Realty Income Corporation (O) Earnings Call Transcript & Summary

Thanks, everyone, for joining us today as we go over Realty Income's operating results for the second quarter. Speaking about those results will be Sumit Roy, our President and Chief Executive Officer, and Christie Kelly, our Executive Vice President, Chief Financial Officer and Treasurer. Also with us on this call are Jonathan Pong, Senior Vice President-Corporate Finance, and the leaders of our One Team. Today, we'll be making some statements that federal securities law may treat as forward-looking. What actually happens for the Company in the future could end up substantially different from what any forward-looking statements describe. The reasons such differences might arise will be laid out in more detail in the Company's Form 10-Q. During the Q&A part of this call, we'll be keeping things to a maximum of two questions per person so that everyone gets a chance to take part. Should you have more questions you'd like to ask, just get back in line and we'll get to you. At this point, I'll hand things over to Sumit Roy, our CEO.

Thanks, Andrea, and hello everybody. Building solid, lasting ties with every one of our stakeholders is at the heart of what makes this company succeed, and I want to thank each of you on this call for sticking with us. I also want to show my gratitude to each of my colleagues at Realty Income, who keep delivering meaningful contributions toward our growth efforts while taking care of our customers and all stakeholders as a single Realty Income team. We feel good about the momentum we're seeing everywhere in our business even with a macro backdrop that's uncertain, and we think this once more proves how stable our business model is and how it can prosper no matter where we are in the economic cycle. Because our worldwide investment pipeline is so robust, we've been able to put more than $3.2 billion into high-quality real estate during the first half of the year, with roughly $1.7 billion of that coming in the second quarter. With that kind of momentum, we're raising our 2022 acquisitions guidance to more than $6 billion; speaking of acquisitions, there are two important trends I want to flag that we're seeing in the market. First, as shown by the weighted average 5.7% cash cap rate we managed to get on our second quarter investments, cap rates in our target markets are heading upward. Our second quarter cap rate came in higher than the 5.6% and 5.4% cap rates we got in the two quarters before it. That positive link between cap rates and interest rates shows up in our acquisition pipeline too. Second, as a side effect of higher debt and equity costs that have hit a lot of our competitors, the set of acquisition opportunities coming our way at accretive spreads keeps expanding. Just to remind you, we report cap rates on a cash basis. If we look at it on a straight line basis, we figure our second quarter cap rate was about 6.2%. And typically, cash versus straight line cap rates differ by somewhere between 50 and 70 basis points in any period. Deal flow is still robust, with sourcing volume reaching roughly $26 billion this quarter, which pushes year-to-date sourcing volume to about $60 billion. We stay picky, having bought roughly 5% of sourced volume year-to-date. In the second quarter, measured as a percentage of revenue, about 39% of acquisition volume went to clients with investment-grade ratings. We're still devoted to our underwriting standards of working with well capitalized clients who lead in their fields. Our international investment volume keeps making up a big share of our total, accounting for 41% of global volume in the second quarter at a cash cap rate of roughly 5.8%. It's encouraging that our size, scale and access to well-priced capital give us the platform and currency to actively put capital to work as we keep building momentum going into 2023. Dispositions also made it a busy quarter; we sold 70 properties, producing net sale proceeds of $150 million at an unlevered IRR of about 9.3%. So far this year, we've disposed of 104 properties, bringing in net sales proceeds of $272 million and producing an unlevered IRR of about 9.4%. Recycling capital keeps creating added value for us. And what matters is that the unlevered returns we've delivered demonstrate how appealing the risk-adjusted investment profile is for those properties that have completed our entire investment cycle. Thanks to our rigorous underwriting approach, our ties to strong creditworthy clients, and the fundamental quality of our real estate, we keep producing steady results. When the second quarter closed, occupancy stood at 98.9% — the best rate we've seen in more than 10 years. Given where our occupancy and client mix stand today, we're raising our occupancy guidance for year-end 2022 to above 98%. In the second quarter, we signed 193 leases again and posted a rent recapture rate of 105.6%, which lifts our recapture rate for the year so far to 105.9%. As of quarter-end, 43.2% of the annualized contractual rent across our portfolios came from clients rated investment-grade. On top of that, properties we lease to clients on our portfolio watch list account for under 4% of the contractual rent analyzed across our portfolios, which lines up broadly with the small percentages recorded so far this year. Lastly, same-store rental revenue climbed 2% in the quarter and 3% year-to-date. Because operations across our portfolio remain strong, we're lifting our guidance for same-store rent growth to roughly 2% for 2022. I'll now hand things over to Christie, who will go deeper into the quarter's results.

Thank you, Sumit. In the second quarter, we produced $0.97 of AFFO per share, which works out to 10.2% growth compared with a year earlier. Accretive acquisitions form the core of how our Company grows. Our investment objectives are backed by a balance sheet with strong capitalization and an attractive cost of capital, and those things continue to give us an edge within the net lease sector. We closed the quarter comfortably inside our target leverage ratios, with net debt-to-annualized adjusted EBITDAR at 5.3 times, or 5.2 times pro forma, after annualizing the effects of net investment activity from the quarter. Capital raising was busy again for us this quarter. We issued roughly $1.8 billion of long-term and permanent capital, among which was close to $1.1 billion of equity via our ATM program along with a £600 million private placement note offering, priced at a weighted average fixed interest rate of 3.22% and a blended tenure of 10.5 years. Consequently, we ended the quarter with about $1 billion of commercial paper and revolver borrowings, net of cash. Across a total debt principal balance of nearly $16 billion, our outstanding CPE and revolver borrowings basically make up our sole variable rate debt exposure. As Sumit said earlier, being able to access attractively priced capital is a competitive advantage, and this quarter we acted to strengthen that capacity further. Back in April this year, as we had announced, we recast and upsized our multicurrency revolving credit facility, moving it from $3 billion to $4.25 billion. After the quarter ended, we raised our U.S. Commercial Paper Program from $1 billion to $1.5 billion and launched our Euro Commercial Paper Program, sized at $1.5 billion. Together these $3 billion Commercial Paper Programs, with our revolving credit facility acting as a liquidity backstop, will let us efficiently fund short-term needs at rates that are materially lower than what comparable facility borrowings would cost. Because of the momentum we keep seeing in our European investment activities, setting up a Euro program was one of our strategic goals for this year. It will also be an efficient tool allowing us to benefit from the relatively lower all-in commercial paper rates available in the Euro market; given our portfolio's health and the investment progress made so far this year, weighed against the timing of capital deployment and ongoing capital markets volatility, we affirm the 2022 AFFO per share guidance we announced earlier, $3.84 to $3.97, which at the mid-point represents almost 9% annual growth. Turning to dividends, as the monthly dividend company, raising the dividend each quarter consistently shows the confidence we hold in our business's capacity to generate cash flow. In June, we lifted our dividend for the 116th time in our company's history. And last month, we declared our 625th consecutive common stock monthly dividend. Turning to sustainability, we also issued our green bond allocation report in June, and it's great to share that the entire net proceeds from our first green bond offering have been assigned to qualifying green projects, consistent with the standards set out in our green financing framework. On the merger side, one last item: I'm happy to say the integration of our VEREIT merger is now finished, which wrapped up with the shift to one ERP system for the merged companies in the second quarter. That never would have gone so smoothly without the hard work and commitment of our amazing one team. And last, we're still on schedule to deliver the $45 million to $55 million in annualized run rate cost energies we first told you about more than a year ago at the time we announced the merger. With that, I'd like to hand the call back over to Sumit.

Appreciate that, Christie. After a 2021 that set records on the investment side, it makes me proud that our group has done nothing but speed up that momentum during this year. Above all, we see a bright future, since our standing keeps improving when it comes to capturing additional share within the investment space. Truly, the edge we enjoy from our size, our scale, and our ability to tap attractively priced capital has seldom stood out more sharply than it does right now. And we're eager to keep taking advantage of that going forward. With that, let's begin taking questions. Operator?

Good afternoon, and thanks for taking my question.

Hello there, Michael.

Hi there, thanks for taking my question. My first one concerns cap rates trending upward and the markets improving somewhat. Because of the VEREIT merger, your acquisition team is bigger. Given that, plus the fact that there's some uncertainty in the borrowing markets too, how could you be somewhat more aggressive or capitalize on the improving markets?

Michael, that's a solid question, since there are conflicting forces at play in today's market. You're exactly right that cap rates are heading the right way. They're adjusting far faster than I'd initially expected. Our team is indeed significantly larger. And thanks to the VEREIT merger, a number of the people we've brought on board are certainly delivering and concentrating on a particular segment of the high real market, and that's actually generating deals for us. The counterweight to that, though, is the capital market. Look, relative to others, we're performing quite strongly. Take our tenure unsecured bond spreads — they've shifted by roughly 85 basis points, I'd say. When you consider our peers, the net lease peers rated BBB, the move there has been 120 basis points to 150 basis points. As for our cost of equity, it's basically flat versus the start of the year. Yet among our net lease peers, it's fallen by roughly 1.8 times. So those are the favorable trends, but it's also true that our overall cost of capital has risen. The real question is whether we can produce the right spreads to make a difference in overall AFFO per share growth. And yes, we can. That said, as you're aware, there's a period of adjustment, which explains why we've raised our acquisition guidance to over $6 billion from over $5 billion — evidence of the benefits we're seeing accrue to us from some of what I just mentioned; we're beginning to see many more transactions return to us. Those we weren't prepared to price at the levels sellers wanted when they first presented them are now returning with a revised cap rate that works. It's also true that the whole team has simply been able to originate more, and that's reflected in the sourcing volumes we've reported to you of $60 billion year-to-date. However, with interest rate shifts and, more crucially, the speed at which those rates have moved, spreads remain at about 110 basis points, 111 basis points year-to-date, a bit under our overall average. So that's why this positive momentum shows up in higher acquisition volume, yet doesn't necessarily convert into higher earnings guidance.

That's really useful. As a quick follow-up, European acquisitions came in at roughly 40% during this quarter. That marks somewhat of a step-up compared with what we've been seeing, so is 40% more or less the correct blend for next year, or at minimum for the second half heading into next year — how are you viewing the U.S. versus Europe split as we move ahead?

Yeah. Michael, it moves around. I'd say there have actually been quarters in which the international acquisition figure wasn't 50% of total volume; and as we begin expanding into newer markets, and so on, clearly our total addressable market keeps growing. And as we get far more established in each of these newer markets, the sourced volume, along with what turns into closed volume, is going to rise. But I wouldn't claim that, right now, we ought to be considering anything above this 40% figure — 41% is what we hit in the second quarter — as though it should serve as the guiding makeup of total acquisition numbers going forward. Some quarters will see us do more, exactly as we have before, yet 40% appears to be the correct figure.

Thank you very much.

Thank you, Mike.

Hey, Nick.

Thanks. Hello, how's it going? You mentioned cap rates widening somewhat, clearly. I'm curious whether you might separate that for us between what's happening outside the U.S. versus domestically — where the increase has been greater, where things have held steadier, or whether any distinctions exist across those two.

Absolutely. Nick, that's an excellent question, and it's good to have you back in our sector. What I'd say is that cap rate shifts within the U.S. are definitely far more dramatic compared with what we've observed abroad; the main reason is that the Fed has acted far more forcefully than either the ECB or the Bank of England. That said, an announcement came out just earlier today that the Bank of England raised its rates by 50 basis points. So we expect that to feed through into elevated cap rates across the UK and the remainder of Continental Europe as well; to put some figures on these shifts, it depends on the asset type — by retail, I mean everything from grocery, which saw the biggest change since it had gotten the most aggressive, rising roughly a 100 basis points, to certain other categories we target in retail, where I'd put that change at approximately 25 basis points to 50 basis points. You ought to begin seeing that show up in upcoming quarters and in the acquisition cap rates — the cash cap rates we'll be providing to the market moving forward. Over in — over in Europe, we've likewise witnessed change, though it's been somewhat less dramatic, perhaps 5 basis points to 10 basis points. When it comes to industrial, the shift has been somewhat more apparent, 25 basis points to 50 basis points, comparable to what we saw domestically. Still, I'd say industrial has kept experiencing cap rate expansion. And from start to finish, you're looking at roughly 50 basis points of average movement; naturally, some markets saw far, far smaller changes — Inland Empire is one that comes to mind. In the more secondary and tertiary markets, though, the change has been more dramatic and might even exceed 50 to 75 basis.

Thank you. That's quite useful. So you brought up deals returning — are those falling out of contract, or was the seller simply unable to secure the price they wanted? Broadly speaking, what do you see in those situations where you get another shot at some of them?

Right; for the most part, it's purchasers who depend on debt capital markets, whether that's CMBS or the bank loan market. You're based in New York, so you're familiar with the money market, the large banks, the BofAs, the JPMorgans, the Wells — I won't claim there's a moratorium on new loans at those institutions, but it has become far harder for them to generate new bank debt or larger revolvers, and so on, for credit that's more distressed. As a result, the broader debt market has gotten significantly pricier for a number of these leveraged buyers; and what we've observed is that they can no longer meet the original cap rates at which transactions were originally agreed. And naturally, we made the decision not to chase those transactions at the pricing in question. So when they return to us, provided we still like the transaction, it was purely a matter of pricing; we can now either meet the cap rate we originally had or even push those cap rates wider to mirror today's market conditions. Yet the reality that certainty of closing has grown so much more critical for sellers these days is plainly evident across many of the conversations we're currently having with sellers.

Thank you.

Sure.

Hello, Connor.

I appreciate you including me. I'd like to dig into the cap rate topic, and I value your observation that there's a link between rates going up and the effect that follows on cap rates. But have you ever managed to pin down what that delay actually looks like? Say rates move up by 25 basis points — what's the timeframe before cap rates show it? Also, on top of that, with some of your lending partners ceasing their operations, is that connection speeding up?

Yeah, good question. Sadly, if we could sit in a laboratory and hold steady every variable that influences this relationship, giving you an answer would be far simpler. In the past, whenever we've run these correlation studies, the delay we've identified ranges from nine up to maybe 12 months at the longest. Entering this specific set of circumstances, entering this year and watching rates climb, I felt far more doubtful. Only because of the enormous amount of money flowing into our sector from institutions. Given that abundance of capital, I hesitated somewhat to keep asserting that a nine-to-12-month delay would occur before cap rates began mirroring the fresh conditions. Still, something I failed to anticipate was how swiftly the debt markets would shift. And even with this fresh capital entering our sector — from private equity as well as from the public side. The debt markets shifted far more rapidly. As a result, the retreat by these newer purchasers in our sector has been considerably sharper, and that has caused cap rates to move much more quickly. After all, we've been in an environment of climbing interest rates for the past six months, and cap rates have already begun shifting by 25 to 50 basis points. As I mentioned, within the grocery sector, sale leasebacks that used to close in the low fours are now returning and closing in the low fives to mid fives. So there isn't a fixed figure I can give you, Connor; it mirrors whatever conditions you happen to be dealing with. But honestly, it benefits us that cap rates are able to move as swiftly as they have while interest rates rise. My only wish is that the opposite scenario doesn't hold true.

Understood; that's quite an intriguing detail. I'll stop my questions at that point. Appreciate it.

Thank you.

Hello, Haendel.

Hey, good to be here. Greetings, everybody. So I suppose what I'd like to hear is how you see the part of the market that isn't high grade at this moment. I realize it isn't where your attention sits, though you do engage with it selectively and hold some positions. What I'm wondering is how the appeal of high grade stacks up against the non-high grade space, and whether a case could arise where the return premium grows large enough that you'd lean further into non-high grade opportunities. Thank you.

Hello, Haendel. Indeed. There's a story that keeps circulating, claiming we either ignore or overly favor the higher-rated portion of things. Take a look at our activity this quarter. Specifically, 62% of our activity fell into sub-investment grade or non-rated territory. So the claim that investment grade credit and that specific product are our sole concern just isn't accurate. What we've attempted to communicate to the market — clearly without success — is that our approach centers on risk adjusted returns, and there are moments when investment grade credit delivers risk adjusted returns that are much better than what the non-investment grade side offers. When we shift focus to that area and attempt to complete those deals, there are also occasions when the reverse situation applies—specifically, below investment grade lets you achieve risk-adjusted returns that are significantly better. That's the kind of market we're in right now, where the non-investment grade portion of the equation is presenting us with really strong opportunities, which means we can push many of those deals through to closing—62% in the second quarter, for instance. So credit ratings don't matter to us one way or the other. Our approach centers on assessing the whole of each specific opportunity, then assigning a return profile suited to the risk we're taking on, and that will keep shifting. Achieving an investment grade rating isn't something we aim for; it usually emerges as a side effect of our underwriting process. I hope that answers what you were asking.

Absolutely, absolutely. Definitely grateful for the insight and the way you've framed things. Is there anything new on Encore — as I understand it, still expected to wrap up during Q4 — and where do things stand with the regulatory and licensing side of it?

We remain on schedule, and we're feeling pretty good about it. We've kept in very tight contact with the MGC and are collaborating closely with them, so we're highly confident it will be finalized before this year wraps up, in the fourth quarter.

Thank you.

Sure.

Hi, Brad.

Hi, everybody. Hello, Christie. I suppose this one's for you. Regarding the updated guidance, could you walk through the components that left the AFFO per share figure the same even though the acquisition total went up? My assumption is that it mentioned possibly narrower spreads relative to the cost of capital, but I'm wondering whether there was any FX effect or an impact from interest expense or something else.

Yeah. Brad, I believe, to kick things off, Sumit — Sumit began to mention this regarding a few of the components, since we had raised our acquisition volume beyond $6 billion, yet held, as you noticed, our AFFO per share guidance at the same level and reaffirmed it. And there are certain elements at play here: first, the turbulence in the capital markets, as we've talked about, the broader rate increases and how large those increases have been, plus any steps that could be taken later on. That applies to both the European and U.S. situations; we also, to the point you raised. We truly do hedge when it comes to FX in order to safeguard our international income, and we've also got hedges set up to bring down our effective interest rates, and we'll get into that a little more shortly. But another factor is simply the timing of the investment volume — the team has been performing excellently. We have genuinely strong momentum, as Sumit mentioned, in the market. And the acquisitions we complete between now and the close of the year, though appealing, will really position us well for 2023. So that timing isn't as favorable for this year's AFFO as it will be for the full-year effect next year; and on the positive side, I think we still have certain clients on cash accounting who have only just begun under their deferral arrangements; so we'll be watching them for continued consistent payment performance, and we'll make the right decisions in line with our policy and guidelines when we might move them off cash accounting. But I'd like to hand it over to Jonathan to speak a bit more specifically about hedging and what it impacts.

Appreciate it, Christie. Right, Brad — clearly we've put out quite a bit of debt in local currencies within the sterling market, and that's by design, since rates there are considerably lower. Still, when you think about it from a natural hedge angle, if our interest costs are in the same currency as the rent we're now collecting, that shrinks how much volatility we're exposed to. Beyond that, we follow a cleanup approach under which we hedge part of the AFFO that isn't otherwise hedged. Given how that works, we believe we've reduced the spread of possible results, both favorable and unfavorable, though some unhedged exposure remains — roughly 60% of the AFFO we earn in foreign currencies carries no hedge. That means a 10% swing in the dollar, for example, translates to about $0.015 of volatility on a yearly basis. So we aren't fully hedged, which leaves room for gains should the dollar revert toward its mean. That said, it's a touch of caution on our part, given we're sitting here in August.

All right, I appreciate all the detail. Then, Sumit, a few of your competitors on this call have mentioned portfolios changing hands for less than what individual properties go for. Have you observed that too? And might you be looking to do additional deals involving portfolios?

Not any more than previously, Brad. Transactions involving a group of properties usually do sell for less, particularly during periods like the current one, when capital has gotten more expensive. Also, many of the possible purchasers for large portfolios are essentially waiting on the outside. So things have basically gone back to the way they used to be, when we'd receive a lower price on portfolio deals. Consequently, if you examine the volume we have right now, roughly 62% of our activity consisted of portfolio transactions. That works in our favor, Brad, and what we're witnessing is precisely the same situation that a number of our competitors have described.

Okay, thank you.

Sure.

Hi, everyone.

Hi, Wes.

Hi. I have a question, perhaps regarding FX, but more specifically about future hedging, I suppose. As you acquire additional properties abroad, would you increase, I suppose, CP issuance as a hedging tool? Also, might U.S. CP issuance potentially drop to zero, with nearly all capacity used overseas?

Hi, Wes, this is Jonathan. I’ll address that. You might have noticed we recently set up our euro commercial paper program, amounting to $1.5 billion equivalent, alongside the increase in size of our U.S. dollar commercial paper program. Regarding the Euro CP side, we definitely plan to make use of it as long as we have a need for euro currency. However, at present, clearly interest rates are comparatively much lower; we could likely issue one-year year-old CP < > at around a 25 basis point level, which is versus revolver borrowings at roughly 75 basis points. So certainly, holding a liability—and a particularly inexpensive one denominated in euros—will be beneficial in every way, reducing the number of derivatives we must use to hedge our exposure and bringing down the old interest rate we pay on your borrowings.

Understood. Now, circling back to that remark — apologies, please continue.

Right, Wes. With all that being said, our aim is to move toward permanent funding for the acquisitions at the earliest opportunity. What I mean is, this serves as a way for us to give the market certainty and to capitalize on the A-/A3 rating we hold; even so, it will keep playing a minor part in our debt structure as a whole. If you check where our outstandings stand at present, that figure is roughly 7%. That's the way you ought to view how we'll grow the business from here on.

Understood. Now I'd like to revisit what you said regarding the reason cap rates are necessary. I'm simply wondering whether you notice any variation across sale leasebacks, marketed assets, developer takeouts — any of the channels you examine?

Correct. The channel isn't what drives it. Wes, I'd put it this way: the broader market matters far more. Once cap rates begin shifting in portfolio deals, whether that portfolio is offered by a different seller or arrives through a sale-leaseback route, that will mirror market conditions. Does a relationship matter at all? Absolutely, it does. Yet we're talking 5 basis points to 10 basis points, or perhaps 15 basis points at the very most. Still, what sets those cap rates is the market itself, far more than whichever channel is involved.

Great, thanks a lot.

Thank you.

Hi, Josh.

Hey Christie, hey, everyone. Now that you've more or less finished bringing the VEREIT merger together, what's your thinking on further M&A?