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Realty Income Corporation (NYSE:O)

Q3 2012 Earnings Call

October 25, 2012 4:30 pm ET

Executives

Tom A. Lewis – Chief Executive Officer

Gary M. Malino – President and Chief Operating Officer

John P. Case – Executive Vice President and Chief Investment Officer

Gary M. Malino – President and Chief Operating Officer

Tere H. Miller – Vice President, Corporate Communications and Investor Relations

Analysts

Emanuel Porchman – Citigroup

Michael Bilerman – Citigroup

Joshua Barber – Stifel, Nicolaus & Co., Inc.

Richard J. Milligan – Raymond James & Associates

Craig R. Schmidt – Bank of America/Merrill Lynch

Todd Lukasik – Morningstar Research

Richard C. Moore – RBC Capital Markets Equity Research

Tom Lesnick – Robert W. Baird & Co.

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to Realty Income Third Quarter 2012 Earnings Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) This conference is also being recorded today, Thursday, October 25, 2012.

I would now like to turn the conference over to our host for today, Mr. Tom Lewis, CEO Realty Income. Please go ahead, sir.

Tom A. Lewis

Thank you very much, operator, and good afternoon, everyone, and welcome to the conference call to review our operations and results for the third quarter. In the room with me today, as usual is Gary Malino, our President and Chief Operating Officer; Paul Meurer, our Executive Vice President and CFO; and John Case, our EVP and CIO and Tere Miller, our Executive Vice – excuse me, Vice President, almost promoted you, Tere, of Corporate Communications.

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

On our call today, we’ll focus on our third quarter and year-to-date operational performance for the company. But before we get into that, let me start with just a brief comment on our merger with American Realty Capital Trust or ARCT. As most of you know, we announced on September 6 that we had reached an agreement to merge the two companies and then after our announcement of the agreement, we filed an S-4 proxy with the Securities and Exchange Commission, which is where it sits today and it is currently in review.

Following that review, which we anticipate will conclude in the near future, we also anticipate getting a final and then effective proxy sent out to all of the shareholders of both the companies. And at that time, we’ll be having an opportunity to talk to all of the parties involved about what we think is an attractive opportunity for the shareholders of both companies and we then move forward towards an approval of that transaction and ultimately close it, but we’ll engage in that time and I’m sure a fair amount of discussion about it.

We continue to anticipate closing the transaction towards the end of the year. So we look forward to more discussion on that once the transaction proxy is effective for us. I’d invite those with any additional questions for now. If they haven’t reviewed the S-4, it is currently filed at Securities and Exchange Commission and is available on EDGAR. And obviously, after we have comments, we’ll make any changes and get that out.

Moving then on to our operating results, let me start with an overview of the numbers and Paul as usual, if you’ll do that for us.

Paul M. Meurer

Thanks, Tom. So as usual, I’ll just comment briefly on our financial statements, provide a few highlights of our financial results for the quarter, starting with the income statement. Total revenue increased 13.2% for the quarter. Our revenue for the quarter was approximately $120 million or $480 million on an annualized basis. This obviously reflects a significant amount of new acquisitions over the past year.

On the expense side, depreciation and amortization expense increased by about $6.2 million in the comparative quarterly period. Depreciation expense obviously increased as our property portfolio continues to grow. Interest expense increased by almost $1.2 million and this increase, this quarter was due to our credit facility borrowings throughout the quarter.

On a related note, our coverage ratios both remain strong with interest coverage at 3.7 times and fixed charge coverage at 2.7 times. General and administrative or G&A expenses in the third quarter were approximately $9.3 million similar to the rate for last quarter.

Our G&A expenses increased this year as our acquisition activity has increased. We have added some new personnel throughout the year and our proxy process this past spring was more expensive than usual. We’ve spent $795,000 of acquisition due diligence costs during this quarter and our employee base has grown from 80 employees, a year ago to 92 employees today. However, our current total projection for G&A for all of 2012 is approximately $36 million, which will still represent only about 7.5% of total revenues.

Property expenses were just under $2 million for the quarter and these are expenses associated primarily with the properties that we have available for lease. Our current estimate for property expenses for all of 2012 remains about $9 million.

Merger-related costs, this new line item refers to the cost associated with the ARCT acquisition. During the quarter, we expensed approximately $5.5 million of such costs and this amount includes accruals for some of the expected total cost for completing the transaction.

Income taxes consist of income taxes paid to various states by the company and they were just over $400,000 during the quarter. Income from discontinued operations for the quarter totaled $1.9 million. This income is associated with our property sales activity during the quarter. We sold 11 properties during the quarter for $15.8 million, an important reminder that we do not include property sales gains in either our FFO or our AFFO.

Preferred stock cash dividends totaled approximately $10.5 million for the quarter. This increase compared to last year obviously reflects the issuance of our preferred F stock earlier this year.

Excess of redemption value, we’re carrying by our preferred shares redeemed, was not this quarter, but it is in the year-to-date column. This refers to the $3.7 million non-cash redemption charge in the first quarter associated with the repayment of our outstanding preferred B stock with proceeds from our preferred F offering. Reminder, that a replacement of the preferred B stock in our capital structure did save us about $1 million cash annually.

Net income available to common stockholders was about $27 million for the quarter. Beginning this quarter, we’ve included a normalized FFO calculation. Normalized FFOs simply adds back the $5.5 million of ARCT merger related costs to FFO.

We believe normalized FFO is a more appropriate portrayal of our operating performance and is consistent with our public FFO earnings estimates and first call FFO estimate that analysts have already published on us. Normalized FFO per share was $0.52 for the quarter, a 4% increase versus a year ago.

Adjusted funds from operations or AFFO or the actual cash that we have available for distribution as dividends was $0.52 per share for the quarter; a 2% increase versus a year ago. Year-to-date AFFO was $1.52 per share, also a 2% increase versus last year. While it may vary by quarter, our AFFO annually will continue to be higher than our FFO.

So far this year, our AFFO has been $0.05 higher. Our AFFO has been higher because our capital expenditures are still fairly low in the portfolio. We continue to have minimal straight line rent adjustments in our current portfolio and we have some FAS 141 non-cash reductions to FFO for in-place leases acquired in some of the larger portfolio transactions that we’ve done. And then in 2012 specifically, we have the $3.7 million non-cash preferred redemption charge.

We increased our cash monthly dividend twice during the third quarter including the larger $0.06 annualized increase in August. We’ve now increased the dividend 60 consecutive quarters and 68 times overall since we went public 18 years ago this month. Our AFFO dividend payout ratio for the quarter was 85%.

Briefly turning to the balance sheet, we’ve continued to maintain a conservative and safe capital structure, we think. Earlier this month, we raised $800 million of new capital with our issuance of $350 million of 2% unsecured fixed-rate notes due in 2018 and $450 million of 3.25% unsecured fixed-rate notes due in 2022. We were very pleased with the successful offering and we are grateful for the bond investors who continue to support us with their capital.

With the bond offering proceeds, we were able to completely payoff the borrowings on our $1 billion dollar unsecured acquisition credit facility, which continues today to have a zero balance. We also have today an excess cash balance of approximately $160 million from the bond offering proceeds.

Our current total debt to total market cap is 30% and our preferred stock outstanding still is only 7% of our capital structure. And our only debt maturity in the next three years is $100 million bond maturity in March of next year.

So in summary, we currently have excellent liquidity. And our overall balance sheet remains very safe and well-positioned to support our acquisition growth including the ARCT acquisition later this year.

Now, let me turn the call back over to Tom and he’ll give you more background on these results.

Tom A. Lewis

Thanks, Paul. And I’ll kind of walk through as is our tradition, the different areas of the business and let me start with the portfolio. During the third quarter, the portfolio continued to generate very consistent cash flow with tenants doing well and no significant issues arising outside of our normal operations.

At quarter’s end, our 15 largest tenants accounted for 46.8% of our revenue, that’s down 520 basis points from the same period a year ago and 170 basis points from the second quarter. So our acquisition efforts continue to reduce concentrations in the portfolio.

The average cash flow coverage rent at the store level for the tenants remains high at just over 2.5 times, which is very little movement from last quarter with a similar number, but quite healthy.

We ended the third quarter with 97% occupancy and 84 properties available for lease out of the 2,838 we own. That occupancy was down about 30 basis points from the second quarter. For the quarter, we had 27 new vacancies. That is a little higher than we usually get and was really a function that we have 25 buffet restaurants that came off lease right at the beginning of the quarter. And we have seen those coming off so I think made some comments on last quarter’s call that occupancy maybe a little softer, but not much, 97% for the quarter.

During the quarter, we did release 15 of those. We’ve released another couple since the end of the quarter and they make a good a good part of the 18 properties that we leased or sold during the quarter. We also acquired 87 properties and that was the reason for the movement, but quite solid at 97%.

As I’ve mentioned, for the last few quarters and we will each time now is, there is three ways to calculate occupancy: one is taking the number of vacant properties, which is 84 and dividing it by our total of 2,838 properties and that’s how we get to 3% vacancy and 97% occupancy.

Second methodology is, take the square footage that is vacant and divide it by the total square footage that would give us a 2.1% vacancy and 97.9% occupancy, 90 basis points higher than the first method.

And then the third way, which is more of an economic way of looking at it is, take the previous rent on vacant properties and divide it by the sum of that number and rent on occupied properties. And if you use that methodology, vacancy is only about 1.7% and occupancy 98.3%. Obviously, any of the three represent fairly high occupancy. And in the press release, we use physical occupancy, which is the lowest of the three.

Looking to the next few quarters, leasing activity today is brisk. Lease rollover is reasonable. The tenants are generally doing well. So we think occupancy should increase a bit in the fourth quarter and increase a bit going into early next year. So we think the portfolio is fairly sound very soon from an occupancy standpoint.

Same-store rents in our core portfolio decreased 1% during the third quarter and 0.8% year-to-date. As we’ve talked about for several quarters now, if we exclude the Buffets and Friendly’s reorganization rent adjustment, same-store rent and the balance of the portfolio increased 1% during the third quarter and 1.1% year-to-date.

As we look forward, the impact of those two will now start rolling off. And we think that we’ll probably have flat same-store rent in the fourth quarter and then in the first quarter likely go back to the more typical increase that we’ve had in the past of about 1% same-store rent growth. So we’re optimistic relative to occupancy and same-store rent growth over the next couple of quarters.

Diversification in the portfolio continues to widen. 238 properties, which is up over last quarter; 44 different industries, 144 different tenants and the footprint in 49 states. From a geographic standpoint, there are no meaningful concentrations around the country. And probably, more important, industry exposures are very well diversified.

Again, with 44 industries now and concentrations in the larger industries are generally continuing to decline each quarter. As you probably saw in the press release, convenience stores, which is our largest industry at 16.3% is down 60 basis points from last quarter and 200 basis points versus a year ago.

Restaurants, if you combine both casual dining and quick service, now down to about 13.2%, that’s off 60 basis points from last quarter and 410 basis points versus a year ago. And I think more importantly of note there to us is really the decline that we’ve had in casual dining as we acquire in other areas and we’ve been selling off properties in this area and we think that’ll continue.

Casual dining is down, I think, 360 basis points year-to-date. And as the chart on Page 11, I believe, in the press release shows, we’re down to about 7.3% in that sector from over 14% in the last five years or so. And we will continue to reduce that.

Theaters are at 9.5%, that’s down a little bit, up for the year. Health and fitness also down a little bit at 6.7%. We continue to like both of those sectors, theaters and health and fitness and I think we’ll be adding to them. And then the only other category industry over 5% is beverages. And additionally this quarter, we added six new industries for the portfolio for the first time. So I think we’re in very good shape and keeping industry concentrations reasonable and generally widening out the diversification.

This quarter in our industry table in the back of the press release, we separated our retail industries from our non-retail industries for the first time, which should make it a little easier for everybody to see the activity in each of those areas and basically how it’s moving over time and we hope that is helpful.

From an individual tenant standpoint, no tenant now represents more than 5% or more of our overall revenue in the portfolio. Of an interesting note, this is the first time in the 43-year history of the company that that has been the case where no tenant is over 5%. So we continue to become more diversified there.

Our largest at forayed is AMC. That’s down a bit. LA Fitness and Diageo are at 4.7% and then everything else is under that. The 15 largest tenants I mentioned is 46.8% of revenue. When you get to the 15th tenant, you’re looking only about 2% of revenue and when you get to number 20, it’s about 1.5%. So we continue to be well diversified.

The other thing I would note is the continued transformation in our top 15 tenants over the last few years. As I mentioned, concentrations are down quite a bit. Tenant quality continuing to move up a bit and industry representations are changing as we continue to focus on moving up the credit curve and away from some areas, we think are vulnerable to a consumer downturn and we think the list will continue to transition in the coming quarters based on the transactions we’re undertaking now where we’re quite active.

Relative to moving up the credit curve, three years ago essentially none of our rent came from investment grade tenants or the subsidiaries; 43-year old company that’s worked very well, in that entire period, occupancy has never gone below 96%. And obviously earnings and dividend growth has been excellent. But it really is – we are trying to make a move in that direction.

And as of the end of the third quarter that number stands a little over, now 20% of the portfolio is generated by investment grade tenants. And upon the closing of the ARCT transaction, that would be roughly 35%. And we continued here in the third quarter and we will in the fourth quarter to buy additional properties leased to investment grade tenants.

We’re also adjusting the portfolio by accelerating property dispositions a bit in certain industries. Year-to-date, we’ve sold 30 properties for $34 million. That’s for us about $12 million of sales for the same period a year ago and we think that will continue to increase. We’ll likely sell around $20 million or so in the fourth quarter. That will get us up around $55 million. And then we think likely to run in the $75 million to $100 million run rate, perhaps a little higher over the next year or so.

Almost all of the sales to-date, as a matter of fact, all of them out of the investment portfolio what we’re targeting in the industry have been out of the restaurant category with the majority being casual dining restaurants.

We have been pleased that the cap rates for sales have been a little better than we thought. The properties would have been closed to-date. The cap has been about $8.19 and on the properties that we currently have under contract for sale now, it’s about $7.55. So it’s been a good environment to be active out in dispositions for us.

Finally, on the portfolio, our average remaining lease term remains very healthy at 11 years and so given the long-term leases that we have and increased diversification in the portfolio and then the idea we think that same-store rent should accelerate and also occupancy debt, we’re very optimistic and continue to see very stable revenue production out of the portfolio.

Let me move on to property acquisitions. We’re obviously having a lot of success on that front for the first three quarters of the year. We see that continuing this quarter and in the next year.

And let me turn it over to John Case, our Chief Investment Officer and you can walk people through what we’re seeing.

John P. Case

Okay. We had a very active third quarter for acquisitions this year. We acquired 87 properties for approximately $496 million. That was our second most acquisitive quarter in our company’s history. We acquired these properties at an average cap rate of 7.11% and the average lease term was 13 years.

The credit profile of the tenants we added was very attractive. 51% of the acquisitions are leased to tenants with investments grade credit ratings. These properties are leased to 19 tenants in 18 separate industries and 11 of the 19 tenants are new tenants for us.

Approximately, 70% of the acquisitions were in the dollar store, wholesale club, food processing and apparel industries and the acquisitions were well geographically diversified and 19 separate states. Just under 70% of the acquisitions we’re comprised of our traditional retail assets, the majority of the balance of the properties were distribution properties.

So through the third quarter of this year, we’ve acquired 234 properties for approximately $718 million at an average cap rate of 7.12%, which we believe is attractive as we continue to improve our tenant credit profile. 64% of the acquisitions year-to-date are leased tenants with investment grade credit ratings.

The average lease term of these year-to-date acquisitions has been 14.3 years. There are at least 21 tenants and 19 separate industries and are located in 33 states. 77% of these acquisitions were comprised of our traditional retail assets, and again, the majority of the balance of the properties are distribution assets.

Let me spend a minute talking about the current status of the acquisitions market. The market is as active as we’ve ever seen it in our company’s history. To give you an idea of that, year-to-date, we’ve sourced $14.9 billion in acquisition opportunities as a company. Last year, during the entire year, we sourced $13 billion of acquisition opportunities, which was our most active year ever for sourcing acquisitions. About 60% of these properties sourced are leased to investment grade tenants.

Now, while the market remains competitive, we’re continuing to pursue a number of these opportunities and expect to close over $1 billion in organic property level acquisitions for 2012. And of course, this would exclude our acquisitions that will be part of our merger with ARCT.

And looking forward, we really don’t see a slowdown in acquisition opportunities. There are a lot of sellers in the market for a number of reasons today and we continue to be engaged in a number of discussions with those sellers. We remain optimistic relative to both our near-term and intermediate-term acquisition opportunities.

Let me spend a second on cap rates. As you may have noticed, the cap rates have contracted a bit more during the year. However, we believe we’ll end the year with average cap rates in the 7.25% area. The investment grade properties that we pursue are currently trading in cap rates in the low 6% to low 7% range. And the non-investment grade properties are trading in the low 7% to low 8% cap rate range. Our investment spreads continue to be at historical highs, though.

Our year-to-date average cap rate of 7.12% represents a 185 basis point spreads, our nominal cost of equity, which again, is our FFO yield adjusted for our cost of raising equity. That 185 basis points compares quite favorably to our average spread of 110 basis points over the previous 17 years when the vast majority of our acquisitions were with properties – on properties lease to non-investment grade and investment grade tenants.

In 2011, our spreads or our nominal cost of equity on our acquisitions was 170 basis points when 40% of the acquisitions were with investment grade tenants. So we’ve been able to improve our investment spreads to 185 basis points while continuing to move up the credit curve this year with 64% of our acquisitions being leased to investment grade tenants. So it’s a great time for us to acquire very attractive spreads while enhancing the credit profile of our tenant base. Tom.

Tom A. Lewis

Thanks, John. Obviously, we’re pleased with the acquisitions we’ve closed year-to-date and that are expected to close in the fourth quarter and certainly where spreads are as John mentioned.

And we also think that we’ll start the year off in 2013 faster than we did this year given the transaction flow. If you recall a year ago, the first quarter was fairly slow relative to closings. And this is all on really the property by property or portfolios we’re seeing here on a granular basis, individual properties and really not part of any volume that comes from M&A.

And if you look at the ARCT transaction upon that close, that would get us to about $4 billion in additional assets for the year. And while that’s been the news as of late, the $1 billion plus in normal acquisitions for this year as John mentioned would be a record for the company.

I mentioned last quarter and it still holds true and we think it will going forward that acquisitions will continue to play a big role in continuing to grow our revenue and AFFO, which is what will drive dividend increases.

And then secondly and equally important to us in adjusting the makeup of our portfolio as time goes on where we’re moving up the credit curve and we’ve made good progress on that front again, this quarter.

Paul talked about the balance sheet in excess to capital. Obviously, we’re in very good shape there with plenty of dry powder to execute on acquisitions as they present themselves. Obviously, the $1 billion credit facility is very helpful for that and that is fully available. And as Paul mentioned, we also have $160 million in cash on the balance sheet. So a lot of capital to do we need to do.

Obviously, relative to permanent capital out there, the markets remained open and quite attractive. Looking at the execution on the recent debt offering obviously, pricing is just absolutely outstanding and historic in the REIT industry and certainly for us on that transaction. Equity is attractively priced. And as is preferred and given cap rates may be 7.25% level for the year spreads very attractive.

Relative to the guidance that we put out a month or so ago, there was no changes on that. In 2012 guidance excluding the one-time costs of the ACRT transaction, we’re looking at $2 to $2.4 per share for the year. Included in that, as Paul mentioned, is the $0.03 per share non-cash charge from the redemption of our preferred earlier in the year, and the AFFO of $2.06 to $2.11 per share, which would be about 2.5% to 5% AFFO growth. And as always, that’s our primary focus as it best represents the recurring cash flow from which we pay our dividends.

On 2013 guidance, again, assuming a 12.31 closing of the ARCT transaction, we’re looking for $2.30 to $2.36 per share and AFFO of $2.31 and to $2.37 that’d be 9.5% to 15% AFFO growth for the year. And again, really is the focus given we pay dividends out of that.

Speaking to dividends, we remain optimistic that our activities will support the ability to continue increase the dividend. As Paul mentioned, we increased it $0.06 in August and ended the regular quarterly increase in September. And as most of you know, we’ve also mentioned that we closed the ARCT transaction. We probably raised the dividend about $0.13 a share.

And historically, what we’ve done for those that haven’t been with the company a long time, we raised the dividend in fairly equal amounts each quarter and then really looked in our August Board meeting to see if a fifth larger increase in the dividend is warranted, in order to keep our payout ratio at about 85% to 87% or so of FFO, which is our target.

Our AFFO payout ratio is in that range now, and obviously, the AFFO growth for next year looks pretty attractive. And in the mid-range of the guidance that would likely get our AFFO payout ratio down around 83% or so by the end of next year, which is below where we target. So at this point, we’d anticipate 2013 to be another pretty good year for dividend growth also.

I think that’s it relative to walking over the different pieces of the business. And, operator, if we can, we’ll go ahead and open it up for questions.

Question-and-Answer Session

Operator

Absolutely (Operator Instructions) And our first question comes from the line of Emanuel Porchman with Citigroup. Please go ahead.

Emanuel Porchman – Citigroup

Hey, guys, how are you?

Tom A. Lewis

Good.

Emanuel Porchman – Citigroup

Looking at the distribution facilities that you acquired, I know, Tom in the past, you’ve spoken about looking at distribution sort of in parallel with retail. Was that the case here? Was there an overlap with your existing retail tenants I guess before buying those distribution facilities?

Tom A. Lewis

Actually no, the majority of the retail tenants as you know before three years ago were all less investment grade. And our comfort level historically on retail is obviously having cash flow – EBIDTA cash flow coverage numbers and knowing the P&Ls of the stores we own. And when we move into the distribution facilities, you really don’t have that. So you’re relying more on the real estate itself. And what you’re buying and how important it is to the tenant and their need to really use that particular facility. And so for us also then what we want to do is, we want to be going up the credit curve when we’re working on those type of properties. And that’s the majority of what we’re doing. So it’s really going to the Fortune 500 or Fortune 1,000 and approaching them, relative to those distribution facilities and trying to buy ones that are either well priced and in very good areas for them to support their long-term activities or perhaps they’re right next door to a manufacturing plant for one of their main product lines.

So if you kind of look through the distribution facilities that we bought and in kind of in the last quarter, the tenants on those were, as an example, Whirlpool Corporation was one, another tenant was Procter & Gamble, another one was PepsiCo, another one was, obviously FedEx and another Toro. So all very large investment grade names and that’s generally where we’re focusing. And I don’t think we own more than one or two distribution facilities and those we bought some time ago with tenants are non-investment grade

Emanuel Porchman – Citigroup

Okay. And then looking at the ARCT transaction sort of, say that’s closest, does that change the way you approach acquisitions to you than expand your net on what you’re out there looking at?

John P. Case

I don’t think it will materially change where we are right now. As we’ve said, in retail, there are areas that we’ve bought in the past that we just want to hold on, those we want to sell, and then a number that we still find attractive. And then outside of that, it’s really distribution a little manufacturing, a little bit of office, but not much, and perhaps agriculture, but all investment grade tenants is what we want to do there. And that’s where we’re focused. So that’s pretty much what we get in the ARCT transaction. And so I would imagine that we’ll stay right on that.

Michael Bilerman – Citigroup

Hey, Tom, it’s Michael Bilerman speaking. Good afternoon to you.

Tom A. Lewis

Hey, Mike.

Michael Bilerman – Citigroup

A quick question just going to the ARCT transaction, in a little bit more depth. You’re clearly aware that there’s probably little bit more investor frustration at least on the ARCT side of the transaction and some pretty vocal shareholders who effectively are going to vote no, as the current deal stands. And I’m just curious as how you’re sort of dealings towards that clearly the proxy is out, and everyone can read it, but you were the only bidder. And that was the negotiated transaction that occurred. But do you have, a lot of accretion built into the deals for next year, you’ve communicated a sizable list in the dividend. I guess do you sort of walk away if they vote no?

Tom A. Lewis

Well, obviously if there is a no vote in the transaction, yes we would walk away. We think and if you look at the proxy and I also want to say that again, since it’s in the SEC and there’s likely to be some comments. We want to make sure we don’t go into too much detail until have a final and effective proxy. But if you read the background section, you can see that the negotiations were discussed over time and both parties kind of drew a line, well it’s valuation is to where they wanted to go, and we weren’t able to get there. And then after – they started trading that both of the equities moved in a fashion, so we could put together a transaction. But our feeling is that at the time that was announced, it was around a 5\9 cap rate, today on price, it’s around six. And it’s a very good portfolio, 75% investment grade, it fits what we’re trying to do strategically very carefully. But we think we paid a bit of a premium to capture this large portfolio and did so with an attractive issuance of equity. But for us, the price that we’re paying here is we think a full price in and yes, we would walk away.

As we mentioned, we have $1 billion plus in acquisition. So that’s granular and we also have a great feeling about how next year is going to work out and so we would do that. However, we do believe that the majority of the shareholders once we have the final perspective, their proxy out, we’ll be able to engage in conversations and think we will get a yes vote on the transaction from both groups of shareholders for whom we think there are very good benefits.

Emanuel Porchman – Citigroup

Is there any cost, if there is a no vote? Do you have to incur or any sort of cost? Obviously, there were some cost to the transaction that, but what would that sort of, is there any penalties or anything that would; we’d have to be mindful of?

Tom A. Lewis

Yeah, I think it’d be minor if there was a no vote by either party and I think in our case, I think we would have about $4 million that would be due as to pay for the fees of the transaction. And then we’re figuring out exactly what those would be if there was a no vote. But it’s relatively closer to that that would pay for the majority of it. And that really wouldn’t see a significant impact. I think it’s the same on the other way with that for us in a no vote. But I don’t think there’s much if any chance of that whatsoever.

Emanuel Porchman – Citigroup

And then I just guessed you had raised a lot of unsecured debt capital. So effectively, you’d be a little bit, I guess over capitalized from that standpoint relative to the transaction?

Tom A. Lewis

Yeah, we would not be, actually Michael, we had obviously a very big quarter in acquisitions and we look for a substantial quarter in the fourth quarter and running the number backwards to get to a little over $1 billion in acquisition. So really with $160 million sitting in cash, we’ll easily use that for closing properties in the fourth quarter. And then it just means the full line would be fully available if we did not do the transaction. And if we do the transaction which we fully anticipate, we can do it on the line.

Emanuel Porchman – Citigroup

Okay, great. Well it’s good to hear that you are going to stick firm on your exchange ratio and not try to engage in a self bidding.

Tom A. Lewis

Right. Thank you.

Emanuel Porchman – Citigroup

Thank you very much.

Operator

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

Joshua Barber – Stifel, Nicolaus & Co., Inc.

Hi, good afternoon.

Tom A. Lewis

Hi, Josh.

Joshua Barber – Stifel, Nicolaus & Co., Inc.

You guys have covered most of my questions already. Just one quick one, I guess getting to the enterprise value that you will be post ARCT. At least assuming that there will be a post ARCT, what would you say your minimum deal size is when you’re looking in the acquisition market today and how that has changed over the last couple of years?

Tom A. Lewis

Yeah, it’s really grown over the years. We’ve always been more than willing to do a one-off transaction of a small nature and add it and happy to do that today. But over the years, we’ve gone where $50 million back when we were $500 million in assets would be a 10% allocation to a tenant. And that was kind of our threshold. And sitting at $11.4 billion, you can go out and do a $0.5 billion transaction with a tenant and still retain under 5% with an individual tenant and then relative to a portfolio or additional M&A, with a multiple tenant portfolio. It really gives us a lot of flexibility. So the ability to do larger transaction is certainly enhanced by completing this merger.

Joshua Barber – Stifel, Nicolaus & Co., Inc.

Okay, and one last thing. You had mentioned some comments about CapEx and why straight-line rents were a bit higher this quarter. Would you expect some more of that, I guess in the next couple of quarters with Buffet’s and Friendly’s releasing, we think process is mostly done at this point?

Tom A. Lewis

Yes, we’re pretty well along the way of getting the majority of anything from Friendly’s or Buffet’s done. So there shouldn’t be a lot there relative to CapEx on that.

Paul M. Meurer

Yeah, CapEx overall Josh, has gone up a little bit. Historically, we had virtually none. Our current projected run rate for this year and next year is about $6 million to $7 million total which of course is on a $500 million plus revenue portfolio. So still a relatively small number, but a little higher than it has been in the past. Some of that is investing in existing properties to assist in the re-leasing of those as you’ve guessed. But overall, still the large portion of the portfolio or most and all of it is more so triple-net and we’re not responsible for those sorts of expenses.

Joshua Barber – Stifel, Nicolaus & Co., Inc.

Okay, that’s great. Thanks very much guys and good luck.

Operator

Thank you. And then next question comes from the line of RJ Milligan with Raymond James. Please go ahead.

Richard J. Milligan – Raymond James & Associates

Hey, good afternoon guys.

Tom A. Lewis

Good afternoon Rich.

Richard J. Milligan – Raymond James & Associates

Couple of questions. Going forward for 2013, do you think the mix of retail versus non-retail at 75:25, do you expect that to continue?

Tom A. Lewis

It’s going to be transaction-driven, RJ, that we think that’s a very nice mix, but if that was 60:40, that wouldn’t really bothered us either way. We’re really out after those areas of retail that we can buy quite aggressively, and if there was 100% quarter where it was all on the retail, that’d be fine with us too. And looking quarter-to-quarter, we’re really not focused on trying to balance that, but overall, if I had to guess 75:25 is not a bad number, 60:40 is not a bad number.

Richard J. Milligan – Raymond James & Associates

Now, in terms of the opportunity set, is there a larger opportunity set of acquisitions in the non-retail bucket and you’re just choosing to pursue that 75:25 mix or what do the opportunities look like?

Tom A. Lewis

I’ll let John comment, but it’s changing as time goes on, as it’s been interesting over the years. In the mid ‘90s, we entered the convenience store business and it really took us two, three years where everybody that was in that business knew we were out acquisitive and we were really able to accelerate thing, and in movie theaters, it was the same thing. And so, now for really last year and this year, and in particular mostly this year because most of what we bought in that area last year came from the ECM transaction. We’re now getting traction with people knowing that we are out there and we are buying this type of property. So our flow is increasing.

John P. Case

Yeah. So let me give you an idea for the distribution of property types within that transaction flow. So what we’ve sourced a $14.9 billion year-to-date that I referred to earlier, about 60% of that is retail properties. And the next largest chunk of that is distribution and industrial at about 25%. So that’s how it shapes out. But it does have inflow depending on what the opportunities are at any specific point during the year. But that will give you a feel for what it looked like year-to-date herein 2012.

Richard J. Milligan – Raymond James & Associates

Okay. Thanks. And, Tom, as part of that strategic review that you guys did a couple years ago, where you decided that you wanted to move up the credit curve part of that if I recall was, wanting to hedge yourselves against inflation and trying to put in contractual rent bumps or CPI bumps into the leases and increase the percentage of leases that you had with those bumps.

Now with ARCT, I’m assuming most of those don’t have any bumps or CPI protection. And I’m just wondering, how you thought about the trade-off there for going up the credit curve yet sort of taking a step back in terms of inflation protecting the portfolio.

Paul M. Meurer

Yeah. A lot of the leases do have bumps, but that’s one of the most difficult things over the last few years has really been trying to building full CPI into the leases and we’ve gotten up and I can’t remember the exact number, but it’s over 20%.

Tom A. Lewis

Yeah, it over 20%, Paul says now that we’ve been able to do that, but it is really a slog. We’ve had 30 years here of declining interest rates and relatively tame inflation and across industries in the U.S., the sellers and particularly in retail have gotten very used to not having big CPI components. So that continues to be a battle on that situation.

Relative to going up the credit curve, the decision to go up the credit curve really was two-fold. One was thinking that retail maybe a little tougher in the future particularly in some segments. But mostly, we’re just – I think September 30 was the 31 anniversary of the 10-year getting up over 14% and starting its decline, that’s gone on ever since then where we’re now down to 1.88. I think I looked this morning. And if you look at the average rate on a 10-year over the last 31 years, it’s been about 6%.

So it was really going back completely underwriting our whole portfolio and acknowledging that we are all kind of running downhill with less than investment grade tenants during that period. And that as we look to going forward and the possibility of interest rates being higher, wanting to disengage from a few tenants that we think would be vulnerable in a raising interest rate environment and move up the curve to protect against that. And everybody’s got their opinion of what the chances are of having much higher interest rates, but we also think even if there was prolonged lower interest rates due to economic weakness, it’s likely to be tough on the more levered people’s business and likely that we would eventually see some credit spreads gapping out. So either way, we think it’s really a good idea to move up the curve. And that was the primary reason behind that one.

And going forward, again, we’re at 20% now closing ARCT, we’d be at about 34%, 35% and be very happy to wake up in four, five years and have that number 60%, 70%, 80% of the portfolio.

Richard J. Milligan – Raymond James & Associates

Okay. So the acquisition is actually going to increase the percentage of the portfolio that has sort of the CPI bumps?

Paul M. Meurer

It now, it’s about the same.

Tom A. Lewis

Well, his comment going 20 to 35, he was referring to the investment grade portion.

Paul M. Meurer

Yeah. Sorry. Investment grade not the part with bumps. I think it’ll keep us right about 20, maybe a little less little more.

Richard J. Milligan – Raymond James & Associates

Okay. And then, a quick question for you, Paul. As we’re just looking at our models and thinking about the proceeds to pay for acquisitions in the ARCT transaction, would you expect, say a year from now, leverage to be pretty similar to where it was a quarter ago, or how are you thinking about leverage and what’s your target over the next year?

Paul M. Meurer

Yeah. As you know, our philosophy is still, go up first, if you will, two-third is common, the remainder really the debt and preferred side in the capital structure. With this recent bond offering, as we speak and sit here today, our leverage, I’d say is a little higher than what we’d like is kind of a longer term run rate, 30% debt, 7% preferred. We prefer that to be 5% to 10% lower in terms of that portion. So we will look to the common equity markets first as a form of financing over the next 12 to 15 months in terms of the balance sheet.

Tom A. Lewis

The other thing is, I think it was 1994 right, when we went public that we said that we wouldn’t want to be over 35% debt on the balance sheet and we’ve never gotten there. And we had a discussion at our board meeting in August just saying that, remains even though we’re – gosh, 20 time the size than we were then. But that, we think is in an appropriate balance sheet strategy. And in the ‘20s, we don’t mind at all either.

Richard J. Milligan – Raymond James & Associates

Okay, great. Thank you, guys.

Operator

Thank you. And our next question comes from the line of Craig Schmidt with Bank of America Merrill Lynch Please go ahead.

Craig R. Schmidt – Bank of America/Merrill Lynch

Thanks. I was wondering is there also a push for more investment grade tenants within the retail space?

Tom A. Lewis

There is. As a matter of fact within retail, we also have a higher percentage going up. If you look in the top 15 in the press release, I think it’s Family Dollar crept in there and we have had some transaction recently with several other investment grade tenants in that space. So we’d like to go up the curve where ever we can both inside and outside. And so that’s definitely the case. And John, if we have any other numbers there, do you for the year within?

John P. Case

I don’t think we parsed it within retail, Craig. But a good part of the retail this year has been investment grade.

Craig R. Schmidt – Bank of America/Merrill Lynch

Okay. Do you have to pay a lower cap rate for those investment grades or is that like a agnostic view?

Tom A. Lewis

You generally do have to pay a lower cap rate. And almost like in the bond markets today, credit spreads are fairly flat. And they do continue to be fairly flat in the net lease business, but it is lower.

As John mentioned for investment grade, you’re kind of in the 6% to 7% cap rate, for less investment grade 7% to 8%. But given cost to capital, when you look today that over 60% of what we bought this year so far and what we’re targeting, is investment grade. But we’re getting an average cap rate of about 7.25%. It’s really one of those funny times when you can go up the curve and still have great spreads.

Recall about 16, 17 years ago, Bank of New York very nicely gave me two – couple of days with their head of credit for Bank of New York, just to talk to him about credit and underwriting and all the rest of it. And I remember sitting down and he said, what are you trying to do? And I said, well I want to increase our volume of acquisitions substantially, I’d like to go up the credit curve and I’d like to have higher spreads between our cost to capital and our interest rate. And he laughed, he said so does every banker in the world who’s lending, but it’s almost impossible to do. And I look at this year and last year given Fed monetary policy and that’s exactly what happened at $1 billion plus an acquisition in each year.

And going up the curve, substantially and the spreads between cost of capital and cap rate, as John went through, being some of the highest we’ve had, maybe 70 basis points over the average for 17, 18 years we’ve been public.

John P. Case

Craig, slightly over 50% of the retail we purchased this year to date has been with retail tenants that have investments grade credit ratings.

Craig R. Schmidt – Bank of America/Merrill Lynch

Okay. I guess we’re living in an impossible time, but it sounds good. Thanks a lot.

Tom A. Lewis

Yeah, I’m not sure what it does for the economy in the world long-term, but in the short-term in the net lease business it’s been fairly attractive for us.

Craig R. Schmidt – Bank of America/Merrill Lynch

Okay. Thanks a lot.

Operator

Thank you. And our next question comes from the line of Todd Lukasik with Morningstar. Please go head.

Todd Lukasik – Morningstar Research

Hey, good afternoon, guys.

Tom A. Lewis

Hey, Todd.

John P. Case

Hey, Todd.

Todd Lukasik – Morningstar Research

Just a question on the capital structure, and I know the preference has always been for the corporate unsecured. And I think you stated that the mortgages that are coming on the balance sheet with some of these acquisitions are you hope to pay those down as soon as possible. But I’m wondering with the move into non-retail and investment grade and with some of the property values maybe being higher now that you’re acquiring than maybe the average has been in the past and also with the investment grade tenants paying the rents if your views changed at all and whether or not there is a place for mortgages in the capital structure going forward or whether you’d like to stick with 100% corporate unsecured?

Tom A. Lewis

Sure. Good question. Now we continue to absolutely pursue the flexibility of dealing in the unsecured markets with the debt and keeping the balance sheet in line. And the only mortgages that we have had to date are those where we bought a portfolio and it was really uneconomic in the short term to payoff the mortgage that anything we could payoff, we will. We’ve never put a mortgage on a property and we don’t intend to going forward, it’ll strictly be when we buy a portfolio. And then we’ll soon as – it’s economic to do so, we would pay it off and we’re very, very much committed now as have been to the unsecured market and that being how we finance the company along with perpetual preferred and common equity.

Todd Lukasik – Morningstar Research

Okay. Thank you.

Operator

Thanks you. And our next question comes from the line of Rich Moore with RBC Capital Markets. Please go ahead.

Richard C. Moore – RBC Capital Markets Equity Research

Yeah. Hi, good afternoon, guys. You’ve mentioned before, Tom, that you expect about $50 million of acquisitions per quarter, which of course is what I had modeled for the next four quarters going forward. But given that, it seems to me that there is something fundamentally changing out there that is bringing more products to market. And I’m curious if you have thoughts, I mean, is that more retailers, let’s say, looking to monetize real estate, is that debt coming due, or what is bringing all this stuff to market? This seems to be bigger than usual. Is that correct?

Paul M. Meurer

It is. And I think as things usually are we’re just looking for one reason, but it’s a confluence of forces. I think the downturn in the economy a few years ago and the credit squeeze scares the heck out of a lot of CFOs. And they started looking at their companies on looking for more non-traditional access to capital and identified real estate as being one source for that. And so I think that’s part of it.

Second, as you see more sale leaseback out there, other people observe it, and act towards it. And then I think there is also feeling that, right now, with interest rates low, that this is a way to obviously lock in permanent, permanent capital over very long period of time. And using the real estate while still maintaining the ownership and the flexibility, and that’s – those are all coming together. And then the last part from me and you can add on if you want to John, is our size really and the size of the net lease business is growing and it’s becoming more visible. And it’s allowed us to go into places we haven’t before, particularly going up the credit curve, into the Fortune 500 and that and in by itself through our efforts has caused us to see more product.

Richard C. Moore – RBC Capital Markets Equity Research

Okay, good. Thank you, yeah that makes sense. Then on the dollar stores, on the addition of the dollar stores category this quarter, is there a story behind that first of all? And I noticed that Family Dollars, I think, 2.5% in the total size of the space is about 3%. So I’m guessing there is obviously more beyond Family Dollar in there, but anyway on the dollar stores?

Tom A. Lewis

Right. As part of the strategic review, one of the things we did is, obviously take a look at the consumer and really divided up to upper income, middle income, lower income. And then divided further between their discretionary and non-discretionary spending to try and pick. What retailers we wanted to be with and we think in kind of the middle income, the lower income, it’s a good idea if you could be with non-discretionary spending. And even within that, that’s really a stressed consumer, which I think, leads retailers in that space today, they need to have a really significant value proposition for the consumer. And I think, our movement into dollar stores is a reflection of exactly that, we did target the industry. We think we will have more and you’ll see that grow over the next few quarters.

By the way, it’s the same thing with the Warehouse, club stores that you also see has come in there. And both have that value proposition and that’s why we upped our investment there. If you look at the wholesale clubs, I think in this quarter it was around 2.8%. That’s BJ’s and there’s going to be another one coming in there. And then on the dollar stores worth three and that’s Family Dollar and Dollar General, both has been added to the portfolio, both of those investment grade tenants. And we expect – we’d like our allocations to grow up if we can find additional opportunities.

Richard C. Moore – RBC Capital Markets Equity Research

Okay. So you’re looking beyond Family Dollar and Dollar General as possibilities are really those two are the targets?

Tom A. Lewis

Well, once again we want to go up to credit curves in both our investment grades. So they’re very attractive to us.

Richard C. Moore – RBC Capital Markets Equity Research

Yeah. I got you. Very good. Thank you, guys.

Operator

Thank you. And the next question comes from the line of Tom Lesnick with Robert W. Baird. Please go ahead.

Tom Lesnick – Robert W. Baird & Co.

Hi guys, good afternoon.

Tom A. Lewis

Yeah.

Tom Lesnick – Robert W. Baird & Co.

Just a quick question. You mentioned that G&A expense would be about $36 million this year. How should we be thinking about G&A expense going forward presuming the ARCT deal goes through?

Tom A. Lewis

Our estimate for next year, I can give you a number. It’s about $42.5 million, kind of what we see in our model right now. That’s some preliminary work on the budget for next year and that sort of thing. That does assume our ARCT closes end of this years. And that would represent about 6% of our total revenues for next year, kind of again on a preliminary budget basis. So from overall ratio, we see G&A going down significantly as a percentage of total revenues, because as we’ve mentioned, we don’t see any material increase in G&A at all relative to the ARCT acquisition.

Tom Lesnick – Robert W. Baird & Co.

Alright, great. Thank you very much.

Operator

Thank you. Ladies and gentlemen, this concludes the question-and-answer portion of Realty Income’s earnings conference call. I will now turn the call over to Tom Lewis for concluding remarks. Please go ahead.

Tom A. Lewis

Thank you, operator and thank you everybody. It’s – with an hour on the call, a little longer than we normally do and we appreciate your patience. We look forward to getting a final and effective perspective in the near future in getting that out. We will have additional discussions on the ARCT transaction. And we’ll now focus on making the fourth another successful quarter and thank you very much for your attention.

Thank you, operator.

Operator

Ladies and gentlemen, this does conclude our conference for today. If you would like to like to listen to a replay of today’s call, please dial 303-590-3030 or the toll-free number of 1800-406-7325 and enter the access code of 4569429. Thank you again for your participation and you may now disconnect.

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