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Executives

Tom Lewis - CEO

Gary Malino - President and COO

Paul Meurer - EVP and CFO

Michael Pfeiffer - EVP and General Counsel

Tere Miller - VP Corporate Communications

Analysts

Anthony Paolone - JPMorgan

Jeff Donnelly - Wachovia Securities

David Fick - Stifel Nicolaus

Eric Rothman - Danske Securities

Philip Martin - Cantor Fitzgerald

Suneet Parikh - Banc of America

David Wellington - Merrill Lynch

Realty Income Corp. (O) Q2 2008 Earnings Call July 31, 2008 4:30 PM ET

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Realty Income Second Quarter 2008 Earnings 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, July 31st, 2008.

Now I'd like to turn the conference over to Mr. Tom Lewis, CEO of Realty Income. Please go ahead, Sir.

Tom Lewis

Thank you very much and good afternoon, everyone. Welcome to our conference call, where we'll talk about the second quarter and a little bit about what's going in the balance of the year.

In the room with me today is Gary Malino, our President and Chief Operating Officer, and Paul Meurer, our Executive Vice President and Chief Financial Officer, Mike Pfeiffer, our Executive Vice President, General Counsel; and as always, Tere Miller, our Vice President of Corporate Communication.

And as I am obligated to do on each call, during this conference call we'll make certain statements that may be considered to be forward-looking statements under Federal Securities law. The company's actual future results may differ significantly from the matters discussed in the forward-looking statements and we'll disclose in greater detail on the company's quarterly 10-Q, the factors that may cause such differences.

And, Paul, if you want to go ahead and walk through the quarter, well do that.

Paul Meurer

Thanks, Tom. As usual I am going to comment on our financial statements and provide a few key highlights of the financial results for the past quarter and start with the income statement. Total revenue increased 17.2% for the second quarter as compared to the second quarter of 2007. Rental revenue increased to approximately $82.4 million in the quarter, as a result, of course, of new property acquisitions.

Same store rental revenue increased 1.4% for the quarterly period. And other income was only $80,000 for the quarter.

On the expense side, interest expense increased by $10.9 million, during the second quarter, as compared to the second quarter of last year. And this increase, of course, due to more bonds outstanding as compared to a year ago, specifically the $550 million of 2019 notes that we issued in September of 2007.

We had zero borrowings on our credit facility throughout the second quarter. On a related note, our interest coverage ratio continues to be strong at 3.2 times, while our fixed charge coverage ratio was 2.5 times. Depreciation and amortization expense increased by about $4.5 million in the comparative quarterly period, as depreciation expense has increased, of course, as the portfolio continues to grow.

General and administrative expenses for the second quarter were about $5.9 million, representing only 7.2% of total revenues for the quarter. We continued to expect G&A expenses in 2008 to remain at or below 2007 levels.

Property expenses increased slightly on a comparative basis by $135,000 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. Income taxes consist of income taxes paid to various states by the company; and these taxes totaled $218,000 for the quarterly period.

Income from discontinued operations for the quarter was $4.7 million. Real estate acquired for resale refers to the operations of Crest Net Lease, our subsidiary that acquires and resells properties. Crest sold seven properties for $28.6 million during the quarter for a gain on sale of $1.7 million. However, Crest also recorded an impairment of $953,000, on one Buffets property held for sale. You will recall that Crest holds three Buffets properties. We impaired two of those properties last quarter. This is the third Buffets property, and this impairment amount was already in our internal projections, which we gave out last quarter, when we updated earnings guidance at that time.

Overall for the quarter, Crest contributed income of $1.295 million. Real estate held for investment refers to property sales by Realty Income from our existing core portfolio. We sold eight properties during the second quarter, resulting overall in income of $3.4 million. These property sales gains are not included in our funds from operations.

Preferred stock cash dividends remained at about $6.1 million for the quarter. Net income available to common stockholders was approximately $27 million for the quarter. Funds from operations or FFO, was approximately $46.8 million for the quarter. FFO per share was $0.47 per share versus $0.49 per share a year ago. However our FFO before Crest contribution or the FFO from our core portfolio increased to $0.45 from $0.44 per share a year ago, an increase of 2.3% in earnings from our core portfolio.

When we file our 10-Q, we will again provide information you need to compute our adjusted funds from operations or AFFO, for our actual cash available for distribution and dividends. Our AFFO or CAD is typically higher than our FFO, as our capital expenditures are relatively low and we don't have a lot of straight line rent.

Our continued growth in core earnings allowed us to continue increase in our monthly dividend this quarter. In June, we increased the dividend for the 43rd consecutive quarter and the 49th increase for the dividend overall, since we went public over 13 years ago. Our current monthly dividend is now $0.138 per share, which equates to a current annualized amount of $1.656 per share.

Briefly turning to the balance sheet, we continue to maintain a very conservative capital structure. Our debt to total market capitalization is 33% and our preferred stock outstanding represents 8% from our capital structure. In May, importantly, we recast our credit facility, increasing it in size to $355 million, plus a $100 million accordion expansion feature. The initial term of this facility is three years, plus two one-year extension options thereafter.

We strongly felt that in this challenging market environment, recasting the new facility was a lot more prudent than simply exercising the one-year extension option, which we did have available to us on the prior facility. We were very, very pleased with the responsiveness of our bank relationships and the speed with which we were able to syndicate this new facility back in May. We continue to have zero borrowings on this facility, however, at this time.

Furthermore as noted on the balance sheet, we also have over $39 million of cash on hand. In November 2008, as many of you know, we have $100 million of bonds coming due and in January '09, another $20 million of bonds coming due. As we said previously we plan to reserve cash or credit facility capacity for this $120 million of upcoming obligations, so that we are not dependent on positive public capital market conditions at that time. Thereafter our next debt maturity isn't until 2013. So, we do not need to access any new capital for any upcoming financing obligations. In summary, we currently have excellent liquidity and our overall balance sheet remains healthy and safe.

Now let me turn the call back over to Tom, who'll give you more background on all of these results.

Tom Lewis

Thank you, Paul. Let me start with the portfolio. As you saw in the release, we ended the quarter with 96.8% occupancy and 75 properties available for lease out of the 2,367, we own. That's off about 60 basis points from last quarter on occupancy. 13 of the new vacancies were from credit default from a couple of small tenants this quarter. That is not a large number, given we have almost 2400 properties. But its an increase nevertheless, but is consistent with what we expected and actually what we included in the guidance that we gave last quarter. And then the balance was just normal leased rollover, that's going on in the portfolio and ebbs and flows.

Our sense is occupancy should rise a bit from this level, the balance of the year. We see good activity in the portfolio management department and releasing space, and don't have anything pending relative to additional vacancy that's not reflected in our guidance. So, things look just about what we thought they would, a few months ago and I would be a bit surprised if occupancy wasn't in the 96% to 97% range, the balance of the year absent anything material from what we see today.

You'll notice, we announced in a press release a couple of weeks ago, an agreement with Buffets to continue to lease all of the 104 properties, we currently have leased to them in our core portfolio. And that the rent would be adjusted from $22.4 million to $19.4 million or about 87% of previous rents. That announcement was generated by a filing at the court that, we had reached an agreement with Buffets. And in response to a number of calls we got after that, we thought it was appropriate to put out that information of what the financial impact would be, so people could see what that was.

We had planned, by the way to do that at the end of the third quarter. When we could sit down and talk more about it, which we can't do today. So that will be the extent of my comments on the Buffets situation.

As I've mentioned before, relative to that agreement specifically we are under a confidentiality agreement. And then secondarily as their process is underway, the reorganization is quite active. We are also on the Creditors' Committee and have a confidentiality agreement subject to that as you would assume. And so, we anticipate no significant news out of that situation in the near future.

I will say though that, that agreement was consistent with what we were looking at last quarter and once again with guidance.

Relative to the balance of the portfolio, I think as everybody knows out there listening into some other calls. The retail environment is weak overall. And it's obviously a very difficult environment, particularly in the last six to eight weeks for the consumer. We can see that in the operations of our tenants and the discussions we have with them, also in the underwriting of new transactions, which we continue to do.

And while we can see some stress in some very small positions we have with some retailers. We would really be surprised by some substantial additional vacancies coming in, over the next quarter though. So nothing really new, we have nothing else significantly going on in our top 20 tenants. We are currently reviewing those, for a meeting we have with the board every August.

So, we are in the midst of re-underwriting and talking to them. And quite frankly, when you get down to below the top 20 tenants, you are looking at about 2% of rents.

Same-store rents on our core portfolio increased a little under 1.5%, during the second quarter and for that year-to-date. Looking forward to the balance of the year, we would see same-store rent increases probably at about that level, and so continued increase. If you look at the 30 different retail sectors that we have in the portfolio, there were two that had declining same-store rents, four had flat same-store rents and there were some increases in the balance of the 24 different industries. But it was really concentrated on and I guess you'd expect this because there are larger industries with about half of the increases coming from restaurants, childcare, auto service, and C-stores.

We continue to be well diversified in the portfolio. We had a decrease of about eight properties, totally in the portfolio from quarter-to-quarter from 2,375 to 2,367. That's really coming from the sale of a number of properties out of the restaurant industry that we used to prune our position there and just slightly reduce overall and just acquiring one property during the quarter.

We continue to be in 30 different retail industries in the portfolio. We have 118 different retail chains and continue to be in 49 states. Relative to exposures to various industries, restaurant is our largest industry. At quarter's end, it was at 21.7% of revenue, down from about 23.9% in the second quarter and from about 24.2% at the end of the fourth quarter. That's a reduction of a couple hundred basis points over the last 90 days or so. And as we've said over the last couple of quarters, we are full in that industry not making acquisitions. We are selling off a few properties and going to get that back down under 20%.

Convenience stores are about 16% of revenue. The next largest industry after that is, feeders at 9, which is down a little bit from 10%, and then childcare, which is at about 7.5% and from there it goes down pretty quickly. We continue to be mindful of diversification in the portfolio, one would like to keep it well diversified.

If you look from a tenant standpoint, our largest tenant as we said in our past press release was Buffets at about 5.9% of rent. The next largest tenant about 5.3% and then every other tenant is below 5% of revenue. Our 15 largest tenants comprise about 54% of revenue today. And just as a data point, when you get to number 15, you are at about 2.2% of revenue. And to take it, when you get to tenant number 21, you are at about 1.4%, and again, it goes down very quickly after that. So, we remain pretty well diversified.

The average remaining lease length in the portfolio continues to be a healthy 13 years. And that's really staying longer as a function of acquisitions over the last year or so, and then secondarily from releasing properties that are coming up and obviously having a longer lease than right before they expire. I mentioned our top 15 tenants comprise about 54% of revenue. As always, our best metric for credit remains the cash flow coverage of rent at the store level, or the individual stores cash flow to their retailer or the EBITDAR, if you will, divided by the rent he pays.

And the average cash flow coverage for our largest 15 tenants on a store basis. EBITDAR coverage of rent was 2.7 times at the end of the second quarter and ranged from a low of about 1.7 times up to about 455. That's off a bit from last quarter, where it was 2.76 and ranged from 188 to 419. But 2.7 times, that's obviously very, very healthy. And we believe gives us an excellent margin of safety relative to the tenant's ability to pay his rent and if they own very profitable property. So we own their profitable properties.

Let me move onto property acquisitions. During the second quarter, we only bought one property for $2.7 million. That was one we had really worked on over the at the in the fourth quarter of last year, that crept into the second quarter of this year, so effectively, we really didn't buy anything in the second quarter, which is what we had expected to do. We continue to have $250 million in acquisitions for the year for our guidance, but with $184 million done today certainly hitting the $250 million number for the year is doable.

While we didn't buy anything during the second quarter, we continue to look at a lot of transactions. From time-to-time, I'll put these numbers out to give you a feel. Year-to-date in committee, we've gone through just under about $2 billion worth of transactions that we've looked at and underwritten. About 61 separate transactions and again, buying about 188 million in eight transactions, we bought about 9% of what went through committee. To put that in perspective for the same period a year ago, that is off a fair amount from what was coming through the committee as we see less transactions generally in the marketplace overall.

I think if you look at the acquisition environments today and you start really on the demand side, the number, you start with the 1031 tax-deferred exchange size of the business that tends to be a fairly large part of the net lease market. And the number of those type of borrowers, which has been very big, I think has declined quite a bit, as you see sales and other property categories declining, which means there are less gains that need to be sheltered through a 1031.

And our people that kind of watch that area think the transaction volume is probably down about 50% in the 1031 market over the last 18 months, relative to net lease properties. Having generally buyers out there that are looking at that type of property are having a harder time finding financing, if they don't have a lot of equity to put into properties. Obviously, the CMBS market is quiet out there and then secondarily, the regional banks but its still some of the lending gaps in recent years, are running into their own areas. And I think financing is a little harder for them to get.

We took a look recently at all of the properties from kind of the 1031 people out there that were listed on the market for sale. And we just made notes that probably about two thirds of them had been on the market for 90 days or longer. So, I think that the inventory is aging a bit and that 1031 market slowing down.

Relative to the segment that we primarily play in, which is kind of the larger portfolio buyers, I think that slowed down a bit too. I think most of the people who bought in bulk to then flipped have exited the market, usually through capital issues having trouble accessing capital. I think there is a lot less other institutions out trying to buy today and a few like us are on the sidelines, waiting for cap rates to move higher.

From the supply side, obviously, there's less M&A related activity out there that would generate these. And that's brought the volume down overall. And then I think just generically, like a lot of real estate sectors, the bid/ask spread out in the net lease market between buyers and sellers was pretty large. And unless owners today are compelled to do a transaction, they are trying to hold out for an improvement in the market at some point and hope cap rates will fall from where they are today.

From our perspective, I think prices are declining and cap rates are continuing the increase. I think on the larger transactions we've looked at, my sense is, they're moving up into the high 8's, and maybe the low 9's, and continue to move up. But there's really not a large volume of transactions being done out there right now.

It's interesting relative to caps, its kind of hard to know exactly where caps are in both transactions because if you look what was reported in second quarter numbers, that's pretty much looking back about 60 days or so into the marketplace. And as we've all seen both at the general retail environment, and I think that's true in the property market cap rates that are 60, 90 days old are a bit stale. And so, it's hard to get a feel on it, but we definitely think that they are moving higher.

I also don't think that you are going to see transactions pickup very much for a while. I think there are lot of people out there that don't have access to other forms of financing, they do have real estate on their books. And at some point, they are going to have to enter the market. I think they are hoping that the credit markets will open up and allow them to access other forms of capital and our sense that it will be difficult to do that.

However I think that most of bad volume that comes on the market will probably be late in the year or early into 2009 and that as that happens if that happens you are likely to see cap rates move up a fair amount. That will close the bid/ask spread I would think and probably cause volumes to pick up.

I think for '08, though we are going to stick with the $250 million number and subject to change depending on how cap rates and seeing what else is going on out there. As Paul mentioned, we are very liquid at the moment. There's no balance on the line. We have just about $40 million in cash sitting around and some property sales and free cash flow coming through. We are very liquid and I'd like to stay that way and intend to stay that way for a while, until there is some definite movement upwards in cap rates and volumes. And then at that point we may put some of the money to work, but not until.

Let me move onto Crest Net Lease for a moment. Most of you know that Crest is our business that we've had the last eight years that helps us buy large portfolios for the core portfolio, where we'll buy some, put them in Crest and then sell them so we can work down our concentration. It has been a moneymaker for us, but as we always say, obviously a very different quality of cash-flow because its cash flow is generated from property sales, which is a lot more volatile. And for perspective, Crest is made in any given year, over the last eight years between $0.02 to $0.11 per share so, it has been a fairly small part of our overall FFO and remains so today.

Last year we did $0.11 a share in Crest, which was a function of having a lot of inventory and a lot of sales last year. Our inventory in Crest peaked last year at about $140 million and we have been paring inventory through sales over the last year or so. We've bought nothing in Crest at five of the last six quarters and the last three quarters, we've made no purchases at all and have really been trying to wind down that activity.

Current inventory at the end of the quarter was only eight properties for a little over $10 million. Close to the end of the quarter, we sold another property, have two more under contract, which really leaves us with only five properties in the Crest portfolio with the inventory of about $6 million. Three of which are the Buffets, that Paul referred to, that have been substantially impaired.

But I don't think there is any risk there relative to valuation and then two small properties that I anticipate no problem selling. So, with inventory at only about $6 million, we are affectively out of that business and until we need Crest for acquisition purposes, or the market really changes, I doubt seriously that you'll see any additional activity going on in Crest.

As I mentioned in the past, we are in a very competitive market with a lot of buying. Crest was very helpful to buy large portfolios with a reduced kind of number of competitors out there over the last year or so, we haven't had to use Crest and our sense is at the current time that that's really where we see the risk of holding a lot of inventory in a rising cap rate environment and we are happy to effectively be out of that business today.

Moving on to dividends, as Paul mentioned, we've continued to increase the dividend. I'd anticipate and would look for dividend growth to continue here in 2008 and absent anything, material also 2009. Relative to FFO obviously, the number was $0.40 versus $0.49, most of that had to do with closing Crest down, having a penny come out of Crest this quarter versus $0.04 a year ago.

On the core contribution pre-quest, we grew from about $0.44 to $0.45 per share in core FFO, which is up a little over 2%. Relative to guidance, there is no change to the guidance from last quarter and we'll stay at $1.84 to $1.90. That includes only a penny or two from Crest versus $0.11 a year ago. And then our expectation, that the core before Crest will grow at 2% to 5% this year.

As we start to think about 2009, I think looking into next year, the numbers we issued have Crest washed out of those numbers. I think we should release a fair part of what's on the vacancy list, and I'd anticipate to be positioned to have a pretty good 2009, relative to FFO growth.

We will put guidance for 2009, at the end of the third quarter and is our, as we're accustom to doing at that point, we'll lay out all of the assumptions relative to the portfolio operations Crest and acquisitions at that time.

To summarize them, I think the portfolio is in relatively good shape, given the state of the overall markets, we're effectively out of the Crest business, being very patient with acquisitions and holding off here for higher cap rate, balance sheet is good, liquidity is good and core operations continue to grow and we think that'll continue through the balance of the year. All of which, I can say I can live with in this type of market, which is certainly interesting.

And I think, that'll wrap up our comments and I appreciate the patience to kind of go through everything. And operator, at this time, we can open up for questions. That will be great.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from the line Anthony Paolone with JPMorgan. Please go ahead.

Anthony Paolone - JPMorgan

Well, thanks Good afternoon.

Tom Lewis

Hi Tony.

Paul Meurer

Hi Tony.

Anthony Paolone - JPMorgan

With respect to the deal pipeline in any of your acquisition targets for the full year. Just what's the visibility for what's remaining on the $250 million, since, it sounds you all are going to be pretty patient with the cap rates to move up.

Paul Meurer

Yeah it'll interesting, I don't think we are going to buy much of anything here in the third quarter. We continue to underwrite transactions. It was really absent something coming in, where I think cap rates might be as we get in the next year. We'll probably remain very patient and then it is a question of, whether later in the year not cap rates really rise.

So, my sense if we miss anything here this year, its really on the acquisitions, but those would have been later in the third quarter or fourth quarter, I think from a model perspective and really have very little of any impact on '08 and then we'll update that relative to its impact on '09 as we do guidance for next year, which we think will be positive.

So, it's really hard to say at this point, it'd be very easy to pull the trigger. We had a number of transactions come through in the mid to high 8s. In the second quarter and I think that'll happen in the third and again unless something comes in the mid 9's or so, given, effectively the nominal cost of capital is up around eight unless you can get into the mid 9's.

I have bit of trouble trying to allocate that capital at an inadequate spread. So, my sense is if we do it'll be towards at the end of the year, Tony. And it wouldn't surprise me at all to do it or exceed it, but wouldn't surprise me all to be a little under it.

Anthony Paolone - JPMorgan

Okay. So, is mid 9s kind of the spot that you think things should go to at this point or would reflect kind of a fair pricing in your minds, where you people are more interested?

Paul Meurer

Yeah I think that's where it would be and maybe even a little higher. Obviously, every transaction is specific relative to the bump that you are getting on the leases but that's probably into the range.

Anthony Paolone - JPMorgan

Okay. Is there any particular industry type that you are seeing more deal for in at the moment or not?

Tom Lewis

It's pretty wide ranging. There is not a big theme, which normally, I think, if you go back about four, five years, I should say we are seeing a seen a lot of restaurants or C stores. But we are really seeing diverse group of things coming off and typically it's somebody who's got a decent size piece on the balance sheet.

They're becoming a little more rationalized relative to where the capital markets are and looking at where spreads have gone, the credit spreads and they are saying, I am going to need to do something for my balance sheet in late '08 or in '09 and have decided that the market may not get better and they are coming to the market. And I think because of that, it's less of a industry theme than it overall is a balance sheet theme and now I wouldn't be surprised if that continues.

Anthony Paolone - JPMorgan

Okay. And then, with respect to you C store exposure. Can you talk to how those properties are performing in light of just considerably relative to gas and the other sort of business?

Tom Lewis

Yeah. We have been watching C store and obviously that's a big story with gas prices. I know one of the public C store chains we know well, reported and I think kind of 4, 5 takeaways from listening to their conference call. Say what we are hearing from pretty much everybody which is gallons are up probably about 4% or 5% over a year ago.

Gas margins have come down $0.03 or $0.04 and are probably around $0.09 to $0.12, first being $0.03 to $0.04 higher from that a year ago. I think where most of them are getting pinched which is something you normally wouldn't look for as credit card piece because even if you maintain the number of fence, you are maintaining your margin yet. Credit card fees obviously are a function of prices, and with higher gas prices they are getting pinched a little bit there.

It's really been hitting their middle line. And so that I think has been almost as hard on them as the reduction in gallon is. Where they make their money inside? Most of them were saying they're off maybe 2%, 3%, 4% inside sales which is not as bad and in this particular one today, the merchandised margin was relatively flat.

And then if you look at net income, it was off probably about 20% quarter-over-quarter a year. But you can take that other way off 20 or maintaining 80% of it. So while there is some stress and a slowdown, which I can see, I think you can see in a lot of retail today, that one is another one of the postal charges a function of gas prices but still not as bad as you might anticipate, just more talked about.

Anthony Paolone - JPMorgan

Okay. And last question. do you have any sense as to maybe what percentage of your tenants or revenue base have a parent that's bankrupt at the moment, that kind of say even though your stores are worked out, the parent is still bankrupt, is there any way to gauge that?

Tom Lewis

You know I haven't run that number but if I had to do that I'd say 7. If I have to guess, the phase is 59 you know.

Anthony Paolone - JPMorgan

Yeah. If you take away the phase', your looking at less than 1%?

Tom Lewis

Yeah.

Anthony Paolone - JPMorgan

How much of that?

Tom Lewis

There is really not much else in there at the moment.

Anthony Paolone - JPMorgan

Okay, thank you.

Operator

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

Unidentified Analyst

Hi, this is [Andy] here with Michael. Could you give some color on the 13 credit default assets that you had with those tenants in any specific industries than who are you really seeing those assets to?

Tom Lewis

Yeah. Well they've just come offline and again they were only 13 and few of them are restaurant and one was the general merchandise. But again you are looking 13 properties out of 2367. So, it's a very small number and we knew those were coming last quarter and we also put them in the guidance and then really its obviously, its going to be restaurant and the other, I think its 12 restaurants, small restaurants and one box and the box is near a mall and can be released to just about anybody.

Unidentified Analyst

And have you found it more challenging to release spaces given softer restaurant operation?

Tom Lewis

I really want to say yes, but I can tell you also that we've had a pretty good flurry of activity recently through those, so I'm not sure that's the case. But I would certainly expect if it hasn't been in the last four or five weeks and its been fairly strong, it will turn around and be worse because as I said in the last call, we have really, we normally use six months to really space and we widened that to nine and I'd still stick with that.

Unidentified Analyst

Okay, great. And then on the reset of the rents for the phase I, when does that hit?

Tom Lewis

That has not hit as of yet, but again I'm going to demeanor from anything else beyond that, that's pending but I just wanted to get out there, the agreement. From a modeling standpoint, I think we're late enough in the year and it's a small enough part of our rents which won't be material.

Unidentified Analyst

Okay. And then on, I'm not sure what you can say on this, but some of the lease terms were changed though they were cut down the lease term. When are we going to be able to get color on the changes in the lease structure [purposes]?

Tom Lewis

At some future date, when they are through with the reorganization.

Unidentified Analyst

Okay, great. And then on the change in the coverage that you mentioned is the drop off on the bottom end, is that related to any specific industry or sector or any trends that you are seeing in your cash flow coverage's?

Paul Meurer

No. that was with one particular tenant, and I looked at that and again, its one out of I think 15, and that tenant was I think 1.2% of rent. They had a rent coverage during the quarter ago from 188 to [17], so it wasn't huge. There was, I think, in the previous quarter, the top end was 488 and it came down to about 452. So, funny enough, thankfully, most of the reduction we saw was at the upper end of the strata of the change of the really strong stores.

Unidentified Analyst

Okay. Great, thank you.

Operator

Thank you. Our next question is from the line of Jeff Donnelly, Wachovia Securities. Please go ahead

Jeff Donnelly - Wachovia Securities

Good afternoon, guys.

Tom Lewis

Hi Jeff

Jeff Donnelly - Wachovia Securities

Paul, I was just picking up on earlier question, I get the sense that you guys never mind, that we are nearly, anything I guess, whose appear to have continued to stress in retailing, can you share those, I guess, the two or three factors that you think are going to bear the brunt of may be, future chapter 7/11 filings and conversely those that you might think come clean and avoid that?

Paul Meurer

I don't know who comes clean, I think restaurants, but I think they've already seen a lot of the stress. And so, that's an obvious one, people are talking about. The convenient store chains, while we've seen their numbers come up, it's a basic human needs business and unless there is really they are heavily levered.

I think there are on a okay shape for now and when you get beyond that. I think the poster child is kind of the traditional hard and soft good retailers that you see out there. And I think one of the reasons we feel little bit better about what we're doing is that's a very small part of our business. I think about 19% of our revenue comes from traditional hard and soft good retailers. And I think that's where you're going to see some of the stress out there. But as you know pretty broad based out there right now and I think its going to be more balance sheet related than its going to be industry specific.

I think, to date, it has been industry specific, looking at restaurant and seeing kind of casual dining get hit, as people traded down in fast food benefit, while the upper sit down dinner house, did just fine and I think now the more aspirational shopper, the guy out on the credit card that has the good job, just starting to step back a bit and then I think it goes pretty broad-based and maybe moves a little bit more into the upper tier that it has been where its been kind of the really low end Wal-Mart consumer.

Tom Lewis

And I think Jeff, this is Tom saying. When you are seeing the hard/soft good retailers it's more the discretionary spending which you know is not kind of a the new spin we are creating in this environment talk about our portfolio, but it's always how we talked about the stuff we are trying to buy where you have the consumer who really needs or enjoys the service that they otherwise can't get easily or can't make a discretionary decision on.

So electronics stores, things that are a little bit more difficult to imagine in this environment, people maybe not waiting a bit, taking a year to buy the new refrigerator what have you and those are the kind of retailers we have always tried to avoid significantly in the portfolio and that's what's given us a pretty good comfort at the moment.

Paul Meurer

Let me Jeff, I was talking through this evidence, pulled something out my book here that I have where we kind of went through. I miss spoke, it's about 15.5% typical hard and soft good and I have a little thing in here that we talk about which who is doing great, who is doing okay, and who is weak?

I'll just run through them in the typical hard and soft goods. I have this great nobody. I have this okay drug craft and novelty and then I really have is kind of a weak general merchandise apparel, books, consumer, grocery anything home related home furnishing, office, supply, supporting goods and that's a small part of our portfolio.

Relative to kind of hard and soft goods with services, who is doing? Auto parts, is actually doing very well. Who is doing okay? Tyre stores kind of the business services at the low end. The weaker obviously are restaurants, motor vehicles, travel plazas, video, home improvement and that's there is really nothing imminent I see there but that said.

And then up in services, I'd say great financial services to small position we have there, those guys are doing really well. Health and fitness continues to do really well. Okay and theaters there is slightly up in box-office this year, childcare, auto service and collision. And then the only thing I have got weak in services is equipment rental. So, that's kind of our laundry list.

Jeff Donnelly - Wachovia Securities

Actually you are drilling there for a second, auto just generally half of the category has been suddenly declining across, I think in all categories last few years. Is there anything specific driving that and then I noticed that I think in the last quarter you guys entered into an area called distribution/office. And I was just curious exactly what that was?

Paul Meurer

Yeah, I'll do the first one second, second one third and the fourth one eight. The first part is relative to and I forgot all three parts of the question.

Jeff Donnelly - Wachovia Securities

Distribution office is the first one.

Paul Meurer

Yeah. Distribution in office as we've done larger transactions. Occasionally they've had a distribution facility or two with it and in almost all most cases what we've done is going out and reached out to somebody else who wants to own distribution in office and we own a couple distribution facilities that were part of a couple transactions that we thought were very well located and that they had to have and then I think we own one office building which is the office of a retail tenant, that we did a larger transaction with but it's a fairly small part of revenue.

Tom Lewis

And then auto Jeff, I think is driven by obviously new auto sales, it's obvious why people maybe slowing down the purchases there. Secondly, maybe little bit less driving to try to conserve on gas, but most of the stuff we are involved in is the auto parts, auto service, auto collision repair, potentially you have to do if you got to get it from your job. And they would prefer to put a few dollars in to keep the old car running rather than to go buy a new one. So, that's kind of where our focus has been.

Paul Meurer

Yeah. Parts is doing very well and I would just have to guess, if you look to tire and you looked at service and you looked at collision and if miles driven in May was off 3.7%, which I think is what the NTSP said. Then maybe and I don't know, you could assume that they'd see a little bit of softness on the top-line. But those are pretty steady businesses and the decline in autos, obviously been kind of a dealership business.

Jeff Donnelly - Wachovia Securities

The response from most of you guys, have been selling out of those, as it is you've been just growing elsewhere in the lost chair of your portfolio?

Paul Meurer

Yeah, exactly.

Jeff Donnelly - Wachovia Securities

And nothing (inaudible) the call, but if I could just ask a few questions about your cap rate assumptions, 8 to 9, throughout. Was that on single asset deals or both portfolios?

Tom Lewis

That's both portfolios. You know as I said the ones transactions we've done this year, we've been watching and we watched them go from the mid 8's to the high 8's and then we're actually having some people say, we could into the long 9's, but either through cap rate. But also underwriting they didn't get there.

So my sense, they are creeping up there. If you look at the individual one off, as I think I talked about last quarter, if you got a good brand, small price point, million bucks and you are in a good market, you can probably creep in around 7 today, up from the high 6s but that's even migrating up from there.

I think those are 60 day ago comps and those are moving up into the mid 7s. But when you get into the secondary market, secondary brands and when your price point gets up around $2 million, $3 million, $4 million, I think you are starting to see low cap rates move. Price point, it's really has to do with financing, but I just think the market spending out and there is less buyers.

Jeff Donnelly - Wachovia Securities

And I guess can you tell us, I guess my last question, what metrics are you look for to know that we've hit a bottom and it's safe for you guys to start treading into the market again or acquisitions and I guess maybe related to that is, why 8 to 9, I guess what are you looking at to derive that?

Tom Lewis

You know I don't think for us to step back in it's 8 to 9. That's just where I have been seeing the high 8's to low 9's as the stuff that's coming through but there is kind of two things going on. If it's in the high 8's, the low 9's and I think it's going to decline, which I do because I think we live in Escondido here and you know where that is and its kind of one of the ground zeros, for what happened in the housing marketing.

And when housing started to decline here obviously, what happened is transaction volume just went away, as the sellers didn't want to sell at a lower price and the buyers were demanding a lower. And so you want through this period of six, eight months where all of a sudden inventory started going up pretty dramatically and then very slowly people who had the sales started selling and you saw prices go down and then over the next six to eight months, that just cascaded.

And we saw that clearly during the housing market, but I could a draw parallel, kind of in the net lease business because I really think there are lot of people out there generically in the capital markets who have balance sheets that are going to be need to be refinanced and they are going to need to be refinanced substantially higher rate and then there are some people who I don't think are going to be able to get the financing they want and real estates one of their alternatives. But I also think they are all, there is a lot of people that are really just don't believe what's going on are hoping it'll get better and they are sitting around and not moving and waiting till they have to.

And so my sense is, if that happens and its an if, but I think a reasonable possibility towards the end of the year and in the next, you just, at that point cap rates are really moved because the guys that can step in with the large amount of capital, I think are more limited and I think there'll be larger transactions charter underwrite and I don't think there'll be a lot of players. So, I think cap rates will move, if not if I'm wrong on that, my sense is, we retained a very high degree of liquidity in an interesting credit market. We missed a couple of quarters of acquisitions and life won't end.

Jeff Donnelly - Wachovia Securities

Great. Thank you, guys.

Operator

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

David Fick - Stifel Nicolaus

Paul, first of all congratulations on the financings, most of my questions have been asked. One general question following up on your assumption that you are going to see better deals, or you hope to see better deals as people don't have financing alternatives. I don't want to imply that you are saying that you're a financier of last resort, but you're taking corporate credit in a declining economy. And I'm just wondering how separate from the cap rate conversation, what are the disciplines you're using in credit committee to make these kind of calls?

Tom Lewis

That's a million dollar question. It's a great question. I think the first thing is obviously, what we've been really eyeing is cash flow coverage during this, as we talk to our tenants. On our portfolio, to gauge how quickly they are moving and while our numbers that I quote every quarter which is the top 15 as we are looking backward number.

What we've tried to do lately, as we're doing underwriting, may be in the past, we would have said, at this point in a year show me your '07 numbers, show me your '06 numbers and see if you can get me an update, to underwrite that. We are now saying, show me your last 12 months trailing and quite frankly, I don't really care about and what's these big seasonal adjustments, the 6 months from the back end to that, I want to see your last 8 weeks, and what you're hearing from your stores.

I think we're really tightening up the number we're trying to use for cash flow coverage's and then if we were looking for a 2.5 in the past, I'd say, we'd be looking for 2 and 3 quarters and a 3 today, because as always, it's margin of safety. And then it'd be really trying to focus in, on the real estate side of the risk and not get too far away from replacement cost and then just be mindful of their industry.

We're not doing any restaurants, but an example, might be if we were doing upper end restaurants and you look at their trailing 12 months and the numbers look just fantastic which some of them do. I think if you look at the last 6 to 8 weeks and their numbers, you'd be looking at, it really declining and I would say that you may see it decline quite a bit more.

So industry specifically, I think we'd be careful. So in this, we're going to have a higher cash flow coverage. We don't want to get away too far from replacement cost and then we just want to think too carefully where they are going. But at this point not buying anything, we haven't had to do that.

Paul Meurer

You know, David I would add that on the credit analysis piece of it. Just as we mentioned that people needing to refinance things coming due on a liability side of their balance sheet might be a driver for us of opportunities to invest as a financier or choice within that might be one of the last remaining choices form.

Similar to that, as we are looking at the balance sheet and underwriting the credit of these retailers, we're looking out over the next handful of years to see what other refinancing is going to happen in there, because as there will be in Corporate America, in general there's going to be a refinancing issue that's going to happen, that's really going to strip a lot of earnings power out of lot of balance sheet and that's true for all of us if you will relative to how much low price that is sitting in those balance sheets.

I assume you guys do the same kind of work yourselves if you are looking at the read. So that part of our analysis this is a kind of new and interesting one as well if you are looking at a retailer today. We actually kind of look at that 2010, 2011 maturity that sitting there at 5.5%. We know it's not going to be 5.5% when it gets refinanced. So we do a little re-jiggering and pro forma work just to kind of understand earnings. We've got 20 or investments here. So it's something we take of kind of longer term approach.

David Fick - Stifel Nicolaus

Okay. We look forward to hearing more about lets say next quarter. Thanks guys.

Operator

Okay. Thank you. Our next question is from the line of [Eric Rothman] with Danske Securities. Please go ahead.

Eric Rothman - Danske Securities

Yeah. Good afternoon. I was curious given that most of your leases are tighter CPI for [bonds]. And given the dramatic increase in the CPI over the last several quarters, why have your central rents kind of not followed a similar trajectory. Basically, kind of where has been forever, should we expect to see higher same-store NOI growth or same-store rent growth , given dramatically higher CPI.

Tom Lewis

I think down the line maybe a little, but I'll backup in this, and try to give a history of leases and you go back years and years and years ago, let me start with the 70's quickly, is basically you had a base rent of percentage of sales, when you had a ton of inflation in the percentage of sales went through the roof, I can remember couple of [taco] bells we had and unit up with a 100%, the rent equally what you originally bought the thing for and the retailers all woke up and said wait a minute, I want to put that breakpoint really high and the lease is written for the next five years had a percentage sales or something at them they went flat.

So, what happened is people started doing 1% to 2% increases, but normally they even did 8% to 10% increases every five years. What we've always done is put in there, that the rent will go up at a couple of times CPI not to exceed than every five. And we did that for a lot of years and then about three, four years ago, we went to a thing that said, it'll go up at two times CPI not to exceed 2% every year.

So, we're starting to see more annual increases in the portfolio for same store rent, I think we'll rise a bit maybe not the balance of this year, but in the next year and the year after. But I don't think its just going to be CPI because we do not have unrestricted CPI, we just have a CPI calculation and how we do the getting to the 2%.

Eric Rothman - Danske Securities

Alright great, thank you very much that's very helpful.

Operator

Thank you. Our next question is from the line of Philip Martin, with Cantor Fitzgerald. Please go ahead.

Philip Martin - Cantor Fitzgerald

Good afternoon, everybody.

Tom Lewis

Hey, Philip.

Philip Martin - Cantor Fitzgerald

Just a couple of quick questions, first of all to what extent are you having discussions with your tenants and probably the stronger tenants in the portfolio, and so [adenizing] over the next 12 to 18 months as an increasing number hopefully of opportunities come up. Our tenants company, you don't wanted to talk about that strategy, are your going to them or is there no discussion taking place?

Tom Lewis

That's a great question. You would think we'd be out talking to everybody and they'd actively talking to us about how they're going to handle those, but I still and I am amazed at I think generically the people in denial about the credit situation we're in. I think most people are saying, "My gosh! Look at this. When will it get back to the way it was?" And we really view that obviously there has been an end to an era out here and credit is not going to be democratized as it has been in the past.

There is likely to be have and have not and generically without securitization out there and with people being more mindful the rates are likely to be higher. But I don't think most people out there are really seeing it that way. I know talking yeah, there is. A lot of, we see the world that way, a few don't but that's the function I think of least being companies that are very active in the capital markets.

And if you have companies that are in it all the time there is still either, I think most people are some what aware but in denial. So, there is not as many of those high level discussions going on as you think that there might be in that would be rational if you had.

Philip Martin - Cantor Fitzgerald

Okay. And lastly and I know you've touched upon it in some of the answers and your upfront comments, but are you seeing a higher percentage of late pays in the portfolio?

Paul Meurer

We are not seeing a higher percentage of late pays in the portfolio.

Philip Martin - Cantor Fitzgerald

Okay, thank you

Operator

Thank you. And our next question is from the line of [Suneet Parikh] with Banc of America Securities. Please go ahead.

Suneet Parikh - Banc of America

Hi, I'm here with Dustin Pizzo as well. Tom, even though you have close to $400 million of liquidity between cash in the line, how are you thinking about the equity markets as the source of funding here, given the probably 8 percentage to imply cap rate at which your stock is trading and the 99.5% cap rates you're targeting in acquisition especially as opportunities increased over the next few quarters?

Tom Lewis

Yeah. For the moment, we're not thinking of doing anything. I think relative to the price of the stock you want a decent price. But we really focused in and will continue to focus in on getting an adequate spread up ever, whatever capital that we issue because it increases our earnings.

So if you are sitting out there and your equity cost you rate on a nominal basis which is taking a forward FFO yield and divided by the inverse of the cost to raise the capital and you take that. And if you can get a 100, 30, 40, 50 basis points above that relative to yield, then it's going to be accretive to earnings to the parties involved.

We are less oriented to NAV discussion but we are mindful of equity shareholders and that we don't want to get anywhere near earnings dilution and that's why we focus on spread and also try to be mindful of what points people have entered the stock past in offerings.

Suneet Parikh - Banc of America

All right, thanks.

Operator

Thank you. Our next question is from the line of David Wellington with Merrill Lynch. Please go ahead.

David Wellington - Merrill Lynch

Hey guys, how are you doing?

Tom Lewis

Good, David.

David Wellington - Merrill Lynch

Sort of quick question. I think you though typically don't miss the individual franchise properties. Just curious if you have seen a difference in the performance say of the franchise portfolio the 2 versus say some of the larger regional national chains?

Tom Lewis

If we ran something, we might even say at this point franchise is doing better. But that's only because of the franchise we have in here have 600 or 800 or 1000 units and they are very big and those few that we have are generally doing pretty well. It was interesting that I was in a major restaurant chain the other night, that's not in our portfolio and then there is a guy I know, who opens new stores for and then sees their numbers and they both have corporate and franchise.

And it was interesting to note from his perspective, he's just been to a meeting in the franchise stores, was substantially outperforming the corporate. And I thought it really interesting and he said that he had heard that in a couple of other chains and he felt it was a function of a fair amount of management chains and stress, put on the corporate side to move people around to get performance, first a franchisee that have stable management and that's anecdotal in nature.

But within our portfolio, I don't think there is really much of a differential because we don't have much in franchise, but it was an interesting comment from this guy.

David Wellington - Merrill Lynch

Okay. Thank you very much.

Operator

Thank you. And at this time, we have no further questions. Mr. Lewis, please continue with any closing remark.

Tom Lewis

All right, thank you very much everybody. I appreciate the participation and I know it's a busy season and it's an interesting world and we look forward to talking to you in the future. Take care.

Operator

Thank you. Ladies and gentlemen, this concludes the Realty Income second quarter 2008 earnings conference call. We thank you for your participation and you may now disconnect.

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Source: Realty Income Corp. Q2 2008 Earnings Call Transcript
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