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Realty Income Corporation (NYSE:O)

Q4 2013 Earnings Conference Call

February 13, 2014 4:30 PM ET

Executives

Terry Miller – Vice President-Investor Relations

John P. Case – Chief Executive Officer

Paul M. Meurer – Executive Vice President, Treasurer and Chief Financial Officer

Sumit Roy – Executive Vice President and Chief Investment Office

Analysts

Juan Sanabria – Bank of America Merrill Lynch

Ross T. Nussbaum – UBS Securities LLC

Todd J. Stender – Wells Fargo Securities LLC

Christopher A. Lucas – Green Street Advisors, Inc

Rich C. Moore – RBC Capital Markets

Emmanuel Korchman – Citigroup Global Markets Inc.

Todd Lukasik – Morningstar Research

Jonathan Pong – Robert W. Baird & Co.

Chris R. Lucas – Capital One Securities, Inc.

Operator

Good afternoon ladies and gentlemen and thank you for standing by. Welcome to the Realty Income Fourth Quarter 2013 Operating Results Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for question (Operator Instructions)

I would now like to turn the conference over to Ms. Terry Miller, Vice President of Investor Relations. Please go ahead ma’am.

Terry Miller

Thank you Danielle and thank you all for joining us today for Realty Income’s fourth quarter and 2013 operating results conference call. Discussing our results will be John Case, our Chief Executive Officer; Paul Meurer, Executive Vice President, Chief Financial Officer and Treasurer; and Sumit Roy, Executive Vice President and Chief Investment Officer. Also joining us on the call is Mike Pfeiffer, our Executive Vice President and General Counsel.

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. We will disclose in greater details the factors that may cause such differences in the Company’s 2013 Form 10-K.

Thank you. 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 certainly pleased with our operating performance for the fourth quarter and our record setting results for the year. I am going to have Paul start and provide an overview of the number. So Paul?

Paul M. Meurer

Thanks John. As usual I will comment on our financial statements, provide some highlights of the financial results for both the quarter and the year starting with the income statement, total revenue increased over 62% for the quarter and over 61% for the year. This increase obviously reflects our significant growth from new acquisitions over the past year as well as healthy same-store rental growth. Our rental revenue at December 31 on an annualized basis was approximately $819 million.

You will note this quarter that we also have added new disclosure regarding tenant reimbursement as an additional revenue line item as well as an identical offsetting amount added to our property expense line. This refers to property expenses that we simply pay first and then get reimbursed by the tenant.

There is no financial impact to our earnings they offset each other as revenues and expenses and this is simply new disclosure in our income statements this quarter. On the expense side, depreciation and amortization expense increased to over $85 million in the quarter and depreciation expense is obviously increased with our portfolio growth.

Interest expense increased in the quarter to $50.6 million. This increase was primarily due to the $750 million issuance of 10 year bonds last July, as well as some credit facility borrowings during the quarter. On a related note, our coverage ratios both remained strong with interest coverage at 3.6 times and fixed charge coverage at 3.0 times.

General and administrative or G&A expenses in the fourth quarter were approximately $16.5 million. They were $56.8 million for the year. Our G&A expense naturally did increased this past year as our acquisition activity increased and we added some new personnel to manage a larger portfolio. Our employee base has grown from 97 employees a year-ago to 115 employees today.

Overall our total G&A in 2013 as a percentage of total rental and other revenues was still only 7.5% for the low end of our historic run rate of 7.5% to 8% from revenues. However, our 2013 G&A also had about $8 million of non-recurring unique expenses from accelerated stock vesting of our old 10 year grant back in the third quarter and the acceleration of our former CEO's pay compensation into the 2013 calendar year. To our current projection for G&A for 2014 it’s only about $50 million or approximately 5.5% of revenues.

Property expenses are noted as $13 million for the quarter and $39 million for the year. However, as I mentioned these amounts include property expenses reimbursed by tenant. The property expenses that we are responsible for were approximately $3.7 million for the quarter and $13.9 million for the year. And our projection for 2014 for property expenses that we will be responsible if $16.5 million.

Income taxes simply consist of income taxes paid to various states by the Company and they were $670,000 for the quarter and $2.7 million for the year. Merger related costs just a reminder this line item refers to the costs associated with the ARCT acquisition earlier in the year and during the quarter, we expensed the remaining $138,000 of such costs.

Income from discontinued operations for the quarter totaled $15.2 million. This income is associated with our property sales activity during the quarter. We sold 22 properties during the quarter for $28 million with a gain on sales of $14.3 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 $53.9 million for the quarter. Reminder that our normalized FFO simply adds back the ARCT merger related cost to FFO. So our normalized funds from operations or FFO per share was $0.61 for the quarter, an 8.9% increase versus a year ago and $2.41 for the year, a 19.3% increase over 2012.

Adjusted funds from operations or AFFO or the actual cash we have available for distribution as dividends was $0.52 per share for the quarter, a 12.7% increase versus a year-ago or $2.41 for the year, a 17% increase over 2012. With this growth and earnings we again increased our cash monthly dividend this quarter. We have increased the dividend 65 consecutive quarters which is over 16 years of consecutive quarterly dividend increases.

Dividends paid for common share increased over 21% this year and our monthly dividend now equates to a current annualized amount of $2.186 per share.

Briefly turning to the balance sheet. We’ve continued to maintain a conservative and very safe capital structure. As you know in October, we raised $397 million of new capital with a common equity offering. Also on October we expanded our acquisition credit facility to $1.5 billion. As of today we have $583 million of borrowings on that line. We did not assume any in place mortgages during the fourth quarter. We did pay off some of the maturity, so our outstanding net mortgage debt at year-end decreased to approximately $755 million.

Our bonds which are all unsecured and fixed rate and continue to be rated Baa1 BBB+ had a weighted average maturity of almost eight years. Our overall debt maturity schedule is also in very good shape, but only $50 million of mortgages coming due in 2014 and $125 million of mortgages coming due in 2015, and our next bond maturity is only a $150 million due in November of 2015.

Our overall current debt to total market cap is 33% and our preferred stock outstanding is only 5% of our capital structure. And our debt to EBITDA is only 6.1 times.

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

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

John P. Case

Thanks Paul. Let me began with this overview of the portfolio which continues to generate consistent cash flow. Our tenants are doing well based on what we're seeing today. As we see, we ended the year with 98.2% occupancy based on the number of properties with just 70 properties available for lease out of our 3,896 properties. This occupancy is from 97.2% one year ago. Our occupancy based on square footage and our economic occupancy are both at 99%.

Our property management growth, the largest department in the company has done a great job managing this occupancy and handling our 1,600 lease rollovers since 1990s. We are expecting our occupancy to remain fairly stable for the foreseeable future.

Our portfolio remains diversified by tenant, industry, geography and property type. At the end of 2013, our properties were leased to 205 commercial tenants in 47 different industries and located in 49 states plus Puerto Rico.

77% of our rental revenue comes from our traditional retail properties, while 23% comes from non-retail properties with the largest component, the industrial and distribution. We believe this diversification is important and leads to more predictable cash flow streams for our shareholders every time.

At the end of the fourth quarter, our 15 largest tenants accounted for 44.6% of rental revenue. That’s down from 47.1% for the same period one year ago. So we continue to make progress on this over time. In 2008, the top 15 accounted for 54.3% of our rental revenues.

Within the top 15 there was very little movement from last quarter to this quarter with 15 tenants being represented. No single tenant accounts for more than 5.2% of rental revenue. The diversification by tenant remains quite favorable for us. FedEx continues to be our largest tenant at 5.2% of rental revenue, which is virtually unchanged from last quarter. Walgreens and Family Dollar are again our second and third largest tenants at 5% and 4.8% rental revenue respectively.

Walgreens was flat from last quarter, while Family Dollar is down 4.3% and then all other tenants are at or below 3.1% of rental revenues. When you get down to the 15 largest tenants which is Walmart/Sam's Club, it represents only 1.6% of rental revenue and the percentages trail off from there.

We’ve added 55 new tenants to the portfolio this year further enhancing our tenant diversification. Convenient stores remain our largest industry but continue to check down as a percentage of rental revenue. Convenient stores now represent 10.6% of rental revenue down from 14.9% a year ago.

Drug stores are now at 9.7%, up from 3.3% a year ago. This was the fastest growing industry for us in the last year. It’s well aligned with our strategy of targeting high quality non-discretionary retailers and attractive locations. Restaurants, if you combine both casual dining and quick service segments are now at 9% down from 12.4% a year ago.

Dollar stores are now at 7.1%, up from 4.3% a year ago. We continue to provide the deep value proposition this industry offers to our consumers in this economy with consumers under a bit of pressure. Health and fitness is at 6.8%, Theaters are at 5.6% and transportation services are at 5.4% of total revenues.

All other industry categories are at or below 4.3% of revenue. So, we continue diversifying our rental revenues by industry. Looking a property type retail always has represents the primary source of our rental revenues at 77% of property revenues with industrial and distribution at 11%, office at 6.5% and the reminder basically evenly divided between manufacturing and agriculture.

Of course, we know retail well we continue to focus on retail tenants that meet our investment parameters, more than 90% of our retail portfolios have a service non- discretionary and/or low price point components to investments. We believe these characteristics better position these tenants to successfully operate in all economic environments and make them less vulnerable to Internet competition. Regarding lease length, the average remaining lease terms continues to be just under 11 years.

Same-store rents increased 1.8% during the fourth quarter, which we’re pleased with, for the year they increased 1.4%. This level of growth is where we expect it to continue for reminder of the year.

Let me take a moment on tenant credit, the credit quality of the portfolio continues to be healthy with 40% of our rental revenue generated from the investment grade tenants. With upon investment grade tenants, those tenants is having an investment grade rating by one or more of the 3 major rating agencies. This revenue percentage is consistent with where it was last quarter, but it’s off from 23.5% at the end of 2012 of the last four years we’ve established a significant foundation of revenues from investment grade tenants, add investment spreads above our historical spreads. Creating a stronger credit profile for our tenant base.

We’re also pleased with the rental growth we have been able to generate from these investment grade tenants, 70% of our investment grade leases have renovate increases in them which average 1.5% annual which is consistent with our historical portfolio rental growth rate.

Moving on to the property acquisitions, we completed $1.5 billion for the year, at an initial yield of 7.1%. This volume is a record, adding the $3.2 billion acquisition of our ARCT that closed in January of last year. We made a total of $4.7 billion in investments.

Regarding cap rates, our policy again is to announce first year cash cap rates for the market and not GAAP cap rates which tend to be notably higher due to the straight lining of rent. We continue to see attractive investment spreads relative to our weighted average cost of capital. During the year, our average spreads to our WAC, our weighted average cost of capital was 155 basis points reverting to our long-term average.

Now, I’d like to hand it over to Sumit, who will provide some additional color on our acquisitions activity for the quarter and for the year. Sumit?

Sumit Roy

Thank you, John. As John mentioned during the fourth quarter, we made $145.3 million in property level investments in 66 properties at an average initial cash yield of 7.3% with a weighted average lease term of 12.5 years.

62% of the revenues generated by these acquisitions is from investment grade tenants. These assets are leased to 21 different tenants in 16 different industries. Most significant industry is represented with discount stores, drug stores, diversified industrial and health and fitness. The properties are located in 28 states, and 80% of the investments are comprised of our traditional retail properties.

In 2013, we invested $1.514 billion in 459 properties, at an average initial cash cap rate of 7.1% and lease term of 14 years. 65% of total rents are generated by investment grade tenants. The assets are leased to 32 different tenants in 23 different industries. Most significant industry is represented with drugstores, discount stores, health and fitness and wholesale clubs. The properties are located in 40 states. 84% of the investments are comprised of our traditional retail properties, 10% industrial and 9% in office.

Including ARCT, we have invested $4.7 billion in 974 properties in 2013. Regarding transaction flow, we continue to see mostly a record volume of transaction this year. We sourced $39.4 billion in acquisition opportunities in 2013 of which $2.6 billion was sourced in the fourth quarter.

To put it in perspective the $39.4 billion sourced in 2013 was more than double 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 of transactions. However, of the 1.5 billion in property level transactions closed in 2013 over 30% or approximately $461 million where one-off transactions.

Our relationships continue to be a paramount importance to us. Approximately 66% of the 1.5 billion in transactions closed in 2013 were relationship driven. As you can see we have continued to leverage our relationships and have remained very selective in our investment and our pursuing only those transactions that offer superior risk adjusted returns and fit our strategic portfolio objectives.

Overall, we have been pleased with the investment results achieved in 2013. After pricing, cap rates have remained stable in the fourth quarter. The stickiness of the cap rates are testament to the amount of capital continuing to pursue transactions. Investment grade property cap rates range from 6.25 to 7.15. Non-investment grade properties are trading from7.25 to 8.25 cap rate.

From 2010 to 2013, we have consummated over $4.4 billion in organic acquisitions, that’s excluding ARCT, of which 55% has been investment grade credit and approximately 45% non-investment grade or non-rated credit. We invested over $1.8 billion during this period in our traditional non-investment grade retail of which approximately $418 million was in 2013.

To put this in context, this was a more active 4 year period for investments in non-rated, non-investment grade retail than any other 4 year period in our company’s history. Our investment philosophy of pursuing opportunities that provide the best risk adjusted returns across the credit spectrum remains consistent with our stated strategy.

For 2013, our investment spread remains healthy. Spreads relative to a nominal cost of equity averaged 112 bps for the year, as compared to our historic average of approximately 110 bps. For the quarter they were closer to 135 bps. As John mentioned, looking at our investment spreads relative to our weighted average cost of capital, we averaged 155 bps which is comparable to our historical average. We have continued to make investment at historic spreads while improving the credit its tenants and cash flows associated with those investments.

So in conclusion we saw an exceptional level of volume in the sector and have been pleased with our $1.51 billion investment in 2013. Including ARCT we invested $4.7 billion in 2013, by par a record investment year for us. John?

John P. Case

Thanks Sumit. We recently disclosed as we know a $503 million acquisition of 84 single tenant net lease properties from d diversified. We believe this acquisition should close in three trenches during the first quarter or first four months of the year. The first tranche of 46% properties closed at the end of January for $202 million. It’s our policy not to announce acquisitions since or after they close, however in this case the seller was required to disclose the contract so we also disclosed a potential sale.

We are subject to a confidentially agreement within one that prevents us from commenting on the transaction, beyond what is already been publically disclosed in the file they case.

As this is our custom we will address all quarterly acquisition activity collectively on the earnings call following the quarter and which is close.

Going to property dispositions we continue selling select properties and redeploying the capital into investment that are better that our investment strategy.

During the year, we sold 75 properties for $134.2 million at a cap rate of approximately 7% on the sale of leased assets. We currently believe our dispositions for 2014 will be in the neighborhood of $50 million possibly reaching $75 million.

Moving on to the balance sheet as Paul mentioned we remain conservatively capital loss with excellent access to all forms of capital. Currently we have more than $900 million available on our line to fund acquisition. We will continue to match fund our acquisitions with permanent and long-term capital, the majority being equity. All our bond issuance in our company’s history that’s 14 of them at a term of 10 years or longer with the exception of one, a five-year notes insurance. We did smooth out our maturity schedule. And outside temporary borrowings on the credit facility 100% of our outstanding debt is fixed rate.

On to our earnings for 2013, normalized FFO and AFFO were both $2.41 per share for the year. Our growth in normalized FFO per share was 19.3%, more than double our previous historical volume. And growth in AFFO per share was 17% versus 2012, also a record.

As we look forward, coming off such a good year from an operational perspective, we remain quite optimistic as we continue to see a robust market for acquisitions with excellent investment opportunities in both non-investment grade retail assets as well as investment grade properties.

Over our 45-year history, we’ve developed many relationships through which we are continuing to generate acquisition opportunities. We are raising our acquisitions guidance for 2014 from $1 billion to $1.2 billion.

Our earnings guidance for 2014 remains at $2.53 to $2.58 per share for both normalized FFO and AFFO. We are maintaining our earnings guidance despite the increased guidance through acquisitions due to the anticipated timing for these acquisitions. Our dividends pay during the year increased by just over 21% compared to 2012, the largest increase in our company’s history.

In December, we declared our 74th dividend increase since the company went public in 1994. We remain optimistic that our activities will continue to support our ability to increase the dividend. Our payout ratio during 2013 was approximately 88% of our AFFO, which is at a level we are comfortable with.

So with that, I’d now like to open it up for questions. Danielle?

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions) And our first question is from Juan Sanabria with Bank of America. Please go ahead.

Juan Sanabria – Bank of America Merrill Lynch

Good afternoon, guys. I was just hoping you could speak a little bit more about the trend you’re seeing, cap rates, you said they were fairly sticky in the fourth quarter partially due to the sort of rate of money I guess. Do you anticipate that the stay that the case kind of for the foreseeable future in 2014 based on what you’re seeing? And, you talked a little bit about historic spreads and the spreads you got in the fourth quarter. But could you give us a sense where spot spread is relative to your cost of capital and how you’re thinking about that?

John P. Case

Sure, Juan. First of all, with regard to cap rates, we expect them to stay pretty steady. There is a lot of capital out there pursuing these types of assets. So we don’t anticipate them climbing from here. With regard to spreads, our spot spread, if you will, is roughly equivalent to where we were for 2013. So at this point it looks like we’re holding our spreads. Spreads are down from their peak year of 2012. Its capital has been reprised and there we just see sudden movement last year in cap rates and then they stabilized.

Juan Sanabria – Bank of America Merrill Lynch

Okay, great. I kind of mixed this rather quickly. The reason the guidance here are the same, yet the acquisitions was prompt for the 2014 guidance, you said it was if I understand correctly because of the timing, would it seems like you’ve drawn on your revolver implying you’ve done a fair chunk of the 1.2% sort of year-to-date, I was just curious if you give little bit more color as I may have missed the details.

John P. Case

Yes, it’s based on timing and as you know from the time we solicit a transaction to the time it actually close, this can take up to six months. So from a timing perspective we would anticipate the additional acquisitions occurring later in the year and having more of an impact on 2015 and 2014.

And as you know the quarter is a pretty lumpy for acquisitions for instance last quarter we did a $145 million in the year end which we did $1.5 billion of total acquisition, so you can never really extrapolate from one quarter to an entire year, so we are comfortable with the guidance where it is.

Juan Sanabria – Bank of America Merrill Lynch

Okay and the drawdown of the revolver since the end of the year that should we assume that is related to acquisitions?

John P. Case

Yes.

Juan Sanabria – Bank of America Merrill Lynch

Okay great thank you guys.

Paul M. Meurer

Thank you, Juan.

Operator

And our next question is from Ross Nussbaum with UBS. Please go ahead.

Ross T. Nussbaum – UBS Securities LLC

Hi guys good afternoon.

John P. Case

Hi Ross.

Ross T. Nussbaum – UBS Securities LLC

My question to you would this, if you are forecasting now $1.2 billion of acquisitions, what probability would you put on doing say twice that versus you are not going to do not, I’m just wondering given the robust pipeline that’s out there and what you’ve got all ready sort of locked up. Do you still think that $1.2 billion, you guys have always been conservative in your guidance and I’m just sitting here wondering are we still in an arena where you could just blow that away?

Paul M. Meurer

Well, we are quite selective Ross, as you kind of let me – over the last few years we’ve been buying 6% to 12% of our source transactions, so it’s always driven by what the opportunities are? Do those opportunities need our investment parameters and are they priced appropriately and so there are always difficult to forecast. Right now investor expectation is approximately $1.2 billion, for organic property level acquisitions.

Ross T. Nussbaum – UBS Securities LLC

And based on what you are seeing, how much of that do you think it’s going to be in portfolios versus more smaller one-offs?

John P. Case

I would say, if you would normalize it for the end of the year, I’d say about 65% to 70% would be portfolio deals.

Ross T. Nussbaum – UBS Securities LLC

And from a property type perspective what are you thinking in terms of how much of that’s going to be retail versus other?

John P. Case

The vast majority would be retail.

Ross T. Nussbaum – UBS Securities LLC

Okay, thank you.

John P. Case

Thank you, Ross.

Operator

Our next question is from Todd Stender with Wells Fargo. Please go ahead.

Todd J. Stender – Wells Fargo Securities LLC

I guess I’ll start with you Paul, just on the sourcing capital front, can you just comment on the preferred market, kind of how it influences your capital sourcing activity and out for sometime that preferred market has been essentially closed and I know you guys have room in your capital stack for, but I want to as you look out over the next couple of quarters how you’re budgeting your capital.

Paul M. Meurer

I think my comments can be fairly short talking about the preferred markets. It is pretty opportunistic as you know. It’s going to ebb and flow kind of be more available at different times, and I have to say as a general remark, it’s not the most available market at the moment. I only say that you could actually do it, but related to where you could issue and therefore have a reasonable spread really doesn’t make sense. I think that case there maybe high fixes on a coupon and so that's not something we're really staring out at the moment. Over time we love preferred, no maturity obviously, and great way to match fund, long-term assets like we like to probably do the longer debt, but at the moment preferred is probably not in the cards for the foreseeable future.

Todd J. Stender – Wells Fargo Securities LLC

Okay. Thanks. And then on the same store growth, it seemed pretty high, was 1.8%. I think, John, you mentioned little closer 1.5%. How did you get that high’s? Usually I guess where you stood may be closer to 1%, but it’s made a pretty good move, I guess what’s contributing to this?

John P. Case

Well, in 2012, we were impacted by a couple of bankruptcies, Buffets and Friendly. So that put a bit of a lid on it and it’s picked back up as we’ve pushed through that into 2013. The growth is coming from a number of industries, in convenient stores, quick service restaurants, beverages, they're all doing quite well for us and we think it should be around 1.5% for the year and that’s sort of a run rate right now we're pretty comfortable with.

Todd J. Stender – Wells Fargo Securities LLC

Okay. Just sticking with you, John, I think you mentioned this. Can you just repeat the percentage of investment grade tenant leases that contain annual rate escalators did you say 7% to 8%?

John P. Case

Yes, 70% of our investment grade leases have rent growth which average 1.5% a year.

Todd J. Stender – Wells Fargo Securities LLC

Okay. Thank you. Just switching gears, I think you alluded to this, but if not can you just talk about some of the qualitative benefits that you’ve realized, I guess going back from your ECM portfolio acquisition, which got you into the industrial segment? And then you’ve got ARCT, which moved the needle for you guys into the investment grade segment. Items like relationships you develop with new tenants or maybe your first look at a sale lease back, anything you can share with us that you benefited from these large portfolio transactions?

John P. Case

Yes, I think you’ve hit on it. We have really been able to multiply exponentially the number of tenant relationships we have and the opportunities for investment in terms of properties. So one reason for the increase and the source volume activity has been your net lease has been mainstream. So I think everybody is seeing more of it. So we’re seeing more of it in the retail alone, but we’re also seeing more of it as the property types in which we can invest or expand it.

So we’ve seen more activity as a result of the acquisitions we’ve done and had really many more relationships through which to generate acquisition opportunities. So, I mean, we had to size today, where we feel like we see everything in the marketplace and I don't think that was the case for apps four, five years ago.

Todd J. Stender – Wells Fargo Securities LLC

Okay. Thanks. And finally, just on the disposition front. How are you kind of thinking about that as you look out to 2014? Are we going to see more of the mix on vacancies, the short-term leases, any property types, any color you can provide on dispositions?

John P. Case

Yes, when you look at the dispositions, we're thinking maybe 50 million to 75 million for this year. When you look at the activity there, it's a combination of assets, where we’ve seen perhaps the operating performance decline, any areas where we would like to decrease our industry exposure, or where we have the few credit concerns. And in a few cases, there is some assets that are performing all right, but just don’t meet our investment strategy, in other words, it could be a multitenant asset that we are selling.

Todd J. Stender – Wells Fargo Securities LLC

Okay. Thank you very much.

John P. Case

Thanks.

Operator

Our next question is from Chris Lucas with Green Street Advisors. Please go ahead.

Christopher A. Lucas – Green Street Advisors, Inc

Thanks and good afternoon guys. The other quick question on depositions in the convenience stores, can you kind of – looking at your portfolio today you mentioned convenience store concentration is down slightly versus Q3. What’s the right level of convenience stores and casual dining restaurants in your portfolio and how long do you think it will stay together?

John P. Case

Yes. We were comfortable with where they are today. We brought and sold significantly down sea stores and restaurants and 10% were comfortable. We had selectively sold some properties in both of those sectors, but really our concentration levels were brought down through our growth and diversified asset pools like the ones that we’ve been watching and a bit concerned with. We continue to look at in particular a couple of casual dining situations and then a couple of the smaller sea stores that don’t produce the same sort of store sales figures that we like to see in our investments there.

Christopher A. Lucas – Green Street Advisors, Inc

Got it. Thanks and just one more question. Just going back to the 70% of investment grade leases that have red bumps, could you give a break down of that by property type?

John P. Case

Yes. The industrial distribution and office are both around 2% and the retail is at 1.25%.

Christopher A. Lucas – Green Street Advisors, Inc

Okay, got it. And then in that 70% how much of that is say, I don’t know 50% retail, maybe 30% industrial in terms of the composition of actual 70%?

John P. Case

Yes, I think retail is probably about half of it. And then the other categories constitute the remaining half.

Christopher A. Lucas – Green Street Advisors, Inc

Got it. Thanks guys.

John P. Case

Yes, thanks.

Operator

Our next question is from Rich Moore with RBC Capital Markets. Please go ahead.

Rich C. Moore – RBC Capital Markets

Hi, good afternoon guys. I am curious, the boundary line in credit John, I mean you have $600 million underlying credit at the moment and I assume we will be taking that out with permanent capital fairly quickly. And then I am wondering why the 1.5 billion, are you anticipating that you will need the 1.5 billion capacity, I guess?

John P. Case

Let me start with the first part of your question. We have plenty of flexibility right now on the revolvers that we have no immediate concrete permanent capital or long-term capital plans. So that’s the first answer to your first question.

Why the size? We like the additional liquidity and security and safety that provides the company and it also allows us to pursue larger transactions on a non-financing contingent basis, which really is a competitive advantage that only a few players in the market have.

Rich C. Moore – RBC Capital Markets

Yes, the other is…

John P. Case

The other piece of flexibility Rich is timing of the capital rates. So kind of looking now, which again John said, is not eminent in terms of definitive plans we have at the moment, but then able to time the market appropriately having the balance they are likely to do that.

Rich C. Moore – RBC Capital Markets

Okay. So, have you guys seen something of the size that you would need a credit line that big to take down?

John P. Case

Well, I mean we’ve seen opportunities with all different forms and shapes and sizes. So we’ve seen over the last several years a few opportunities that would have required the vast majority of that revolver.

Rich C. Moore – RBC Capital Markets

Okay, good. Got it. Thanks. And then, I’m curious on the operating expense. I’m not sure why you made that change and it’s interesting that you did, but it’s probably just more detail, but so I guess that’s each question…

John P. Case

Question about the tenant reimbursement stuff?

Rich C. Moore – RBC Capital Markets

Yes, including the tenant imbursements and breaking it out.

John P. Case

You know what, Rich, I don’t like it. I mean, it’s one of those things at the disclosure standpoint. It’s an appropriate accounting approach and it doesn’t add anything for you guys, because these are basically expenses that we do get reimbursed for. We don’t have major outstanding receivables related to them anything like that, but disclose rate through.

The issue was they’ve just gotten to be a little bit more in size. So once they reach little bit more of a material amount, which is now about $25 million annually it was prudent to break it out at some additional disclosure. But I wanted to make sure I was highlighting to you don’t count that in the revenue line and forget about the fact that it offset immediately down the expense line.

Rich C. Moore – RBC Capital Markets

Right. Okay. I got your point. So, when you’re looking at the small operating expenses with the operating expenses that are reimbursed, it went down a little bit this quarter, I mean, it’s not a huge number to begin with, but only down. And remind me, is that just a vacant asset or do guys have some of the multi-tenant or double net type leases or something like that that is also part of that?

John P. Case

No, it’s both. I mean, historically it was primarily carry cost on the vacant properties, tax of insurance, utilities. But over the last 18 to 24 months we have purchased properties with double net structure where we have some responsibilities for roof and structure and as such that budget is in there as some additional property expenses, still only $16.5 million budgeted for next year on what the current run rate of $890 million of annualized revenue. So, still not a huge number, but it has gone up a bit past few years.

Rich C. Moore – RBC Capital Markets

Okay, good. Thanks. And then, the last thing. The other revenue line item, which you know has a couple of crazy things in it. Do you guys have an estimate for what that might be or is there just no way to do that?

John P. Case

Yes, the way I will answer that is don’t put zero in because something always tends up there. Business property taking, which could be an eminent domain grab of some property line if they widened the highway, it’s kind of pretty money if you will. In many cases not impinging on your parking or things of that nature.

And then, interest income. If you have cash that’s received early that you’re putting away in a bank briefly for some income or you’ve raised something on offering that you haven’t used for a day or two. So it just ends up being something. So my only advice it’s to not put zero in, but I hate to give a number, but there is always going to be something there.

Rich C. Moore – RBC Capital Markets

Okay, good. Great. Thank you, guys.

John P. Case

Thanks, Rich.

Operator

The next question is from Emmanuel Korchman with Citi. Please go ahead.

Emmanuel Korchman – Citigroup Global Markets Inc.

Hey, guys.

John P. Case

Hi, Emmanuel.

Emmanuel Korchman – Citigroup Global Markets Inc.

When you guys think about the investment spreads you’ve been quoting in the spreads, your weighted average cost of capital. Do you think that was permanent financing or using a line especially in sort of spot investments?

John P. Case

No, we’re looking at it based on permanent financing using roughly two-thirds equity, one-third 10-year fixed rate notes.

Emmanuel Korchman – Citigroup Global Markets Inc.

Got it. And then, if we think about the pipelines that we look at and maybe passed on, I think you’ve quote numbers around $60 billion over the last couple of years. How much of that is ended up in sort of either public or other known hands and how much of it has been bought from the market?

John P. Case

I’d say a significant portion has ended up in the hands of public or private. So we see a lot of it in terms of the exact breakdown.

Paul M. Meurer

You’re right. Yes, you’re right, John, I’d say a majority of them have ended up in either public or private hands, but there have been occasions on large, very large transactions that we aware of where those transactions will float.

John P. Case

Yes.

Emmanuel Korchman – Citigroup Global Markets Inc.

And was it mostly a pricing thing that it ended up, that you guys passed on it or where there other considerations?

John P. Case

The situations that I’m alluding to you were all driven by pricing considerations.

Emmanuel Korchman – Citigroup Global Markets Inc.

Great. That’s all from me. Thank you.

John P. Case

Thanks, Emmanuel.

Paul M. Meurer

Thanks.

Operator

Our next question is from Todd Lukasik with Morningstar. Please go ahead.

Todd Lukasik – Morningstar Research

Hi, guys. This is Todd Lukasik. Thanks for taking my questions today.

John, P. Case

Hey, Todd.

Todd Lukasik – Morningstar Research

Hey. It’s just a question on office. 6.6% of revenue, it looks like and there is a [indiscernible] submitted into the portfolio again this past quarter. I think in the past you guys have talk about that not being one of your favorite property types. I’m wondering if there is anything in particular about the assets that you’re buying there that are especially attractive or sellers are requiring that those be concluded in deals or that may change in thinking around those office properties?

John, P. Case

Well, the office asset, we were typically acquiring office properties that are part of larger portfolios of retail and industrial and distribution properties. That is not always the case. Times will extend our relationship, for instance, with some of our retail tenants by purchasing their office or industrial property as well. So we’ll see some activity from those areas, but our objective is keep office fairly low as a percentage of our overall property rental revenue.

Todd Lukasik – Morningstar Research

I know some of those are coming on the balance sheet because the seller is requiring that be part of the deal?

Paul M. Meurer

No fairly. I mean, like John said sometimes they’re any larger portfolio meaning a service pack transaction that was already affected by another service pack provider in this part of a portfolio or it’s the direct conversation with a strong long-term retailer relationship where the assets take a look at, say, their headquarters’ location as an asset we consider doing something with. But not fortunate as that’s part of a larger deal in dialog.

Todd Lukasik – Morningstar Research

Got you. Okay, that’s helpful. And then, just with regards to AFFO coverage on the dividend, with more industrial and distribution facilities office assets on the balance sheet, those things expire if the tenants doesn’t renew there may be more leasing cost or CapEx that needs to be put into some of those properties to define a new tenant. Is that the kind of thing that might cause you to think to lower the AFFO payout ratio overtime as those we can start to roll or is that you’re comfortable with sort of 88% level in light of those possible incremental cost on the road?

Paul M. Meurer

Don I think over time we would like to see at the just bit lower somewhere in the mid 80s is the level we think we will be comfortable with.

John P. Case

Having said that we’ll continue to grow the dividend, as it relates…

Todd Lukasik – Morningstar Research

Sure

John P. Case

Our overall earnings growth so, if you are talking about x percent of growth, then we are going to be try and grow the dividend 0.8x or whatever might be, to try to move that payout ratio down a little bit over time but it will certainly result in what we think will be dividend growth that will be amenable to and helpful to the investor from a return perspective over time.

Todd Lukasik – Morningstar Research

Yes, okay, got you. That’s helpful. Thanks a lot guys.

John P. Case

Thanks Todd.

Operator

And our next question is from Jonathan Pong with Robert W. Baird. Please go ahead.

Jonathan Pong – Robert W. Baird & Co.

Hey good afternoon guys.

John P. Case

Hey Jonathan.

Jonathan Pong – Robert W. Baird

Sumit I think you mentioned earlier there is a 65-35 split between portfolio and single tenant deals for 2014, is that 65 include the MN deal or I just think going forward deal yet to announced is going to be 55% portfolio?

Sumit Roy

Yes, Jonathan that was a back foot looking that is for 2010 to 2013 so it been obviously included inline transaction which has been closed which includes till 2014.\

Jonathan Pong – Robert W. Baird

Got it, so 2014 what do you think that split ends up?

Sumit Roy

No, it’s going to be similar, I think there was a question asked around where do we see a lot of our volume composition, how do we see our volume competition on the opposition side and I still believe that it’s a big chunkier transaction drive volume and that will represent 65 to 70% of it. And in terms of investment grade versus non-investment grade, it;s going to function of our cost of capital and what we see in the market. There was a repricing of our cost of capital which allowed us to look at areas that we have traditionally being perusing to get the kind of spread we been able to track and so I could see it being right around that 50% to 60% investment grade for 2014 as well but it could be different.

Jonathan Pong – Robert W. Baird

All right, Then Paul may be a balance sheet question, on the inland purchase there another some debt that you are assuming there of the trenches that are yet to close how much more the revolver is inland going to take on?

Paul M. Meurer

Well, as you know with $202 million at the end of January close and some of that involved assuming mortgages about $50 million or so and though you cannot do the math from there because $500 million transaction the montage amount on it, is that 150 so a 100 is assumed out of the $300 million left to close so say $200 million is need on the facility to ultimately close the balance of the inline transaction.

Jonathan Pong – Robert W. Baird

Great that’s helpful. Thanks a lot.

Sumit Roy

Thanks Joe.

Operator

Our next question is from Chris Lucas with Capital One Securities. Please go ahead.

Chris R. Lucas – Capital One Securities, Inc.

Good afternoon guys. As John I just want to see if you can give some more color on the acquisition environment and particular I guess what I am trying to under is where the most competitive size of deal, is it the one-off, is it the small portfolio, where is the market most competitive right now?

John P. Case

It’s most competitive on larger portfolios where there – you’re definitely seeing spell in this market, premium cap rates, foreign cap rates for the same asset and a $300 million portfolio transaction then you would see any one-off asset transaction. And again, I attribute that to the fact that there is a fair amount of capital in our industry and business and to deploy it efficiently and quickly once they premium paid for the asset at the. So we do see that spread all things being equal, and asset acquired on a one-off basis. That’s going to have a higher cap rate than one acquired on a larger portfolio. However, that is not universally the case, but that’s certainly the trend perhaps.

Chris R. Lucas – Capital One Securities, Inc.

And then just a question on that. If the 10/31 market is recovering at all, is there much activity coming from sort of that one-off buyer, the small individual tax incentive buyer?

John P. Case

There is more activity. We saw more activity in 2013 than we did in the previous few years combined property. So it's come back. It's still not back to where it once was, pre-Great Recession, but we’re seeing more activity there.

Chris R. Lucas – Capital One Securities, Inc.

So what do you think changes that momentum? Is this financing availability or – well, turned up investments. What you think of kind of gain.

John P. Case

Yes this is a bit more of an impressive investment environment that you had. Again, people are getting their feet under that and feeling a bit more confident even though the economic signals appear to be mixed. They're just seeing more people go into transaction in that marketplace.

Chris R. Lucas – Capital One Securities, Inc.

Okay. Thanks a lot guys. I appreciate it.

John P. Case

Thanks Chris.

Paul M. Meurer

Thanks.

Operator

Ladies gentlemen, this concludes the question-and-answer portion of Realty Income conference call. I would now turn the call over to John Case for concluding remarks.

John P. Case

Thanks, Danielle, and thanks everyone for joining us today. We appreciate your time and we look forward to speaking with you again next quarter. Take care.

Operator

Ladies and gentlemen, that does conclude the conference call for today. Thanks again for your participation and you may now disconnect.

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