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Realty Income Corporation (NYSE:O)

Q3 2013 Earnings Conference Call

October 31, 2013 04:30 PM ET

Executives

John P. Case - CEO

Paul M. Meurer - EVP, CFO and Treasurer

Sumit Roy - EVP, Chief Investment Officer

Gary M. Malino - President and COO

Michael R. Pfeiffer - Executive Vice President, General Counsel, and Secretary

Terry Miller - VP, Investor Relations

Analysts

Daniel Donlan - Ladenburg Thalmann & Co.

Juan Sanabria - Bank of America Merrill Lynch

Emmanuel Korchman - Citigroup

Jonathan Pong - Robert W. Baird

Wes Golladay - RBC Capital Markets

Ross Nussbaum - UBS

Todd Lukasik - Morningstar

Todd Stender - Wells Fargo

Operator

Good afternoon ladies and gentlemen and thank you for standing by. Welcome to the Realty Income Third Quarter 2013 Earnings Conference Call. During today’s presentation all parties will be in a listen-only mode. Following the presentation, there will be an opportunity to ask questions and instructions will be given at that time. (Operator Instructions) And as a remainder this call is being recorded October 31, 2013.

I’d now like to turn the call over to Terry Miller, Vice President of Investor Relations for Realty Income. Please go ahead.

Terry Miller

Thank you, Craig and thank you all for joining us today for Realty Income’s third quarter operating results conference call. Discussing our third quarter results will be John Case, Chief Executive Officer; Paul Meurer, Executive Vice President, Chief Financial Officer and Treasurer; Sumit Roy, Executive Vice President and Chief Investment Officer. Also joining us on the call are Gary Malino, President and Chief Operating Officer; and Mike Pfeiffer, our Executive Vice President and General Counsel.

During this conference call, we’ll 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. We’ll disclose in greater detail the factors that may cause such differences in the Company’s Form 10-Q.

I will now turn the call over to Mr. Case.

John P. Case

Thanks, Terry. Good afternoon, everyone and welcome to our call. We are pleased with Company’s operating performance for the third quarter with solid results coming from our areas of the business. Paul is going to start and review the financial numbers, so I’m going to hand it over to Paul. Paul?

Paul M. Meurer

Thanks, John. So as usual, I’m going to comment on our financial statements and provide a few highlights of our financial results for the quarter starting with the income statement.

Total revenue increased 70% for the quarter. Our current revenue on an annualized basis is approximately $805 million. This increase reflects positive same-store rents of 1.3%, but more significantly it obviously reflects our growth in new acquisitions over the past year. On the expense side, depreciation and amortization expense increased significantly to almost $81 million in the quarter as depreciation expense has obviously increased with our portfolio growth.

Interest expense increased in the quarter to $49.7 million. This increase was primarily due to the $800 million of bonds that were issued last October and the $750 million bond issuance in July, as well as some credit facility borrowings during the quarter. On a related note, our coverage ratios both remain strong with interest coverage at 3.5 times and fixed charge coverage at 2.9 times.

General and administrative expenses or G&A in the third quarter was approximately $16.6 million. Our G&A expense has naturally increased this past year as our acquisition activity has increased and we did add some new personnel to manage a larger portfolio. Our employee base has grown from 92 employees a year-ago to 114 employees at quarter end.

The other unique factor though in our third quarter G&A was a $3.7 million non-cash expense related to the acceleration in July of our older 10 year stock brands to five year vesting. Overall, our total G&A year-to-date as a percentage of total revenues was still only 7.3% compared to historically our G&A at a run rate of about 7.5% to 8% of revenues. Our current projection for G&A for 2014 is about $50 million or less than 6% of revenues.

Property expenses were approximately $5.9 million for the quarter. Our property expense estimate for all of 2013 is about $18 million. And our projection for 2014 is $20 million. Income taxes consist of income taxes paid to various states by the Company and they were $671,000 for the quarter. Merger-related costs, obviously this line item refers to the costs associated with the ARCT acquisition earlier in the year. During the quarter, we expensed $240,000 of such remaining costs.

Income from discontinued operations for the quarter totaled $6.6 million. This income is associated with our property sales activity during the quarter. We sold 19 properties during the quarter for $22.4 million with a gain on sales of $6.2 million. And a reminder that we do not include property sales gains in our FFO or in our AFFO. Preferred stock cash dividends totaled approximately $10.5 million for the quarter and net income available to common stockholders was about $41 million for the quarter.

Turning to FFO and AFFO, reminder that our normalized FFO simply add back the ARCT merger-related costs to FFO. Normalized funds from operations or FFO per share was $0.59 for the quarter, a 13.5% increase versus a year-ago. It would have been $0.61, but it was reduced $0.02 by the non-cash expense for the accelerated stock vesting I already mentioned.

Adjusted funds from operations or AFFO or the actual cash that we have available for distribution as dividend was $0.60 for the quarter, a 15.4% increase versus a year-ago. We again increased our cash monthly dividend this quarter. We have increased the dividend 64 consecutive quarters and 73 times overall since we went public over 19 years ago.

Dividends paid per common share increased 23% this quarter versus the same quarterly period a year-ago. And our current monthly dividend now equates to a current annualized amount of just over $2.18 per share. Our AFFO dividend payout ratio is currently about 89%.

Briefly turning to the balance sheet. We’ve continued to maintain a conservative and very safe capital structure. As you know in July we raised $750 million of new capital with a 10-year bond offering. Earlier this month we did a $397 million common equity offering. And just this week we closed on the accordion expansion of our acquisition credit facility for a new capacity of $1.5 billion. We currently have about $100 million of borrowings on that line.

We do want to take a moment to say thank you to the investment banks and commercial lending partners who helped us access this capital over the past several months and we’re grateful to the bond and equity investors to continue to support us with their capital as we continue to grow as a Company. We do not assume any in-place mortgages during the quarter, so our outstanding mortgage debt has decreased to approximately $780 million.

As for debt maturities, we have a $11 million of mortgages coming due in Q4 this year, $64 million of mortgages due in 2014 and $125 million of mortgages in 2015 and our next bond maturity is only a $150 million due in November of 2015. Our overall current total debt to total market cap is 30% and our preferred stock outstanding is only 4.5% of our capital structure. And our debt to EBITDA today is currently only 5.8 times.

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

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

John P. Case

Thanks, Paul. I'll begin with an overview of the portfolio which continues to generate consistent cash flow. Our tenants are doing well and based on what we're seeing now, we do not anticipate any issues in the foreseeable future. We ended the third quarter with 98.1% occupancy based on the number of properties with 73 properties available for lease out of 3,866 properties.

Our occupancy is up from 97% one year ago. Occupancy based on square footage is 98.9% and the economic occupancy is 99%. Our occupancy remains stable and strong and we expect our occupancy at the end of the year to be in these areas, so we're comfortable with where they are.

Same-store rents increased 1.3% during the quarter and year-to-date versus the same period last year. We're pleased with this level of growth and think it will continue over the next few quarters and perhaps be even a touch higher.

At the end of the third quarter, our 15 largest tenants accounted for 44.4% of our revenue. That's down 2.4% from the same period one year ago. However, it's up about 1% from last quarter. And as you know, this number will ebb and flow from quarter-to-quarter but generally speaking our acquisitions efforts will continue to diversify our rental revenues.

We've continued to make progress on this over time. If you look back to 2008 in the top 15 accounted for 54.3% of revenue and again today it's 44.4%. We continued to diversify our overall portfolio, again with 3,866 properties lead to 200 commercial enterprises and 47 different industries across 49 states plus Puerto Rico.

We remain well diversified by industry, no industry accounts were more than 11.2% of our revenue. Convenient stores are our largest industry at 11.2% and that's down 5.1% from a year ago. Drug stores are now at 9.3%, up 5.8% from a year ago.

Restaurants, if you combine both the casual dining segment and the quick service segment, are now at 9.2% of our revenues, down 4% from a year ago. As you may recall, in early 2008, restaurants were approximately 24% of our revenues.

Dollar stores are now at 6.3%, up 3.3% from a year ago. Health and fitness is at 6.1% of revenues virtually unchanged from a year ago. Theaters are at 5.9%, down 3.6% from a year ago. And finally transportation services are 5.3% up 2.8% from a year ago. All other industry categories are below 4.5% of revenue. So we're in good shape keeping our revenues diversified by industry.

Looking at individual tenants, our largest tenant remains FedEx at 5.1% of revenues; Walgreen and Family Dollar are second and third largest tenants at 5% and 4.9% of revenue respectively. Walgreen is up by about 1% from last year and Family Dollar is up by about 1.5% from last quarter.

L.A. Fitness is now at 4.2% which is down 30 basis points from last quarter. All other tenants are at or below 3.1% of overall revenues. When you go down to our 15th largest tenant which is Walmart and Sam's Club, it represents only 1.6% of revenue. If you move another five spots and go to our 20th largest tenant, it represents just 1.3% of revenue. So we're still very well diversified by tenant.

The credit quality of the portfolio continues to improve with about 40% of our revenue generated from investment grade tenants. This is up about 1.5% from the last quarter and 19% from quarter end 2012.

In terms of our top 15 tenants, about 26% of that is generated from eight investment grade tenants. As recently as 2010, there was only one investment grade tenant in our top 15 and that tenant generated just over 5% of revenue. So we remain comfortable having a significant portion of our rental revenues coming from high credit tenants.

In terms of lease length, the average remaining lease term is just under 11 years at 10.9 years. Relative to property dispositions we continue selling select properties to further strength the portfolio. During the quarter, we sold 19 properties for $22.4 million which brings us to 53 properties sold for the year for $106.1 million.

The sales this quarter were primarily in the restaurant, child daycare and convenient store and the streets. For the year we're looking at approximately 125 million in properties dispositions.

Moving on to property acquisitions. During our third quarter we completed approximately 503 million in property level investments at a yield of 7.1%. This gets us to 1.37 billion for the first nine months of the year, excluding the $3.2 billion acquisition of ARCT that closed in January of this year. So we are raising our acquisitions guidance for 2013 to approximately 1.5 billion from the previously leased 1.25 billion.

We're quite pleased with the continued momentum we're seeing on the acquisitions front and now I'd like to hand it over to Sumit Roy, our recently appointed Chief Investment Officer who's headed acquisitions for about a year now to discuss acquisitions. Sumit?

Sumit Roy

Thank you, John. We remained active on the acquisition front. During the third quarter, we made 502.7 million in property level investments in 219 properties at an average initial cash yield of 7.1% with a weighted average lease term of 14.7 years. 72% of the revenue generated by these acquisitions is from investment grade tenants. These assets are leased to 20 different tenants in 15 different industries.

Four other tenants are new to our portfolio and most significant industries represented with discount store, drug stores and health and fitness. The properties are located in 33 states. 81% of the investments are comprised of our traditional retail properties. We were successful in accelerating the closing on a number of transactions in the third quarter and were pleased with the activity this quarter.

Through third quarter 2013, as John mentioned, we've invested 1.37 billion in 407 properties at an average initial cap rate of 7% and lease term of 14.1 years. 65% of total rent was generated by investment grade tenants. These assets are leased to 35 different tenants in 21 different industries. The properties are located in 40 states. 84% of the investments are comprised of our traditional retail properties. Including ARCT, year-to-date we have invested approximately $4.5 billion in total investments.

Regarding our outlook. Given our current pipeline for the remaining quarter and as John has mentioned, we now think 2013 acquisitions will pencil in at approximately 1.5 billion for the year versus our last guidance of at least 1.25 billion. The 1.5 billion in forecasted acquisitions is an addition to the 3.2 billion in acquisitions of ARCT during the first quarter.

On transaction flow, we continue the theme of seeing a record amount of transaction flow this year. We sourced 37 billion in acquisition opportunities through the third quarter, 17 billion of which was sourced in the third quarter alone. To put it in perspective, the 17 billion sourced in the third quarter is equal to the volume sourced in all of 2012 which was a record year of sourcing for us. The volume of opportunities were primarily driven by large portfolios and entity level transactions as compared to one-off transactions.

We have remained very selective in our acquisitions and are pursuing only those that match what we are trying to do strategically with the portfolio. We continue to analyze a number of these sourced opportunities but have ceased to pursue a majority of these transactions that came in third quarter. In a large portfolio, unless the vast majority of the properties fit our investment strategy, we will elect to pass.

Overall we are pleased with the acquisitions volume and a lot of it has been smaller, organic, relationship driven property transactions that offer superior risk adjusted returns and fit where we’re trying to go with the portfolio. As to pricing, cap rates has stabilized at the levels where they were at the end of the second quarter. Still a lot of capital perusing transactions. Investment grade property cap rates range from 6.25% to 7.25%. Non-investment grade properties are trading from 7.25% to 8.25% cap rates.

Looking at spreads, third quarter investment spreads remained healthy. We invested $502.7 million at a 7.1% cap rate. As we have frequently discussed we look at our investment spreads relative to a nominal cost of equity and that has averaged 111 bps over the last 20 years with most of that leased to non-investment grade tenants. With over 72% of acquisitions investment grade, our cap rate of 7.1% represents a spread of approximately 110 bps to our current nominal cost of equity. We like the ability to continue to upgrade the tenant credit quality and yet remain close to our historical average spread.

So in conclusion, we continue to see an exceptional level of volume in the sector and have been pleased with our $1.37 billion in acquisitions to date including ARCT we’ve closed $4.5 billion in acquisitions. John?

John P. Case

Thanks, Sumit. Obviously we’re pleased with the acquisitions we closed this quarter and our level of activity, and we expect acquisitions to remain active for us for this foreseeable future. Yeah, acquisitions also continues to be the primary driver of our revenue, earnings and dividend growth. We are pleased with our earnings in the third quarter our growth in normalized FFO per share is 13.5% versus the third quarter of 2012 and our growth in AFFO per share is 15.4% versus the third quarter of 2012.

As Paul mentioned our balance sheet and access to capital remain strong so we have plenty of flexibility to pursue acquisitions. Just last week we completed our second largest equity offering in the history of the company by raising $378 million in net proceeds. We used the proceeds to repay borrowings under our credit facility to permanently and accretively finance third quarter acquisitions activity. Additionally you may have seen two days ago we announced the expansion of our credit facility from $1 billion to $1.5 billion by exercising the in-place $500 million accordion feature that Paul spoke to a few minutes ago.

Given the level of acquisitions activity we had been experiencing, we like the additional flexibility to $1.5 billion capacity gives us. We currently have $1.4 billion in available credit capacity on our facility. Relative to the earnings guidance for this year, we’ve tightened our range for FFO and raised and tightened our range for AFFO. We now expect normalized FFO per share to be $2.38 to $2.42 for the year, which represents 18% to 20% FFO per share growth. We also adjusted our AFFO per share to $2.38 to $2.42, which represents 16% to 17% AFFO per share growth.

AFFO continues to be a primary focus of ours as it does represent the recurring cash flow from which we pay dividends. We’ve also established earnings guidance for 2014 with normalized FFO estimated to be $2.53 to $2.58 per share which represents 5% to 8% FFO per share growth over the 2013 estimated range. AFFO is estimated to be $2.53 to $2.58 per share as well which represents again 5% to 8% AFFO per share growth.

Regarding dividends, we remain optimistic that our activities will continue to support our ability to increase the dividend. Last month we announced the 73rd dividend increase since the company went public in 1994. This brings the annualized dividend amount to just over $2.18 per share. Our dividends paid year-to-date have increased just under 22% over the same period last year. Our payout ratio is currently at about 89% of our AFFO which is a level we are comfortable with.

And finally, I’d be remiss if I did not note that this is our Company’s first earnings call since our former CEO, Tom Lewis announced his retirement. I want to take a moment to thank Tom for leading the Company as CEO for over 16 years and helping produce outstanding results for our shareholders. So Tom, if you’re listening out there. Thanks.

With that I’d like to open it up for questions. Craig.

Question-and-Answer Session

Operator

Thank you very much. (Operator Instructions) And our first question does come from the line of Daniel Donlan with Ladenburg Thalmann. Please go ahead.

Daniel Donlan - Ladenburg Thalmann & Co.

Thank you and good afternoon.

John P. Case

Hi, Dan.

Paul M. Meurer

Hi, Dan.

Daniel Donlan - Ladenburg Thalmann & Co.

A couple of questions here on the office that you guys acquired in the quarter, could you maybe tell us if that was kind of above that 7.1% cash cap rate range or was it above it or where did this come in if possible?

John P. Case

Yeah so, on the office activity for the quarter which represented about 18% of the quarterly volume, we’re not at liberty to discuss the exact economics there. It was a situation where we invested in the office facilities that went out of our largest retail clients within investment grade rating. They brought the opportunity to us, and it was an attractive opportunity on an economic basis with the added benefit of enhancing our overall relationship with that tenant. We’re not at liberty to discuss the economics related to the transaction there.

Daniel Donlan - Ladenburg Thalmann & Co.

Sure, understood. And then just, as far as of the third quarter activity was concerned, how much was sourced directly from tenants or retailers versus market transactions?

John P. Case

Yeah, I’d say around 30% to 40% was directly sourced from relationships with tenants and other retailers, and the rest was sourced either from private developers or private owners or through marketed transactions through the advisory and brokerage community.

Daniel Donlan - Ladenburg Thalmann & Co.

Okay, I appreciate the color there. And then, just two questions for Paul. Paul, it looks like your stock comp as a percentage of G&A is kind of moving towards this 30% number. I think previously it’d be kind of in the low-to-mid 20% range. Should we expect that level of stock comp as a percentage of overall G&A going forward?

Paul M. Meurer

No. I think this year you’re seeing two events. One was the July acceleration relative to the old 10 year vesting converting to the 5 year which is our stock best now for all outstanding old 10 year grants. And then the other is the process of our transition at the executive suite level and as it relates to what would, I would just describe a slight anomaly in the level of stock issuance this year now versus the run rate going forward.

Daniel Donlan - Ladenburg Thalmann & Co.

Okay. I guess given that your AFFO is equal to your FFO, are you going to see then since you’ll probably going to have less stock comp next year, are you going to see maybe a drop off then in CapEx versus what you recognized this year?

Paul M. Meurer

That’s part of it. The other thing you’re seeing in the AFFO calculation is a little bit more amortization related to above market leases in our FAS 141 work if you will. So there’s offsetting factors there that historically we didn’t have in the portfolio, whether it be assumed mortgages or assumed existing leases and the accounting related to them that created -- create differentials between FFO and AFFO. In the past all we had was adding back amortization of financing cost of dot comp offset by straight line rent in CapEx. As for CapEx specifically to answer your question, we see a similar run rate for next year, call it a $8 million projected number as it relates to 2013 as a whole and 2014 as a whole.

Daniel Donlan - Ladenburg Thalmann & Co.

Okay. Thank you very much.

Operator

Our next question does come from the line of Juan Sanabria with Bank of America.

Juan Sanabria - Bank of America Merrill Lynch

Good afternoon, guys. I was just wondering for 2014 kind of what you're penciling in for acquisitions, I don't think you touched on that in the prepared remarks and as well as on same-store rent growth?

Paul M. Meurer

Sure. We are expecting approximately 1 billion in acquisitions at roughly on the yields we are seeing today in the market, so that's what we budgeted for 2014. And with regard to same-store rents, we think they'll continue around 1.3% or be perhaps a bit higher. So those are the numbers we're using in our estimates for 2014.

Juan Sanabria - Bank of America Merrill Lynch

Okay, great. In the acquisition pipelines you look at, are you guys looking at all or interested going forward to looking at potential public transactions for publicly traded companies?

John P. Case

We look at really everything that comes across our desk. And I'd say that as the largest player in the sector and one of the more active players in the sector with a long successful history, we believe we see most major opportunities whether it be at the property level, property portfolio level or entity level. So we'll consider all of that but it will need to meet our investment strategies. So we've been, as Sumit mentioned, quite selective this year relative to the transactions we sourced and a lot of that is just remaining true to what we want to accomplish with the portfolio. So we've passed on a number of opportunities obviously based on the source transactions and what we've done year-to-date.

Juan Sanabria - Bank of America Merrill Lynch

And just one other quick question. With regards to the payout ratio, it seems like CapEx is going to be fairly stable but as we think of the portfolio longer term with a greater percentage of office and industrial versus your historical retail focus, how should we think of CapEx as leases mature and kind of thinking about your payout ratio needing to retain presumably some CapEx to re-lease this space?

John P. Case

Yes, that's a good question and we're comfortable with it at 89% as I said, but we would expect it to move into probably the mid 80s over time and that's primarily to accommodate a little bit more on the CapEx side associated with the non-retail properties.

Juan Sanabria - Bank of America Merrill Lynch

Thank you very much.

Operator

Our next question does come from the line of Emmanuel Korchman with Citi.

Emmanuel Korchman - Citigroup

Hi. Thanks for taking the questions guys.

John P. Case

Hi, Manny.

Emmanuel Korchman - Citigroup

Maybe with the CEO transition, could we discuss any potential changes in strategy or should we just expect status quo going forward?

John P. Case

Yes. I don't see any major changes in strategy. We're going to remain careful and selective in our underwriting approach. We'll maintain our conservative balance sheet philosophy and our focus will be on the income generation from which we pay dividends that we intend to increase over time. The core team remains in place as you well know and Tom will continue as Vice Chairman of the Board and he's also serving as an executive advisor. So we see a fair amount of him. One thing I am looking at are our internal systems and staffing and making sure we're adequately structured for the anticipated growth we'll have in the future on those fronts, so we could see a few changes on that front or some additions, I should say. But overall the successful philosophy we've implemented here over the last cycle will continue.

Emmanuel Korchman - Citigroup

And then maybe we can go back to that point that you had made on G&A earlier and that's – you're building up sort of staffing to deal with a larger portfolio. Then you can staff [ph] it to what you guys did when you bought ARCT where you didn't bring any staff on board. Can you help me kind of connect the dots and why didn't you bring any ARCT people on board if you're going to effectively higher and how do we think that's scalability going forward? I think the triple net model has always worked as one where you need kind of limited heads to make a model work and so how do we think about that?

John P. Case

Yes. Well, our staffing our grown less than our overall portfolio has grown, so the business remains scalable. A lot of the staff being – we've added and we're considering adding is related to what we anticipate will be additional growth in the future. We were able to take on the ARCT acquisition without bringing in any of their people and do it primarily in-house. Historically, our G&A has run probably between 7.5% to 8% of revenues, it's going to be just over 7% I think for this year. We would expect that number to decline closer to 6% of revenues next year. So you can see the impact of the scalability.

Emmanuel Korchman - Citigroup

Thanks, guys.

John P. Case

Thank you.

Operator

Our next question does come from the line of Jonathan Pong with Robert W. Baird.

Jonathan Pong - Robert W. Baird

Hi. Good afternoon, guys. Just like to dig in a little bit on the office asset topic and maybe just what you guys think about your exposure going forward. You had about 6% today. Are you thinking about doing just more of these strategic types of deals or could you see that percentage moving higher because you see attractive risk reward on a valuation basis for these assets?

John P. Case

Yes. With regard to office, typically when we acquire office, it's part of a broader portfolio of properties that we like that happens to have an office component. There are a couple of exceptions to that. One is, if we find a facility that is associated with the retail operations of one of our major tenants and they asked us to take a lot at that, we'll pursue that on a one-off basis. But our real emphasis continues to be on retail as demonstrated by the completed acquisitions to-date as well as industrial and distribution, leased investment grade tenants with tenants that have – generally Fortune 1000 characteristics and good revenue basis and are in industries that we're comfortable with and locations that are strategic to their business. So on the office front that was a heavy quarter for us on the office side and I really wouldn't expect that sort of percentages going forward. So with regard to office, those are our views Jonathan.

Jonathan Pong - Robert W. Baird

Great, thanks. And maybe on the implied guidance for fourth quarter acquisition activity, just being a little conservative about a 130 million, are you seeing a slowdown in attractive opportunities for the one-off deals and I hear what you're saying on the M&A side, but are you seeing people pulling back a bit on sourcing for the one-off ones?

John P. Case

Yes. Well, as you know our acquisitions have always been lumpy. That's the word we just use to describe on. In the first quarter of this year they were 128 million at the property level, 738 million in the second quarter which was a record quarter and then another heavy quarter, 502 million. So 75% of these acquisitions really come in, in the form of portfolios. And if you miss a portfolio or two or win a portfolio or two, it can really swing your numbers. And then if they slip a date or move up a couple of weeks into a new quarter, they can really make the quarters quite lumpy. So it's never been a smooth acquisition process for us. We have pretty good visibility with just a couple of months remaining in the year, so we feel comfortable with approximately 1.5 billion in guidance we've given you.

Jonathan Pong - Robert W. Baird

Great. Thanks for the color.

John P. Case

Okay. Thank you.

Operator

Our next question does come from the line of Wes Golladay with RBC Capital Markets.

Wes Golladay - RBC Capital Markets

Hi. Good afternoon, guys. Congratulations John. Wondering if you could touch upon the disposition side of the equation, I think you guys had done an extensive analysis in the past of all the properties you wanted to sell, so want to get some color on where you guys are in the process of that and how big is the bucket?

John P. Case

Yes, with regard to dispositions we're going to end up the year having about 125 million which is a pretty good number for us in terms of size. Last year that was closer to 50 million. Next year we're anticipating in access of 75 million to 100 million. And most of what we're selling is kind of coming out – is our kind of bottom bucket which is sort of a watchlist. And as we've grown the company through acquisitions and made dispositions, we brought the watch list down of a black as we call it group of companies from 23% in July of 2011 to 9% today. Now, that doesn’t mean we want to sell everything that’s in that 9% category. That just means those are properties that we’re watching, maybe we have industry concerns or credit concerns or specific real estate concerns. So, generally the dispositions will come out of that pool. So we’ll remain active on that front. But as you know our ability to transact in very large quantities there is offset by what we acquire in order to minimize the dilution from the activities. We normally budget on the property dispositions 8% sales cap rates or say that that’s a bit conservative. This year we run around the mid 7’s in terms of sales cap rates and we’re pleased with that, but we’ll continue to budget through conservatisms right around an 8% for the disposition cap rates.

Wes Golladay - RBC Capital Markets

Okay. Thanks for the color.

John P. Case

Sure.

Operator

And our next question does come from the line of Ross Nussbaum with UBS.

John P. Case

Hi, Ross.

Ross Nussbaum - UBS

Hi, guys, good afternoon. I missed the last quarter’s call, so I’d be remiss if I just didn’t give a big shout out to Tom, and I had the pleasure working with him for most of his 16 years with the Company, and I always said I thought he was one of the most underappreciated CEO’s in the business. That means John; you’ve got some big shoes to fill.

John P. Case

I’m aware of that. Thanks.

Ross Nussbaum - UBS

So, now with that I can give you a hard time. Can we talk a little bit, and I might have missed this; did you give the underlying assumption behind that 5% of 8% FFO growth next year. What's the acquisition volume that’s behind that?

John P. Case

Yeah, it's approximately $1 billion at cap rates consistent or in the area of where we’re seeing them today, so below 7’s.

Ross Nussbaum - UBS

Got it, okay. And can we talk a little more about your portfolio strategy, because if I think about the last couple of decades at Realty Income, and I think about the ARCT transaction that took place, that was the first in my mind, the first big departure in terms of buying a large group of assets at a premium to what was then the NAV. So as you look at acquisitions going forward, can you talk a little bit about, how do you balance what the underlying market real estate value is versus how accretive that portfolio might be to your bottom line, because as I am sure you know the math works out that you could pay all-day long 10% and 20% premiums to what an asset or portfolio is worth and still make it accretive.

John P. Case

Right. Well; we’re out there and I think we’re as active as anyone in the sector in terms of investing and purchasing property, so it's important to us to do transactions that are accretive. But it's also very important for us to be protected relevant to replacement costs and relevant to market rents. So we look at all of that. In terms of asset values, yeah we see transactions that we like where we don’t lend those due to pricing. So, we try to be quite cognizant of that. I mean ARCT was a transaction that accomplished a lot for us on the strategic side. And as you know we financed it, two thirds equity, one third debt and locked in the spreads there. It was at a cap rate that was below what we were achieving at the time on our organic property level acquisitions that was in the high 5’s, but we looked at that transaction differently than we do some of our property level organic acquisitions.

Ross Nussbaum - UBS

Yeah. And that’s sort of where I am going, because as you might expect we have received quite a few phone calls over the last week or two from folks wondering if you would be interested in going in and topping ARCT’s deal with coal, basically on the same premise, that hey you’ve paid big premiums to NAV before you can still make the deal accretive. So, can we maybe just nip that one in the bud to start with? I mean do you have any intent of, is coal on the table for you or were not?

John P. Case

Well we don’t comment on pending merger and acquisition activity. I will say this, with regard to the activity that’s occurred in the sector, I think its positive. We’ve seen a lot of private to public consolidation, public-to-public consolidation in the sector, which I think attracts more interest into the sector. And being the largest company with the longest operating track record, I think that interest in the sector with new investors and new awareness can only help us. But I cant speak specifically as on any pending acquisition opportunities.

Ross Nussbaum - UBS

Okay. Let me see if I can tackle this way strategically, so clearly the ARCT deal was a bit of a game changer for you strategically. Are you -- is the portfolio at where you would like it to be from that perspective or do you feel like you need another quote unquote game changing transaction to ultimately meet your strategic goals?

John P. Case

Yes. Well, ARCT was a very, very strong strategic bid for us. And when we pursue entity level acquisitions, we look for a number of checks, the transaction needs to be immediately accretive as our team was on a leveraged neutral basis. It needs to generally improve our overall diversification and our portfolio credit quality. Ideally it would improve occupancy and link in our average remaining lease terms and reduce concentrations in our portfolio. We see few of those opportunities, but ARCT was one of that.

Ross Nussbaum - UBS

Okay. Thanks, John. I appreciate it.

John P. Case

Thanks, Ross.

Operator

And our next question does come from the line of Todd Lukasik with Morningstar.

Todd Lukasik - Morningstar

Hey, good afternoon guys. Thanks for taking my questions.

John P. Case

Hi, Todd. Yes.

Todd Lukasik - Morningstar

Just to follow along the same line of questioning there with regards to the large entity deals. The ones that you’ve seen come across the desk recently have they been relatively quick no’s or have they been interesting enough where you spend a lot of time looking at them and the final details just didn’t work out?

John P. Case

Yes. We thoroughly analyzed everything that comes through the door with our acquisitions team and the broader team here and make decisions either prior to investment committee or within the investment committee in terms of what we do on all acquisition. So seldom do we dismiss things quickly, but it does happen.

Todd Lukasik - Morningstar

Okay. And then just on the acquisitions guidance for 2014, of the roughly $1 billion, would you expect more of that to be in the investment grade area or the non-investment grade area? And what’s the spread that you’re seeing between those initial yields today?

John P. Case

I would think that it would be consistent with the percentages we’ve seen this year maybe a little bit lower in terms of spreads, Sumit touched on those. The cap rates seem to have stabilized and adjusted to the change in capital costs that occurred really in May. So cap rate seem to be holding steady at where they’re today. In terms of spreads, our spreads are actually debt or relative to our weighted average cost of capital on our acquisitions this quarter than where they’ve been historically. We are running in at about a 165 basis points spread relative to our weighted average cost of capital currently and over the life of the Company that’s been about 145 basis points. So our spreads to debt have gotten better, while our -- as Sumit mentioned, our spreads to our nominal cost of equity have come down a little bit to the average levels during the life of the Company. So I think those spreads, I mean, I don’t know where our capital will be priced next year, but we’re anticipating those spreads to hold for now.

Todd Lukasik - Morningstar

Okay. And then maybe a couple of questions for you too Paul, if you could just first comment on what was in the other revenue line this quarter and accounting for that increase? And then secondly, I don't know if there were any takeaways from the increase with the revolver, but I'm wondering if one of them is that you guys keep a balance on there, accumulating a little longer and go to market with larger capital transactions like we've seen recently?

Paul M. Meurer

Yes. The other income line is one that I typically don't comment on because it's not a line that we want people to kind of underwrite from a run rate perceptive. It typically includes ongoing property level type issues like easement or eminent domain takings where you receive a payment. Those are usually very positive cash flow transactions by the way, but they flow into that line as well as interest income that we might have, cash on hand, rent come in early if you raise money that sits for a week before you invest it into that nature, it kind of flows into that line. So it's not one that we try to project out and have people underwrite in their projections or earnings for us. But there's always going to be something there and that's what fell into that line as is the norm. In terms of the credit line, yes, we're real pleased with our existing bank group of 15 lenders all saying yes and participating in the increase there and the exercise of our accordion. And what it does do it give us more flexibility. John referenced on the acquisition front gives us more flexibility. The ability for Sumit to proceed with LOIs [ph] that have no financing contingency in them because we have a large line to draw upon so that it makes your offer naturally stronger when you have the ability to do that. And then yes, on the permanent capital financing front gives us more flexibility and patience to wait for the appropriate market windows, whether that be for equity or bonds or preferred, but to be able to carry a little bit of balance and wait for a good market window in order to raise the permanent capital. So it kind of gives us flexibility on the front-end with acquisitions but also in the capital markets front as well.

Todd Lukasik - Morningstar

Okay, great. Thanks a lot guys.

John P. Case

Thank you.

Operator

Our next question does come from the line of Todd Stender with Wells Fargo.

Todd Stender - Wells Fargo

Hi. Thanks guys. Is your visibility – would you say is your visibility better on deal flow as we sit here today? I mean if you look back to this time last year, your original guidance for 2013 was 550 million and now you're saying you could do 1 billion next year. Is that just a reflection that you're a bigger company at this point or is there anything to kind of look at the pace of deal flow?

John P. Case

Well, we're seeing activity based on our sourcing numbers which are very high, so we continue to work some of that. So we do have some visibility over the next few quarters and Todd it remains very difficult to predict and project, but we thought that it would be more appropriate to come out with a number of approximately 1 billion next year. And part of that is guided based upon our view of what's happening today and may spillover into the early part of next year.

Todd Stender - Wells Fargo

Okay. Thanks, John. And you also indicated with the office property acquisition that you highlighted or a previous caller highlighted, lease back to your second large retail tenant that did not close yet. Did I get that right?

John P. Case

No, it's closed.

Todd Stender - Wells Fargo

It's closed. You can't disclose any color on that?

John P. Case

No, we can't subject to the confidentiality agreement we signed with the tenant.

Todd Stender - Wells Fargo

Will that unlock at some point to get more information or is that – what kind of window is that?

John P. Case

It's as long as we own the building.

Todd Stender - Wells Fargo

Okay. And just switching gears, Paul, your operating expenses I think you indicated that you can kind of look at maybe a $20 million number for next year. What is in that number? What kind of property operating expenses would Reality Income be responsible for?

Paul M. Meurer

Yes, we historically as you know the property expense line was going to be related to taxes, maintenance, insurance, utilities all on vacant properties. So it was catch on a line for the 50 to 100 properties in any given point in time that we were carrying until we re-lease them or sold them, but we were responsible for those expenses. That was a different number. That was a number that was more in the $12 million to $13 million, $14 million type range I'd call it. And that is still in that number and part of that. The reason it's increased a bit from a run rate obviously, it's still a pretty manageable number is that we have had a portion of our portfolio grow into more of a double net structure. Some assets that we bought do have leases that give us some responsibilities as landlord. That's primarily [indiscernible]. Those costs are not – on an order of magnitude there are concerning, the ones that we budget for and they could range from $0.05 a square foot to $0.30 a square foot, if you will, in terms of what we're budgeting for those. And that's what has increased that run rate. It started to hit the $50 million area beginning of the year and now we're looking at more of a $20 million of run rate into next year as we look at our existing portfolio.

Todd Stender - Wells Fargo

Thanks for that. Would you purchase new acquisitions in the double net lease or is that just going to be legacy assets?

Paul M. Meurer

Well, I think we'll be open-minded.

John P. Case

Yes, we'll be open-minded. I think it depends on what the property is and the overall return and economics. But in the industrial sector they often refer to triple net lease in a manner that's different than we do in the retail sector and it's triple net and that the tenant is responsible for maintenance, insurance and taxes, but there may be some structural components that the landlord is responsible for and that's the primary difference and that's what Paul was alluding to.

Paul M. Meurer

So having those responsibilities would not preclude us from pursuing the right assets there, Todd.

Todd Stender - Wells Fargo

Okay. Thanks guys.

Paul M. Meurer

Thanks, Todd.

John P. Case

Thank you.

Operator

This concludes the question-and-answer portion of Realty Income's conference call. I will now turn the call over to John Case for concluding remarks.

John P. Case

Okay. Thanks, Craig, and thanks everyone for joining us today. We appreciate your time and we look forward to seeing many of you at NAREIT and speaking to you again at the beginning of the year for the fourth quarter call. Everybody have a great Halloween. Take care.

Operator

Thank you. Ladies and gentlemen, that will conclude the conference call for today. If you would like to listen to a replay you may do so by dialing either 303-590-3030 or 1-800-406-7325. You'll need to enter the access code of 4644579. Those telephone numbers once again are 303-590-3030 or 1-800-406-7325 with the access code of 4644579. Again, we thank you for your participation. You may now disconnect your lines at this time.

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