, then we are happy to do it. And we would be just (inaudible) retail space right where it is.

However, we are also focused on generically moving up the curve. And so if it's out to do that, we are happy to do it. We don’t have a target. It's right now 78 or 79, 21-22 is the mix, and over the course of the year if I had to guess, we will probably see a little more outside of retail, but we’re probably in the year where retail is still over 70% of the portfolio.

Joshua Barber - Stifel Nicolaus

Last question. When you’re looking at some larger scale acquisitions, given that you have significantly [priced] your enterprise value than you have in the past, do you think you have a little bit more room today to take on secure debt from another company, from another portfolio? Would you have a little bit more ability to do that or would that be something that you just don’t want to risk the balance sheet on?

Thomas Lewis

We have done that. We’ve got over $700 million of secured debt naturally come from buying portfolio. So we’re willing to do it. But when we do it we try and pay off anything we can that doesn’t have significant prepayment penalties and is an economic payoff. And then we will even place if there’s one, two, three, four year debt and see and pay that off as soon as we can. So it is our preference not to have any secured debt, but given size to buy portfolios I think that that will be the case from time to time. But it’s going to remain a very small part of our balance sheet. And it is something we could consider, but as soon as we get it on the books the purpose is get it off.

Operator

Our next question comes from the line of Tom Lesnick with Robert W. Baird. Please come ahead, sir.

Tom Lesnick - Robert W. Baird & Co.

I’m just standing in for Paula. I just wanted to follow up on an earlier question about the competition. I know you guys talked about competition across the credit spectrum already, but are you seeing increased competition in certain industries relative to other industries that you’re looking at acquiring?

John Case

Not really. There’s pretty strong competition across the board and we’re not really seeing it vary by the industry of the tenant.

Thomas Lewis

Yeah. There’s enough people that are broad in terms of what they’ll look at, whether it’s investment grade or non-investment grade, but I don’t think there are any sectors that are just standing there with gaping holes with nobody investing in them. And we look through all the industries we’re in. we buy convenience stores. Other people do. We buy theatres. Other people do and you can go right across it. We’re not buying casual dining, sit down dinner house restaurants, but other people are. So the fact we’re out of that doesn’t mean I think there’s a gaping hole. It’s competitive throughout. The performance of the net lease companies obviously has been relatively good for most of just the last few years and with the demand for yields, both institutionally and retail, given the yield characteristics in that lease it’s pretty much across the board everywhere. We’re fortunate that we have done this a long time. We have the experience and size and so the deal flow has been equally good. But it’s competitive all the way across.

Tom Lesnick - Robert W. Baird & Co.

And then secondly, I just wanted to hone in again on the disposition guidance. I know you mentioned $100 million plus. In your comments you said well over $100 million potentially and it could accelerate through the year. Could you ballpark that as maybe $100 to $150 or $100 to $200? How much of a disposition pipeline or backlog do you guys have that you’re trying to get through?

Thomas Lewis

That’s a good question and let me take a little time here and give some clarity how we look at it. First the number of saying 75 to 100 and that’s up from 50, it was up from 25 or so the year before. So I now would be surprised if we didn’t hit over 100, but I don’t have this backlog of stuff that I really feel I need to get out because I’m very much worried about it. The objective is just generally sell if it will increase the cash flow, if it materially increases credit quality or if it reduces concentration. Bu the primary area is where we’ve gone through the portfolio really parsed it and seen where we see risks. And that’s what we’re trying to sell and we originally targeted, if you recall I spent some time on a previous call and maybe it’s a good time to talk a little bit of that now, focusing around what we’re trying to do and changing the portfolio.

I think you know that will do it quick and then related to because of that we look at dispositions. As I mentioned, we’re trying to go up the credit curve and really trying to hit retailers that hit the consumers in certain way and stay away from the rest of them. That’s just a function of how we see the economy going forward and interest rates. A few years ago, what we did is we sat down and reenter the whole portfolio and it was 67 tenants that do 83% of revenue. And we rerated all the industries based on our views and then the consumer they serve. And then there were 24 different metrics which were a lot of debt, fixed charge coverage and margin and the big part of it though was saying if they had to refinance the whole balance sheet and permanent financing costs were 300 basis points higher, what it would look like, and then 600 basis points higher. And then we model the perfect storm which is revenues down, margins tightened and then interest rates up by 600 basis points. And when we finished, we really dropped everything in the four categories. And we had a kind of green color code which is strong buy, that was 23% of our revenues were generated by tenants who did that. Yellow, which was buy, was 21% of revenue. Red, which was hold, was 16% of revenue. And then kind of black, and this is for retailers who are in 23% of the revenue, and that’s kind of sell.

And so we looked at that and said, okay, we want to materially change the composition of the portfolio. And starting three years ago, the easiest way to do that is acquisitions. And when you do it with acquisitions, there is a side benefit and that is, it increases your earnings and your dividends materially. So that really was the focus. And so we drove in and said, as I talked about a couple of times now, consumer non-discretionary, the value propositions. Consumer discretionary, making sure it's low price point in ticket and going up the credit curve and outside of retail. And the result, we bought the $6.2 billion, it's a 120 different tenants, 41 industries. 60% of it was retail, 40% wasn’t. But 63% of everything we bought in the last three years was investment grade.

And so that took investment grade from zero to about 35% and it really changed the portfolio. The property sales program is the other way to do it. And if you take what was 23% of revenues that comes from retailers that are rated black or sell, that’s the first step. But the second step is then, we don’t own their bonds and stock, we own their property. So we need to look at the individual properties we own and we want to look at their profitability to see how big the margin of safety is. And that might cause us to want to keep the property even though we are not particularly enamored with that particular retail and the area they are in. And then we want to look at if the rent on the property is above or below market. And if it's above, see where the risk is and if it's below, if there is an opportunity to capture rent if it came off lease.

And then we will want to probably keep the rest, even though the retailer might be rated down in that area. So initially, we came up with a list of 190 million of property sales that we wanted to make that we thought would make a material dent in reducing the risk of our existing portfolio coupled with a pretty large acquisition pipeline. Today we have sold 162 million of that 190. So I do have a list there. And then we will move further into kind of black or so rated tenant but with some better properties. And at that point we may just move into the red a little bit. So there I don’t have this pressing, pressing need. And if you combined the sales and the acquisitions -- you want to grab a pen, these might be interesting numbers.

In 2011 when we reentered the portfolio, it was 67 tenants that did 83% of our revenue. And I mentioned a minute ago, 22.8% were in the green strong buy. 21.4% were in the yellow buy. 15.9% were in the red hold. And then we have 22.9% of our revenue came from people at black, sell. Now roll forward to be in the first quarter, and it's now 118 tenants that make up 87.2% of our revenue that are in these numbers. And we now have, in the strong buy green category, 58 tenants that now do 42.7% of our revenue. So we are from, in that category, up from 22.8% of revenue to 42.7%. In the yellow we have got 21 tenants that are 21.9% of revenue. So that’s up a bit. In the red or hold, we have moved to 25 tenants that are only 9.8% of revenues. So we have gone from 59% to 9.8% there. And then in the black that was 22.9% of the portfolio, is down to 12.8%, and its only 14 tenants.

And I think of one individual tenant that’s chunky in that 12.8%. And in that one we went through and did an analysis at property level and found that we had properties where the rents were above market and the cash flow coverages were okay and we have sold those. We had some where the rent were about at market and the cash flow coverage were just okay and we have sold those. But in that particular tenant there was just a lot of property where the cash flow coverage was modest but the rent substantially below market. We actually think there is a recapture there, so we won't sell those. But that’s kind of it. I mean we can make more progress on this in the acquisition side and we also increase earnings and dividends and we have done a lot of what we were really worried about on the sales. So I am going to plug it at $100 to $125 million and then if over the course of the year we decide to do a little more we’ll communicate that.

Operator

Our next question comes from the line of Todd Stender with Wells Fargo. Please go ahead, sir.

Todd Stender - Wells Fargo Securities

The same-store growth you highlighted was 1.5% in the quarter. It’s historically only been about 1%, maybe a little bit better than that. Is this a rate we should expect the rest of the year and what do you contribute this a little bit above the average growth to?

Thomas Lewis

It’s funny. I think it was a little above average and if you want a run rate I think 1% is a good one to use. Interestingly enough if you go back a few years ago in the recession you’ll recall we had a few tenants out of our very large group of tenants that went through some chapter 11s and one of the things we did when we set some rents lower for them, we were also to build in some recapture if their business rebounded and their business has now rebounded and so strangely enough a good part of that comes from the restaurant industry and it comes from tenants that there was a problem and their rent accelerated over the last few months as their business was better and our leases had been changed to capture part of that. But we think going forward and particularly with the RT coming into the numbers over time, I think 1% is a good run rate.

Todd Stender - Wells Fargo Securities

And then you guided for 7.25% for 2013 acquisitions. And the average lease term was up around 14 years in the quarter. What’s the fair lease term average for the remainder of the year? You think it will be that long or closer to the in-place average of about 11?

John Case

I think it could range from 11 up to 15, 16, right in there. It’s hard to tell at this point. But they are all pretty much initial terms above 10. You see some 20. You see a fair amount of 15. It just depends on how much you end up doing at each lease side.

Thomas Lewis

And then it could be impacted if one of the larger transactions come through and that can change the cap rate up or down depending on who the tenant is. Those numbers John gave you are the ones that we’re using for modeling.

Todd Stender - Wells Fargo Securities

And just to stay on that theme, if a good portfolio of assets was presented to you with an investment grade tenant roster, would you deemed an attractive price, what would be the shortest average lease time you would consider?

Thomas Lewis

Interesting. I would never say never and I think that’s smart to do. But when you get inside of 10 years it starts growing some concern from us and you would have to be able to get in and establish that the rents were at or substantially below market before you want to go much inside 10 years I think. And that’s in a chunky one or two tenant acquisitions something that could be done, but in a broad M&A type situation it becomes a bit more challenging. So on any granular acquisition 10 years is where we just draw the line and if it was an M&A situation we’d like to think 10 years subject to review of where rents are verse market.

Todd Stender - Wells Fargo Securities

That’s helpful Tom. And Paul, I assume you used a line to meet your March debt maturity?

Paul Meurer

That’s correct.

Todd Stender - Wells Fargo Securities

Is that factored into guidance and how long would you assume if that would sit there and how long is that factored in and I guess how much is factored in the guidance?

Paul Meurer

Well, that was factored in the guidance. We just planned since it was only $100 million to do it on the line and then let the line balance run up a bit before we would consider a more permanent financing activity in concert with the acquisition deal flow run rate and what happens there. So we sit here today in very good shape in terms of what that line balance is and no imminent capital needs. But that would really at this point be dependent upon the acquisition deal flow and when that stuff closes.

Thomas Lewis

We also when we were looking at whatever financing we do next and plugging in what it would cost us, tried to use a rate substantially higher than where debt is sitting today and then that gives us the option of doing equity preferred without materially moving the model. And if we decided to do debt it would have an impact.

Paul Meurer

Yes. We basically modeled it where we could do anything if you will at that time, equity preferred or debt.

Operator

Our next question comes from the line of [Daniel Dowling with Landenberg Dowling]. Please go ahead, sir.

Unidentified Analyst

Just real quick on the 7.9% acquisition cap rate. Is that (inaudible) cash?

Paul Meurer

Yeah.

Unidentified Analyst

So on a GAAP basis, what would that be?

Thomas Lewis

More.

Paul Meurer

It would be probably 8.10%, in that area.

Unidentified Analyst

Okay. And then what is the interest rate -- what is the average interest rate on the 700 million that you guys (inaudible) that ARCT?

John Case

That’s part ARCT and parts other we have taken.

Unidentified Analyst

Right. So the total portfolio of mortgage is 729 million then?

John Case

Yeah. As a weighted average and straight right now of 5.4%.

Unidentified Analyst

Okay. All right. And then as we look at kind of the rent increases or decreases, I guess you could say, on the subsequent expirations versus your initial lease expirations. Who should we look at that, would you expect to see higher rent growth on the initial expirations and then less on the subsequent or does it...?

John Case

We do better on the subsequent then we do on the initial. And traditionally, the subsequent has done very well and is up and the initial is down. Roll overs, this year so far and the ones we have done are up about 3.3%. Modeling for the year will kind of just assuming that they will be pretty much flat. Traditionally, and this gets back very historical, we had rolled down. And the roll down, I think back in 2002, was about 24% in that peak. And one of the things that we did, started seeing in the mid-90s, is that roll down at the end of the lease was really starting to hit us, and this is in the mind-90s. And we dramatically changed how we acquire. Previous to that, everything we acquired was a new store, and we didn’t have cash flow coverages, and they were all less than investment grade. And we found they did pretty well throughout the lease, but at the end of the lease if we bought a bunch of new stores, about a third of them were below average, a third average and a third above.

So we totally changed our underwriting in retail to pre-select those with high cash flow coverage and profits. So we would not preselect the one-third that were underperformers. So over the years what's happened is the burn that we get in lease rollover keeps declining pretty substantially. And yet the portfolio that’s rolling over is stuff that was bought still quite a bit ago, particularly the subsequent. So the last year there was a roll down of about 4%. And so far this year it's up 3% and we are thinking it will be closer to zero. And I think that’s a good way to think of it.

Unidentified Analyst

Okay. I appreciate that. And then just two quick housekeeping items. What is the amortization of net mortgage premiums that you guys recognize in the AFFO line? What's the run rate there, (inaudible)?

Paul Meurer

Yeah, obviously, that’s associated with any portion of the mortgages that we assume that are above market. And the projections for the year is about $9.2 million. You see the quarterly amount, just trying to grab the AFFO page, indicated in here, just under $2 million that occurred in the quarter. But the projections for the year, right now based on the mortgages that we currently own is about $9.2 million. And that is an amount that we reduced from AFFO, in order to arrive a real bottom line cash flow amount for us.

Unidentified Analyst

Okay. And the capitalized interest in the quarter?

Paul Meurer

That’s a pretty small number. I don’t really have that handy. You don’t mean capital expenditures?

Unidentified Analyst

No, no, just capitalized interest. I was just curious if you guys are doing any, funding up developments and what not. I know you have done that back in the past, so.

Thomas Lewis

We are, and I don’t know, John, if you have the number handy, but we definitely have some development commitments underway. But it's a pretty small amount. And total for the currently...

John Case

Let me give those numbers, Tom.

Paul Meurer

Yeah, in the first quarter of our activity, 11 million of that was in development funding and funding of expansions on existing assets. And we have $21 million in development funding or banking. So it's a pretty small number relative to our overall size. But I don’t have the capitalized interest associated with that.

Thomas Lewis

And (inaudible) those numbers and is not looking for capitalized interest but thinking about development risk. All of those are on existing properties where a lease has been placed so there is no lease-up risk on that. It's just expansions or we bought the land and we are funding the development, but we have the lease in place from the tenant already.

Operator

Our next question comes from the line of Todd Lukasik with Morningstar. Please go ahead, sir.

Todd Lukasik - Morningstar

Just a quick one on property site distribution. I know that healthcare is now on the roster. It’s just under 2% of revenues. I just wonder if you could explain a bit more about what that is and then in general if you could talk about your attitude toward triple that lease healthcare and whether or not you expect that to be an area that grows in the portfolio.

Thomas Lewis

Most of that came from the RT acquisitions. The tenants there are DaVita which most people know is one of the largest in the dialysis area an also Fresenius. There’s also a few express scripts properties, actually a few leased to GE Healthcare and then like four MOBs I believe they are that are at the Saint Joseph’s. So it’s fairly limited. It is not an area we’re targeting. If it grows it would surprise me as of now. I guess it could a little bit. But those are mostly that came out of that area and I don’t think I have a formal attitude towards it outside that it’s an area and an industry that is very well financed by some very smart folks. And if we find something at the margin time but it’s not anything we’re pointing to.

Todd Lukasik - Morningstar

And then just wanted to see if you could update us on rent escalators related to inflation across your portfolio. I know a few years back you guys were trying to get more of those written into your leases. I was wondering if you could tell us what percentage the portfolio now has escalators specifically related to something like CPI and whether or not you have better success today than you did in the past on new sale lease back transactions, getting something like that written into the initial leases.

Thomas Lewis

Today the number is 15.61% of like real inflation percentage sale, that type of stuff going into it. And that’s up substantially from a few years ago and I would give us a C to D grade at best in getting that done. It is extraordinarily difficult. It is not the norm in the industry and is really an out wire and is probably one of the more frustrating things in the management of the business and something that we really continue to work on. And as we drop back into a strategic planning mode which we’re going to do this year, that is something that we’re really going to think about where we could go to try and accomplish that. But today in the net lease business it’s C&O. it’s the fountain of youth that comes daily on but nobody ever finds. And I really think that’s the case and you have to really parse how you ask the question because if you say do you have CPI accelerators in your leases? Well yeah. It would be a massive number for us, but they’re capped. So what they really are is fixed increases. So, it really does need to be asked, but it’s unrestricted and that’s about 15.6% for us and very unusual to get.

Todd Lukasik - Morningstar

And then just last question with regards to the assets for divestiture. I know you had an industrial property in there I guess you said this quarter. Going forward, is it reasonable to assume that those are pretty much going to be all retail or are there any other property sectors that you guys have invested in more recently that have properties that are falling into that bucket for divestiture?

Thomas Lewis

I think the bucket is going to be retail and I think it’s going to be the ones that have fallen down in that category. And tenants that are very levered and it will probably be dominated by restaurants and there may be some convenience stores and then a smattering of other things.

Operator

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

Richard Moore - RBC Capital Markets

Right now about a third of your portfolio is investment grade and that’s obviously up substantially over the last couple of years. As we listen to the call, Tom, I’m wondering, the ultimate goal clearly is 100% investment grade even though you keep moving up the investment grade curve and during the quarter you had below one third investment grade tenants come up. And I’m wondering, has big move in investment grade change to the portfolio occurred and 35% is about right for the total? Or is there much more to go from this point?

Thomas Lewis

I hope it hasn’t occurred and I hope there is much more to go because I’d like that number to be substantially higher. But I want to modify it in that it’s not just buying investment to buy investment grade. The reason we want to do it, is over the last 30 years the tenures quite frankly have just gone from 15% to 1.7% when I looked at it this morning. And that has made a lot of very levered business strategies that involve a lot of financial engineering work. And should interest rates go up, which were really low, I want to focus on companies that would really have trouble refinancing their balance sheet.

Now that means generally investment grade companies are going to be less impacted. There are tenants who are not investment grade. Who don’t have a lot of debt but they are not investment or a even a [shallow] rating might be less than investment grade because of their size. But if they are size and they don’t have big refinance risk exposure and the customer they serve doesn’t, then still interests us very much. Even though they are not investment grade because we are really for that lack of risk relative to refinance. However, the bigger the entity, the lower the default rate. The rating agencies will tell you, all your research tells us that. But I don’t want to say always, but I would like it to continue to increase. But we are happy to have some of the tenants not being investment grade.

But even those that aren’t, I will tell you, have moved up the curve where they are closer to investment grade substantially then they were a number of years ago. Much less of the highly levered private equity M&A type of stuff.

Richard Moore - RBC Capital Markets

Okay. Good. I got you. That makes sense. Then on the disposition just for a moment. How much of the portfolio is double net, non-triple net, maybe multi-tenants which I assume aren’t as attractive, that fall in not so much into a tenant category but fall into a tight category that you would want to divest. Is that part of the strategy as well?

Thomas Lewis

Yeah, I mean you know the industrial property that we sold during the quarter was like 400,00 square feet with 375 small tenants. And so you start looking at a weak economic environment, you would worry there. But we are kind of pretty much done with that. We have sold most of what we had there. The double net that we might have is actually more up the credit curve with people and it's just that it’s 2.5 net where you may have some responsibility with it. But those aren’t things that we are really looking to get out of. We are looking at those when we underwrite them relative to the cap rate we get and try and amortize some type of expense ratio for them, even if the expenses are lumpy.

Richard Moore - RBC Capital Markets

Obviously, so you didn’t get multitenant from RT that you are trying to get rid off?

Thomas Lewis

No. No, that portfolio was almost all pretty straight net lease. You know if we get a bunch of grocery anchor centers, we will think about (inaudible).

Richard Moore - RBC Capital Markets

Yeah, I got you. Okay. And then on the G&A front, it sounds like you are just annualizing this quarter pretty much for the year, which means that you have done the hiring and the additional infrastructure that you need to support things like RT. Is that true? So you are pretty much done with that sort of aspect of business?

John Case

Well, yeah. That’s part of the answer, and then the other part is we did have some G&A reduction because some of the employees who were associated with the large multi-tenant asset we sold, effects that employee count if you will. So that kind of offset the number a little bit but got ahead in the last one (inaudible).

Thomas Lewis

Yeah. And I will tell you one of the reasons I don’t want to move the guidance right now, we feel very comfortable where it is, is I think it could get better but I also think we may do some more G&A this year. We are kind of doing a project in house from looking at, if the company was twice as large, what it would need to look like, how would reporting look, what would people be doing. And then we have identified a number of areas where we want to add staff and expertise. And there's probably a number of people and acquisitions where we are going to do that. A number of people in research, we want to do that. There has been some movement internally, so we need to do that portfolio management. And we will have a, I think a pretty good increase in employee count during the course of this year. We just kind of earned the midst of our recruiting and the undergrad out there and we will probably do a much bigger class this year then we have done in the past. So we have grown substantially and I think we need to add a few people for that even though this addition to the RT is very efficient, but we also want to plan for growth. And so we are going to need, I think a couple of more executives around here and a good group of professionals added in. So there will be more.

Paul Meurer

And most of that won't affect the 2013 estimate too much, Rich. But it will certainly increase the annualized run rate as we add in people over the course of the year on a go forward basis.

Richard Moore - RBC Capital Markets

Okay, I got you. So that’s all in the $45 million. So it sounds good. The last thing, Paul, the other income line items was, I think, substantially higher. What was that exactly?

Paul Meurer

That’s always a mixed bag of interest income on cash if we do a capital raise and the cash sits around for a few days or a week if you will. Interest income in that sense also evenness in takings which are a normal part of the portfolio manager process. So if you have a situation where there’s an eminent domain or a portion of your parking lot, sometimes it doesn’t mean it affects the viability of the asset itself. It actually ends up being pretty positive proceeds that we receive in this situation. So that’s all that 1.4 is is a mixed bag of those items if you will. Nothing different about the normal business.

Richard Moore - RBC Capital Markets

So that goes back down I assume most likely in 2Q?

Paul Meurer

Correct. I don’t think 1.4 million is an appropriate run rate. No.

Operator

This concludes our question-and-answer portion of the Realty Income conference call. I would now like to turn the conference over to Tom Lewis for concluding remarks. Please go ahead, sir.

Thomas Lewis

Thank you everybody for joining us for this. I know it’s a busy season, particularly a busy day and we appreciate the attention look forward to talking to you at one of the upcoming events. Thank you.

Operator

Ladies and gentlemen, that does conclude our conference for today. You may now disconnect.

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