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Realty Income Corporation (NYSE:O)

Q4 2011 Earnings Conference Call

February 9, 2012 4:30 PM ET

Executives

Tom Lewis – Vice Chairman and CEO

Paul Meurer – CFO, EVP and Treasurer

John Case – EVP and Chief Investment Officer

Analysts

Lindsay Schroll – Bank of America/Merrill Lynch

Joshua Barber – Stifel Nicolaus

Todd Lukasik – Morningstar

Todd Stender – Wells Fargo Securities

Anthony Paolone – JP Morgan

Rich Moore – RBC Market

Presentation

Operator

Good day, ladies and gentlemen, thank you for standing by. Welcome to the Realty Income fourth 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) This conference is being recorded today February 9, 2012. It is now my pleasure to introduce your host for today Mr. Tom Lewis, CEO or Realty. Please go ahead.

Tom Lewis

Thank you, Joe. Good afternoon everyone and welcome to our conference call. We will go throw the operations and results for the fourth quarter and full year 2011. In the room with me as usually is Gary Malino, our President Chief Operating Officer, Paul Meurer, our EVP and CFO, John Case, our EVP and Chief Investment Office and Mike Pfeiffer, our EVP and General Counsel and Terry Miller, our Vice President Corporate Communications.

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

And we will start as we always do with the numbers Paul?

Paul Meurer

Thanks, Tom. So as usual, I will provide some brief comments on our financial statements and provide some highlights of the financial results for both the quarter and the year starting with the income statement. Total revenue increased 23.6% for the quarter and 22.6% for the year. Our revenue for the quarter was $114 million or approximately $456 million on an annualized basis. This obviously reflects the significant amount of new acquisitions over the past year and positive same store rent in our portfolio increases per year of 1.3%.

On the expense side, depreciation and amortization expense increased by about $9.5 million in the comparative quarterly period as depreciation expense increased obviously as our property portfolio continue to grow. Interest expense increased by just under $3.9 million and this increase was due primarily to the June issuance of $150 million of notes in the reopening of our 2035 bond, as well as the $237 million of credit facility borrowings, which we had at year end. On a related note, our coverage ratios do remain strong with interest coverage at 3.5 times and fixed charge coverage at 2.9 times.

General and administrative or G&A expenses in the fourth quarter were $7.95 million or 7% of total revenues. Our G&A expense has increased as our acquisition activity has increased. And we invested in some new personnel for future growth. G&A was also impacted by the expensing of acquisition to diligent cost $357,000 during the quarter and a total of $1.5 million in expense during the year.

Our current projection for G&A for 2012 is approximately $33 million, which will continue to present only 7% of total revenue. Property expenses were $2.3 million for the quarter and $7.4 million for the year. These in course of the expenses primarily associated with the tax of maintenance and insurance one properties where we are responsible for those expenses and properties available for lease. Our current estimate for 2012 is similar at about $7.5 million. Income tax consistent income tax paid to various dates by the company there were $367,000 during the quarter.

Income from discontinued operations for the quarter totaled $1 million and this income is associated with our property sales activity during the quarter. We did sell five properties resulted in a gain on sales of $1.2 million during the quarter and a reminder that we do not include these property sales gains in our AFFO or in our FFO.

Preferred stock cash dividend remained at $6.1 million for the quarter and net income available to common stock holders increased to approximately $34.9 million for the quarter. Funds from operations or FFO per share increased 8.5% to $0.51 for the quarter and 8.2% to $1.98 for a year. Adjusted funds from operations or AFFO are also bad but the extra cash we had available for distribution and dividend was higher, higher than FFO and it increased 8.3% to $0.52 for the quarter and 8.1% to $2.01 per share for the year.

Our AFFO will continue to be higher than our FFO and its differential between our AFFO and FFO will continue to increase. Our capital expenditures are fairly low, we have minimum straight line rent in our portfolio and we believe we will continue to have some FAS141 non-cash reductions to FFO due to in place leases that we acquire in large portfolio transactions that we do. In addition, in 2012 we will have a $3.7 million non-cash charge to FFO for the redemption of our preferred D stock representing approximately $0.027 per share in FFO.

Our 2012 AFFO earnings projection is $2.07 and $2.12 per share or an increase of 3% to 5.5% over our 2011 AFFO per share of $2.01. We increased our cash monthly dividend again this quarter we have increased dividend 57 consecutive quarters and 64 times overall since we went public over 17 years ago. And of course as we announced this week we have not declared 500 consecutive monthly dividends over the past 42 years. Our dividend payout ratio for the quarter was 85% of our funds from operations and about 84% of our AFFO.

Briefly turning to the balance sheet we have continued to maintain a conservative and very safe capital structure. This week we closed on our recent preferred stock offering, which raised over $373 million in gross proceeds at a coupon rate of 6 5/8%. We were very pleased with the strong investor demand in the offering and we very much appreciate the underwriters who supported us and did a terrific job on this offering.

User proceeds will be to repay our outstanding 7 3/8% class D preferred stock, which will save us $1 million cash expense annually and also to pay off all of our acquisition credit facility borrowing. Our balance sheet continues to be well positioned to support our acquisition growth. Our current debt to total market capitalization now is only 25% and our preferred stock outstanding still represents only 8% of our capital structure.

Our $425 million credit facility did have $237 million of borrowings at year end. But as I mentioned we used the preferred proceeds this week to pay off all of those borrowings on the facility. We had no debt maturities until 2013.

So in summary, we currently have excellent liquidity and our overall balance sheet remains very healthy and stable.

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

Tom Lewis

Great, I will start with the portfolio. During the fourth quarter the portfolio continue to generate very consistent cash flow. At the end of the quarter our largest 15 tenants accounted for about 49.8% of our revenue that’s down 480 basis points from the same period a year ago and 220 basis points from the third quarter. So our acquisition efforts continue to help us reduce our concentrations in the portfolio getting that down to 49.8.

The average cash flow coverage at the store level for those top 15 tenants, which we mentioned each time was right at 242 times so very healthy. We ended the fourth quarter with 96.7% occupancy and 87 properties available for lease out of the 2634 in the portfolio that is down about 100 basis points from the third quarter and up about 10 basis points for the same period a year ago.

During the quarter, we had 43 new vacancies 25 of those came from expirations at the end of the lease and that is a little higher number than usual but occasionally with the expirations it gets a little bit lumpy and that was the case in the quarter. We also had 18, which were defaults primarily related to Friendly’s we also leased or sold 15 properties during the quarter and also added properties portfolio, which is how you get to the 96.7% number. If we look forward into the first quarter I think it was about phase filing and as we begin leasing the properties up that they are on the vacancy list we could see another 20 or 30 basis points decline in occupancy down to around 96.5 or 96.4% is the best estimate right now. And then we would anticipate that we would see occupancy increasing from there over the next few quarters as we really generate more leasing activity on these.

Let me take a moment and kind of walk through how we calculate occupancy and then give you some color on it. For the last 18 years or so we calculated occupancy by taking the number of vacant properties we had, which was 87 and dividing that by the number of buildings that we have in the portfolio, which was 2634 and that’s pretty simple methodology that gives us 3.3% vacancy and 96.7% occupancy.

For a number of years now internally we would run occupancy a couple of other ways. Just eyeballed the numbers, other ways to take it just on a square footage basis instead of property, where we take the vacant square footage and divide it by the total square footage in the portfolio. Another way to do it is on a dollar basis, which was to take what was the previous ramp on any properties that are vacant and divide that by the sum of that number and the ramps on all of the occupied properties and that gives us to you on a dollar basis and we’ve run all three methods for quite a while and generally they would be around the same numbers as historically our building sizes and kind of rents for property overall were pretty consistent. However, in the last few years as we bought some larger properties that is skewed the numbers and we also have about 4.5% of the portfolio now in agricultural land that have no buildings on it, yet are under long-term leases. And so we are getting some variance in the three different methods of it.

Somebody recently asked me when I said occupancy they said it’s physical or economic and well I don’t wasn’t quite sure what their version of economic occupancy was, we thought we would go ahead and provide all three numbers. Then again the traditional way is 87 properties vacant 2634 total and that’s a 3.3 vacancy rate and a 96.7% occupancy rate. If you do buy square footage the total vacant square footage is 746,000 square feet you divide that by the 27,369,000 square feet in the portfolio that gives us a 2.7% vacancy and 97.3% occupancy rate.

And then the last way if you take the former contractual rent in the fourth quarter for the vacant property it was about 2.48 million and if you combine that and the rent on the occupied property of $113 you will get $115.78 million and then if you divided that back into the $2.48 million that will give you a vacancy of 2.1% at an occupancy of 97 9 on a dollar basis. So you can pick your own number, we will for historical continuity continue to report it on the fiscal occupancy number, but make those other numbers available and I will figure out how to get them into our reporting and then mention him on the calls if anybody wants to know what they are. Obviously all three are fairly close and represent fairly high occupancy.

Same store rents on the portfolio increased 1.1% during the fourth quarter, which was in the kind of average range in our mind for the year since rents increased 3.3% taken a look at where those came from during the year, we had three of the industries declining same store rents in the portfolio book stores was one automotive services and quick service restaurant, which was fast food but it was relatively modest decline of only about 492,000 so fairly small.

Two industries have flat same store rents that was drug stores and transportation services, which was fairly new to the portfolio. And then 24 industries saw some same store rent increases the majority of that kind of going from highest to lowest was increases was movie theaters, motor vehicle dealerships, casual dining restaurants, convenient stores, sporting goods, automotive tire and health and fitness. In the balance we are fairly small increase in those numbers casual dining restaurants and motor vehicle dealerships making surprising relative to a contribution for the same store rent increases. But I would note we gave a few temporary rent reductions to a few of those tenants in those industries during the recession those expired and that’ what caused the increases in those industries and it’s not a trend we would think it’s going to continue. And again the balance of the increase is fairly small increase.

The 24 increase industries together had a total increase of about $4.7 million and that gets to a net gain of $4.25 million in same store rent. Diversification in the portfolio continues to widen we are in 38 industries that’s up 6 from a year ago. Concentrations in the industries continue to climb convenient stores is our largest at 17.2% that’s down 110 basis points from last quarter and we think we will continue to bring that one down. Restaurants if you combine both casual dining and the quick service are little less than last quarter now at 16.4% that’s down 90 basis points from last quarter casual dining is now under 10% at 9/8 it’s down about 110 basis points from the last quarter.

Quick service, fast food was up about 20 basis points to 6.6%. The next one is Peters, which rose 9.8% as we made some acquisitions this year. Also, health and fitness was up 80 basis points to about 6.9%, both areas we continue to like and will likely add to. The only other category that’s over 5% now is beverages at 5.3%. So I think we are in very good shape relative to industry concentrations. We’ll keep them reasonable and try and continue to lower them.

On a tenant basis, the largest individual tenant at 5.3% of rent is AM Peters, that’s down 10 BPs, Diageo is 5% and then everything else in the portfolio is under 5% and again when you put the 15 largest together they are just under 50%, 49.8% and then when you get back into the 15% it’s about 2.2% of rent and if you even went further to 20% it gets down to about 1.5% of rent and then goes down pretty quickly after that, so fairly well-diversified from a tenant standpoint.

Geographically, we also remain well-diversified. The average lease term remaining is 11.3 years, that’s up a little bit over the quarter with recent acquisitions.

We announced a couple of weeks ago that Friendly’s is back out and operating, having completed their reorganization fairly quickly and also announced Buffets is in the process and we work with their management, who we know well, very quickly to structure an agreement with them. As we said in our press release a couple of weeks ago, it is subject to court’s approval and the reorganization process which is underway.

Like in the Friendly’s situation with Buffets, Mike Pfeiffer, our General Counsel co-chairs the creditor’s committee and we’re hopeful that a process can be completed expeditiously, which I think could benefit all parties involved and we can move through that one fairly quickly.

Relative to a theme with those two, I think it continues to be a difficult environment for retailers that sell discretionary goods to generally lower income consumers. I think tenants, like these two in the casual dining area will generally fit into that category in our mind. And as we’ve mentioned we wouldn’t be surprised to see a little more softness with another tenant in that area and as the year goes on. Fortunately, our exposure to that area is modest and continues to climb, although we would prefer if more of that decline was generated from asset sales and investments in other areas as a way that it declines. The majority of the portfolio continues to do quite well and occupancy as I’ve mentioned is very high.

We’ll move on to acquisitions now. It’s obviously a very strong year in that area and I’ll let John Case, our Chief Investment Officer to comment on activities there.

John Case

All right, Tom. We remain quite active on the acquisitions front in the fourth quarter. We acquired 39 properties for approximately $190 million. The average in this release yield on these investments was 7.5%. The average least term is just under 20 years. Properties are diversified by geography, tenant, industry and property type. They are located in seven states, 100% leased to four tenants in four different industries and represent three property types with our traditional retail investments accounting for 86% of our funds invested during the fourth quarter. 80% of the acquisitions are leased to new tenants, which further diversifies our portfolio.

In the fourth quarter we closed to file $19 million of the $544 million diversified net lease portfolio or ECM transaction we announced in the first quarter of 2011.

Our fourth quarter activity brought us to $1 billion…

Tom Lewis

Is that a billion?

John Case

That’s a billion, Tom.

Tom Lewis

With B?

John Case

With a B, $1 billion in property investments for 2011, the most we’ve ever completed in a single year in dollar terms. The billion for the year was comprised of 164 properties having initial average initial yield of 7.8% and an average lease term of 13.4 years. The properties are leased to 22 separate tenants and 17 different industries. We continue to be pleased with our level of acquisition activity, which really helped us drive our FFO growth in 2011.

Most of you have heard Tom describe our acquisition activities lumpy before. Well, it continues to be that way. $852 million of our 2011 acquisitions came from three large portfolio transactions. The remaining $148 million of acquisitions came from single property and smaller portfolio opportunities. We generally this from quarter to quarter by just being in the marketplace and this should lead to about $100 million to $150 million of acquisitions annually. So our success on the three large portfolio has really drove our volume in 2011.

On this yearend call, we usually give you an overview of the previous year’s acquisition transaction flow and provide some additional perspective. I’m going to go slowly here because there are a lot of numbers I want to share with you.

In 2011, we sourced $13 billion in total acquisitions opportunities. This is everything that comes in the door, not all of it makes sense for us. So of the $13 billion sourced, our acquisitions team analyzed about $8 billion in opportunities in 2011, an increase of about 70% versus 2010. Of this amount, just under $3 billion was taken through our investment committee. The $3 billion represented 1,300 properties with 45 different tenants. Over the last 10 years our investment committee has averaged working on about $3 billion in opportunities per year, ranging from a low of $1 billion to a high of $5 billion. So 2011 was right in line with our long-term average.

The $1 billion we acquired represented 33% of what our investment committee worked on and of course was a record year for acquisitions. Over the last 10 years, on average, we have acquired 15% of what our investment committee worked on. This year’s 33% figure reflects our success in closing those three large portfolio transactions.

Our initial yields or cap rates have averaged 8.9% during the last 10 years, with a high of 10.4% and a low this year of 7.8%. Cap rates declined over this period as interest rates have declined and as net lease properties have become more main stream and more investors have entered the market. We have historically tracked our cap rates relative to 10-year treasury yields. Since we went public in 1994 our cap rates have averaged about 475 basis points over the corresponding 10-year treasury yields. The 2011 average 10-year treasury yield was 2.8%, so our initial yield of 7.8% was 5% over the average 10-year this past year, a bit better than our long-term average. Obviously, now with the 10-year treasury yield at 2% our cap rates are closer to 5.75% over the 10-year.

Another factor impacting our cap rates is our move up the tenant credit curve the last two years. In 2011 41% of our acquisitions are with investment grade tenants. Our completion of these high credit tenant acquisitions reduced our overall initial yields by about 30 basis points to 40 basis points in 2011. However, our investment spreads remain very attractive to our long-term average and we improved our tenant credit profile. Over the last 17 years our acquisition cap rate spread over our nominal cost of equity has averaged about 110 basis points. We calculate our nominal cost of equity by taking our forward FFO yield and grossing it up for issuance costs. Last year that spread was approximately 170 basis points.

As we have moved into 2012 our acquisitions transaction flow has continued to be quite active consistent with the volume of opportunities we were seeing in 2011. Sellers were motivated by the significant liquidity in the net lease market. Continued private equity and M&A activity are also leading to sale lease back opportunities. The flow is fairly evenly divided between investment grade and non-investment grade opportunities and the majority of it is in our traditional retail properties but we are seeing possibilities in all of our property types. There continues to be significant competition for property portfolios but we should continue to be competitive in the marketplace.

Cap rates are turning down slightly from where they were in the second half of 2011 as interest rates have declined a bit. Cap rates generally range from the low 7% area to the high 7% area for investment grade tenants and from the high 7% area to the high 8% area for non-investment grade tenants. We currently anticipate our initial yields on acquisitions for 2012 to average around 7.75%.

Tom?

Tom Lewis

John’s promise still average 7.75%.

John Case

Yeah.

Tom Lewis

Thanks. Obviously we’re pleased with the results for 2011 in acquisitions and I think is much from by the pace of transactions just coming in the door right now that will drive what we are able to do this year and we think that will continue to play a role in obviously growing the revenue and AFFO, which is what drives dividend increases.

I think secondly and equally important for us is it will also help us in adjusting the makeup of our portfolio where we’re trying to do a couple of things, which is move up the credit curve with the tenant base and then also into areas both inside and outside of retail that we think want to make up a larger piece of the portfolio and going forward.

If you look at the last 24 months or so, we bought about $1.7 billion of property, $1 billion of it was in retail and I think much in the sector is that we think will do well if we continue with a tougher retail environment where lower income consumers continue to struggle. $720 million of the properties we bought are into areas outside of retail that we think will do well for us and of the $1.7 billion total about $770 million was done with investment grade tenants and a good measure of the rest of the acquisitions are also up the credit curve close to investment grade and we’re pleased with that.

The other thing about it is how we’ve funded the acquisitions. Living in a very low interest rate environment that’s largely generated by monetary policy at the federal level, I think it’s easy to get lulled in to the assumption that rates will stay low, which they might. However, we want to be mindful of where they could go in the future particularly if they were to go up substantially and I think that is true not only for our tenants as they would refinance their balance sheet down the road but I think also for our own balance sheet.

And one of the things we want to make sure we do is we are fairly active here in acquiring is we don’t materially add to our levels or to our near-term maturities. So if you look at the permanent financing that we’ve done or our funding of these acquisitions over the last 24 months or so, we did four equity offerings that generated gross proceeds of just over $1 billion. We did $150 of debts that had a maturity of 20, 35 and then last week we did the perpetual preferred offering, which is – was $373 million. And that is about $1.5 billion in capital and with either no maturity or a small piece of maturity there the far end of the future. And as we think about capital we’ll continue to keep in mind that the cost to capital could be materially higher in the future and the cost of refinancing that could be an issue. So we’ll try and take care of that in terms of how we are funding the acquisitions.

Relative to the balance sheet and access to capital, we’re in very good shape. As Paul mentioned there’s plenty of drive powder to continue to acquire. On earning and guidance, obviously the acquisitions, occupancy and same-store rent increases the portfolio had in 2011, really drove the revenue, FFO and AFFO and that will benefit us with the acquisitions here in 2012.

In the release a couple of weeks ago, we adjusted our guidance for the preferred issuance to 201 to 205 on FFO and that included that non-cash charge that Paul talked about and then AFFO 207 to 212 and that’s 3% to 5.5% AFFO growth and that number will be our primary focus as Paul mentioned into the best we have for recurring cash flow right now.

Kind of finally before we take questions, I’d be remiss if like Paul, I didn’t mention the press release yesterday announcing the 500th consecutive monthly dividend. That’s over 41 years of monthly dividends, it’s a long time. I think the company was about at 108th consecutive dividends when I came in to do due diligence in the company and met the founders Bill and John Clark. It’s probably over 200 when I came to work here 25 years ago and I called the Clarks who are actively retired to talk to them about getting to 500 and I liked their comment which is very typical for them which was “That’s great and I hope you guys are focused on the next 500,” which we are. Anyway a nice milestone for the company that they founded a long time ago.

Operator, we will now open it up to questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question and answer session. (Operator Instructions) And we have a question from the line of Lindsay Schroll from Bank of America/Merrill Lynch. Please go ahead.

Lindsay Schroll – Bank of America/Merrill Lynch

Good afternoon. Can you guys please discuss the health of the casual dining (inaudible) overall and whether the filings by Friendly’s and Buffets are more retailer specific issues or indicative of broader industry trends?

Tom Lewis

Yeah. It’s a good question, happy to do that. We’re not overly positive on the industry to say the least. I think a theme in almost everything we’ve looked at today is whether it’s in casual dining or somewhere else is to try and look at the consumer at that individual retailer or here restaurant is targeting because if you look at kind of the upper income consumer, they are spending both discretionary and non-discretionary. The middle market consumer which seems to be a little smaller group today is spending on non-discretionary but is really looking for value when they’re our doing discretionary spending and that includes casual dining. And then when you get to the lower end consumer, not only are they extraordinarily value-conscious on discretionary or non-discretionary they are almost aren’t spending on discretionary. So pick your casual dining and pick who their customer is but I think for a lot of people most of those changed or appealing to the middle and lower market and it’s a tough operating environment and we think it will continue to be so.

The other thing that’s going in there over the last couple of year is also minimum wage has gone from I think $5.85 an hour up to over $7 in the quarter, so they’ve seen some labor pressures and then at the same time had some commodity costs move. But we have the industry rather – relative to further investment kind of we’re not going to do it and then we’d like to continue to reduce it as part of the portfolio because it’s an area that even though for short periods it can snap back. We are not overly positive with it. I’d be remiss if I didn’t note there were chains doing very well in that industry and there are but casual dining for us as we watch is an industry that we’re not going to be doing additional acquisitions in.

Lindsay Schroll – Bank of America/Merrill Lynch

Okay. And then I think you’ve talked about wanting to dispose of your office assets and I’m just wondering what demand is those versus retail, if the cap rates are similar, the buyer is the same. If you can just talk about that?

Tom Lewis

Yeah. I don’t think we’re looking to dispose of it. We don’t have much in that area and they’re with very high quality tenants. I think it’s more of comments that that’s not something we’re looking to aggressively add to the portfolio. In the ECM transaction we had a couple of few office buildings that came with that but it’s still a relative small part of the portfolio, it’s only about 2.6% of rent. So I wouldn’t see it increasing but currently we don’t have plans to sell the assets.

Lindsay Schroll – Bank of America/Merrill Lynch

Okay. Thank you.

Operator

Thank you. And our next question comes from the line of Joshua Barber with Stifel Nicolaus. Please go ahead

Joshua Barber – Stifel Nicolaus

Hi, good afternoon. I certainly hope there’s not going to be a quiz on all those numbers that you guys threw out.

Tom Lewis

Sorry about that.

Joshua Barber – Stifel Nicolaus

That’s okay. Just a couple of quick questions, when you guys were talking about the eventual rents from releasing the Buffets and the Friendly’s deal what’s the time horizon that you’re using for releasing those assets?

Tom Lewis

It varies a little. In the Friendly’s, I believe we assumed in our -- that we didn’t lease anything until late in the year or early in the next year. We think we’ll do better with the Buffets. We had a little more aggressive move on it because we’ve had a little better luck as we’ve gone through this recently.

Joshua Barber – Stifel Nicolaus

Okay. Has any of them actually been released so far?

Paul Meurer

There are LOIs in place in a handful and so I think of that estimate is kind of 6 to 18 months and what that means is you’ll have some outliers that happen sooner and you’ll have some outliers that happen later than that.

Joshua Barber – Stifel Nicolaus

Okay. And regarding casual dining, obviously we’ve talked a lot about that. Can you talk about these sponsors of the casual diners especially the ones that you have exposure to and what their wiliness to restructure or to keep those entities going rather that bankrupt them right now? What those owner posture tends to be of today?

Tom Lewis

They tend not to be 7s, they tend to be 11s. Certainly that was the case in Friendly’s and that’s the case in Buffets. And when you think to sponsor you kind of wanted – there’s a couple of things obviously, these are levered entities and one of the strategies in the toolbox of these people has been to – if the chain starts to struggle in the debt trades to a discount, go into the market, buy the debt and they become both the debt and equity owner and that gives us some optionality to go through an 11, continue it on the chains and do some work on the contracts, other contracts of it. But I think as long as they can see in the properties profitability and the chain overall they’re obviously going to look for an 11 and that will either be through the debtor is becoming the owner or in the case as I mentioned were both – both have the same. But if you look Friendly’s and Buffets both the rents are pretty low, which gives them the opportunity to do that and the what we’ve tried to do in all of these of course is get some optionality for if the business recovers that we can get a piece of that. But in most cases, they do want to operate but it’s a chain by chain basis.

There has been a fair amount of bankruptcy in that industry over the last four or five years, 34 or 35 of them and the vast majority have been 11.

Joshua Barber – Stifel Nicolaus

Great, thank you very much.

Operator

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

Todd Lukasik – Morningstar

Hi good afternoon guys.

Tom Lewis

Hey, Todd.

Todd Lukasik – Morningstar

Just a quick question on the acquisitions. Do you guys have a preference right now for doing deals with the credit tenants in 7s versus the non-credit tenants in the 8s or still happy to do either category?

Tom Lewis

We are happy to do either and it really is investment grade and we would like to take it up the credit curve when we can find them. It’s a competitive world today, but like to do that. And then, when they are not investment grade, we’d rather be moving kind of up the cusp with it. And when you get to non-investment grade, it again is kind of a tenant with a low income consumer and discretionary we really don’t want to be investing there even though yields can be very attractive and we are willing to do both today.

Todd Lukasik – Morningstar

Okay. And then, just the acquisition assumption that’s currently embedded in your guidance?

Tom Lewis

I think right now about $0.5 billion is what I have got in there.

Todd Lukasik – Morningstar

Okay. And in thinking about same store rent growth, is 1% to 2% still a good long-term assumption for that?

Tom Lewis

Yeah, I would think I would hang around the 1% level or closer to that through the first half of the year as we deal with some of these properties and that was a case a few years ago. And then, I think it probably – long-term probably 1% to 1.5% is to consider average, when we get above 1.5% that’s high just given the way lease structures work.

Todd Lukasik – Morningstar

Okay. And you mentioned that I guess a couple of other categories that contributed to the increase in the last quarter, the motor vehicles and the casual dining that was from the expiration of rent reductions. And this quarter, I guess is that something that lasts than for 12 months in the same store numbers, but that this time next year that impact would drop off?

Tom Lewis

Yes, I think that’s the case and then I would also think we will get some boost from leasing.

Todd Lukasik – Morningstar

Okay, great. Thanks for taking my questions.

Tom Lewis

Okay, you bet.

Operator

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

Todd Stender – Wells Fargo Securities

Hi guys, thanks. Tom, you were indicating a vacancy that’s higher than expected in the fourth quarter. Other than the friendly stuff, who was the tenant on the bulk of those?

Tom Lewis

I would have to go look. It was an automotive, it was service, but what it was is, we have vacant properties and then we have a list and there is generally 20 to 30 properties on it that are closed properties, but they are still under a long-term lease and the tenant is healthy.

And what happened at the end of the third quarter, there was a bunch of properties that a tenant has closed about two years that was still under lease and still paying. And those all came off at once and so, we've gone back and we've looked at that list, which O exists at this very little of that this year, very little next year, but it was one little lump and I forgot, but it is an automotive service tenant I believe that was a bunch of them and then there were just a couple of others.

Todd Stender – Wells Fargo Securities

Okay. Will they likely be teed up for sale?

Tom Lewis

We will tee them up for re-lease or sale both.

Todd Stender – Wells Fargo Securities

Okay. And just along those same lines, could you be – say any disposition volumes increase maybe ahead of schedule, maybe where you thought you would be this time last year, just to get out in front of some of these credit issues?

Tom Lewis

That’s exactly what our plan is in terms of property sales. We have typically sold $25 million, $30 million of properties a year, but that’s mostly just working through lease roll over and occasionally tenant issue and that’s just been kind of the average, but we really do want to accelerate that kind of bid and if it’s okay, I will spend a second on it.

Over the last year, we want back and undertook a very lengthy project that took about 7 to 8 months where we re-underwrote basically the majority of the portfolio. I think we picked the largest 67 tenants and they combined at about 83% of our rents. And we went through a rating of each industry, we then went through our exposures relative to how many of their units we own, how many units we own, percent of rent and then, went back to their credit ratings around their balance sheets, debt maturity schedule, usage of line of credit cash, debt after cash liquidity revenue.

And then, went after their trends and looked at the margin trends and revenue trends and fixed charge coverages. And then literally remodeled each one of them once again and started running some stress tests where we move their revenues and margins and then kind of refinance their whole balance sheet over the next 5 to 7 years. And we added on 300 basis points, a higher financing cost of 600 basis points and then did some mixing of that to get a perfect storm.

And we took all of that and that kind of guided us along with some themes we had, their interest rates too, how is retail going to be different that the low end consumer may have trouble coming back, the non-discretionary is going to be difficult. And in doing that then really we kind of laid out our top to bottom in the portfolio.

At the same time, we did the same with properties and when we got through, we merged that and basically came up with a group of the portfolio that over time that we would like to move out of and in combinations with acquisitions and sales, kind of re-orient the portfolio.

And initially, we targeted a little over a 100 properties about $110 million or so we bought those out, about $100 million of carrying value. And we have started a process to market them and we have done some staffing, done some systems and we have just literally launched that over the last month or so. So, for this year, if we can move that up to $50 million from the normal $25 million to $35 million that would be just great.

My sense is to do the whole $110 million will be moving in through this year and early in the next year, but the plan right after that will then be to take the next on the list and we would like to over the next three, four, five years be fairly active in recycling capital and moving into some new areas that we’d rather have in the portfolio.

Todd Stender – Wells Fargo Securities

Okay, that’s really helpful, thanks Tom. And just lastly, it looks like, did you have one agricultural property? Did I see that right?

Tom Lewis

We did. We had one additional property, Diageo, it’s in the Napa Valley. It’s kind of wedged in between the other vineyards that we owned and it is one that we had looked at doing a ways back, but there were a couple of complications operationally for them on it, but we were able to do that. So, it’s a little addition to the Diageo portfolio.

Todd Stender – Wells Fargo Securities

Any pricing on that, any indication what the cap rate was?

Tom Lewis

It’s relatively similar to what we did two years ago.

Todd Stender – Wells Fargo Securities

Okay. Thanks guys.

Operator

Thank you. And our next question comes from the line of Anthony Paolone with JPMorgan. Please go ahead.

Anthony Paolone – JPMorgan

Thanks, good afternoon. Just following up on that Tom and thanks for laying out your thoughts on dispositions. Can you give us any sense of what that magnitude might look like against the $500 million of acquisitions you are thinking about for 2012?

Tom Lewis

Yeah. There is about – well acquisitions for 2012. Again, our best guess this year is we would like to do 50 and that probably adds in 25 to 30 of this new grouping of investment properties we’d like to sell. So that’s the number there, but there is $110 million probably over the next 18 to 24 months.

And then behind that as we went through and did the whole portfolio it wasn’t we need to sell these now, but these are areas we want to move out of. It is about 20% of the portfolio where you looked at, instead over the next four or five years that’s what we would want to recycle.

Anthony Paolone – JPMorgan

When you say 20% of the portfolio, is that 20% of value or 20% of the buildings?

Tom Lewis

Revenue.

Anthony Paolone – JPMorgan

Revenue?

Tom Lewis

Yeah.

Anthony Paolone – JPMorgan

So, I mean, does that suggest there’s a lot, like a much bigger ramp in sales beyond 2012 and 2015 with that?

Tom Lewis

No, if you think of about 20% that’s 400 or 500 properties, so I think over three to five years that’s about 80 properties a year or something.

Paul Meurer

And to some extent more art than science Tony. So, for example if we – buy $1 billion worth of real estate again this year, then maybe we can do more than $50 million in sales this year, who knows. So, we will kind of manage that from an earnings run rate perspective as well.

Tom Lewis

Yeah, it’s a balancing act with acquisitions and all the other things going on in the portfolio and still hitting good numbers and raising the dividend, but we think we can move a good part of the portfolio over the next two years.

Anthony Paolone – JPMorgan

Okay. And then, you talked a bit about same store revenue. I was wondering if you would give a sense of same store NOI maybe net of things like the $7.5 million of property expenses that you bear. The effect of the phase and in Friendly’s this year, just some the vacancy ticked up in the fourth quarter from some of those leases that burned off and just how that roles into a same store NOI number for 2012?

Paul Meurer

Okay, let me.

Tom Lewis

Let us work on that.

Paul Meurer

And the one thing we do, I think we do a pretty good job of giving you the specifics of how we approach same store calculation in the 10-Qs and 10-Ks, but we will have that laid out to give you exactly what we have put in it versus what’s not it, because everyone does it a little bit differently.

I think what you are generally going to find and that’s why Tom tried to give you some guidance on where we get some bumps in which industries and which ones were down is that obviously, the ones that we got bumps in, it was probably a number of slightly healthier than 1% to 1.5%. But the ones, the vacancy is what really drives it down to that kind of overall run rate. So, when you are modeling for the overall portfolio that’s why we are guiding you to that 1% to 1.5% area.

Tom Lewis

Yeah, and I don’t have that number off the top of my head Tony, but if you want to e-mail what the piece of puzzle is, let us take a look at it.

Anthony Paolone – JPMorgan

Sure, and I guess, what struck me and where I was coming from was even between the 1% to 2% ban being towards the lower end of that, it still seemed like not a whole lot of impact given what's happened with Buffet’s and Friendly’s and stuff. Is that like all those things?

Tom Lewis

Yeah, that’s very fair, it definitely impacts. When we talk about an 80% recovery rate that is when we get those leased up, so if you have a event happen for the 12 months after that the impact is certainly greater than the 20% that you don't recover, because that's during the period where they are vacant and aside from not gaining rent, there is also the triple net expenses and so, in a year like this and it really bans the year between Friendly’s and Buffet’s. That does have a pretty good impact, it may exceed the same-store rent for a period of time until you get those leased.

Anthony Paolone – JPMorgan

But even with the impact on a top line of Friendly’s and Buffet’s, you still think you will come in that low 1s?

Tom Lewis

I am only hesitating, because I'm trying to make sure I understand what the numbers are.

Paul Meurer

Obviously, you understand why 2011 wasn’t as affected because Friendly’s occurred late in the year and Buffet’s have not occurred yet.

Anthony Paolone – JPMorgan

Right.

Paul Meurer

Fair enough. Your question is on the projection for 2012 and I think what we are seeing is, we were expecting same-store rent to be more like 1.5% plus next year, reasonably healthy from an overall historical perspective for us. And the Buffet’s and Friendly’s vacancy is what's dragging that down closer to a 1% number, certainly for the first nine months of the year or so.

Anthony Paolone – JPMorgan

Okay. Yeah, no I just wanted to make sure that was in that low 1s, because I would have actually guessed it to have had a greater negative impact in that. Great, and then, just the last thing, just curious as you thought about your strategy in the push towards a little bit more higher credit quality, a desire to go up the credit quality spectrum.

Like how do you think about going higher credit quality versus perhaps maybe any other options like staying where you are on the credit spectrum and focusing more on certain MSAs or just a different product category or something like that?

Paul Meurer

Yeah, that's a very good question. I think rather than what we are doing talking about why we are doing, it's really important. And starting about four or five years ago as we were doing strategic planning, one of the things we did is, let’s look back at the last 20 years and say, it obviously went really well.

And then say, okay, why did it go really well and to try and differentiate between being in the right place at the right time and then secondarily, what we did and there are kind of three themes in there that are driving it. One is looking at retail, in our business if you look at the last 20 years, you had great domestic economic growth, personal income growth, the baby boomers were peak earnings and spending years, the next one is very important, the consumer levered up.

Retail spending growth rates were really high, retailers added a lot of new stores and it was the right place to be at the right time and we were. And then we said, okay, let's look forward, there is a bid of the new normal the term goes around, debt to GDP is approaching 90%, which takes something out of GDP growth and personal income growth, the baby boomers are ageing, you got the baby bus behind them. And the consumers unlikely to lever up at the same rate, because they can't and may even de-lever a bit.

And so, maybe retail isn’t as – the growth rate isn’t as high as it was in the past. And then, you throw in kind of the impact of Internet on retailing and you say, it’s the difference between running downhill and the difference between running on flat ground or flat land and the first step was to say, okay, industry and tenant selection will be more important in the future than in the past, because it’s just not as a environment.

And then, really going to one step further and saying, let’s take a look at the consumer. The low-end consumer did pretty well over the last 15 to 20 years with all of the growth in construction and real estate and the building trades. Home improvement, there was a fair part of what normally would be kind of the lower income market that we think crept into the kind of middle income market and we are not sure that will be the case in the future. So, let's look at each business we have and which consumer it serves and assume it's not going to be as good as it could.

The second thing which is also really, really important and I alluded to that, take a minute [ph] is with interest rates and I get the tenure year over the last 30 years ago from 14% to 16% to 2% and that's very much running downhill. And that obviously made asset prices rise, but kind of more importantly made leverage always work and refinance always work and there were a lot of what might have been marginal business models that worked, because interest rates were falling so fast.

And there was a fair amount of our tenants that used a fair amount of leverage in environment when interest rates were going down. And so, with the tenure 2%, the chance of having a material declining interest rate environment is almost zero, because if you go from 2% to 1%, it’s only 1% and so that benefit won't be as robust. And then you say okay, what if rates stay low, well, that’s generally because the economy is probably limping along and very timid [ph] relative to economic growth and in that environment over time, the possibility you could see credit spreads gap, which means refinance rates for those tenants would be higher.

And then moving out 5 to 7 years, you take a look at those tenants and you say, if they had to refinance their entire balance sheet, what it would do? And that's what started that project which we did where we really know what it would do. And then, you throw in obviously, anybody that has impact by Internet.

And when we got done with all of that, we said okay, look, we want to go up the credit curve, so 5 to 7 years from now interest rates are higher and the tenants have to refinance their balance sheet and that sucks cash flows really out of their income statements, it can have an impact and default rates will be greater in the next 20 than the last 20.

So you put those two together and then kind of the last one that’s the net lease retail spaces become more competitive and more mainstream and so, that launched us in a couple of directions. One, just generically up the credit curve and not just into investment grade, but in the portfolio for those less investment grade higher up the curve. Second, in terms of the type of consumer they really serve, again, we want to stay away from more of the consumer discretionary.

And then third, where can we go outside of retail that should benefit, good examples are FedEx, and the impacted as for them with Internet taking more and more of retail sales and other areas where we can also get investment grade credit and then maybe even have some very large Fortune 1000 tenants that are benefiting from having a presence overseas where we are not, but as they are our tenant of ours, we would benefit.

So, it was all of those kind of put together that we said, okay, in retail, up the curve, out of certain areas and into others and then outside of retail up the credit curve, so we wake up 5, 7, 8 years down the road and we have kind of remade the portfolio. And if it is that’s going to slow our retail environment and/or interest rates were materially higher, it won't have near the impact that might have because the last 20, 30 years and track record, it was put together because that is a function of the operating conditions to some extent and it’s unlikely that that will persist into the future, so that was kind of the thought process.

Anthony Paolone – JPMorgan

Okay, yeah, thank you. I appreciate that.

Operator

Thank you. And our next question comes from the line of Rich Moore with RBC Market. Please go ahead.

Rich Moore – RBC Market

Yeah, hi, good afternoon guys. I was looking at the or thinking about the impact of Friendly’s. And I went back to the press release you guys had, is that what you pretty much are seeing what you put in the press release on January 18, is that still what you expect from the Friendly’s closures and then how much you recover of what's left?

Paul Meurer

Yes.

Rich Moore – RBC Market

Okay, and at what point in the year did they stop, did all of this take place. I mean you said it was late in the year, but was it – how much of that fourth quarter rent I guess we see?

Paul Meurer

We received October rent and then the impact say 15 of the 19 rejections, we did not receive November or December rent. And then, the other four rejections we haven’t received January’s rent, just to kind to give you a feel.

Rich Moore – RBC Market

Okay, that does. And then as far as what you will recover from the others, when did that start, the reduction?

Paul Meurer

All of that started November 1 basically, on the concessions and that sort of thing on any properties where we agreed to a lower rent level. But October was a full rent.

Rich Moore – RBC Market

October was a full rent. I got you. And then for the phase, you are thinking, obviously nothing is happening. Are you thinking the same that you have in the press release, the same sort of same sort of parameters that you mentioned in here?

Paul Meurer

That all come back to January 1 basically. And that’s all again loaded in our projection both Buffets and Friendly’s, those recovery numbers and with the expectation as mentioned call it a six-month to 18-month general window, some earlier, some later than that in terms of re-leases on the rejected one.

Rich Moore – RBC Market

Okay. And those parameters Paul as far as how much base rent you will lose and what the concessions will be on there mainly. Do you still feel comfortable about that?

Paul Meurer

Yes, we are at the same place where we were with the press release a couple weeks ago.

Tom Lewis

Yeah, absolutely.

Rich Moore – RBC Market

Okay. And that all comes back to January 1?

Tom Lewis

Correct.

Rich Moore – RBC Market

Okay. I got you. And then, I wanted to ask you guys, when you re-leased some of these, when you redo Friendly’s overall [ph], do you have to put capital in, in any way for the new tenant?

Tom Lewis

Sometimes a little.

Paul Meurer

A little, but generally not huge amounts. Historically, the revenue tenant was that’s part of the work he does on it and we agree to a long-term rental agreement, it's generally not, it's also you don't get two years free rent and you do it, it’s generally renegotiated rent and that’s his responsibility. So, it's a marginal amount of CapEx that it adds in.

Rich Moore – RBC Market

Okay. And users for these would probably be restaurants again? Is that the typical use for a restaurant?

Paul Meurer

Yeah, a lot of the buildings are set up for that, so it generally is and I could give you other things they would become, but it’s really anecdotal, they are restaurants.

Rich Moore – RBC Market

Okay. All right, very good. Thanks, guys.

Operator

Thank you. This does conclude the question-and-answer session for the Realty Income operating results conference call. Mr. Lewis, please go ahead.

Tom Lewis

Okay. Well, listen thanks everybody for being with us today, I know it's a busy schedule and we appreciate the attention and we will talk to you in about 90 days and thank you, Diane.

Operator

Ladies and gentlemen, that does conclude today’s teleconference. Thank you for your participation. You may now disconnect.

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