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Realty Income Corp (NYSE:O)

Q2 2013 Earnings Call

July 25, 2013 4:30 PM ET

Executives

Tom Lewis – CEO

Paul Meurer – EVP, CFO and Treasurer

Sumit Roy – EVP, Acquisitions

Analysts

Juan Sanabria – Bank of America Merrill Lynch

R.J. Milligan – Raymond James & Associates

Jonathan Pong – Robert W. Baird

Todd Stender – Wells Fargo

Operator

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the Realty Income Second Quarter 2013 Earnings conference call. During today’s presentation all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) This conference is being recorded today Thursday, July 25, 2013.

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

Tom Lewis

Great. Thank you, Sheryl and good afternoon everyone. Welcome to the conference call and thank you for joining us. In the room with me today, I have Gary Malino, our President and Chief Operating Officer; Paul Meurer, our Executive Vice President and Chief Financial Officer; Mike Pfeiffer, our EVP, General Counsel; and Sumit Roy, our Executive Vice President, Acquisitions.

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 the forward-looking statement. We will disclose in greater detail on the company’s Form 10-Q the factors that may cause such differences.

And as is our custom, why don’t we start with Paul to walk through the quarter.

Paul Meurer

Thanks, Tom. As usual, I’ll comment briefly on our financial statements, provide a few highlights of our financial result for the quarter starting with the income statement.

Total revenue increased 63% for the quarter. Our current revenue on an annualized basis now is approximately $765 million. And of course this increase reflects positive same-store rents of 1.1%, 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 $78 million in the quarter as depreciation expense has obviously increased naturally with our portfolio growth.

Interest expense increased in the quarter to $39.1 million. This increase was primarily due to the $800 million of bonds that were issued last October as well as some credit facility borrowings during the past quarter. On a related note, our coverage ratios both remain strong with interest coverage at 4.1 times and fixed charge coverage at 3.3 times.

General and administrative or G&A expenses in the second quarter were approximately $12 million dollars. Our G&A expenses naturally increased this past year as our acquisition activity has increased and we added some new personnel to manage a larger portfolio. Our employee base has grown from 89 employees a year ago to 104 employees at quarter end. However, our total G&A as a percentage of total revenues has decreased to only 6.5% and this compares to a historic run rate for G&A of about 7.5% to 8% of revenues. Our current projection for G&A for all of 2013 is about $58 million. Property expenses were just under $3.3 million for the quarter and our property expense estimate for all of 2013 remains about $15 million.

Income taxes consist of income taxes paid to various states by the company. They were $722,000 for the quarter. Merger-related costs, obviously this line item refers to the costs associated with the ARCT acquisition. During the quarter, we expensed $605,000 of such remaining costs. Income from discontinued operations for the quarter totaled $3.9 million. This income is associated with our property sales activity during the quarter. We sold 17 properties during the quarter for $23.7 million with gain on sales of $5.7 million. And just a reminder that we do not include property sales gains in our FFO or in our AFFO.

Net income attributable to noncontrolling interest refers to the limited partners of the operating partnership that we purchased in the ARCT acquisition and a new Realty Income LP, we formed this past quarter. The assets and operations of these two subsidiary partnerships are 100% consolidated into Realty Income.

Preferred stock cash dividend totaled approximately $10.5 million for the quarter. Net income available to common stockholders was about $44.2 million for the quarter. Reminder that our normalized FFO 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 first call FFO estimates that analysts have published on us.

Normalized FFO per share was $0.51 for the quarter, a 24.5% increase versus a year ago. Adjusted funds from operations or AFFO or the actual cash that we have available for distribution as dividend was $0.59 per share for the quarter, an 18% increase versus a year ago. We again increased our cash monthly dividend this quarter. We have increased the dividend 63 consecutive quarters and 72 times overall since we went public over 18.5 years ago.

Dividends paid per common share increased 24.5% this quarter versus the same quarterly period a year ago. Our current monthly dividend now equates to a current annualized amount of approximately $2.179 per share. Our AFFO dividend payout ratio year-to-date has been 87%.

Briefly turning to the balance sheet. We have continued to maintain our conservative and safe capital structure. Earlier this month as you know, we raised $750 million of new capital with a 10-year bond offering at 4.65%. Our $1 billion unsecured acquisition credit facility currently has zero borrowings and this facility also has a $500 million accordion expansion feature. We assumed approximately $65 million of in-place mortgages during the quarter as part of our property acquisitions. We now have 51 assumed mortgages on 229 properties, totaling approximately $793 million. Our upcoming mortgage maturities though are only $24 million the reminder of this year and $64 million in 2014. Our next bond maturity is only $150 million, which is not due until November of 2015. Our overall current total debt to total market cap is 29.5% and our preferred stock outstanding is only 4.5% of our current 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 on these results.

Tom Lewis

Thank you, Paul. Let me start just by saying I think in the second quarter, we continued pretty good positive momentum from the first quarter and had I think, excellent results in each facet of the business and I’ll start with the portfolio, which again generated very consistent income during the quarter pretty much across the board the tenants are doing well no issues arose with any of the tenants during the quarter and based on what we see now that should be the case during the third quarter very, very smooth.

At the end of the quarter, our largest 15 tenants and they are listed in the release accounted for 43.5% of our revenue that’s down 500 basis points from the same period a year ago and up 90 from the first quarter. There may be some I think ebb and flow from quarter-to-quarter in that but our acquisition efforts continue to help us reduce concentrations pretty much throughout the portfolio. And we have made continuous progress in that over time. If you look back say five years ago to 2008, our top 15 tenants accounted for 54.3% of our business, of our revenue and today that’s 43.5%.

Relative to occupancy, we ended the quarter at 98.2% with 68 properties available for lease out of the 3,681 we own that occupancy is up 50 basis points from the first quarter and up 90 basis points from the same quarter a year ago and really is a function of very good progress on leasing during the quarter. And I would say looking forward here in the third quarter, we think occupancy should remain at this level or perhaps up a bit more and overall occupancy is very strong.

We reported occupancy this way for very long time, which is taking vacant buildings against those that are occupied to figure those numbers. There is another way to do it. We can do it by vacant square footage and divided by total square footage that would give you occupancy of 90% or the third way is to take previous rent on vacant properties and divide that by the sum of that number and the rent on occupied properties and if you use that methodology vacancy is only 0.9% and occupancy 99.1%. So, each obviously of the three methodologies indicates very good occupancy.

Same-store rents on the portfolio increased 1.1% during the second quarter and 1.3% year-to-date. As you recall, during last year, same-store rent was just modestly positive for the year so getting back up to a run rate of 1% plus is pretty good. And I think a good rate for the portfolio and we think that will continue over the next few quarters. Diversification of the portfolio continues to widened we are up to 3,681 properties we have 194 tents we’re in 46 industries and 49 states around the country.

I think industry exposures are well diversified given we have 46 industries and the concentrations on the major ones continue to come down a bit and this has been going on really for the last few years. Our largest industry right now is convenient stores that’s at a 11.4% that’s down 60 basis points from last quarter and 550 basis points from a year ago that was once closed to 20% of the portfolio and so getting it down and inside 10% is something we want to do.

Restaurants if you were to combine both categories casual dining and quick service we now have down to 9.9% or below 10 that’s down 60 basis points from last quarter and 390 basis points from a year ago and I’ll note that was once 22% of revenue. We then jumped to drug stores at 6.9% theatres at 6.3% and health and fitness and transportation at 5.9% and then dollar scores at 5.6% and all of the other industry categories that we have are under 4%. So I think pretty good shape and keeping an eye on concentrations by industry.

I think that’s true also from a tenant standpoint. Our top three tenants number one is FedEx at 4.3% that’s down 40 basis points from last quarter. L.A. Fitness is at 4.5%, Walgreens which we have been adding to the portfolio is at 4.1% that’s up about a 120 basis points and every other tenant we have is below 3.5% and when you get to the 15th largest tenant which is Wal-Mart Sam’s Club. You are looking really only to about 1.7% of revenue and it goes down from there.

So certainly well diversified from a tenant and we also think geographic standpoint. Average remaining lease term remains very positive at a 11 years and overall we are really pleased with the portfolio and it’s generating very consistent income with very high occupancy. Relative to portfolio dispositions. We continue to sell some properties out of the portfolio during the quarter. The goal obviously is further strengthening the credit quality, the portfolio and doing that by reducing exposures to industry and tenants and properties where we think they might be particularly sensitive to reduce economic activity or a slowdown in the economy.

We are also maybe with tenants whose balance sheets are significantly levered and might be impacted by higher interest rates and that has been a theme for us for a while. Paul mentioned during the quarter we sold 17 properties for $23 million. For the year it’s 34 properties with $83 million. For those that are on the call on a regular basis you will recall that our goal was over a $100 million and perhaps up to a $125 million and sales will have been flow on a quarter-by-quarter basis but $100 million plus is definitely where we are heading and where most of the way they are now and we may up that estimate in the coming quarters and do some additional dispositions above and beyond that.

And once again the sales primarily during the quarter we are in the restaurant industry which we continue to reduce and the child daycare industry and both are targeted we would like to sell off some properties in those area. I think overall we are very pleased with the operations of the portfolio and have made good progress.

Let me move over to property acquisition for a moment. As I’ve said virtually every quarter forever but it’s a good remainder acquisitions can be quite lumpy quarter-to-quarter and year-over-year and a challenge to predict certainly by the quarter and that continues to be the case.

In the second quarter we were very active on the acquisitions front and pleased with the really high level of activity in acquisitions. We acquired $738 million in properties invested in a 190 different properties and that is the most accusative quarter for property level acquisition in the company’s history and average cash on cash cap rates were at 6.8% kept nice along lease terms and the acquisitions at 14 years and also 70% of the properties acquired during the quarter were leased to investment grade tenants as most of you know that has been one of our focuses.

Also good diversity they released a 19 different tenants in 16 industries with the most significant industries represented were in drug stores, wholesale clubs and in convenient stores and well diversified geographically in 32 states and 90% of the acquisitions during the quarter were in our traditional retail properties that gets us for the first six months of the year then to $867 million that we invested in 206 properties. Cap rates there 7% and long-term leases again at 14 years and about 61% of the acquisitions leased to investment grade tenant.

That’s obviously well above at 860 excuse me $867 million our initial full year 2013 guidance of $550 million. Couple of weeks ago we’ve bumped that guidance up in excess of $1 billion and given really some transactions that have come to fruition in the last few days yesterday in the release we changed that to $1.25 billion and very, very pleased with that process but we think a good share of him as we get now later in the year we’ll close towards the end of the third and fourth quarter that’s fairly typical. And so the impact to 2013 numbers maybe modest depending on when the closings actually happened but obviously very accretive to the 2014 numbers and that $1.25 billion will be in addition to the $3.2 billion acquisition of ARCT that we did in the first quarter.

Looking at transaction flow I talked about it being very, very robust last quarter and it’s really been a record amount of flow that has come into the market substantially. During first six months of the year we’ve sourced about $20 billion in acquisition opportunities that have come through the door and $15 billion of that alone came in the door during the second quarter. To put that in perspective that’s more in sourced acquisition opportunities year to-date then we’ve ever seen in a full calendar year.

Last year was very heavy year for acquisition opportunities at $17 billion. The year before was $13 billion and previous to that it had never really exceeded much over $5 billion so the $15 billion during the quarter and $20 billion year to-date represents really just a stunning level of opportunities that were out there in the market place with people bringing properties out for sale.

A number of those as some people have probably noticed we’re large portfolio entity level acquisition opportunities but also there were a lot of very small kind of granular individual property opportunities that came to market during the quarter so it remain very active. I think we remained very selective in the acquisitions and have been trying to pursue only those things that match where we are trying to take the portfolio strategically and we continue to look at few of the acquisition opportunities that came into the second quarter but have elected not to pursue the vast majority of them.

And again number of the transactions for us had issues relative to the industries the tenants were in and who the consumers are also with pricing and structure. And I think it’s generally been the case then in the large portfolio unless the overwhelming vast majority of the properties fit the invest strategy will likely elect to pass on them and not pursue growth just for gross purposes but overall obviously very pleased with acquisition volume and also very pleased that in past years and we had some descent size acquisitions go through this quarter that just as I said a moment ago a lot of the acquisitions have been property by property and smaller organic level transactions and really allowed us to make some good progress with the portfolio.

Let me talk to pricing and cap rates which I think is really interesting. Cap rates have ticked up a bit over the last six weeks or so as we saw movement in rates in the capital markets. Cap rates started moving and at the same time and probably seen about a 25 basis point move up in cap rates overall just in the last six weeks or so. And historically that does not usually happened this fast and usually it takes longer for cap rates to adjust movements in the capital markets and sometimes they may even lag by six to 12 months.

And in the recent kind of movement in the capital markets things seem a bit different this time and put some thought to it and I think the reason that the cap rates started to moving quicker this time is that more and more of the acquirers in the net lease business now are institutional buyers such as ourselves certainly then was the case in the past.

And I think our business historically has been dominated by a very large group of one-off transactions primarily driven by individual investors that had a big impact on the pricing in the market and that’s flip-flopped a bit as more institutional buyers have emerged and it’s a smaller group albeit of large players that seem to be impact the pricing. So really a movement in the cap rates stands by a few larger buyers, I think like can adjust cap rates a bit faster than what we’ve traditionally seen in the net lease market for a very long time and I think that’s been the case here.

In the market right now investment grade properties – properties leased to investment grade tenants cap rates have moved kind of in the 6.25% up to 7.25% certainly up 25 basis points maybe a few basis points more, and I think the same thing with non-investment grade cap rates which were in the 7.25% to 8.25% range also up 25 basis points and again that’s just really over the last five, six weeks or so and normally I’d wonder about that and wonder if its anecdotal but, given the flow and the volume of activity that we see and that we’re working on I think it’s pretty representative of what’s going out happening in the market. So caps moving up with capital cost this quickly as unusual, but obviously we’re pleased by that.

Looking at spreads, our investment spreads remained very healthy in the second quarter, as I mentioned a minute ago invested $866.5 million at a 7 cap rate. We financed basically almost all of that recently with the 10 year unsecured bond offering that Paul talked about with a 4, 6, 5 coupon, so a spread of little over 230 basis points which is excellent and that’s pretty much everything that we’ve done year-to-date.

And as we frequently discuss, when we talk about spreads historically, we’ve looked at our spreads first relative to a nominal cost of equity which is taking a forward FFO yield dividing it by the price of the stock and then grossing it up for issuance cost. And if you look back over the last 20 years that spread over a nominal cost of equity is averaged about a 112 basis points and I had mentioned that during the last 20 years the vast majority of the time we were acquiring properties leased to less than investment grade tenants.

And if you look today with well over half of the acquisitions little over 60% going to investment grade tenants cap rates for the first six months were at 7% and that nets you about a 130 basis point spread to the nominal cost of capital if you calculated it where we are today. And that’s a good 20 basis points over the 20 year historical average. So in a little a bit, but still quite healthy and then relative to what we did in the quarters obviously spreads are higher using debt issuance.

So I think we still like the spreads relative to what we’ve achieved historically out there when most of our acquisitions were less than investment grade and today the majority are investment grade and obviously on the spread fund caps – cap rates ticking up a bit is helpful. Relative to the volume and what we’re looking at going forward, we feel it is still a very robust market with a lot of product to look at, we’d be very surprised to see the volume of opportunities in the third and fourth quarters that we saw in the second quarter, the $15 billion again was pretty exceptional.

But going forward there is still very active flow and we expect our activity there to remain pretty robust remainder of the year, but likely as always continue to be lumpy, but we’re very optimistic we’ll have a banner year. You noticed in the release, we moved the estimate as I mentioned to $1.25 billion we’re highly confident on that and then we’ll see if we can make some additional progress for the remainder of the year, very positive on acquisitions.

Let me just get back to the portfolio for a second and all this acquisition activity obviously has had a big impact on the financials, revenue earnings and dividend which is apparent the number is here. But it’s also had a material impact on the makeup of our portfolio and where we’re trying to move it up to credit curve and we continue to make good progress on that. The percentage of our revenue during the quarter that is generated by investment grade tenants was up to 38.2% for the quarter that’s up 240 basis points over the first quarter and I just to update a few numbers here that I went through in the first quarter and I think it’s helpful to do. Over the last 36 months or so we’ve acquired about $6.6 billion in property about $4.5 billion of that is in retail which is traditional for us and sectors that we think will continue to perform well if we get a tough retail environment goes on. And then $2.1 billion we’ve acquired in areas outside of retail almost all investment grade that we think will do well for us. Out of that $6.6 billion, $4.1 billion or 62% has been with investment grade tenants and a good part; I think of the balance of the acquisitions will amount our investment grades certainly are further up the credit curve than we had averaged in the portfolio just a few years ago.

Some other interesting numbers and I’ll track this back over the last five years from 2008, as I mentioned earlier in 2008 the top 15 tenants did 54.3% of our business, if you look at their average DAR score and as a lot of you know that’s the credit score internally we use that approximates the credit score somewhere to what the rating agencies do. The DAR score on average for the top 15 tenants was a 6.92 which equates to about a BB minus credit rating and in 2008 none of the top 15 tenants had investment grade ratings.

Today the top 15 do 43.5% of the revenue that average DAR score is now 11.78 which approximates to about a really BBB that closer to a BBB plus credit rating that’s up substantially and eight of the top 15 tenants now carry investment grade ratings. So if you look at really in the last for the top 15, 4.5 years percentage of revenue from 54% to 43%, the DAR score from 6.92 to 11.78 and then from zero to eight of the top 15 tenants with investment grade ratings, and so pretty pleased with – with those trends.

At a couple of the industry meetings lately and I’ve alluded to this on the call there is another way to look at the adjustments, I’ll spend a minute on and if you go back two years ago from right now in July of 2011 we went back and re-underwrote our largest tenants, we did that for 67 tenants that produced 83% of our revenue and really did that using 19 different metrics to try and assess the risks that they might represent to our revenue stream in a rising interest rate environment or a weak economy and it included rankings on each industry based on that industry and how it operates just margins and the consumer that really they serve, an analysis of concentrations, balance sheet and income statement analysis and then a pretty heavy sensitivity analysis where we stress tested them moving their revenue and their margins and then their sensitivity to interest rates on refinance and their balance sheets.

And based on that if you took the portfolio at least the 67 tenants that did 83% of our revenues, we broke them up into four categories and I’ll do and one is green, which is strong buy, one is yellow which is buy, red which hold, black what you sell. And back in 2011 tenants representing about 22.8% of our revenue were in the green strong buy category, 21.4% in the yellow or buy category, about 15.9% in that red or hold category and then 22.9% in the black or sell. And again they represented about 83% of our revenue. Pretty much two years here exactly we just recently updated that and given the pretty robust acquisition and disposition activity, we now do that each quarter and it represents a 121 tenants that do 88.1% of our revenue, but if you look at the breakdown today the green or strong buy category tenants in that category have moved from 22.8% of our revenue in 2011 to today over 45.1%. In the yellow and buy its gone from 21.4% to down a bit 18.4% in the red from 15.9% to 15.8%, but most importantly in the black or sell category which was 22.9% of our revenue in 2011, it is now 8.8% of the revenue.

So substantial and I think material progress in moving the portfolio to some degree would dispositions obviously to a lesser extent, but certainly with all the acquisitions we’ve done it had a pretty material impact. Let’s move to the capital side for a minute, you know I mentioned that we’ve bought about $6.6 billion over the last three years, I think how that’s been capitalized is important, I’ll run through the numbers. We’ve issued about $1.8 billion of long-term notes or bonds at very good rates. We’ve assumed on some larger transactions about $793 million in mortgage debt.

We also generated about a $178 million from property sales and then $409 million in perpetual preferred offerings, but most importantly in the last three years we’d issued equity six times during the period equivalent to about $3.7 billion. So that’s about $6.8 billion in capital total, over $4 billion of it was common and preferred and of the remaining none of the capital is variable rate most all of it long-term and I think that puts us in pretty good shape relative to if we see a further rising interest rate environment and as those of you who were on the calls know preparing for a rising rate has been a theme for us on the calls in the last three years relative to capital issuance and trying to grow up the curve. And I think we’ve been able to do this while moving the needle pretty well on FFO and dividends.

Let me finish off with just a few relative access to capital now as Paul mentioned we’re in good shape, plenty of dry powder and no balance on the line and even with the tenure moving up we have accessed to capital at good rates and more importantly good spreads on the acquisitions.

Earnings for the quarter as Paul mentioned, we’re very strong so let me just move on to guidance. We made the adjustments a couple of weeks ago to a $1 billion and then as I have said a couple of times up to a $1.25 billion, however on earnings guidance we did not change I mean, we did a couple of weeks ago and that is now 237 to 243 on normalized FFO and at 17% to 20% growth and on AFFO 235 to 241 or 14% to 17% growth. And even though we think acquisitions will now be larger than expect as we left the guidance where we took it a couple of weeks ago.

I noticed in some of the research notes this morning there were some question on that. So let me – take a moment and kind of go through the thoughts there. we just up the guidance a couple of weeks ago by a nickel on both FFO, AFFO and it was really just some transactions coming together in the last couple of days that really made this confident to move the acquisition’s guidance too $1.25 billion and that again causes us to be very confident on current guidance.

But I think there is some – variables or levers in the business I’d like to maintain some optionality on for now rather than moving guidance up further. One is the timing of the closings, and how that’s going to impact numbers, obviously sooner creates a little more FFO on the 2013 numbers than later and as we get here later in the years the acquisitions have less impact. And then next trying to discern what if any volume there is going to be above and beyond that. And I think that will lay itself out over the next couple of months or so.

Next is – what are permanent capital costs, given the volatility lately we liked to hedge that a bit and so we’ve done that. And then I think also one of the levers we’d like to keep is whether or not we expand the disposition level a bit over the $100 million to $125 million level and we may do that. And then finally I think it comes down to trying to assess what type of capital we would use next, do we use equity or something else and those would have different impacts on the numbers, different share count. And – and then really it’s just you know trying to maintain some optionality primarily on capital and dispositions. So we will revisit it down the road we don’t want to get too far ahead on the numbers at least for right now, but obviously the growth numbers and the guidance having recently up to the very positive.

Finally I’ll end with our for our shareholders who were primarily – who’s primary focus is dividends which as you know is a great deal of them, Paul mentioned dividends paid were up 24.5% quarter-over-quarter, we’ve increased to three times this year and we remain optimistic that our activities will support continued increases in the dividend.

Want to thank you for your patience with an active quarter. And Sheryl, if you’ll come back we’ll now open it up for questions.

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session (Operator Instructions) And our first question comes from the line of Juan Sanabria with Bank of America Merrill Lynch. Please go ahead.

Juan Sanabria – Bank of America Merrill Lynch

Hi, good afternoon. I just had a quick question with regards to your capacity from a balance sheet perspective. How much could you debt fund out for you’d be a bit uncomfortable with your leverage ratio? And I guess the second question what I’ve got the floor is just what are your views on acquiring assets with lease terms below 10 years what sort of cap rate spreads, which you have to see relative to your traditional focal point?

Tom Lewis

Well from an overall leverage standpoint Juan, we historically have run kind of in the – I’ll give a broad range for a second, 20% to 35% leverage range, 5% to 15% preferred, when I referred to 35% debt and 15% preferred I’m referring to maximum that we’re comfortable with relative to that. So today debts around 30%, preferreds around 5%, we obviously do have capacity in both buckets and certainly stayed in concert with issuing equity as well. We would continue to have capacity in those buckets, but we view maximum levels of kind of a 35% debt, 15% preferred.

And actually preferred that they be more in the 25% debt level and in the 5% to 10% preferred level. So we have an all phrase we use internally which is go equity first so to the extent that common equity is well priced and accretive that’s something we would – always keep our eye on as something we’d be more likely to take a look at before we looked at the fixed income side.

Paul Meurer

On the second question Juan, relative to shorter leases it has been very, very, very rare for us to go much inside 10 years the only time I can remember is when we bought a large portfolio on just a couple of three, four, five of the properties would be inside of that. We’re really trying to go longer up in the 14, 15, 16, 18, 20 to keep the lease duration on the portfolio long, and allow the revenue to be very stable. When you’re in the net lease market and you’re out there selling properties if you’re lease linked is 10 years or longer generally the cap rate will command, we’ll be much, much better than when it moves inside 10 years and as you get shorter down in the 6,5, 4 cap rates rise pretty dramatically. And that’s generally a function of released risk that is hard to tell on a lot of net lease assets.

And when you’re out buying shorter-term leases generally those aren’t generated in a direct transaction with a retailer or a large corporate tenant generally you’re buying those out from another owner in the open market. And if you didn’t underwrite them to yourselves you may not have cash flow coverages or the profitability, the individual stores that you’re buying and that’s makes it difficult to assess the risk of whether the tenant will re-lease certainly in the case of retail, and you want to make sure you have that and if you didn’t have it then the cap rates going to rise because of the uncertainty relative to rollover.

So you’d really have to be assessing what you paid per square foot and what the rent is per square foot, and what you think the market would be, but generally those command much higher cap rates and it’s very rare our strong, strong prejudice is not to go into that game. We’ve looked at that business may be 15 times over the last 20 years but really found it difficult to underwrite. So generally we’re looking up in the 12, 13, 15 to 20 year lease when we’re – acquiring properties.

Juan Sanabria – Bank of America Merrill Lynch

Thank you very much.

Operator

Thank you. Our next question comes from the line of R.J. Milligan with Raymond James & Associates. Please go ahead.

R.J. Milligan – Raymond James & Associates

Hey guys, good afternoon and good evening.

Unidentified Company Speaker

Hey R.J.

R.J. Milligan – Raymond James & Associates

Just curious Tom, what – the volume – the $15 billion in the second quarter is that – was that a reaction to the tenure moving or was there something else driving that surge in volume?

Tom Lewis

Yes. And that was really pre the temper tantrum as somebody said at the other day, and the movement in the tenure because most of that that hit the market came in middle earlier the quarter and also came of course was structured before that in the decision to bring it to the market generally is a few months before that. And it’s a couple of things going on one is, is just there has been a growing knowledge of net lease sale and leaseback and I think that’s a function of a lot of the talk in the fourth quarter and the first quarter with bankers out calling on really Fortune 500 and – every tenant they have or every company they have about using the real estate take it up balance sheet.

So just a wider knowledge of using sales and leaseback is part of the capital structure by corporations. I think also there is just been a lot of potential M&A transactions a number of those had been noted in the press and, those came to market and I think it was also representative the companies are figuring out the rates are pretty good, and it might be a good time to do it if you’re going to couple with some of the private REITs or fund business that is really the part of the cycle where they need to come to market and the confluence evolve so one time led to a lot coming on the market very quickly. A lot of that will get done, got done some of it won’t and then when the tenure moved you saw the – saw cap rates move a bit. But it was just a heavy quarter and it was all of those things coming together and I don’t think we’re going to see that this quarter and next quarter but the volume still remains very elevated over where it was a couple of years ago.

R.J. Milligan – Raymond James & Associates

So, it’s slowed since the middle of May or…

Tom Lewis

Yes, I mean $15 billion is a ridiculous number. But if you go back again two, three years ago I think $5 billion a year was the number and it’s certainly running way the heck ahead of that. It’s still very strong. We saw $5 billion in the first quarter and assume you want to hazard a guess so what you think we’ll see in the third and fourth…

R.J. Milligan – Raymond James & Associates

Subset of the $5 billion for the remainder of the year.

Tom Lewis

Yeah, okay.

R.J. Milligan – Raymond James & Associates

Okay. Thanks.

Operator

Thank you. Our next question comes from the line of Jonathan Pong with Robert W. Baird. Please go ahead.

Jonathan Pong – Robert W. Baird

Hey, good afternoon guys.

Tom Lewis

Hey, Jonathan.

Jonathan Pong – Robert W. Baird

(inaudible) thoughts as you look at the potential large portfolio deals you have done on the publicly traded side and the non-traded side that might need a liquidity event over the next year or so. What says your appetite right now for those kinds of deals and all of equal and tenant quality lease duration, which says that the yields probably need to see between the portfolio deal and one-off deals that would make you more constructive in pursuing those?

Tom Lewis

Yes it’s really interesting – that’s an interesting question. Let me comment it a few ways. I said in last quarter’s call something very strange in the business right now is because of the additional institutional buyers. Traditionally, if you had a large portfolio transaction the cap rate on that would be higher than a one-off really rewarding the person for putting out a lot of capital in one fell swoop and starting about a year ago that all reversed as you had a number of institutional buyers, who were trying to put capital out and had raised funds and had difficulty putting it out and a one-off transaction would move the needlework for them.

So, it’s only time in and then came in at $75 million or $100 million, $200 million, $300 million all of a sudden there were a lot of people looking at it and so cap rates really inverted where those were going trading inside a one-off of the same tenant. So, that’s unusual as long as I’ve been in the business but I think still where we are.

And so if I – I said earlier that investment grade cap rates worth 6 in a quarter and 7 a quarter rate, I think a large transaction would fit in bidding that and same thing in a less than investment grade. And relative to us looking at them we’d love to do it. We’re more than happy to do it but one of the terms brought up here recently is given all the volume that came to market the odds were good but the goods were also odd.

So, when you start looking at the quality of portfolio we’re trying to move more investment grade and there was a number of the things that came to market that were not and some that didn’t had a makeup in the portfolio. They didn’t fit some other characteristics rather the industry, who want to be in. And so, we’re really going to limit what we do on those unless the vast majority of the properties I said earlier kind of fit. But with that said we’re open to it. There is some floating out there and we’ll have to watch where they are.

Jonathan Pong – Robert W. Baird

I guess if I look further out into that pipeline that M&A pipeline are you thinking of deals that might come to market that you are sort of holding off or are you sort of taking a more short-term view?

Tom Lewis

Yeah no I mean we’re just taking them as we come. As I said, we’re really happy Sumit Roy, who is running acquisitions and John Case our Chief Investment Officer kind of took our acquisition group and split them up into different areas earlier in the year. And we’re very happy with kind of the granular one-offs that we’re able to bring in much more than in the past.

And that’s really led from the reliance I think for us on larger transactions but we’re pretty happy with the volumes coming in. So, we don’t feel compelled to go out and grab them. But we’re more trying to watch what’s really steaming up out there and what would fit. And then when those come wanting to make sure that we pursue them fairly aggressively and on the other ones not a high level of interest if it doesn’t fit, where we’re trying to take the portfolio.

Jonathan Pong – Robert W. Baird

Got it. That’s helpful. Thanks a lot.

Operator

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

Todd Stender – Wells Fargo

Hi, Tom since it’s a big number in Q2 that $15 billion that came in is that absolutely everything that’s being marketed or is that has been screened through you guys and then from there you break it down to see if it fits your long-term lease profile?

Tom Lewis

Yeah I’m sure that there were sort of things that we didn’t see particularly smaller but those are all of the things that came in the door that would reasonably be assumed that they would fit into categories that we would buy. And then we started screening and from there what happens is the acquisition group and they all have financial backgrounds do the initial screening, understanding our objectives.

And they can start throwing things out pretty quick with just a day or two looking at them and trying to be more selective with what we then released and it goes over to research, the financial analysis are done and we get deep into it and then goes to the investment committee from there. So, that is the all-in kind of number of everything we see that is net lease that Realty Income would look at the category, look at the type of tenant that comes in the door.

Todd Stender – Wells Fargo

And is it reasonable to assume that that could be a long runway for you guys its stuff you are looking at in Q2 could still be closing in Q4 and Q1 of next year should this really provide a pretty visible runway for acquisitions?

Tom Lewis

Sumit, why don’t you take that?

Sumit Roy

Sure. Most of the $15 billion that we referenced we’ve decided to pass on. Some of them we’ve already found out who the eventual buyer is. Some of it is still going through the process and I’m sure the eventual buyer will emerge over the next couple of quarters. But none of those $15 billion that we’ve referenced are portfolios that we’ve decided to pursue outside of the ones that we’ve either pursued or is in the pipeline to close and that’s a very, very small percentage less than 5%.

Tom Lewis

Yes. And the comfort level for the $1.25 billion is really taking those and the ones that we pursued and we are going to get and kind of looking at the timing and closing and that’s how we kind of jump from the $866 to $1.25. And there is a few exceptions but then you really want to start thinking that anything additional will come from what we’re looking at right now not what we look at last quarter.

Todd Stender – Wells Fargo

And that’s helpful. And then Tom, you referenced the cap rate movement up about 25 basis points in the last six weeks. Is it fair to say that that was more on the low investment grade and that investment grade cap rates a little more sticky.

Tom Lewis

No, actually we believe they both moved. We’ve seen a lot of volume in it and that was the major point of our discussion a few days ago sitting there just parsing everything coming in the door. So, we’ve seen it across the board.

Todd Stender – Wells Fargo

Okay. And then Paul you get pretty good color on how you are dealing the preferreds and it sounds like the preferreds at the bottom half of your range or what should expect maybe 5% to 10%. Can you just kind of go under what the current market pricing is for preferreds and tenant of your philosophy of convertible preferred would be considered?

Paul Meurer

The, as you know the preferred pricing widened over the last 45 days or so with the moving interest rates may be even more so than bonds. It kind of made a big jump and it’s taken a while for that to settle down. Current pricing for us would be in the 6.5% range call it from a coupon perspective. We suspect that will continue to tighten as things settle a bit in that preferred market and there is some demand on the horizon in that market but not at a level that it makes sense so for example to issue and takeout our existing preferred or that sort of thing but it is a bucket that we have capacity for and its reasonably priced and of course has a great maturity date if you will. So, it matches up well in our balance sheet for long-term assets and not matching with long-term liabilities.

Convertible preferred is something we are open minded about. I think it would need to be done in concert with a larger strategic entity level type situation, where an equity element would be something to be considered. But as a normal ongoing corporate finance product in the balance sheet it’s not really how we choose to match fund our assets and not how we chose demand into the equity side of the balance sheet but it’s something we listen to. We’re open minded about and are knowledgeable about and we’d, never say never but it’s not something we look to in the near term or as a regular course of financing.

Todd Stender – Wells Fargo

Okay. Thank you.

Operator

Thank you. This concludes the Q&A portion of Realty Income’s conference call. I’ll now turn the call over to Tom Lewis for concluding remarks.

Tom Lewis

Great. Well again thank you everybody for your patience. It was a very active quarter and we really appreciate you taking the time with us and with Sheryl I want to thank you for your help there and this will conclude my part of the call.

Operator

Ladies and gentlemen, this concludes the Realty Income second quarter 2013 earnings conference call. If you would like to listen to a replay of today’s conference please dial 303-590-3030 or 1800-406-7325 with the access code 4628874. We thank you for your participation. And at this time, you may now disconnect.

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