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Executives

Tom Lewis – Vice Chairman and CEO

Paul Meurer – EVP, CFO and treasurer

Analysts

Jeff Donnelly – Wells Fargo

Anthony Paolone – JPMorgan

Greg Schweitzer – Citigroup

David Fick – Stifel Nicolaus

R.J. Milligan – Raymond James

Todd Lukasik – Morningstar

Rich Moore – RBC Capital Markets

Chris Lucas – Robert W. Baird

Realty Income Corporation (O) Q3 2009 Earnings Call Transcript October 29, 2009 4:30 PM ET

Operator

Welcome to the Realty Income's third quarter 2009 earnings conference call. (Operator instructions)

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

Tom Lewis

Thank you very much, Jeremy. Good afternoon, everybody and welcome to the conference call. And as was said, we'll try and run through the third quarter results. And with me in the room today is Paul Meurer, our Executive Vice President and Chief Financial Officer; Mike Pfeiffer, our Executive Vice President and General Counsel; and as always, Tere Miller, our Vice President, Corporate Communications.

And as I’m obligated to do, I will say that during this conference call, we will make certain statements that may be considered to be forward-looking statements under federal securities law. The company's actual future results may differ significantly from the matters discussed in any forward-looking statements and we will disclose in greater deal on the company's quarterly and Form 10-Q the factors that may cause such differences.

And we’ll have Paul start out and begin with the overview of the numbers. Paul?

Paul Meurer

Thanks, Tom. As usual, let me comment on the financial statements; just provide a few highlights of our financial results for the quarter, starting with the income statement.

Total revenue remained flat at around $82 million and this is primarily because we’ve sold 24 properties over the past year and have acquired only three additional new properties. We owned 2,355 properties at September 30th of last year while we own only 2,334 properties today.

Same-store rental revenue increased 0.4% for the quarterly and year-to-date periods. On the expense side, depreciation and amortization expense increased by $176,000 from the comparative quarterly period. Interest expense decreased for the quarter to $21.4 million. This reduction reflects of course the retirement of $120 million of our bonds over the past year. We continue to have zero borrowings on our credit facility. And on a related note, our coverage ratios remain strong with interest coverage at 3.5 times and fixed charge coverage at 2.7 times.

General and administrative or G&A expenses in the third quarter decreased by $191,000 and we continue to expect G&A expenses in 2009 to remain flat or lower as compared to 2008 at only about 6.5% of total revenue. Property expenses decreased by $102,000 to about $1.6 million for the quarter as these expenses have continually decreased each quarter since the beginning of the year. These expenses are primarily associated with the taxes, maintenance, and insurance expenses, which we are responsible for properties available for lease.

Our current estimate for property expenses for all of 2009 is about $7.4 million and our estimate for 2010 however is significantly lower at approximately $6 million or back really to 2008 levels.

Income taxes consist of income taxes paid to various states by the company. These taxes totaled $74,000 for the quarterly period. Income from discontinued operations for the quarter totaled $2.1 million. Real estate acquired for resale, refers to the operations of Crest Net Lease, our subsidiary that acquires and resells properties. However, Crest did not acquire or sell any properties in the quarter. Overall, Crest contributed to income or FFO of $207,000 in the quarter.

Real estate held for investment refers to property sales by Realty Income from our existing core portfolio. We sold seven properties during the third quarter, resulting overall in income of approximately $1.9 million. However, these property sales gains are not included in our funds from operations.

Preferred stock cash dividends remained at $6.1 million for the quarter. Net income available to common stockholders was $27.1 million for the quarter. Funds from operations or FFO was approximately $48.2 million for the quarter. FFO per share was $0.47, an increase of 2.2% in the comparative quarterly period.

When we file our 10-Q, we will again provide information you need to compute our adjusted funds from operations or AFFO, or the actual cash we have available for distribution as dividends. Our AFFO, or the actual cash available we generate, which is available to pay out as dividend, as usual, is higher this quarter than our FFO. This is typical because as I’ve always said, our capital expenditures are very low and we have very minimal straight line rent in our portfolio.

We increased our cash monthly dividend again this quarter. We have increased the dividend 48 consecutive quarters and 55 times overall since we went public 15 years ago. Our dividend payout ratio for the quarter was 90.9% of our FFO and even lower on an AFFO basis.

And now, let's turn to the balance sheet briefly. We have continued to maintain a very conservative and safe capital structure. Our debt-to-total market capitalization today is about 30% and our preferred stock outstanding represents just 8% of our capital structure. And of course, all of these liabilities are fixed rate obligations.

We continue to have zero borrowings on our $355 million credit facility. And this facility also has a $100 million accordion expansion feature. The initial term runs until May 2011, plus two one-year expansion options thereafter. We had $20 million of cash on hand at the end of the quarter and our next debt maturity isn't until 2013.

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

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

Tom Lewis

Thanks, Paul. Why don’t I start with the portfolio and just generally say that the portfolio is doing very well given the state of retail today. I think our tenants have generally seen their business stabilize over the last couple of quarters and so far here in the fourth quarter that remains the case and we talk to them, there seems to be a bit more positive tone about where they are today and I think for them, it’s really the comment of the new normal and flats to new up and since they haven't seen declines and they’ve had a little more positive vent in their business, they seem to be a lot more positive. But I don't want to get carried away relative to what they are saying. I think they are just more relieved than anything else.

We worked with a few of them over the last 18 months or so to get through issues that have hit some of them during the recession. Fortunately, we missed most of the failures that have occurred out there in retail and in the cases where we had properties with retailers that did have problems, we generally have owned them more profitable properties, which means that we were impacted much less than others might have been or some might have expected.

And I’m also really happy to say that as we sit here in the fourth quarter, none of that is going on in the portfolio as of right now. All the tenants today are current with their rent; we have no discussions going on at all with any of the tenants about problems paying their rent or a desire for rent reductions. There is nobody in Chapter 11 that we are talking to about problems with their properties and it is unusually quiet in the portfolio and clearly a more positive environment relative to their operations and what’s going on in their business as it impacts us for maybe over the last 18 months, which has been very nice to see.

We often talk about owning the more profitable properties in our portfolio and that really focuses around looking down at the store-level cash flows and having a good idea of how profitable our properties are to the retailers, which is really the key as to how we perform in the long term, and our largest 15 tenants use those as an example as we frequently do to about 52.9% of our revenues.

And at the end of the third quarter, the average cash flow covered in those 15 largest tenants was just under 2.5 times or about $2.50 in cash flow that they produced off the stores on average that we own with them for every dollar they pay in rent and I think really that those coverage is why the portfolio has done pretty well over the last 18 months are so and really, over the long term for the company.

We ended the third quarter with 96.8% occupancy in 75 properties available for lease. That’s out of 2,334 properties. It’s up about 20 basis points from last quarter to 96.8% and just around where we were pretty much in the portfolio a year ago, which I think is positive.

Our same-store rents continue to increase, up about 0.4% and that includes the reductions that we did a year ago with Buffets as they went through their Chapter 11. Absent that, it would have been a little higher. Our census right now looking into our crystal ball for the fourth quarter that we should see same-store rent growth being positive in that quarter and for the coming quarters, albeit at a modest rate, really as we have seen over the last year and I think you’d expect in this type of environment.

To give you an idea where same-store increases came from, of the 30 retail industries we have in the portfolio, seven had declining same-store rents. Restaurants were most of it, primarily coming from the Buffet’s renegotiation. Two of the industries had flat same-store rents and then 21 of the industries in the portfolio had rent increases with the majority coming from convenience stores, tire stores, child care, and then health and fitness were the largest contributors.

And I think the general theme we see in our portfolio and we continue to hear from the retailers is that kind of basic goods and services that people buy on a regular basis at low price points seem to be certainly outperforming the results over those people that have more discretionary and durable goods type businesses and that seems to be a good part of our portfolio in the low price point.

Relative to diversification in the portfolio, we continue to have good diversification. Out of the 2,334 properties, they represent 30 different industries and 118 different chains and in 49 states. The industry exposures were pretty balanced, the largest industry is still restaurants, which is at 21.2%. That’s down a bit from the end of the year and we’ll continue to work that number down. If you break that out, about 12% of that is in family restaurants or what a lot of people call “casual dining.” About half of that is Buffets. About 1% is in dinner houses and in the other 8% is in fast food, which seems to be over-performing the rest of the restaurant industry.

Convenience stores are at 17%. They’ve done up a bit due to pretty much across-the-board rent increases this year that we’ve seen from them. Theaters at 9.2% and then child care, which was – has been in our portfolio an awfully long time, is down to 7.6%.

From a tenant standpoint, the largest tenant in the portfolio is just over 6%. The next one is 5% and it goes down pretty quickly from there. If you take our top 15 tenants, again, it’s about 52.9% of revenues. When you get to the 15th largest tenant, you are talking about 2% of rent and everybody else in the portfolio is below 2%. So I think pretty well diversified out there, which has been helpful.

Average remaining lease terms, about 11.3 years. That's nice to have in this environment. And so as we look at the portfolio, given the tone from the tenants, really not anything going on in the portfolio today and occupancy helping and same-store rents up, we feel pretty good about where we sit with the – here in the fourth quarter. And I think kind of looking forward to the end of this quarter, we really think that we’ll see continued high occupancy and modest same-store rent growth.

Kind of the other major thing to talk about today is property acquisitions and after 20 plus months of not buying property and waiting to see if prices would adjust and cap rates get a little better, we have started acquiring again pretty much on a modest basis. You saw in the release during the third quarter, we bought three properties for just short of $11 million at just over 10% cap rate. That transaction was one where a tenant had some immediate cash needs and we were able to go in and help them solve their problem at a pretty good rate of return and was really us getting started again in acquisitions.

And it’s kind of interesting. We continue to look at additional transactions. I think we’ll buy some properties here in the fourth quarter and there are a number of transactions in the marketplace that we are looking at today. But if you look at overall volume, I’d have to say it’s certainly modest compared to a few years ago and of the transactions that you do see out there now, I think a number of them still are some people coming to market with some immediate financing needs that might not meet the quality of some of the portfolio acquisitions we would want to make. However, we are starting to see some people tiptoe back into the market with some larger transactions and I’d really say buy size is kind of in the $10 million to $15 million range is what we are seeing out there.

Cap rates seem to have stabilized in these portfolio transactions kind of in the 9% to 10% cap rate range and that’s how they are coming out and depending on what they are of the size, the immediacy of need, we’ll kind of tell you whether they are trying to play closer to the 9% side or to the 10% side of that.

So while I do see transactions moving up a bit, I think it’s still is pretty modest. I don't think there is a rush of sellers. However, there are not a lot of buyers out there either. So from a competitive standpoint, I think we are in decent shape to compete on the transactions.

Relative to themes along industry lines, there doesn't seem to be a lot there. I think we could – anybody could buy a lot of restaurants today. That’s not in our target, given concentration levels. And outside of that, most of what we see is, I think, balance sheet generated as you have folks that are looking – needing to do some financing in the months coming up, that are starting to come out on to the market. And as that continues and you see kind of general balance sheet re-financings needed to be done over the next year or so, we think that will probably accelerate the number of transactions that we see out there in the market, but still pretty modest to date.

Moving on to dividends, as always, that’s priority for us and I’d anticipate that the cash dividend would be higher this year than last year and higher next year than this year and that is why we are here and what the shareholders look for. Paul commented on the balance sheet. We did spend about $10 million in cash during the quarter on those acquisitions. We have $20 million in cash sitting there today, continue to have no balance on the $355 million line and with no debt due or mortgages or development JVs, obviously very liquid and able to act should we see something attractive coming up.

Let me move on to guidance. For 2009, we tweak the estimates to the $1.83, $1.84 and that’s flat to about 0.5% FFO growth and as we pretty much said over the last year, our estimate range on the low side was from zero acquisitions and then kind of up to $125 million a quarter and since we bought very little this year and quite frankly, since I think anything we might buy in the fourth quarter is likely to close fairly late in the quarter, the impact to incremental acquisitions this year would be very small and so we think the $1.83 to $1.84 is probably a good level given the stability that we are seeing in the portfolio right now.

Also, it’s pretty interesting to look at the company right now and it’s one of those moments in time where you say kind of we really haven't bought property over the last 20 months or so. Our Crest Net Lease subsidiary has been essentially shut down. There has really not been any cost cutting going on in the company and pretty much what you are seeing in the company’s operation is our core operations on the portfolio and what is pretty deep into a tougher recession and I think things have held up pretty well. So it’s a good time to observe the portfolio before we go out and start buying again, which then mixes up the numbers a bit.

We are also initiating our 2010 estimates in there at $1.86 to $1.92 or 1% to 5% FFO growth and I think that assumes pretty good continued stability in the portfolio, which is what we are seeing at the end of the year now and then also consistent with acquisitions on the low side being very modest next year, maybe zero. And then on the higher side, $250 million to get to those numbers. I would say, however, unlike the beginning of last year when we were out of the acquisitions market, I’d certainly think we would be more acquisitive in 2010 than we were in 2009.

The $250 million is not a target. It just was a range from which we could generate some guidance numbers and as we get further into 2010, we will see if we are below the $250 million or above the $250 million and really what happens then.

To kind of summarize operations, we are real pleased with the stability of the portfolio and occupancy and same-store rent growth. Our balance sheet is in good condition and then basically, a good quarter and a quiet portfolio and if we can start seeing over the next couple of quarters from acquisition opportunities, that will allow us to accelerate the business a little bit.

And with that, I think we’ll go ahead and open it up to questions.

Question-and-Answer Session

Operator

Thank you, sir. Our first question comes from the line of Jeff Donnelly with Wells Fargo. Please go ahead.

Jeff Donnelly – Wells Fargo

Good afternoon, guys.

Tom Lewis

Hey, Jeff.

Jeff Donnelly – Wells Fargo

Tommy, you talked about it a little bit in your comments, I guess, and I had asked you last quarter, I think where you thought we were in the cycle of store closures and bankruptcies and I guess I’m curious, have you changed at all I guess in the last 90 days, you’ve become more encouraged?

Tom Lewis

Well, I like the idea that we are not dealing with any of them today, which we have been dealing with over the last 18 months. But I think like everybody in the industry today, you spend your time kind of doing scenario planning and our “you and me” camp of – was the flattening out going to be a V or a W and my answer is I really don't know. It wouldn't surprise me to see some continued bankruptcies over the next year or so, absent things really picking up.

As we look out there, you see just a little tweak on the durable goods side, getting a tiny bit better, but not much at all and generality, I think people just quit declining and up a little bit. So I don't – I really – I'm not so sure that we are in a stage where, “Gee, it’s recovery from here.” I just think things quit getting worse and some of the retailers that were going to have problems have them.

Jeff Donnelly – Wells Fargo

Is there anything you can share with us I guess on the market for DIP financing because anecdotally we continue to hear that has been challenging for retailers to obtain that sort of financing and that’s been holding off restructuring? If you think that is truth said, do you have any, I guess, impact there?

Paul Meurer

I think dip financing is certainly more easier to get than it was earlier in the year. We were involved in a couple of Chapter 11s where we sat on the committee and chaired committee. And if you go back to January and February, it was a period where I think in everyone you looked at, the company had to work very hard to go out and get their dip financing and if you look today into the ones we hear about, people are able to get a little lease here and it’s opened up a bit.

Jeff Donnelly – Wells Fargo

Just a – last question is, I’m just curious, you have a little over I think 11 years on remaining lease term on all your existing leases. I can’t recall, but has that fluctuated much over time and I guess I’m curious from a portfolio management standpoint. Do you take into consideration when – I guess, as you think about acquisitions and you manage your portfolio? So I would imagine shorter lease terms become more challenging to finance our buyers over time.

Tom Lewis

Yes. Generally, we are seller primarily of properties when we have a problem with them and tend not to be out selling a lot on a regular basis. So that didn’t impact us as much. We are very much at hold for long-term income production. But it’s – that numbers, if you look in the Annual Report you can kind of see it, it just kept kind of going up over the years as we continue to buy and about six, seven years ago we really started moving to a 20-year initial lease terms more than we did 15 and we were buying a lot. So that really expanded out.

The second thing that happened is as we started having lease rollovers you get like this year’s lease rollovers that have a month or two or three left and they weight that average and then as soon as you write a new lease, it’s three and usually five years, it goes back up again. Over the last 20 months when we haven't been buying, it’s kind of gone from 12 years down into the lower 11s and now it will be a mix depending on how much we are really buying.

But let me try and – absent kind of steady – if you put steady acquisitions not in, not absent, over the years as we get larger and acquisitions are steady and as the portfolio matures, I do think you see the lease terms getting shorter and you have more of the leases turning over each year, it’s more of an issue I think for eight, nine, 10 years down the road and the interesting thing is though you really have to bifurcate the lease rollovers because if it’s the first lease rollover after the end of a 15, 20-year lease, generally it’s a more challenging role than one that is rolling for the second time where they already had a foot on the property and the ones that they are getting now are more profitable.

So long and short, as we get out and buy again now, maybe it will move up again.

Jeff Donnelly – Wells Fargo

Okay, thank you.

Operator

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

Anthony Paolone – JPMorgan

Thanks. Good afternoon. My – Tom, I just want to understand. You had mentioned you had given the rent increases and decreases by industry. Was that just the revenues that those properties produced in the last quarter versus I guess the prior year or was that actually on leases signed in those industries? But I guess I just don't understand what that measure was.

Tom Lewis

Yes, that measure, same-store rent increase is just the same-store properties that were occupied and what the rents were this year versus last year. So if you look across the rent increases that we got were in the industries I mentioned and that’s just the same property, that’s not on new leases signed, that’s on the ones that are existing.

I think if you look at new leases signed, you are probably looking at lower – we sign new leases when we buy properties, both actually would be higher today, we haven't bought much. But in terms of looking the lease rollovers, that had some flows and generally has been a lease roll down to over the last couple of years when it picked back up again.

And we started the year kind of thinking rollovers were going to be a break-even. I think now we have a – we are thinking more to about a 4% rent roll down and as we get late in the year and we look at lease rollovers, I think we have 2.6% of leases rolling over here in the fourth quarter and that’s our sense on that and that’s what we put in the guidance.

Anthony Paolone – JPMorgan

Okay. Okay, got it. And that was – my next question was on the 2.6% rolling over in the fourth quarter. I mean, that’s about the level that you typically announce full year. Is that just a matter of mix and timing or how should we think about that?

Paul Meurer

Yes, that’s exactly what it is. It’s just mix and timing. There were some third quarter ones, but the people also had some fourth quarter rollovers and so they’ve just taken those sum of month to month for a short period of time, we would kind of do a global on it.

But if you look at it, there are 92 leases, 70 are second rolls and very profitable properties. So my sense is that those are going to go down pretty smoothly. And some of them went right after the end of September 30 and we are pretty far down the pike on them. So my sense is that you are not going to see a meaningful change in occupancy as a function of those rolls in the fourth quarter.

Anthony Paolone – JPMorgan

Okay. And then on your 2010 guidance, just a couple of items. One, do you assume much in the way of an occupancy change, either up or down, in the portfolio?

Tom Lewis

We –

Paul Meurer

About 1% down, just part of the assumption there.

Tom Lewis

And I’m not so sure we think –

Paul Meurer

We are not predicting that. But in terms of the projections, we were assuming say about 1% we have issues with.

Tom Lewis

And we’d be happy not to have it.

Anthony Paolone – JPMorgan

Got it. And any major change in G&A next year?

Paul Meurer

No, about the same. About 6.5% to 7% of revenues. We have a plug [ph] now of about $25 million and that – but it really depends on acquisitions. It will be lower if there is a lower acquisition volume number or it will be a full $25 million, maybe a little bit more if we had a lot of acquisitions because acquisition commissions are in that number.

Anthony Paolone – JPMorgan

Okay. And then just last question. Give us a sense as to maybe what portion of your leases have tenants where they are leveraged through maybe an LBO and might have upcoming debt maturities that you think about. Just like what portion of the portfolio that might be.

Tom Lewis

Yes, I think there is a fair amount of it that is represented that way. As you know, over the last 40 years, pretty much everybody we’ve worked with have been less than investment grade and I think you look out over the next two, three years, they like most people out there have some maturities that they are going to have to deal with and work on. So I think – I think it’s fairly widespread in the portfolio, which I think we’ve been fairly upfront about.

Anthony Paolone – JPMorgan

Okay. And I appreciate the extra disclosure on the tenancy. Thank you.

Tom Lewis

Our pleasure and thank you for those people’s input who gave it to us quite firmly and occasionally you need that and I appreciate it.

Operator

Our next question is from the line of Michael Bilerman with Citigroup. Please go ahead.

Greg Schweitzer – Citigroup

Hi guys. It’s Greg Schweitzer here.

Tom Lewis

Hey, Greg.

Greg Schweitzer – Citigroup

So I’m just talking about the acquisitions that you did this quarter. What type of industry were the assets that you acquired in?

Tom Lewis

Primarily health and fitness and obviously, there weren’t a lot. So that’s an area that we continue to be focused on we liked a lot.

Greg Schweitzer – Citigroup

And you said those were more to do with specific problems with those tenants.

Tom Lewis

Not a problem with the tenants, it’s just that they had some debt coming due and needed some money and I got them on the balance sheet and that was an opportunity that we could help them out very quickly. But I’m – I wouldn't put it as a problem they had. They just needed some capital.

Greg Schweitzer – Citigroup

Right. Could you provide a bit more detail into the sort of deals that you have seen for this quarter, the process on how you switched through them, if that changed a little?

Tom Lewis

Yes, I don't know that it’s really changed. I know that we are not focusing on restaurants at all. The only thing that’s really changed is we had a few more one-off property things come through that we’ll take a look at and that’s really a function of the vast majority of the buyers and tripling that leases over the last six, seven, eight years have been guys doing 10-31 exchange, buying one or two properties and they pretty much exited the marketplace in mass. I think primarily it’s a function of not having sold properties with gains anymore.

And so you see a few more one-offs and so that’s one difference. And then you tend not to see a lot of big M&A transactions. There are a few rumbling, but – so I think it’s rather than the $100 million to $200 million portfolio as you look at, more of them – most of them were more buy sized and I described kind of the $10 million to $50 million to $60 million size transactions and it’s really I think by the tenants as more of a financing that they are doing. It’s been a question from them, do they do access to the bond markets, do they have access to the bank markets. Certainly don’t have access to CMBS that they might have a few years ago. And so they are coming out and testing the waters there.

I would also say though that as you look is the debt markets have opened up and I think some of the people have been able to access the high-yield market more. I think most of them have had a little pressure taking off and maybe there hasn't the volume come to market that you thought there would be.

But outside of that, they look pretty much like what we were looking at a couple of years ago. The cap rate is different and then I think tenants are a little more open to us, discussing with them that the cash flow coverages need to be a little higher than maybe they were a couple of years ago.

If you probably took the average over the last three, four years, the coverages we were buying out was around 2.5 overall on a portfolio and then the spread was kind of 175 [ph] up to whatever, 3 or 4. And as you look today, it’s 2.5 plus and you are probably looking on the low side that if they have properties today that are below much of a 2 coverage, you are saying to them that you don't really want them and unlike a couple of years, the comment you get back is not, “Okay, I’ll sell them to someone else,” because there is not a lot of buyers.

Greg Schweitzer – Citigroup

Okay, great. And could you provide some more just general industry color, specifically on the auto and tire services, home improvement and health and fitness exposure?

Tom Lewis

Yes. I mean, if you – let me glance at the press release here and get back to those pages. Maybe we can go through them kind of one by one. You want to give me those industries again?

Greg Schweitzer – Citigroup

Auto and tire service.

Tom Lewis

Yes, auto and tire service, you see there is 6.8%. You noticed in our disclosure that we did mention TBC, which is a very large – Sumitomo is a very large seller of tires and they were a primary tenant there. And then we have a number of other chains. They are the only one that over – that approaches 2% and the rest of them below them and we have four, five tenants in there.

Their business generally has been perked initially by the recession because I think on a marginal basis they make their money when someone comes in and buys some rims or upgrades tires and what you found is people stepping back away from that and then trying to defer buying tires and now what you are seeing in the cycle is that the folks that didn’t go out and buy new cars and kept driving their car, now they are having to replace the tires and they tend to be doing okay. I wouldn't say it’s great, but okay. But I would also say we have pretty good coverages in those stores.

Greg Schweitzer – Citigroup

How about auto service, without the tires?

Tom Lewis

Yes. Auto service is kind of the same business for it. The loop business, which we have a little bit of, is probably a little more meaningfully impacted because they used to come in with a cheap loop and try and sell up and I think the customer is more resistant, but we really haven't heard any noise there out of the tenant. And then in the repair area, it’s kind of the same thing. People put off repairs early on, but we are getting deep into the recession and you don't buy new car, and they seem to be doing a little bit better there. But I wouldn't say that it’s doing great, they are doing okay.

Greg Schweitzer – Citigroup

And then the other two, home improvement and health and fitness?

Tom Lewis

Yes, home improvement for us is actually doing okay because that’s some hardware stores that we have and it tends not to be a lot of home improvement, it’s more kind of hardware, but we tucked them into that one and they’ve reported to us that their business isn’t bad and that’s kind of the majority of it in there.

And what was the last one? I’m sorry.

Greg Schweitzer – Citigroup

The gyms.

Tom Lewis

The gyms are doing fine. We have – our primary tenant there is L.A. Fitness and there are 300 – I think 49-unit chain that we’ve dealt with since they had 40 units and they’ve rolled out across United States. That industry is generally doing pretty good, but it’s bifurcated depending on the revenue structure of how these guys book their revenue and what they are selling and those that were the really fancy gyms with a lot of add-on services that were sold in products, I think have seen a softening while the overall membership has held up okay. But these guys are kind of bread and butter, which is basically working out and training. They have a really good store and a really good model and they’ve kept their profitability up very nicely.

Our other tenant in the industry has had some problems, but we were able four, five years ago to kind of cherry pick up six or seven of their very profitable properties. So we like that industry. The baby boomer seem to be migrating to it as they realize they are not going to live forever and generally, these guys have held up pretty good when we look at the numbers.

Greg Schweitzer – Citigroup

That’s helps a lot. Thank you.

Operator

Our next question comes from the line of David Fick with Stifel Nicolaus. Please go ahead.

David Fick – Stifel Nicolaus

Thank you. Good afternoon. I’d like to second the appreciation for the added disclosure. Tom, I’m wondering if you might care to comment on some of the public statements that have been made by some short investors in your stock. I know you’ve been getting calls from investors about that as well as the (inaudible) that occurred this quarter. Any response to the specific commentary that’s been out there regarding tenant quality and your business model?

Tom Lewis

Yes, I’ll kind of do a wandering response, maybe. I don't have anything specific. First of all, just relative to short positions, I got into the securities in the ‘70s and one of the things we understand about the public market is people who are always long, people who are short, you are going to have people with buy rating, sell ratings, and neutral and between that and buying, selling that’s kind of what makes up liquidity and valuation, which is great. And generally, we’ve been very well treated by the market and quite frankly, we continue to be so.

But I think overall, I kind of get the mathematics of the simple story, which is real estate plus retail plus less-than investment grade tenants plus recession might equal short or a problem. And I think there is a pretty good disconnect out there in the market and it’s not atypical for people that are fairly new to looking at the company about how we fare with our tenants that are less than investment grade, generally verse the unsecured debt and equity of those people and maybe a good way to talk about it, David, is just kind of talk about bankruptcy and kind of our history there. Is that kind of a good way to go?

David Fick – Stifel Nicolaus

Sure.

Tom Lewis

It’s kind of interesting; in 40 years we worked almost exclusively with less-than investment grade tenants. Occupancy has never been below 96% and if it’s 96.8% today and I think it’s interesting to note that tenants having problems, having bankruptcies has been a normal part of our business, pretty much as long as we’ve been in business. And I think we understand the process and what happens. And I also think that we understand that the misperception really lies in that the equity gets pretty hard when these guys go into bankruptcy. The debt gets substantially refigured and we tend to do pretty well and I’ll – first, I’ll just kind of give you the numbers.

Since we went public 15 years ago, we have had 22 of our tenants file for bankruptcy. Those 22 tenants represented 33% of our revenue, not all of them obviously went at the same time, but you take them in mass for those 22 and at the time they went, you add them all up, it’s a third of our revenue.

And they’ve – that represented 414 properties over that period of time. 322 of them or 78% were accepted in bankruptcy, which meant there was very little that happened to us on those properties and we kept leasing those and obviously got paid during the reorganization. 92 were rejected, which is 22% of the properties and if you take the 22 bankruptcies, in the year at – in the year after the end of the bankruptcy and we got paid rents during the bankruptcy, we recaptured 89% of the pre-bankruptcy rents.

So as the landlord – and in particular with the landlord with their profitable stores, we have tended to do better than one might have thought. And the interesting thing, you take those 15 years and those tenants and I think during that period of time are FFO went up about 80% and our dividends went up about 75%. And so we know how to process works, it’s the normal part of the business.

I think kind of the second question for the few people who’ve done some work on this is they didn’t say, “Okay, that’s great. But today is different, it’s a harder environment, we are in a recession, the consumers were soft.” And so, let me just kind of little additional disclosure, take the last 18 months and I’ll walk you through. In 2008 and 2009, which is pretty during the middle of the recession, we had six of our tenants in our portfolio that filed for bankruptcy. The six tenants over the last 18 months represented 12.6% of our revenue. This time, it was pretty much all at the same time that involved 208 properties. 172 of the properties were accepted, that’s 83%. 36 were rejected, that’s 17%. And if you look at the six bankruptcies, the recapture is about 83.3% of pre-filing rents in the year following.

So kind of six tenants, 12.6% of revenue and 83% recapture during the last 18 months and as I mentioned before, during the process we generally get administrative rents on the properties. So if you kind of look over the 15-year period, the recapture rate is about 89% and I think 78% of the properties were accepted. If you look over the last 18 months, which was six of these Chapter 11s, you've had 83% accepted, actually a little higher rent rate, but I think the recapture a little lower than one might accept during the recession.

And if you look relate it back to what I said earlier, it’s kind of interesting given we haven't bought anything and Crest isn’t doing anything and we haven't cut expenses, you can get an idea of deep into a recession, having 12.6% of our revenue with tenants in bankruptcy, what happens to FFO, which is fairly flat over the last year, same-store rent up a bit, occupancy basically flat. So I think that might be illuminating for some of the folks out there.

David Fick – Stifel Nicolaus

Very helpful. One specific question. Going through your Form 3, we noted that you’ve got a handful of entertainment properties, probably list of this entertainment that have a fairly large land base and minimal construction or building improvement. What is the nature of those assets? Is it just categorized as entertainment?

Tom Lewis

Yes, those have been in the portfolio for a long time and generally, those are a combination, they are primarily small properties located on freeways where you’ve got miniature golf, you’ve got go-karts, and you’ve got a wide variety of entertainment.

And a couple of chains that we've worked with – because I don't think we bought any of those in five, six, seven years. But what we did when we went and looked at those is we looked at them primarily on a land basis and not paying for the improvements, because obviously the improvements are a little difficult to lease to somebody else for a different purpose, and basically tried to value the land and the surrounding areas and pay that. And then what we did is we wrote a very long-term triple net lease on it and the net effect to it is the cash flow coverages were extraordinarily high and it was the way we cut on the land and quite frankly, over time, prices of land went up and if those guys there were defaulted we would be in very good shape.

The other nice side of it is it’s fairly low-priced entertainment and so, the cash flows have held up decently. We haven't had close to a default in any of that. But it’s land under those type of properties, if you are in Orlando – not Orlando, if you are in South Florida right of the I-75 across from a major shopping center and you looked, you would see a 100-acre site and it would have some rice on it and it would have miniature golf and baseball and all the rest of it and it sits right in the middle of retail and the 100 acres, the lands owned by us, we bought it at 4 bucks a foot and now you just spread that around the country.

We own some of that up in riverside in San Diego and really throughout the country. So a very small part of the portfolio, we tried like heck to go out and buy tons of it. The problem is we just couldn’t find enough chains that were in that business.

David Fick – Stifel Nicolaus

Just looked a little unusual, but it sounds like it’s actually relatively healthy. So thanks. My last question is, I’m wondering if you had a look at the Exxon portfolio that recently transacted into Greater Washington area, one of your peer group companies, Getty Realty, buying it at an 11-4 cap rate convenient stores and Exxon gas station.

Tom Lewis

Yes, we were aware of that transaction out there and others like it, but kind of the policy is post we tend not to comment on it and then we find that we continue on the list of people that see that stuff.

David Fick – Stifel Nicolaus

Okay, very good. Thank you.

Tom Lewis

I don't comment on that so well on it, just so you know.

David Fick – Stifel Nicolaus

Right.

Operator

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

R.J. Milligan – Raymond James

Good afternoon, guys.

Tom Lewis

Hi, R.J.

R.J. Milligan – Raymond James

Just a quick question. Most of my questions have been answered, but the – typically you guys provide the range for the top 15 tenants in terms of coverage.

Paul Meurer

Yes.

Tom Lewis

Yes, I didn’t – I’m happy to do it. I didn’t do it this quarter. A lot of these people report annually, some of them report on the date of the lease of the various properties and if you run through the third quarter, it tends to be when there is smallest amount of changes of people reporting the cash flow coverage.

So I think there was only one or two, but it was relatively flat. I think the low end was 155 [ph] and the high end of kind of doesn't matter because it’s so good, it’s somewhere up 3.5 or so, but it didn’t really change much at all because the tenant that did report, the major one, was right in the middle and the other reports we got, which had to do with individual properties, didn’t change the numbers that much. Probably the best time of the year when that – when we have the best numbers there is after the first quarter.

R.J. Milligan – Raymond James

Okay, thanks. And one more quick question. Can you just describe the thought process for including the additional disclosures this quarter?

Tom Lewis

Yes. Really and I’ll kind of go back to the start. Previous to – right after we went public, we continued with the policy where every year we put every tenant, every property and its address on the back on the Annual Report and then what we would do is at the end of the quarter, we’d say what we bought, who the tenant was and what the cap rate was and we did our first conference call just probably 12 or 13 years ago and when we did, the world listened in and we lost our biggest tenant we were buying things from when they got under-priced by a competitor who just went right 25 BPs below and we lost a big deal.

And then we lost the second biggest guy we were doing business with when they were bombarded with calls saying, people would their properties 50 to 75 basis points below what we would do. And if you look back then, pretty much anybody we were doing new transactions with would move into the top 10 or 15. So we came out with the analysts that covered us and said that we are not going to disclose tenant name and a lot of all this other disclosure and because we’d rather be doing business and not reporting the tenant name than not doing business but having more disclosure and everybody were fine probably until about I’d say a year ago.

And as we moved into the recession, we understand there – understood there were some more pressures and we were kind of stuck on the policy. And I will tell you that one of the analyst that’s on the call and then somebody also who is well known in the industry, very well respected, might have known for 25 years, called me up said, “Hey, can we have an open conversation”? And I listen to them and then we discussed it in-house.

And what we also realized is now if you look at the top 15, the chance that we are doing substantial acquisitions with those guys is much lower than it used to be and it’s probably going to be a name that won’t get into the top 15. So we’ve put on a lot of acquisitions. But I think the reason for not doing it didn’t have the efficacy it had in the past and the added disclosure everybody would find helpful. So that was the decision process.

R.J. Milligan – Raymond James

Great. Thanks, guys. I appreciate it.

Operator

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

Todd Lukasik – Morningstar

Hi, thanks for taking my question.

Paul Meurer

Hi, Todd.

Todd Lukasik – Morningstar

Hi, just one thing you had mentioned earlier, Paul, I think with reference to an assumption that you are using with regards to 1% decrease in occupancy. Was that for through the rest of '09 or was that for fiscal year of 2010?

Paul Meurer

Fiscal year 2010.

Todd Lukasik – Morningstar

Okay, great. And then, Tom, you kind of answered this with your last answer I guess. But I was just curious if you all would be inclined or if you had a preference to increase your exposure through future acquisitions through existing tenants or if you had a preference to looking at new tenants to add to the roster?

Tom Lewis

We’ll do both, new tenants are always the best because we really like the diversification. But we are aware of the kind of the concentration, so when somebody gets up over 5% then we look very carefully before we want to add very much more on, not because we don't like the tenant, just general diversification. And we’d like to keep the industries down a bit. So new tenants are always the best, but we do have some tenants that were fairly small and you look at the top 15 and they get to down 2% of rents, there are only seven tenants between 1% and 2% and then it goes down very quickly. So there is still a pretty good list of 90 tenants or 85 tenants that are out there.

Todd Lukasik – Morningstar

Right, okay. And then one last question too with regards to your top 15 tenants I guess and my guess is that it’s very small, but I was wondering if you could give an average and maybe a range for your top 15 tenants for the percentage of their stores that you will own in your portfolio?

Tom Lewis

Yes, let me see if I can kind of run through it. I’ll do it quickly. Buffets have 547 units, we have a 104; Kerasotes has 98 theaters, we own 17; L.A. Fitness has 329 units, we own 18; and TreeHouse 1,667 stores, we own 147; Friendly’s has 311 stores, I think we own 121; Rite Aid has 4,825 stores, we have 42; La Petite has 1,112 stores and we have 111; TBC, which is the highest stored chain, has 1,186 stores, we have 68; Boston Market has 541 stores, we have 77; KinderCare has 1,800 units, we have 85; Couche-Tard, which is Circle K, has 5,900 stores, we have 108; NPC International, which is Pizza Hut’s largest franchisee, has 1,153 stores, we have 141; FreedomRoads has 46 stores, we have 16; Regal – Regal has – do you have Regal there, Paul?

Paul Meurer

Yes. Regal has 550 stores, we have 12.

Tom Lewis

And then, Sports Authority has 463 units and we have 12.

Todd Lukasik – Morningstar

Okay. That’s very helpful. Thanks. Yes, that’s all I had. Thanks again for taking my questions. And Paul, we are looking forward to your participation in the Morningstar Stock Conference next week.

Paul Meurer

Thanks, Todd.

Todd Lukasik – Morningstar

Thanks a lot.

Operator

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

Rich Moore – RBC Capital Markets

Hi, good afternoon guys. With the acquisition this quarter, was that a new tenant?

Tom Lewis

It was, yes.

Rich Moore – RBC Capital Markets

Any – your comments there, any – is there any additional stores that those guys might have beyond the three that they have?

Tom Lewis

Not at the moment, but should they, we'd be interested.

Rich Moore – RBC Capital Markets

So they – did they actually have other locations or it was just those three?

Tom Lewis

No, they have other locations at the chain.

Rich Moore – RBC Capital Markets

Okay, okay. So there is a potential possibility to have those guys again. Okay. And then, health and fitness you were talking about, that seems to something that’s growing – that's certainly growing in the table. Is that – is there any particular reason for that target? I mean, are you seeing more of that kind of product out there?

Tom Lewis

We’ve really gone to – we actually own some health and fitness. I mean, going back 25, 28 years, had some problem with it like 22 years ago and got out of the business, but continued to watch it and what happened is that about – oh gosh, 12, 13 years ago, these guys came up with a new model and now basically all of the chains that are growing have gone through, which is like a 40,000 square foot store and there is an area to the left where they kind of have their sales team and then it’s got the basics out there and has training and it’s got room where they can do a lot of things with it.

And they started booking their revenue differently and their newer, larger units right about that 40,000 really took off and we got together with L.A. Fitness and the vast majority of their stores didn’t hit that model, but their first few that did the numbers were just off the chart. So we started doing those.

And then, later on the other chart change started going in that area and it was first a change in the type of building that worked very well for them and then I think what’s happened in the last few years is demographics that helped them out and the baby boomers are kind of rediscovering that they are not going to live forever, I’m one of them, so I belong to two of these things. But much to my chagrin, I recently learned you have to actually go to them, you don't have to just be a member.

Rich Moore – RBC Capital Markets

And you can’t go to it once I guess so [ph]?

Tom Lewis

You can’t, but by the way there are about 30,000 clubs nationwide. I know they all don't fit the silk, but that’s the size of the industry and if you look from 1991 to 2009, kind of the compound annual growth rate for the industry has been close to 9% a year. So it has been a big growth industry and continues to grow.

Rich Moore – RBC Capital Markets

Okay. So you would see that 6%, that is health and fitness, that you would see that growing over the next couple of years?

Tom Lewis

We wouldn't mind it at all if it went up to 6%, 7%, 8%, 9%. We think it’s a great industry and kind of hits the baby boomers moving into their – the age they are moving into. The issue then is trying to find the appropriate tenants and it isn’t a huge list of chains out there, but it’s a good list.

Paul Meurer

Hey, Rich, one thing I’ll add is that Tom’s comment is very positively on L.A. Fitness specifically. That’s actually a perfect example of why we hesitated for so long with our tenant list. When L.A. Fitness was in that, say, 10th largest tenant or in that 10 to 15 range, we were still doing a lot of business with them and they really weren’t doing business with other net lease providers at that time. So that’s a good example of that and somebody we’ve been pleased to work with and really rises up in terms of our investment with them.

Rich Moore – RBC Capital Markets

Okay, good. Thanks, guys. And then, I thank you, Paul, and then on the flipside, child care was coming down pretty fast as a percentage. Does that continue to fall like that or it levels off this quarter, but does it – do you think it kind of keeps going down?

Tom Lewis

I really think it will continue to go down. We’ve been in the business now. I think we started buying it 28 years ago when we started in the child day care business, it was 50% of our portfolio and now it’s down to about 7.6%. And when we founded it was really just starting to grow and the kind of the primary driver of the business is going back to the ’60s. The numbers were only about 20% of women of childbearing age in the United States worked. And so there was a lot of stay-at-home and that obviously has changed dramatically.

I think the last time I looked a few years ago, it was up to 60% plus of women of childbearing age worked and that was the primary growth of the industry and then you really coupled it back when we got into it that the baby boomers were having kids and so the growth was really fantastic, nobody else was financing the business. There weren’t any institutional players and we got involved. We then backed off primarily as a function of what was 50% of our revenue when went public and have worked it down.

And then the second thing that really happened is the percentage of women in the workforce kind of flattened out, it got to where it was kind of going to get. So that growth you had really went away and then the second thing is as the baby boomers kind of moved out of childbearing age and the baby bust moved into it and so you really saw a moderation of the growth of their business. As you look at the business today, I don't think the percentage of women in the childbearing age in the workforce is going to go up dramatically, but the one thing they do have that will help them out is you now have the echo of baby boom moving into childbearing age.

So it’s a good industry, but I don't think it’s going to grow much larger.

Rich Moore – RBC Capital Markets

Okay, all right. Good, thanks. And then remind me again what the 300 non-same-stores are.

Tom Lewis

Yes, that is those stores that were vacant at anytime during the comp period. It’s also those stores that went through lease rollover for a period of time and came off lease for a short period of time. It’s those properties that have been released and anything that wasn't in the comp set that had been acquired.

Rich Moore – RBC Capital Markets

Okay, great. Very good, thank you guys.

Paul Meurer

Thanks, Rich.

Operator

Our next question comes from the line of Chris Lucas with Robert W. Baird. Please go ahead.

Chris Lucas – Robert W. Baird

Good afternoon, guys.

Paul Meurer

Hey, Chris.

Chris Lucas – Robert W. Baird

Just a couple of detail questions, Paul. On the G&A guidance, you will include – your numbers include the FAS 141R expenses?

Paul Meurer

Yes, it does.

Chris Lucas – Robert W. Baird

Okay. And then, are you going to be providing at least a footnote to separate out that from what has been the traditional sort of accounting process so we could get an apples-to-apples view?

Paul Meurer

Yes, we’ve been thinking about that because we only had a little bit of it with these couple of properties we brought in the third quarter, but I think that’s a very good suggestion and I don't think it’s going to be a huge number, but we’ll certainly break that out.

Chris Lucas – Robert W. Baird

Is there a – I mean, as you think about your range of acquisitions and obviously filtering into your numbers, how should we be thinking about that relationship between acquisition volume and the ramp in G&A?

Paul Meurer

I – the acquisition commissions are one thing, meaning kind of what we pay a little bit of additional compensation internally relative to our acquisition folks or maybe if we have to pay a – maybe an outside advisor who is involved in helping us get an acquisition across the line. But in terms of the due diligence side of it, it’s not a big number. So it depends on the property type and the number of properties we are dealing with, but we are estimating 5,000 to 7,500 if you will, per property is that. So it all depends on the particular situation and the work that needs to be done.

Chris Lucas – Robert W. Baird

And that would include your transfer taxes or whatever that would be applicable to the various regions?

Chris Lucas – Robert W. Baird

Yes. For the most part, yes. You are going to have a few states where you have an anomaly on that where your transfer taxes are going to be a little higher.

Chris Lucas – Robert W. Baird

Okay. And then on the unsecured debt market, can you give us a sense as to what you are hearing in terms of what your debt would be issued at this point?

Paul Meurer

We actually aren’t actively asking for quotes every day. So I don't have this week’s quote, if you will. But we certainly know the market is and if you assume the 10 years around 3.5%, I think you are looking at a spread for us of somewhere certainly in the 350 to 400 over range, I would hope on the tighter side of that. So with that a cost of 7% to 7.5%.

Chris Lucas – Robert W. Baird

Okay. And then on the – on – just on underwriting acquisitions, I guess with some of these additional details you guys have provided today, which has been very helpful, is there a limit as to how many units you’ll take from a particular credit?

Tom Lewis

I don't. We don't have an absolute limit, but when wee start owning all of it or close to all of it, then we are thoughtful about it. However, what we have found out is if we do have a big position, then certainly if something goes sideways, we can be a player in it because we control a lot of the assets. It really speaks to more, if you take a retailer and you look and say, okay, this retailer has an average of – I’ll just ballpark it if there are any pays, cash flow coverage EBITDA, cash flow coverage at 2 times, it almost though is it’s going to a bell curve, Chris.

And to one side, he is going to have some low coverage units and so if you bought all of them, you would end up with low coverage units. So we just assume trying to get a small enough subset so we can say to the other side of the bell curve and have higher cash flow coverages.

Chris Lucas – Robert W. Baird

Okay. And then my last question. Just on the – obviously, you exceeded the bogey you wanted to hit you talked about for several quarters in terms of the cap rate on the deals that you closed this past quarter. What are your thoughts right now in terms of where – what cap rates you would be looking at doing given the sort of healing that’s going on in the debt markets?

Tom Lewis

I really that’s moderated, I think, caps a little bit and we’ll have to see what happens there, but my sense is of the deals that we kind of – transactions going through the pipeline, probably the best is to say in the 9% to 10% range and then you are thinking 9.5%, but then you watch the debt markets very closely because that will move things along. So I’d ballpark it at 9.5%.

Chris Lucas – Robert W. Baird

Great. Thank you, guys. I appreciate it.

Paul Meurer

Thanks, Chris.

Operator

Since there are no further questions at this time, I will now turn it over to management for closing remarks.

Tom Lewis

Well, thank you very much everybody and we’ll see you again in another 90 days and see how this all carries along in the economy. I appreciate the support.

Operator

Ladies and gentlemen, this concludes the Realty Income second quarter 2009 earnings conference call. You many disconnect. Thank you for using ACT Conferencing.

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