Realty Income Corporation (O) Earnings Call Transcript & Summary

Thanks to each of you for being here on this call as we go over Realty Income's results from operations for the fourth quarter and full year of 2019. Sumit Roy, our President and Chief Executive Officer, will walk us through the numbers. Over the course of this call, some of what we say might count as forward-looking statements under Federal Securities law. It's possible the company's actual results down the road could end up materially different from anything covered in those forward-looking statements. The reasons such differences might arise will be spelled out in more detail within the company's Form 10-K. Throughout the Q&A section of this call, we'll stick to a limit of two questions per person so that everyone gets a chance to take part. Should you wish to pose more questions, just get back into the queue. At this point I'll hand things over to Sumit Roy, our CEO.

Thank you, Andrew. Hello, everyone. We closed out yet another year of solid operating performance, which produced attractive risk-adjusted returns for those who hold our shares. It's a pleasure to report that in 2019 our shareholders received a total return north of 21.2%. Across the year, we put more than $3.7 billion into real estate properties while lifting AFFO per share 4.1%, reaching $3.32 per share. Property-level acquisitions hit a record in 2019, and that figure encompassed roughly $798 million of investments abroad, among them our very first international sale-leaseback, covering 12 properties in the U.K. that are leased to Sainsbury's, a top grocer; during 2019, we marked the 50th anniversary of when our company was founded as well as the 25th year since we became publicly listed. Earlier this month we were delighted to join the S&P 500 Dividend Aristocrats Index, recognition that comes from being an S&P 500 constituent that has lifted its dividend annually across the last 25 consecutive years; as we head into 2020, every part of the business is in a very strong position, and we're putting forward 2020 AFFO per share guidance of $3.50- $3.56, which works out to an annual growth rate of roughly 5.4%-7.2%. Earlier this month, we let everyone know that Paul Meurer, our Chief Financial Officer and Treasurer, will be departing the company. To keep the transition seamless, Paul will act as senior advisor to the company until the first quarter comes to an end. A search is now underway for a new Chief Financial Officer. I'd like to express my thanks to Paul for his invaluable partnership and the enormous contributions he has made to this company across so many years. Our portfolio stays diversified when it comes to tenant, industry, geography, and to some degree, property type, all of which helps keep our cash flow stable. When the quarter closed, we had 301 commercial tenants leasing our properties, spread across 50 different industries in 49 states, Puerto Rico, and the U.K. Our traditional retail properties generate 83% of rental revenue. Industrial properties make up the biggest piece beyond retail, accounting for nearly 12% of rental revenue. Walgreens is still our number one tenant, at 6.1% of rental revenue. Convenience stores remain our top industry, at 11.6% of rental revenue. Looking at our entire retail portfolio, about 96% of rent comes from tenants whose businesses include a service component, a non-discretionary component, and/or a low price point component. In our view, those traits let our tenants compete more effectively against e-commerce and function across a range of economic conditions; these factors matter especially in the current retail environment, since most recent U.S. retail bankruptcies or closures have occurred in industries lacking those traits. Our confidence in the portfolio's credit quality remains strong. Roughly half of annualized rental revenue comes from tenants rated investment grade. For our retail properties, the weighted average rent coverage ratio stands at 2.8x on a four-wall basis, and the median is 2.6x. Our watch list represents 1.9% of rent, which is fairly in line with where we've been over the past few years. Occupancy by property count came to 98.6%, up 30 basis points from the previous quarter; we anticipate occupancy of roughly 98% in 2020. In the quarter, we re-leased 28 properties, recapturing 106% of the expiring rent. Across 2019, we re-leased 214 properties, recapturing 103% of the expiring rent. Since our 1994 listing, we have re-leased or sold more than 3,100 properties with leases expiring, recapturing over 100% of rent on the properties that were re-leased. Same-store rental revenue rose 2% in the quarter and 1.6% in 2019, above our full-year projection of about 1%, mainly because of percentage rent recognition. We expect same-store rent growth to normalize in 2020, with our projected run rate for 2020 at approximately 1%. About 86% of our leases carry contractual rent increases. Turning next to more detail on our financial results for the quarter and the year, beginning with the income statement. G&A expense as a percentage of revenue was 4.3% for the quarter and 4.7% for the year, in line with our full-year projection of below 5%. We still have the lowest G&A ratio in the net lease REIT sector and expect our G&A margin to be approximately 5% in 2020. Non-reimbursable property expenses as a percentage of revenue were 1.4% for both the quarter and the year, below our full-year expectation in the 1.5%-1.75% range. Briefly on the balance sheet; we have continued to maintain our conservative capital structure and remain one of only a handful of REITs with at least two A ratings. In the fourth quarter, we raised $582 million of common equity, primarily through our ATM program, at approximately $75.52 per share; for the full year, we raised $2.2 billion of equity at approximately $72.40 per share, finishing the year with a net debt to EBITDA ratio of 5.5x. Our fixed charge coverage ratio remains healthy at 5x, which is the highest coverage ratio we have reported for any quarter in our company's history. Back in January, we finished paying off early our $250 million of 5.75% bonds from 2021 by way of a full par call. Going forward, the schedule for when our debt comes due looks really solid overall, since the weighted average maturity on our bonds sits at 8.3 years, and just $334 million of debt matures during 2020. After that, the maturities are nicely staggered; to sum up, our balance sheet is quite healthy, and we still enjoy low leverage, strong coverage metrics, plenty of liquidity, and terrific access to capital at attractive prices; during 2019's fourth quarter, we put roughly $1.7 billion to work across 556 properties in 42 states plus the United Kingdom, at a weighted average initial cash cap rate of 6.8% and a weighted average lease term of 11.2 years. Around $1.2 billion of what we bought that quarter tied to the CIM portfolio acquisition announced in September. Measured by total revenue, roughly 47% of acquisitions in the quarter came from tenants rated investment grade. All 100% of revenues came from retail tenants. These assets are leased to 78 separate tenants across 26 industries. Bless you. Among the bigger industries represented are convenience stores, dollar stores, and drug stores. During the fourth quarter we closed 12 individual transactions, and sale-leaseback transactions accounted for approximately 10% of investment volume in that quarter.

Out of the $1.7 billion that was deployed in the quarter, $1.5 billion went into domestic investments across 551 properties, carrying a weighted average initial cash cap rate of 7% along with a weighted average lease term of 10.6 years. In that same quarter, $221 million was placed internationally into five properties situated in the U.K., with a weighted average initial cash cap rate of 5.2% and a weighted average lease term of 17.1 years. Across 2019, our investments totaled more than $3.7 billion in 789 properties spread over 45 states plus the United Kingdom, at a weighted average initial cash cap rate of 6.4% and with a weighted average lease term of 13.5 years. Looking at revenue, investment grade-rated tenants account for 36% of all acquisitions, while retail contributes 95% of revenues and industrial makes up 5%. These assets are leased out to 112 separate tenants spanning 31 industries. Among the 72 independent transactions that closed in 2019, 11 were valued above $50 million. Sale-leaseback transactions accounted for roughly 38% of 2019 investment volume. Within the $3.7 billion invested in 2019, close to $2.9 billion went to domestic investments in 771 properties at a weighted average initial cash cap rate of 6.8% and with a weighted average lease term of 13 years. Over the course of 2019, roughly $798 million was invested internationally in 18 properties in the U.K., at a weighted average initial cash cap rate of 5.2% and with a weighted average lease term of 15.6 years. Transaction flow continues to look robust, with approximately $11.7 billion sourced in the fourth quarter. Breaking down that $11.7 billion sourced during the quarter, $9.8 billion came from domestic opportunities and $1.9 billion from international ones. Investment-grade opportunities made up 17% of the volume sourced in the fourth quarter. Among the opportunities sourced in Q4, 58% were portfolios, while 42% — or roughly $5 billion — were one-off assets. During 2019, we sourced around $57 billion in potential transaction opportunities, the largest annual volume ever sourced in our company's history. Of that $57 billion sourced in 2019, 42% were portfolios and 58%, or approximately $33 billion, were one-off assets. Within these opportunities, $45 billion were domestic and $12 billion were international. Of the $1.7 billion in total acquisitions closed during the fourth quarter, 15% were one-off transactions. Turning to pricing, U.S. investment-grade properties are trading in a cap rate range of around 5% to high 6%, while non-investment grade properties are trading in a high 5% to low 8% cap rate range. When it comes to cap rates in the United Kingdom for the kinds of assets we target, investment-grade or implied investment-grade properties are trading in a low 4% to high 5% cap rate range, and non-investment grade properties are trading in a 5% to low 7% cap rate range. Our investment spreads relative to our weighted average cost of capital stayed healthy during the quarter, averaging approximately 325 basis points for domestic investments and 228 basis points for international investments, both comfortably above our historical average spreads. In 2019, the spreads on our investments came to an average of 271 basis points across everything we invested in, which stands as the broadest yearly spreads ever recorded in our company's history. When we talk about investment spread, we mean the initial cash yield minus our nominal first-year weighted average cost of capital. Our pipeline of investments, spanning both the U.S. and abroad, is still strong, and we think we're the sole publicly traded net lease firm possessing the size, scale, and cost of capital needed to go after big corporate sale-leaseback deals through negotiation. Given the ongoing strength in that pipeline, along with our superb access to attractively priced capital, we're putting forward 2020 acquisition guidance of $2.25 billion-$2.75 billion. Our disposition program is still busy. In the quarter, we disposed of 29 properties, generating net proceeds of $36.3 million, at a net cash cap rate of 6.8%, and we achieved an unlevered IRR of 10.4%. That takes us to 92 properties sold during 2019 for $108 million, at a net cash cap rate of 8.1%, and we achieved an unlevered IRR of 8.3%; through selling non-strategic assets and channeling those proceeds into properties that align better with our investment criteria, we keep enhancing our portfolio's quality. For 2020, we anticipate dispositions somewhere between $200 million and $225 million, with a big chunk of that having already closed earlier this month. Back in January, we raised the dividend for the 105th time since our company began. Our annualized dividend right now is up roughly 3% versus the same period a year ago and works out to a payout ratio of 79%, using the midpoint of 2020 AFFO guidance. Since the company listed in 1994, we've raised our dividend annually, boosting it at a compound average annual rate of about 4.6%. We take pride in being among just three REITs in the S&P 500 Dividend Aristocrats Index. In closing, 2019 was a successful and busy year for us, and we aim to carry that momentum into 2020. Our portfolio is doing well, our worldwide investment pipeline is strong, and our cost of capital plus plentiful liquidity puts us in position to seize our growth opportunities. Right now, I'd like to open the floor to questions. Operator?

Hello, Greg McGinniss here alongside Nick. We want to look a little more closely at the acquisitions guidance — could you share your estimate of how that breaks down between the U.S. and the U.K., tell us if the EU might be possible in 2020, and what cap rate or investment spread you're factoring into the underwriting? Thank you.

The composition should come in at roughly 20% international and 80% domestic, and as for the spreads, what we're hoping for is considerably above our typical spreads of 150 to 160 basis points.

Alright, so that's a little below what you all managed to deliver, and my read is that this is simply extra caution on your part, more than anything?

That's the guidance we're at ease putting out to the Street. Clearly, what we saw in the prior year is a trend we anticipate carrying forward; we have strong conviction when we state that our acquisition range will land between $2.25 billion and $2.75 billion. Our goal is to outperform our typical spreads by a wide margin, and those, as I mentioned, came in at approximately 150 to 160 basis points. So yes, there is some degree of caution baked in.

Alright. We understand that the guidance for acquisitions excludes possible portfolio purchases. Could you perhaps provide some insight into what you're observing in today's market regarding that area? Is anything in the way of portfolios being pitched to you at the moment? Are you currently evaluating any? What size are they? Just attempting to gauge the situation.

Yeah.

What would count as decent upside relative to the acquisition guidance?

Yeah. Let's clarify exactly what we mean when we say portfolios. The big portfolio deal we closed during the prior year was the CIM transaction worth $1.2 billion. A deal of that magnitude is not something that has been factored into our 2.25 to 2.75 figure. Obviously, we're active in the market and routinely completing portfolio deals sized between $100 million and $200 million, and those absolutely form part of what our guidance assumes. Look, we already told you what the sourcing figures looked like for 2019. So far, and this early in the year, we haven't observed any slowdown in what's coming across our desk. Our outlook on the pipeline is quite positive. We feel quite positive about hitting the targets we've provided to the market. Right now, nothing on the horizon suggests to us that this year will end up moving at a far slower pace than the one we just came through.

All right. Thanks, Sumit.

Sure.

Hi there, good morning, Sumit, and thanks. With more open-air retailers having filed for bankruptcy lately and announcing store shutdowns, plus word that additional companies are bringing in restructuring advisors, could you discuss which particular tenants you're exposed to that belong in that group, or which parts of your portfolio might worry you regarding potential fallout over the coming year?

Certainly, some tenants are receiving very close scrutiny from us. The positive side, Christy, is that our diversification is so strong that our exposure to these tenants is extremely small — far under 1%. Take Pier 1, for example, which is among the tenants we're monitoring. It has sat on our credit watch list for some time now. We hold 12 assets involving them. That represents roughly 10 basis points of rent; back in 1998 we completed a sale-leaseback with them. Honestly, it has worked out extremely well for us. Whatever direction things go with them, we're nearly unaffected. For nine out of those 12 properties, we're already receiving inquiries from big national tenants. That makes us quite confident about our ability to reposition this asset. There are a few other names we're watching closely. Krystal is another, which came to us via a sizable portfolio acquisition. Basis points of rent. Given the full wall coverage, we believe our portfolio stands in a very strong position. Again, this is a corporate-level credit that's making headlines, and one we're monitoring carefully. Taken together, we've clearly factored all of this into the AFFO per share guidance we're projecting. As the guidance we've provided shows, Christy, hopefully this year will once more prove to be an excellent one for us.

During your opening comments, you discussed the spread between cap rates for investment grade versus non-investment grade. Given the tenant fallout situation we're observing, do you believe those spreads are sufficiently wide? I believe I heard you mention that roughly 70% of deals you're sourcing are investment grade, compared to about 50% currently in place. Will you keep trying to increase investment grade exposure?

What we're actually observing is quite fascinating, Christy. My view is that certain higher-yielding assets have seen cap rate compression, and they're getting nearer to where investment-grade cap rates sit in the market. The shift in the investment-grade market hasn't been nearly as significant as what's happening in the higher-yielding market. On a risk-adjusted basis, you have to ask yourself where your money is better deployed. I believe we've discussed this with you before, Christy. Credit plays a major role in the analysis we do; we aren't chasing any specific credit profile; we examine everything together and try to determine whether, for the risk being taken, the returns make sense. That's our approach to every investment. What I'm getting at is that higher-yielding assets that previously carried a high 7%, or even an 8% cap rate, are now trading at a 6% cap rate. Investment-grade assets that might have been in the high 5s are now in the low 5s. The compression we're witnessing on the higher-yielding side is much more dramatic. Looking at it on a risk-adjusted basis, it certainly makes us hesitate about whether we should keep chasing all of those deals.

Yeah, that makes sense. Thank you.

You're welcome.

Hi, appreciate you taking my question. I wanted to build on what was asked before regarding portfolios. I'm wondering whether you've noticed more competition lately for bigger portfolio buys or sale-leasebacks coming from private buyers, and how that has shifted the way you source deals and handle the process so you stay out in front?

Sure, Shivani, from our standpoint nothing has really shifted. None of our approaches to sourcing or chasing possible deals are being changed when the risk involved isn't warranted by the cap rates being assigned or requested. I mean, back in 2019, relationship-driven deals made up 89% of what we closed. Those are the ones we keep going after. We keep contacting our clients whose credit we're very at ease with. Such assets never even hit the market, and we keep expanding what we do when it comes to sale-leasebacks. Setting CIM aside, sale-leasebacks accounted for 61% of our activity in the prior year. I wouldn't claim that we've in any respect changed our approach to going after acquisitions. On the global side, what we've clearly done is keep forming fresh relationships, once more having done our preparation regarding clients we'd want to work with over the long term; growing our international platform has been a big priority for Neil and for me. Fortunately, we've achieved a decent amount of headway there.

Appreciate that detail. Moving to a different subject, the recapture rate on occupied boxes came in really strong this quarter. Could you give us more insight into what was behind that?

Yeah, absolutely. Essentially, two factors were behind it. As you can observe, our 2020 guidance sits right around 1%, which is what we've historically communicated. Not each of our leases includes annual rent growth. Certain ones have rent growth on a three-year cycle, others have rent growth on a five-year cycle. It simply worked out that an outsized share of leases had growth arriving in 2019; for example, if you examine the dollar stores, 46% of every asset we hold in that bucket saw an increase in 2019. The majority of those were either a three or a five-year rental increase. That represented roughly 34% of the outsized rent increase, the 1.6% that we managed to deliver. As a second point, a lesser contributor to the increase came from the timing of percentage rent accruals, and that also provided a boost. If you removed those two from the picture, we would land right around what we've guided the market to for 2020.

Thank you very much.

Hello there, and good afternoon. What's your current sentiment regarding the office segment? Over the past 12 months, you brought in a single asset. Does that signal future dispositions? Does it point toward future acquisitions? What's your thinking on this across the coming 3 years?

Rob, to the best of my knowledge, our office exposure has kept shrinking across recent years. At one point it exceeded 6%. Right now, it sits within the 3% ZIP code. This is a product type we mostly built up via sizable portfolio deals; we have not actively pursued purchasing single-tenant net lease office properties. That said, everything I'm telling you is very much a U.S.-focused perspective. My guess is the situation will look quite comparable in the international market as well. Our stance on office remains the same. It's a category we remain highly wary of, and we lean toward being extremely choosy whenever we consider a given opportunity and conduct a thorough examination of the deal's underwriting.

Alright. So the next item I'm curious about is this — when you look at the balance sheet over the next 2 years, a good deal of the heavy lifting has already been done. Now that rates have bottomed out again, do you see any opportunities for you all to make an acquisition within that same 2-year window?

To me, that's really a third-order lever or tool we could deploy to help grow our earnings. I appreciate that you picked up on it — by and large, our success with balance sheet financing has largely been realized. As I remember it, there's one remaining unsecured instrument with a coupon in the high 4% range, coming due in 2023. That's one we might look at paying off, depending on where the rate environment stands. It's such a third-order consideration whenever I think about what truly drives AFFO per share growth. And we've got about $1.1 billion in liquidity. Yes, I'm very pleased. Jonathan, anything else you'd like to add?

Okay, Rob, so as we think about the coming several years, extending through 2023 — clearly we retired the 2021 notes back in January — during 2023 and 2024, there's $1.7 billion in debt coming due on us. The 2022s carry 3.25%. The 2023s sit at 4.625%. Fingers crossed, rates remain low. What's notable is that a 3.25% coupon looks pretty elevated by today's standards. We're constantly evaluating liability management opportunities. We're continually examining how the make-whole calculation maps to a break-even rate, should we refinance specific portions of the capital stack. You should expect that we'll keep at it going forward.

Is there still a role for preferred within the capital stack as we move ahead?

We might be able to issue somewhere around the mid to high 4s, for instance when it comes to preferred.

That's something we'll keep evaluating. If you consider what it would cost us on an indicative basis to issue 30-year unsecured paper, which currently sits in the low three range, that spread simply isn't very compelling from our standpoint.

All right. Thank you, everyone.

Hello. How at ease are you regarding your C-store exposure, and to what level would you feel fine about it rising?

The tenants we're exposed to, which make up the bulk of our industry exposure, leave us feeling quite at ease. 7-Eleven, Couche-Tard operating under the Circle K banner — those are names we feel very good about. They rank among the finest convenience store operators in the business; we keep an eye on how they're doing. Our relationship with them is quite close. We're very comfortable on that front. What does make us uneasy is the smaller format kiosk style C-stores that depend heavily on fuel sales to generate profitability. Fortunately, those are mostly outside our portfolio; a few do exist, but on the whole, the majority of that 11% exposure comes from 7-Eleven and Circle K.

Alright. Have the people renting from you brought up anything about increasing wages affecting their coverages, or their coverage ratios?

How many was it that we looked at? More than 200 leases — obviously I can't claim those discussions happened with every single tenant, though I'm certain that in certain instances, higher labor costs must have come up. On the whole, we're glad to say that things are going pretty well for our tenants. The fact that we managed to recapture 103% net of expiring rents suggests that at minimum, the sorts of tenants we're exposed to aren't shielded from it, yet they can still handle the higher labor costs.

Great. Thank you.

Sure.

Thanks. When it comes to the $12 billion in transactions you sourced from outside the U.S. during this year, could you give us some detail about which specific property categories or sectors are being marketed most aggressively overseas?

For the most part, that's grocery stores. That's convenience stores. That's cinemas. That's discount retail; those are the categories they'd fit into, along with a bit of industrial.

Alright. Turning back to what was asked earlier regarding that latest string of bankruptcies plus the persistent pressures facing retail, would you expect that CapEx might gradually drift upward within the net lease space, specifically when it comes to TIs or possible deferred CapEx tied to properties sitting empty?

What we observed was completely the reverse. Over the past 3 years, our CapEx has mostly stayed steady, while the thing that truly went down was our property expenses. As you may have seen, we told the market to expect something in the 1.5%-1.75% range, yet we finished at 1.4%. Two factors drove that outcome. First, the property taxes we had projected on our vacant assets turned out to be much greater than what we ultimately achieved, because we managed to dispose of those empty properties at highly attractive total returns. Clearly, the top line expanded well ahead of our forecast. Together, those two elements brought property expense margins in under 1.5%. Based on today's environment, we aren't observing any movement in our CapEx figures. I believe this mostly comes down to the kind of retail we put money into. It's net lease. When it works for the tenant, they gladly put up the CapEx on their own, reconfigure the properties so they stay relevant, and generate profitability from the store. That's the reason the net lease sector is generally such an efficient one. Once again, it truly depends on which clients you decide to build exposure to. With the wrong group of clients, I'd tell you, Spenser, the outcome might look different; across our portfolio, that isn't what we're seeing.

Okay. That's helpful color. Thank you.

Sure.

Thank you. When we look at the typical lease duration, it now sits at a bit more than 9 years. That figure has been slowly declining. You folks have definitely recognized this. Could you discuss the latest leasing renewals, perhaps regarding the length those tenants signed up for? The properties you've bought have generally had longer terms than that typical figure. The overall portfolio's average continues to slide downward. Perhaps just address the renewal leasing, if you would.

Yes, absolutely. This is a topic we've addressed before too, Todd. When you consider a net lease, the initial contract usually runs 15 years, 20 years, or perhaps even 25 years for a sale-leaseback. There are options embedded within those contracts, and typically those are 5-year options; all of this is available in our supplemental. If you examine our track record with renewals, we've completed more than 3,000 leases, 80%, and lately it's been greater, 80%-90% of current tenants take advantage of those options. Upon resetting the lease duration, it lands at approximately that 5-year period; it's only when we pursue and secure a replacement tenant or locate a new tenant even with no empty spaces, that we get the chance to extend past 5 years to something resembling 10. Those have typically fallen within the 6 to 7-year bracket. If we made no purchases at all, I think the standard pace for a net lease business, a highly, highly established net lease business, one completing zero purchases or minimal ones relative to its total portfolio, the standard weighted average lease term would land at approximately 6 to 7 years; that's the point where our asset management and real estate operations group becomes essential. We foresaw this and structured the team appropriately, and I believe the outcomes demonstrate that. Each quarter, we report to you the renewal spread, and we report to you the capital deployed concerning tenant incentives, etc. Most of the time, those come out to zero. We've been achieving more than 100% of rents coming due. 103 this year, last year was comparable, and the most recent quarter came in at 106%. I think our team could actually be seen as one capable of generating value. As these leases begin to expire and we can sustain the level of renewal activity we've managed to deliver across the past 3 to 4 years, that might turn into a source of growth for us. Obviously, for fresh purchases, one would anticipate that a sale-leaseback ought to fall within that 15 to 20-year bracket. If they're acquired leases, they'll carry double-digit figures. As our company expands, and unless our purchase volume fails to match proportionally, the weighted average lease term will keep trending downward and ought to settle at approximately 7 years.