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Realty Income Corp (NYSE:O)

Q3 2011 Earnings Call

October 27, 2011 4:30 pm ET

Executives

Tom Lewis - Vice Chairman

Gary Malino- President

Paul Meurer- EVP and CFO

John Case - EVP and CIO

Mike Pfeiffer - EVP and General Counsel.

Analysts

Lindsay Schroll - UBS

Joshua Barber - Stifel Nicolaus

Greg Schweitzer - Citigroup

Tayo Okusanya - UBS

RJ Milligan - Raymond James

Todd Lukasik - Morningstar Securities

Richard Moore - RBC Capital Markets

Todd Stender - Wells Fargo Securities

Operator

Good afternoon ladies and gentlemen thank you for standing by. Welcome to the Realty Income Third Quarter 2011 Earnings Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions)

I would now like to turn the conference over to Mr. Tom Lewis. Go ahead sir.

Tom Lewis

Thank you, Joe. Good afternoon everyone and welcome to our conference call. We will go throw the operations and results for the third quarter and year to-date. With me in the ring today as usually is Gary Malino, our President, Paul Meurer, our EVP and CFO, John Case, our EVP and Chief investment Office and Mike Pfeiffer, our EVP and General Counsel.

And as always during this call, we will make certain statements that may be considered to be forward-looking statements under Federal Securities Law and the company’s actual future results may differ significantly from the matters discussed in the forward-looking statements, we’ll disclose in greater detail in the company’s Form 10-Q, the factors that could cause the differences.

And as usual Mr. Meurer will start with the review of the numbers,

Paul Meurer

Thanks Tom. As usual let me go through the financial statements briefly, provide a few highlights of the financial results for the quarter, starting with income statement. Total revenue increased 23.6% to $107.39 million this quarter versus $86.8 million during the third quarter of last year. This obviously reflected a significant amount of new acquisitions over the past year, but also positive same store rent increases for the quarterly period of 1.8%.

On the expense side, depreciation and amortization expense increased by $7.9 million in the comparative quarter, as depreciation expense increases obviously as our property portfolio continues to grow. Interest expense increased by just over $3.4 million, this increase was due primarily to the June issuance of $150 million of notes in the reopening of our 2035 bond, but also because of the $96.6 million credit facility balance at quarter end.

On a related note our coverage ratios both remain strong; interest coverage is now at 3.9 times and fixed charge coverage now at 2.9 times. General administrative or G&A expenses in the third quarter were $7.1 million, representing 6.7% of total revenues, as compared to $6.2 million during the third quarter of last year, which represented 7.1% of total revenues at that time.

Our G&A expense has increased a bit, as our acquisition activity has increased and we have invested in some new personnel for future growth. This quarter’s G&A was also impacted by the expensing of $233,000 worth of acquisition due diligence cost. Our current projection for G&A for 2011 is approximately $30 million, which will represent only about 7% of total revenues.

Property expenses decreased to just under $1.7 million for the quarter. These expenses are primarily associated with the taxes, maintenance and insurance expenses, which we are responsible for on properties available for lease. Our current estimates for all of 2011 is about $7.5 million.

Income taxes consist of income taxes paid to various states by the company and they were $367,000 during the quarter. Income from discontinued operations for the quarter totaled just over $3.1 million. This income was associated with our property sales activity during the quarter. Our Crest subsidiary did not acquire or sell any properties in the quarter. We did sell 12 properties from our core portfolio resulting in gain on sales of $3.1 million and a reminder that these property sales gains are not included in our FFO or in our AFFO calculation.

Preferred stock cash dividends remains at $6.1 million and net income available to common stockholders increased to approximately $34.7 million for the quarter. Funds from operations or FFO increased 32.6% to $63.4 million for the quarter. FFO per share increased 8.7% to $0.50 for the quarter. Adjusted funds from operations or AFFO are the actual cash we have available for distribution as dividends was higher at $0.51 per share for the quarter and our AFFO is usually higher than our FFO because our capital expenditures are fairly low and we have minimal straight line rent in the portfolio.

We increased our cash monthly dividend again this quarter, we’ve increased the dividend 56 consecutive quarters and 63 times overall since we went public over 17 years ago this month. Our dividend pay-out ratio for the quarter was 87% of our FFO and 85% of our AFFO. Briefly turning to the balance sheet, we have continued to maintain a conservative and safe capital structure. In September as you know we raised just over $200 million of new capital in a common stock offering.

Our current debt to total market capitalization is only 28% and our preferred stock outstanding represents to 5% of our capital structure. And as I mentioned we have $96.6 million of borrowing on our $425 million credit facility. We have no debt maturities until 2013 and so in summary we currently have excellent liquidity and overall balance sheet remains very healthy and safe.

Let me turn the call now back to Tom, who will give you a little bit background on these results.

Tom Lewis

Thanks Paul.

I will start with the portfolio which performed very well during the third quarter operations continued to improve across portfolio. At the end of the quarter, our largest 15 tenants accounted for 51.2% of our revenue that was down a little bit from last quarter and the average cash flow coverage to store level for those 15 tenants remains fairly high at 2.41 times during the quarter.

We ended the third quarter at 97.7% occupancy and 59 properties available for lease out of the -- this is unusual where even number and number of properties 2,600 properties and that’s up about 40 basis points and occupancy from the second quarter and up about a 130 basis points for the same period a year ago.

In the quarter, we had only six new vacancies and then we lease ourselves 15 properties and obviously added to the portfolio and that’s the reason for the increase in the occupancy but obviously very healthy at 97.7%.

My sense is, we should look for some moderation in occupancy in the fourth quarter and that’s primarily due to a number of lease rollovers that occurred at the beginning of the quarter. There were 18 that came off lease and sometimes these rollovers get a bit lumpy and that was the case this quarter. And then a 15 Friendly’s properties we got back.

Our best estimate right now is about 97% of our occupancy at the end of the fourth quarter. And then we would anticipate as we re-lease, those properties that came off the rollover and Friendly’s that would go back up in the first quarter of next year, but a good guess is 97%.

Same-store rents on the core portfolio increased 1.8% during the third quarter that’s same as the second quarter and 1.5% year-to-date, that’s a very healthy number for us in that lease company.

And if you wanted to look across portfolio kind of where the increases and decreases came from, we had only four industries that have declining same-store rents during the quarter that was office supplies, child care, auto service and book stores, but was a very small decline of only $50,000. Two of the industries were flat, and then 23 had same-store rent increases with the majority coming from motion picture theaters and convenient stores and then to kind of my surprise casual dining restaurants and motor vehicle dealerships, both of those as a function of.

During the recession we had some rent reductions, we did for those tenants and those burned off, their businesses come back very nicely and that’s the reason that happened this quarter even though I think their fundamentals may not be a representative of that we did see the rent go up.

The balance of the industries had fairly small increases during the quarter, but the 23 industries together had increases of about $1.45 million per net gain of $1.4 million. And obviously, the occupancy gains and things for rent increases over the last four quarters have been very healthy and it continued in the third quarter.

A relative to diversification, obviously up to 2600 properties at the end of the quarter that is up 77 properties from last quarter, 38 different industries, 134 multiple unit tenants in 49 states. From an industry exposure standpoint, we continue to diversify with 38 industries that’s up six from the same period a year ago. And our major concentrations of the top couple came down a bit. Convenient stores were 18.3% that’s down about 70 basis points from last quarter. And then restaurant is a little less than last quarter also at 17.3%.

Theaters were up a bit at 140 basis points to 9.2% that’s a function of some recent acquisitions and then health and fitness which is 6.1% then the only other category that are over 5% today is beverages at 5.6%, automotive tire stores which have been along with convenient stores both at 5.2% and those were much larger concentrations going back quite a ways. So, pretty good shape by industry, the large is tenants switch this quarter to AMC theatres to 5.4% and again that’s a function of some acquisitions. Diageo second at 5% and then everything else is under 5%. I mentioned our 15 largest tenants are 52% of rent. When you can get to the 15th largest tenant, as you can see in the release, its about 2.2% and goes down from there and when you get to the 20th largest tenant you are only about 1.5% of rent. So, we continue to diversify the portfolio.

That’s also true from a geographic standpoint. Still in 49 states everywhere but Hawaii. Average remaining lease length in the portfolio at 11.1 year remains pretty healthy so obviously good quarter for the portfolio.

As we look forward kind of in the next year we thing expectations for economic growth not withstanding higher than expected GP numbers today that have moderated over the last couple of quarters and I think that will lead us to be a little more cautious about the portfolio going into 2012.

If we look across the retail landscape, I think most of us deserve that the kind of high end and retail are holding up well. We don’t have a lot of that. At the low end, it is tough in retail, but the dollar stores and the value retailers club stores seem to be doing pretty well, serving that market. And as we look out there and in areas that might highlight some concern I think it’s really in the consumer discretionary area to the middle and lower class and you can see their businesses being stretched a bit. Some of it margin compression is there as the cost go up. But if you look in to areas like casual dinning and similar electronics auto supplies we think those are all worth watching.

Fortunately, most of our portfolio is in the basic needs type of businesses with the tires stores auto service, C-stores that type of things which are doing pretty well. But, looking at the portfolio absent Friendly’s nothing is popped up, that gives us concern from a tenant standpoint. But we adjusted our expectations a bit for the portfolio. And in the guidance for 2012, is our expected impact from the Friendly’s filing. And as well, we also added into the estimate an expectation of additional filings of tenants equal to about 5% of revenue with what has been our normal recovery rates over time. And while we don’t know would be we just think in an environment the little tough in retail, it was good for us to do that in our guidance. We also in the guidance assume that none of the properties come back from Friendly or the other tenants would be leased during 2012. So, I think that we have been conservative in our estimates relative to the portfolio. That now we understanding, we still think that our occupancy will remain very high in 2012, in the 97% range and we will have to see that works out. But overall, we think we will have high occupancy.

Moving on the property acquisitions obviously a very strong quarter and year for acquisition and I'll let John Case, our Chief Investment Officer, comment on kind of what we bought and what the environment is.

John Case

Our acquisitions activity continue to be robust in the third quarter. We acquired 89 properties for approximately $462 million making the third quarter or second most active quarter for acquisitions in our company’s history. The average initial lease yield on these investments was just the shade over 8.1%, and the average lease term is approximately 10 years. Properties are diversified by geography and industry and property type. They are located in 15 states, are 100% lease the nine tenants in seven different industries and represent three property types with our traditional retail investments accounting for just over 88% in the third quarter acquisition volume.

The industries are automotive collision services, food processing, how to get quick service restaurant, theaters, transportation services and hotel plus. Of the $462 million that we acquired in the third quarter, a $189 million is part of the $544 million diversified net-leased portfolio acquisition we announced in the first quarter. At the third quarter end, we had closed $525 million of the $544 million acquisition during the first, second, and third quarter. The final $19 million of the portfolio should close in this quarter.

So for the first three quarters of 2011 then, we have acquired a 125 properties for $826 million with an average initial lease yield of approximately 8% and an average lease term of about eleven and a half years. The properties are leased to 20 commercial tenants in 15 different industry segments. The $826 million in acquisitions we have completed in the first three quarters, the most we have completed in any previously full calendar year. For the entire year, we expect to complete just over $850 million in acquisitions at an average initial yield of about 8%. So, we continue to be pleased with our acquisitions activity.

As we look forward, acquisitions transaction flow remained strong. With the high-yield and CNDS markets cooling off since this year, property owners continue to turn to the sale lease back market for liquidity. There continues to be significant competition with property portfolios with multiple sources with a good bit of capital. But we should continue to be competitive in the marketplace. We are currently seeing opportunities in all of our property type and in a wide variety of industry from tenant. The majority of our current acquisition opportunities are in our traditional retail property. Initial yields and cap rate seem to be holding steady for now ranging from the mid 7% area for high credit tenants up to the low 9% range for some of the smaller non-investment grade tenant property. We continue to believe that our initial yield on future acquisitions should average right around 8%. Tom?

Tom Lewis

Thanks, John. I would like the higher credit tenants at 9%, can you arrange that for us?

John Case

Yes, I will do my best.

Tom Lewis

Okay. As John mentioned the pace of transactions, we look that has been very good and obviously we have gotten enough of share over the last 18 months or so, and that's let do a couple of year-to-year record acquisitions. But, I also want to note that that level has been very heavily impacted by a few large transactions, if you recall the Diageo we have done over $300 million. The ECM portfolio earlier in the year is $544 million, and then there were several others that equated to about a half a billion dollars and those transactions account pretty much for the majority of the acquisitions that we have done this year and last year.

And so I just want caution to extrapolate that out and assume the same things happen in 2012 might be aggressive. And aggressive assumption, we said for many years kind of being out there in the business you do. 25 to 35 a quarter by being in the business and if you do a run rate that works up to $100 million or $200 million a year. And then it’s really a function of whether we grab 0, 1, 2, 3 or a couple of larger transaction and while lately we have obviously had a bunch of them, each year it kind of unfolds with last two years itself. I think more than our fair of share.

So for our planning purposes and our guidance for some acquisitions for next year, we are assuming $315 million of acquisitions of what we are using in guidance that an age cape rate, and obviously it could be more but that’s a I think a good number to start with. We'll adjust as 2012 develops. But the transaction flow remains very robust currently.

As far the balance sheet and access to capital, as Paul mentioned, we are in fairly good shape on that. We have only $96 million sitting on the $425 million line. So the vast majority of the acquisitions we made this year have been permanently financed at fairly attractive rates. And with the balance sheet in great shape with good metrics that leaves us plenty of dry powder to execute on an acquisitions to come up.

Let me go back to guidance and kind of walk through that, obviously with acquisition things strong and occupancy and same-store rent up, that’s been very health for FFO and AFFO numbers. And we think that will continue to be the case the balance for this year and moving in to next year.

We did release a couple of weeks ago where we updated guidance and initiated for 2011 initiated 2012. For this year we are estimating FFO of a $1.97 to $1.98 at 7.70% to 8.2 % FFO growth and then AFFO of $2.01 to $2.02 and that’s 8.1% to 8.6% AFFFO growth. And as usual our AFFO, Paul mentioned this, but really wanted to highlight it, its higher than our FFO. And lately that’s been widening a bit, which is a function of a number of the acquisitions that we made this year, we are on existing properties with existing leases. And so we had to do a FAS141 adjustment. And in net lease generally that means that you reported cap rate when that been slightly below the actual cash you receive on the leases. And that really is going to widen the gap to get between FFO and AFFO, with AFFO being higher. We obviously take dividends from cash, so AFFO number continue to be our primary focus.

For 2012, right now you can see the estimates FFO $2.07 to $2.11, that’s about 4.5% to 7% of FFO growth. And AFFO of $2.11 to $2.16, also about 4.5% to 7.5%. with this growth rate the dividend payout ratio is falling down into the kind of 85%, 86%, 87% rate and we would achieve the guidance that would continue next year and really accelerate that. And generally we want to keep our payout ratio in the 85% to 90% range. So we are optimistic about additional growth in the dividend and the amount of growth looking into 2012. I think it would be a good time for dividend increases.

I’ll take a second since we just came out with 2012, kind of walk through again the assumption that are embedded in the 2012 guidance. As I mentioned, acquisitions of $350 million at an 8% cap rate, that’s less than half this year and last year. But, as I said, these were exceptional years driven by some large transaction. So I think it’s proven to keep the expectations moderated for now.

Our capital will depend on the timing of the acquisition. Estimated property sales we put in at $25 million. We have interest rates moving up modestly throughout the year but still very low, so not a huge impact. We’re putting occupancy kind of in the 96%, 97% range, and that is really where we’re reflecting the front lease plus an addition on identified tenant issues that can come up. And again, we have built into the assumptions for front lease outcome as well as it’s 5% and also the fact that we’re just assuming conservatively that it takes through 2012 to lease any of them, which is a conservative assumption.

Same-store rent, we modeled at about 1.50% growth, which would be pretty good. Free cash flow at $50 million. And, as I mentioned, AFFO of $0.04 to $0.05 above FFO, and that’s what gets us to the 4.50% to 7.50% FFO and AFFO growth rates.

To the extent that tenant issues do not materialize that obviously would be great. Our acquisitions would have had $350 million that also would be very good. I think we would probably take the opportunity to do some paring to the portfolio and sell some properties and move out maybe some of the tenants or properties that we think might have more exposure from an economic and interest rate standpoint going forward. That would likely burn off a little bit of FFO during the year, but really above the 4.50% to 7.50% rate that would probably be prudent and something we would like to do in the next few years. So we think the assumptions we made are pretty good assumptions.

Really to summarize then obviously continued stability in the portfolio and a good quarter relative to occupancy and same-store rent increases. We remain very active in acquisitions with good FFO and AFFO growth, this year, and I think, pointing into next year, one again makes us somewhat optimistic to for dividend growth.

And with that, we will open it up for questions. So Joe if you want to comeback and remind everybody how to do that again, I would appreciate it.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question comes from the line of Lindsay Schroll. Go ahead please.

Lindsay Schroll - UBS

Tom, I know that you mentioned casual dining rents were up. But I was just wondering if you can discuss more to the fundamentals of that segment and if there are any other tenants that are kind of on your watch list in that segment?

Tom Lewis

Yeah, it’s, if you look at casual dining they’re a very good example. I was looking at some numbers yesterday relative to food prices this year that have been moving up pretty aggressively. And if you look at the grocers, they’ve been able to pass a lot of that on, I think was about 6% increases in food prices at grocery stores. But if you look at restaurants they haven’t been able to pass it on and consumers have been pretty tied with their wallets, wallet to the restaurants. And so, you’re seeing their cost move up and they’re not able to pass it on. And I think it’s really starting to wear on their margins. And so that’s one area that’s kind of upfront for us. And we think other areas in consumer discretion that are impacted by commodity cost are similar.

The other ones, and I also mentioned, is if you just look at kind of the big box that tends to be discretionary purchase. We look at them and you continue to see the growth of Internet retailing and that’s kind of front and center right now as we move into the holidays, and we think their business could be a little weak. But it’s primarily consumer discretionary, middle class, lower class, and I try to light on restaurants. Normally fast food does very well in a downturn but I think even they’re having trouble kind of passing it all along.

Lindsay Schroll - UBS

Okay. And then just turning to acquisitions, what do you think in the macro environment can change that would potentially shutdown some of the opportunities you’re seeing decrease the flow?

Tom Lewis

I think it would take a pretty good drop in the economy on one side. But John mentioned the high yield market, while it’s had a little bit of resurgence in the last week or so, has been weak, but still breathing and CMBS has been very weak. And a lot of times Paul has used the term we like those markets breathing but not too robust, because it helps transactions to happen and yet it makes our type of financing very attractive. And even though they’ve been very weak we found that people have really started turning to net lease. So those markets came back very strong. It would be a mixed bag. I think we would see a lot more transaction activity out there. But the debt markets would be much more competitive. So that’s one thing to watch or if we just get a big double dip and the economy pull us down. But it’s a fairly active environment for people viewing their real estate as a source of capital today are very active.

Operator

Thank you. Our next question comes from the line of Joshua Barber. Go ahead please.

Joshua Barber - Stifel Nicolaus

First of all John, would you be able to comment a little bit further, in your press release a couple of weeks ago and you alluded to it again today about the 5% of rents that you were looking at. Can you just talk about what sectors you’ve seen, I guess, get the worse over the last six to nine months, and which ones would also have the tightest net coverage today?

John Case

Yeah, I think the tightest rent coverage you come back to casual dining and kind of the restaurant sector overall. And again, as I just said that’s where the margin compression is going on. So that’s kind of front and center as we look at it. And as we put that in there, we have a couple decent size exposures. But tenant gets into a lot of little ones. And so that wasn’t meant to be somebody at 5%, it could be one at 5%, two at 2.50%, and we just thought it was, it’s time to be a little more conservative in that area. But restaurants are kind of front and center, but when you get out of basic human needs, kind of a C-stores and the rest of it, it’s, I think their business is weakening a little bit and I was buoyed by things and higher GDP numbers but I’m not sure if I’m really believe them, we will see how that revise.

Joshua Barber - Stifel Nicolaus

I mean, following on that would you say that most of the bankruptcies that we have seen year-to-date in casual dining have actually been a case of landlord so far is that trend starting to work a little bit?

Tom Lewis

What two are you referring to?

Joshua Barber - Stifel Nicolaus

The Mexican dining with most of the markets, not necessarily in the Reality Income?

Tom Lewis

Oh, yes, yes, yes, there was Realmax and that’s (inaudible) and Falcao. We didn’t pay that much attention to it but they are kind of larger billings like that hurt a bit. It’s been a pretty good year as we said throughout the year was pretty quite out there. But, I think in the restaurant industry particularly you can see some more but so far it is been pretty good for the landlords and continued for us. We keep her running tall bankruptcies and if you look at the fourth quarter, I have only got four on my list and I have got five in the third quarter and before that there would be 8 or 10 or 12 in retail. So it’s been a fairly short list and so not a lot to work with recently. We think we will work out pretty well in the one we are working on and generally if you didn’t over paid too much it shouldn’t be that bad.

So I don’t want to ring a bell that everything is getting negative it’s just, it’s really been nearly quite for about a year here in the portfolio and it was nice to see the economy come back a bit. But it’s not really running forward hard with some commodity price increases we just kind of saying somebody got to be impacted by this, if they are not able to pass through to the consumer ultimately those costs.

Joshua Barber - Stifel Nicolaus

Well, I guess the fourth quarter is still young, so.

Tom Lewis

It’s still young.

Operator

Thank you. Our next question comes from the line of Michael Bilerman. Go ahead please.

Greg Schweitzer - Citigroup

Hi, it’s Greg Schweitzer here with Michael, Citigroup. Tom, as you continue diversifying and increasing industry exposure to new areas apart from some key new hires is that anything new you are doing or investing in internally to better manage or handle the increase and improve core competency there?

Tom Lewis

Yes, I mean, we have hired people on research and then we have hired people that have background in those areas and we continue to work very hard on all of that a lot of it is just expanding a corporate underwriting, we have done for many years in retail and fortunately our people are – credit people being trained in and able to move outside of retail pretty good.

The other area that we will down the road is portfolio management but that’s something that really comes later, we have 28 people in that department which is up substantially in the last 7, 8 years dealing with retail, so we would anticipate if you look for five years down the road, we will have to widen it there. But it’s really three, four people on acquisitions who have some background in that and then a couple of people in research.

Greg Schweitzer - Citigroup

Okay. And anything you could discuss related to the impact from Friendly's and the press is going on there?

Tom Lewis

Really not that much, I think just for anybody I think most people are aware that Friendly's filed a couple of weeks ago and we have 121 properties that are about 3.6% of rent. We bought starting 10 years ago 138 and 140 of those units we sold off a number of them which got us down to the 121 to-date.

They filed rejected 15 properties which equates to about $1.3 million of rent which we will have now available to us to go back and release. But as its normal in these processes I think this is the 24th filing we have had since going public of this type and we’ve got fairly strong retention rates of rents up in the 80% and generally we feel pretty good about these processes, we have done a lot of them.

But now we have to just wait and let it work. There kind of two issues that will go on. One is obviously as we work through this process there are some negotiation that goes on. So talking about what we would perceive as an eventual outcome is not probably the best strategy there.

And then we found it very useful to try and stay very involved in the process and our General Counsel is Co-Chair of the Creditors Committee and obviously that requires non-disclosure agreements as it goes through the process in the Court of Delaware. But, as the Court decides anything that can be seen publicly and then over the next few quarters, if this works out we will fully report. We feel pretty good about the properties we own relative to the profitability of what we have paid and with expectations we’ll pretty well. And we did build that end of the disclosure as well as some assumptions that there would be other one next year.

Operator

Thank you very much. Our next question comes from the line of Tayo Okusanya. Go ahead please.

Tayo Okusanya - UBS

Quick question if we were to come up with – if 2012 ends up being an Utopian World, where you don’t see a lot of retail bankruptcies, this and you take out this 5% of rent that you kind of put at risk in your2012 guidance, by how much would guidance grow up?

Unidentified Company Speaker

Well I think it’d probably go back up to where everybody pretty much have it before we first guided and which is lower, but as I’ve said earlier Tayo and there is one analyst I know who has talked about capital recycling a lot, which is you I think that’s something that’s coming up and the level and the amount of capital recycling we can do which I think does burn off some FFO, if things are better and there isn’t as much tenant activity and if acquisitions are a little higher I think we’d take the opportunity to do and then hopefully stay about where we are today. So I think that’s a – I can say it’s slower, but that was a message we are trying to give.

Tayo Okusanya - UBS

Okay so basically say things were better on the retail side, you may take it as an opportunity to divest a few more assets, and that include some dilutions in, net-net it would still kind of – you would still kind of end up where you are?

Unidentified Company Speaker

That would be our expectation.

Operator

Thank you very much. Our next question comes from the line of RJ Milligan. Please go ahead.

RJ Milligan - Raymond James

Tom, question for you on the 350 for next year in terms of acquisitions at least as a ballpark or the way to think about it, how much of that do you think is going to be non-retail or can you tell us how you think about that?

Tom Lewis

And John you want to comment relative to kind of transaction flow and legacy in [ph].

John Case

Yeah, I will tell you sort of what we are currently seeing right now is predominantly retail and we are seeing in queue investment grade distribution centers, but we would expect obviously based on what we are seeing now 80% of our acquisitions next year could be retail oriented acquisitions in our traditional industries and property types. But that can change with one large significant portfolio.

RJ Milligan - Raymond James

Yeah, as you predict.

John Case

Yeah if you look at this year its kind of interesting, 55% of what we’ve acquired to-date is retail, 21% distribution, 17% office, 6% manufacturing and 1% to 2% industrial. But the vast majority of that came through that one transaction with ECM and its interesting thus over the last quarter or two, we thought we could see moderation in the number of kind of traditional retail transactions come up and they are actually accelerating a bit, so we have to take this transaction flow right now and look forward, it would be heavily retail or the smattering of some investment grade in other areas, but as John said one transaction can change that.

RJ Milligan - Raymond James

Is there a specific non-retail property type that’s more attractive to you or is it just the credit quality?

Unidentified Company Speaker

It’s well – it’s very much credit quality when we move outside of retail because in retail you can have the four walled EBITDA cash flow coverage, which can give you a lot of protection even when working with some weaker tenants and when you get outside of retail you can get at a case only, but it’s a little harder to tie down, so we think its absolutely necessary to go up the curve and then kind of our greatest comfort level to-date relative to the other areas has been distribution. As we’ve done with Diageo there is a fair amount of the agriculture that you see ended up 4.6%, its pretty much all the Diageo. That’s very comfortable, that’s a function of where it is and who the tenant is. So I would say tenant first and going up the credit curve to investment grade and when we get outside of retail and that’s our intention and distribution most comfortable out of - of that group and probably manufacturing industrial after that, probably office last.

Operator

Thank you very much. Our next question comes from the line of Todd Lukasik. Go ahead please.

Todd Lukasik - Morningstar Securities

Just a question, I guess is the plan still to get up to sort of 20% to 30% of the portfolio in non-retail over the medium term?

Unidentified Company Speaker

Yeah that - for us that’s a ballpark four to five year feeling and its one of those things or once you are – well that’s what’s the objective and so 20% is a good initial number, when we are off to a good start, but it is so underwriting specific that the number could freeze where it is if we weren’t able to pull good investment grade stuff in, but if we were able to pull investment grade in then higher would be okay too because there is a strong desire to do two things right now, one is when working within retail to have even higher cash flow coverages up above 2.5 where I think over the last few years its been in the 2.3 million to 2.5 million, and or go up the credit curve. And that’s really a function of looking forward and understanding in the last 20 years that a lot of these less and less NAREIT retailers have to wend at their back if you were in a declining interest rate environment.

And if you look forward we’re fairly close to zero to-date in interest rates. And so the expectation that you might have see a higher interest rates in the future, were kind of undertaking a big project to look at the impact for all of our tenants, if they had to refinance their balance sheets over five to ten year period at 300 basis points higher in permanent financing costs and 600 basis points higher. So to the extent that we’re working on retail, we would like higher coverages and to the extent we can, we would like to go up the credit curve whether it’s in or out of retail.

Todd Lukasik - Morningstar Securities

Okay. And as you get some of those higher credit tenants in the portfolio does that change your outlook on your use of leverage at all?

Tom Lewis

At the moment, not right now, I think we’re okay to use leverage right now. We’ve been reducing it a bit as you’ve seen debt fall from about 35% down to 27%, 28%. But we’re more focused on the maturities of that. If you start again worrying about interest rates over five to ten years, you look at your maturity schedule. So we’re fine adding debt like we did earlier in the year, where we opened up $150 million of our 2035. So we’re comfortable with more leverage, a little bit more leverage. So if we’re going to do, we would like the duration to be fairly lengthy, but don’t want it to get too high.

Todd Lukasik - Morningstar Securities

Okay. So in terms of sort of an average leverage that we could look at historically it probably wouldn’t increase much even though you will have higher credit tenants on thereafter?

Tom Lewis

Yeah, we put, the Board put a policy in 1994 when we went public, 17 years ago, that we didn’t want leverage debt over 35% kind of gross assets, market cap, and we didn’t want preferred over 10% and we stayed inside of that and that hasn’t changed.

Todd Lukasik - Morningstar Securities

Okay, great. Thanks. And probably looking forward to see you in Chicago in a couple of weeks and get our management behind (inaudible) conference.

Operator

Thank you. Our next question comes from the line of Richard Moore. Please go ahead.

Richard Moore - RBC Capital Markets

Following up on that for a second, knowing how much you guys hit at, should we think in terms of you guys clearing of the acquisition line here, given the market was up gigantic today, if it keeps going like this, I mean clearing with common equity at some point or do you have to wait until to gets maybe it gets say half full something like that?

Tom Lewis

Yeah, generally we would like it to get up $150 million plus before we do something. And we just did a fair amount of equity, we’ve done kind of four in the last year, it’s just under $1 billion, and well the prices were very good and they were very accretive transaction relative to the impact to cash flow. And we’re not in a hurry to rush into one right now. And so we would like to do some additional acquisitions build the line of debt and then watch for things go. We took the opportunity this year to add to the equity base substantially.

Richard Moore - RBC Capital Markets

Okay, good. Thanks. And then, I want to go back for a second to your comments Tom about, about getting rid of stuff, as times get better. I mean it sounds like you look at different segments of what you have maybe consumer discretionary or casual dining as a whole group that’s something you might get rid of maybe do a portfolio transaction that’s a couple of hundred properties is that how we should think about that?

Tom Lewis

My sense is, is in this business when you have a large portfolio and you’re trying to put it out and at the best price. You do that better on a one-off basis kind as you go along one at a time. That was our experience we learned from Crest, when we bought 30, 40 at a time, put them out one at a time, and that’s how we would probably want to do it. So we’ve got, out of the tenant base, maybe 70 tenants of decent size, and we’re going through and passing them very carefully given a lot of metrics, and refinance the balance sheet and how we feel about the industry and our position with them and how much debt when it comes to a wide variety of metrics. And then rating from top to bottom, and if you put them into kind of four quartiles and looked at the bottom quartile, you would say cheap. We’re going to be lovely five to ten years from now those one in the portfolio, and then you’ve to look at your growth rates and making sure you deliver for the investors, while you’re doing it, and to the extent that acquisitions are good, the portfolio performs, you can do that at accelerated rate. And that if it doesn’t maybe at a little slower rate.

So I think it will be just picking out really a group of tenants in the lower quartile and then there is a separate project we have to take all 2600 properties and put a rating on them for the market they’re in, for what we paid, for what the cash flow coverages are, how much we’ve less than lease, and when you marry those two together, ultimately they become a mix of tenant and property, but over the coming years we would like to accelerate those sales but it will be a function of how much we can do and still maintain a decent growth rate and dividend growth.

Richard Moore - RBC Capital Markets

Okay, okay. But the lower quartile is about 650 properties. So we should think maybe if you really get going on this you could do 100 in a year, is that what’s you’re thinking?

Tom Lewis

I think it’s possible, but I don’t think that’s in the cards at all for 2012 and that’s probably aggressive for 2013. But it will all depend on the growth rate, because if you’re adding a lot, on the high credit side, it gives you a lot of flexibility to still pose pretty good numbers and accelerate it. But there were years in Crest, where I think we had $130 million as inventory in 2007 and we got it all out of the door in about a year. And those were in right sized properties of $1 million to $2 million. So we’ve done it before, but I wouldn’t look forward to ’12, because we’re still crunching the numbers and in the middle of the analysis.

Operator

Our next question comes from the line Todd Stender. Go ahead please.

Todd Stender - Wells Fargo Securities

Your assumptions for next year Tom you’re talking about interest rates picking up, does that mean initial lease yields they just go or is there a longer lag maybe that’s more of 2013 event just in your estimations?

Tom Lewis

Great question. I would assume if our guys lag, because that’s almost always what happen, you’ll start seeing your line cost rising, and we -- it hasn’t been happening but we put I think 10 basis points in for it to go up on a regular basis. And so your line cost go first, your permanent financing cost go second, and the net lease cap rates tend to lag, that’s true on the way up and the way down. So for modeling for us or anybody in the business that be our best cap that’s what we’ve seen over the years.

Todd Stender - Wells Fargo Securities

Thanks. And the ECM deal it came with some secured debt. Do you have your sale with that right now; if you sell a portfolio would that be a deal breaker, what’s -- what are your comments on that?

Tom Lewis

Well I think, Paul said $64 million or $68 million.

Paul Meurer

$67 million.

Tom Lewis

$67 million. There was $90 million we thought we would be left with, but we’ve been to pair that down. And so $67 million you said. So we’re about $67 million above where we would like to be. And but that doesn’t mean we wouldn’t if a portfolio came in and have some secured debt, we take it, but as we do hit here, we will do our debt immediately to payoff everything that we can payoff without it being just a huge economic drain, and then paying off the balance as fast as we can. So we don’t want to say it will preclude us from doing a portfolio, but at the same time we’re not looking to add it, and we would like to get rid of it as soon as we can. We like a unsecured balance sheet strategy.

Todd Stender - Wells Fargo Securities

As far as your underwriting new deals are rent coverages being adjusted higher as well then you have less visibility on how the company cash flows are going to look, next 18, 24 months?

Tom Lewis

Yeah, if you look at the cash flow coverages on our recent purchases they’ve been 20, 30, 40 basis points higher than the last few years. So you’re really looking up in the very high twos as where we’re pointing into the threes if we can get it. But, and it changes from industry to industry but we’ve been trying to really adjust that up because that’s the kind of lesson that’s investment grade retail and then obviously up in the other areas we’re looking for investment grade credit.

Operator

Thank you. That concludes the question-and-answer session. I would like to turn it back to Mr. Tom Lewis for any closing comments.

Tom Lewis

Thank you very much. I know it’s a busy earning season and we appreciate the time spent and look forward to seeing many of you coming up at NAREIT some other function. Thank you very much and thank you Joe.

Operator

Thank you. Ladies and gentlemen this concludes the Realty Income third quarter 2011 earnings conference call. If you would like to listen to a replay of today’s conference please dial 1-800-406-7325 and enter the code 4480899. Again I would like to thank you for your participation. You may now disconnect.

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