Realty Income Corporation (O) Earnings Call Transcript & Summary

We appreciate everyone being here today for the conference call covering Realty Income's operating results from the first quarter. Speaking about what we achieved will be Sumit Roy, who serves as President and Chief Executive Officer, Christie Kelly, our Executive Vice President, Chief Financial Officer, and Treasurer, and Jonathan Ponton, Senior Vice President, Head of Corporate Finance. Throughout this call, certain remarks we make could fall under the definition of forward-looking statements according to Federal Securities law. It is possible that the company's actual future results will end up differing substantially from whatever is addressed in any forward-looking statement. A more thorough explanation of the elements that might lead to such discrepancies will be provided in the company's Form 10-Q. To ensure everyone gets a chance to take part, we will be enforcing a limit of 2 questions while we conduct the Q&A segment of this call. Should you wish to pose more questions, you are welcome to get back in the queue. At this point I'll hand things over to Sumit Roy, our CEO.

Thanks, Andrea. Hello and welcome to all of you. It's a pleasure to share that our results for the first quarter of 2023 were solid and showed ongoing momentum within our business. I want to convey my deepest appreciation to our one team, whose hard work makes it possible for us to keep meeting our growth objectives. I'd also like to extend thanks to those who invest with us in equity and fixed income for the ongoing confidence they have placed in us. The dedication of our team along with what we gain from our size and scale came through in what we delivered during the first quarter, most notably roughly $1.7 billion in high-quality investments purchased at a cash cap rate of 7%; that marks a rise of 90 basis points relative to the investment cash cap rate we posted during last year's fourth quarter and produced an investment spread of 163 basis points, which sits above our historical averages. As we've seen during earlier cycles, once an adjustment period passes, cap rates on our investments have historically tended to move in positive correlation with interest rates, and following the recent increase in rates, that is largely the pattern we have kept seeing this year. Being able to obtain capital at attractive prices has long functioned as a competitive edge for us and stands as evidence of our lengthy record of keeping a conservative balance sheet alongside a diversified real estate portfolio backed by clients who lead in the industries they operate in. In a setting where capital is costly and or hard to come by for a great many of our clients, the value we offer becomes all the more evident; you can see this dynamic at work in the portfolio acquisitions we've recently made public, the active deal pipeline visible right now, and the attractive pricing spread for large portfolio transactions when compared with one-off single asset transactions. Our differentiated platform reaches past the external growth perspective. Lately, we've been taking actions to capitalize on the scale of our portfolio and the track record of our operating business by further building out advanced analytics. This initiative's goal is to create forward-looking and action-oriented insights that draw on the proprietary data we alone hold, built up across 34 years of buying, operating, and selling single-tenant net lease assets. That rich store of information feeds our team's proprietary predictive analytics engine, which we apply in underwriting investments, running portfolios, managing assets, and pursuing development — letting our best-in-class team members make decisions with better information. The tool's forecasting strength should increase alongside our business, and we think it will deliver meaningful value to stakeholders as we sharpen its precision, validate its outputs, and extend its reach into additional industries, property categories, and regions. A central piece of our investment thesis is that our size and scale let us act as a source of capital for best-in-class partners seeking other ways to finance themselves while debt costs stay elevated; during Q1, we reached an agreement to buy as many as 415 top-quality convenience stores from EG Group for $1.5 billion. We anticipate that properties operating under the Cumberland Farms banner will account for more than 80% of the portfolio's total annualized contractual rent, and we expect the deal to close in Q2. This transaction shows why we think our capacity to provide both closing certainty and attractively priced capital as a single-source answer for sale-leaseback deals is especially valuable right now to institutional sellers of real estate; we expect that advantage to keep widening. Abroad, we keep pushing into new geographic verticals and enlarging the total addressable market. During this quarter, we capitalized on attractive international pricing to buy assets valued at roughly $390 million, achieving an initial cash lease yield of 7.6%. Since first entering markets outside the U.S. in 2019, 11.7% of total portfolio annualized contractual rent now comes from those markets. This organic broadening of our platform has driven growth for 4 years running and demonstrates how we can systematically build and scale a new vertical. With the acquisitions pipeline still gaining steam and the progress we've made so far, we are raising our 2023 investment guidance to more than $6 billion, up from the earlier figure of over $5 billion. In line with our investment approach, we continue to keep our balance sheet disciplined. Following our April bond offering, which settled on April 14th, we had roughly $5.6 billion of liquidity, including $1.5 billion in unsettled forward equity. Our present financial standing lets us move toward near-term investment opportunities. Turning to operations, our platform keeps producing durable cash flows that underpin our steady earnings profile. For Q1, we're happy to report 99% occupancy, equal to last quarter and the highest figure at the close of a reporting period in more than 20 years; across 176 leases renewed or newly signed in the quarter, we achieved a 101.7% recapture rate. What we're seeing here stems from the skill of our asset management group and from a steadfast adherence to fundamental capital allocation tenets — among them, targeting best-in-class tenants that frequently sit at a low price point, within service-oriented or non-discretionary sectors. We deliberately spread risk across sectors, regions, and customers, while stressing top-tier real estate sites and strict credit analysis. Our approach to investing is subtle; it isn't merely about chasing investment-grade tenants, who made up 40.8% of annualized contractual rent when the first quarter closed. A number of our most capable operators, Sainsbury's being one example, carry no public debt, meaning they hold no rating whatsoever. Even so, the steadiness of how they run their businesses and the strength of their balance sheets are positive traits matching what an investment-grade rated firm would show; we figure roughly 5.3% of annualized contractual rent derives from unrated operators lacking public debt. We stay dedicated to deals delivering appealing risk-adjusted yields, as our track record demonstrates, and moving ahead, places where — per our rigorous underwriting and analysis — we secure improved returns for each incremental unit of risk taken. Let me spend a moment on Cineworld, accounting for 1.3% of annualized contractual rent. Even with the Chapter 11 bankruptcy still underway, we kept collecting 100% of contractual rent during the first quarter and into April. By March 31, 2023, reserves accumulated on our Cineworld properties totaled $33 million. Receivables still owed, after reserves and not counting straight-line receivables, came to $14.1 million. Talks with this tenant continue, and we'll inform the market about how they conclude when the moment is right. Prior to handing things to Christie, I want to note that back in March, we released our third annual sustainability report, spelling out our sustained dedication to acting as a responsible corporate citizen on behalf of stockholders, our team, the communities where we do business, and the planet. Our ongoing strides on ESG efforts make me proud as we aim to honor our pledge to cultivate sustainable relationships, and I urge everyone listening today to visit the sustainability section of our website and look over the report. With that, let me pass it to Christie.

Thank you, Sumit. Alongside our clients and our single unified team, we pulled together to make this a strong quarter across multiple measures, generating AFFO per share of $0.98 for the benefit of everyone with a stake in our company. Worth pointing out is that the same period in 2022 gained roughly $10.2 million from reversals of rental revenue reserves, which created a headwind of about $0.015 per share to our AFFO per share growth in the first quarter of 2023. On top of that, short-term interest rates running higher than a year earlier added another headwind of roughly $0.02 to growth, since our weighted average rate on revolver and commercial paper borrowings came in around 300 basis points above where it stood during the comparable stretch of 2022, on a comparable average borrowing base. Once you set those two factors aside, our AFFO per share grew roughly 3.5% versus the prior year this quarter. As we look at the underlying fundamentals of the business, our attention stays fixed on long-term delivery for those with a stake in the company, and we feel good about what lies ahead. Along those lines, we are lifting the bottom end of our AFFO per share guidance by $0.01, bringing the range to $3.94-$4.03, which works out to 1.7% annual growth at the midpoint of that revised range. The year has gotten off to a bustling and fruitful start when it comes to raising capital. Even with markets still swinging around, we have brought in roughly $3.9 billion of capital during the year, not counting $1.5 billion of forward equity that has yet to settle; back in April, we completed a $1 billion bond offering made up of $400 million in 4.7% senior unsecured notes maturing in 2028 plus $600 million in 4.9% senior unsecured notes maturing in 2033, giving us a weighted average tenor of 8 years and a semiannual yield to maturity of 5.05%. Through that issuance we met our near-term debt issuance requirements and cut our exposure to variable rate revolver and commercial paper borrowings down to nearly nothing following the closing of that transaction on April 14th. During March, we lifted our dividend for the 120th time since first listing publicly in 1994, taking it to an annual rate of $3.06 per share, which marks 3.2% growth over the prior year period. A steady dividend that keeps growing sits at the heart of what we do at Realty Income. We are deeply proud to count ourselves among just 66 members of the S&P 500 Dividend Aristocrats Index, having increased our dividend annually across the last 25 consecutive years. I want to express my gratitude to our one team, whose dedication and hard work have cleared the path for our ongoing growth as we continue building on our record of consistency. With that, I will hand things back to Sumit.

Thanks, Christie. So to wrap things up, when markets get shaky or go through dislocation, we try to find value by making the most of what our platform naturally gives us; among those trends are the fairly appealing pricing we keep getting on capital, plus the scale of our portfolio, and we aim to use that to generate distinctive investment chances as a top provider of sale-leaseback capital. Add in the combined abilities of our best-in-class team members, who source, underwrite, and close inventive acquisition opportunities offering strong risk-adjusted returns, and we think our position is very strong to keep building on our competitive advantages for our clients and stakeholders; we're grateful to every one of our stakeholders for the support, loyalty, and trust they give our company. With that said, let's open the line for questions.

Hi there, good afternoon. Yeah, I appreciate the remarks. I wanted to ask about deal flow specifically, comparing the U.S. with Europe. How many deals did you review during the quarter? I believe that's a figure you typically provide. Regarding cap rates. A year ago, the gap between cap rates in the U.S. and Europe was quite narrow. I think they were nearly identical. This quarter, Europe sits 60 basis points wider. I'm just curious whether there's anything worth pointing out there.

Thanks for your questions, Nate. Those are good ones. Let's begin with the sourcing figures. During this quarter, we sourced roughly $16 billion in product, and 25% of that came from the international markets. I'd note that if you look back to when we first entered the international markets, the split between international and U.S. has generally been around 30% and 70%, give or take 5%. This falls squarely inside that range. What you may have picked up on, though, is that in terms of closings more recently — both in last year's fourth quarter and this year's first quarter — the international side's contribution has come in somewhat below what you'd typically expect. I'd say the international business has accounted for roughly 35% of volume in terms of what we ultimately close, compared with closer to 20%-22% in this particular quarter. The primary driver of that is we observed a lag in adjustments on the cap rate side within the international markets relative to the U.S. markets. We began seeing cap rate expansion in the U.S. around the middle of the third quarter, into the fourth quarter, and clearly through this year's first quarter. We didn't really have that same experience in the U.K. market and certain other international markets until, I'd say, near the end of the fourth quarter. What was mostly causing potential sellers to rethink the market wasn't so much driven by actual trades occurring, but rather more idiosyncratic to their specific needs around redemption issues or, you know, refinancings that were approaching in the nearer term; that's mainly what's driven these opportunistic transactions that we managed to get across the finish line in last year's fourth quarter and this year's first quarter. That's what's led to cap rates being considerably higher than what I'd describe as the norm, or what we're observing in the everyday market, in some of these, some of these international markets. That accounts for the 60 basis point higher cap rate we were able to achieve. I might add, this is excellent product, largely driven by, you know, idiosyncratic issues being experienced by buyers who wanted to get this off their books, to meet, you know, some of the things I've just discussed; that's, that's the dynamic we've seen with that.

All right, that helps. Perhaps only a single fast question regarding development yields. Those sit clearly under the yields from acquisitions. Are they simply older commitments made prior to rates shifting? Or perhaps you could explain what is going on in that area.

Yes. Nate, you have described it perfectly. That is precisely the situation. As you are aware, development obligations carry a far longer lead time. Much of what appears — you know, what you observed during the fourth quarter, the third quarter of last year, and the first quarter of this year, although it is beginning to rise, has not risen quite so rapidly, mainly since what you are seeing, you know, passed through the investment figures were deals we had agreed, I would say 3 quarters back, 4 quarters back. You ought to anticipate the yield on development moving nearer to what we are truly seeing in the investment, you know, traditional acquisitions market across the coming couple of quarters. It is purely a matter of timing.

Yes, thanks. Christie, could you walk us through a few of the pluses and minuses in the guidance, and explain why there's just a 1 cent bump at the low end when the acquisition guidance went up and the expense categories are trending favorably?

Sure thing, Brad. So, I think, first off, regarding what Sumit talked about and raising our acquisitions guidance to more than $6 billion, we're staying conservative on that. Looking ahead to the back half of the year, even though conditions are still strong. Like Sumit said, we're taking a wait-and-see approach as things play out. Another point on the guidance we've laid out — and I touched on some of this in my prepared remarks — is the headwinds we're facing on the debt side. Even though we've been very focused on making sure we're de-risking our balance sheet, and you can see that in the deals we've closed through April. We're watching how that might develop in the back half of the year and don't think it will ease beyond the competitive cost of capital we've been able to achieve compared with last year. Then lastly, on the positive trends you saw with the tightening of the G&A guidance, we're staying especially disciplined given this macroeconomic backdrop and are concentrated on controlling our G&A. On top of that, there are the advantages of size and scale, and you can see that over the years in how G&A trends relative to revenues. Finally, when it comes to the unreimbursed property expense margin and the tightening there, we're simply continuing the positive trends we've been able to deliver on.

Okay, thanks for that. Sumit.

Thanks, Brad.

When you look at this EG Group transaction, would you say you're coming across a greater number of these really big sale-leaseback chances compared with the typical flow? And has the level of competition around those deals dropped off as well?

Not at all, Brad. I wouldn't characterize it as having thinned out. Actually, that momentum has kept going, and our expectation is that it stays robust. You know, I'm not sure of the exact count of billion-dollar-plus deals, but deals of that size are going to be, well, the thing that fuels some of the short-term financing challenges plenty of companies will need to work through. Given what's unfolding among banks — with fewer institutions around to supply capital, and the price of that capital being where it is because of the rate backdrop — it's my genuine belief that sale-leasebacks will stay a highly appealing route for bringing in capital to help companies tackle their financing requirements. Remember, EG had never executed a sale-leaseback before. That choice was available to them for a great many years. You know, they decided to take this route, mostly to tackle certain leverage worries they were carrying on the balance sheet. Our expectation is that this pattern keeps up. That's what's behind why we concluded we ought to lift our acquisition guidance by $1 billion.

Hello, all, and I appreciate you spending some time with us. I wanted to ask a bit more about the EG Group transaction. I'm just wondering how that transaction came about, and perhaps what capacity you have to collaborate with them even more down the road.

Appreciate that question, Josh. In the U.K. market, EG is clearly a highly established brand. Neil and I had been reaching out to them for some time, as well as to TDR Capital, who had been their capital partners for a while, and you know, this was a relationship where we understood that early on, when we began talking with them, they weren't especially keen on pursuing sale-leaseback financing. I believe that connection ended up working in our favor when the deal came our way, once they decided to go the sale-leaseback route to address some of their shorter-term capital requirements. This was a competitive situation. Eastdil ran it; we, you know, we went through... We were clearly also in direct, close communication with EG. Three finalists were in the mix, and we felt the deal came to us because of our reputation, our certainty of closing, and the time we'd invested in building a relationship with them. That's really what won us the deal in the end, along with our capacity to be creative and, you know, they had certain requests, and our ability to satisfy those requests, I believe, also worked to our advantage. I think every one of those elements contributed to, you know, us winning the transaction even though we weren't the top bidder.

All right. Perhaps we shift the topic slightly. What's your take on increasing or building up your exposure to tenants with lower credit quality, as a means of sort of broadening the scope and sustaining growth?

Well Josh, that's a really solid question. I'm going to circle back to that EG Group discussion we were just having. When you examine the portfolio itself, Cumberland Farms makes up 80% of it. I'd like to remind everyone that 3 years back, when Cumberland Farms came up for sale, every one of the natural operators showed tremendous interest in this extremely well-run private company. The numbers being thrown around for a possible sale-leaseback were in the low 5s, high 4s zip code; ultimately EG Group came out on top in that transaction, and clearly they had no interest in using sale-leaseback financing to get the buyout done, yet that tells you the caliber of the real estate Cumberland Farms was commanding at that moment. Jump ahead to now, and the four wall coverages on these assets have done nothing but get better, and I'd say dramatically so. The assets are still precisely the same assets, and we managed to get this deal done at a 6.9%. Sure, if you look at EG Group, the credit operating these assets is sub-investment grade. If you look at the asset quality, it hasn't changed at all; our view is that EG Group runs a very good convenience store business. We can observe that in the track record they've built in the U.K., and we definitely observe it in how these assets have performed, comparing where they stood 3 years ago and commanded a price in the low fives, high fours against what we were able to achieve. So now you jump ahead and ask, "Alright, you're picking up 150, 160 basis points of extra spread on this real estate. Are you getting paid for the credit risk that comes with the operator?" That's exactly where risk-adjusted returns enter the picture for us, and it sits so front and center in every single thing we do. For us, the answer was a resounding yes, we are being compensated. As we've said before, an investment grade rating is a by-product of the actual underwriting for us. It isn't something we chase; it gets factored into the collectibility of the rent flow across the 20-year or 25-year leases we underwrite to. But in the end, we evaluate every transaction on a risk-adjusted basis, and if it makes sense, even though it may or may not carry an investment grade rating, that's something we will keep pursuing.

Good afternoon, and thank you very much for taking my question. Sumit, at the beginning of this call you mentioned that momentum in the business has continued. Could you just talk—since re-rates usually function as lagging indicators, could you sort of describe what visibility you have into the business and into that ongoing momentum? I'm just trying to get a better grasp of how long a runway you have where you feel really confident about the spreads and the backdrop, because over the last several quarters, everything has seemed quite solid.

Yeah. Michael, that's an excellent question. Everything is moving at such a rapid pace. A bank shows up in the headlines every other day. The news moves extremely quickly. How should we think about our business, and why do I use terms such as continued momentum? Even if this could be a lagging indicator, you know, we examine transactions and lease renewals on a daily basis. When we observe the reality that we can keep producing releasing spreads of 102%, 103%, sure, it lags, but honestly, you know, only by weeks, by months. That provides me with ongoing hope that, look, for our product—you know, where we compete in the market, and so on—there is still a considerable amount of demand. It shows up in certain favorable releasing spreads that we report to the market. The second element, which is far more forward-looking, is this: what are the ongoing conversations we're having that subsequently help propel our pipeline on the investment side? What types of conversations are we having? What is the magnitude of the conversations we're having? What yield is tied, you know, to those conversations? I believe all of that gives us, you know, confidence that momentum is still there. The reality that we managed to raise $3.1 billion over a span of three months, you know, in the fixed income market. The reality that we managed to close on $800 million of equity and have $1.5 billion, sorry, of unsettled equity, once again, keeps giving me, you know, confidence that even on our capital side, for us, you know, we remain in a highly favorable position. We have the opportunity, we have the ability to raise capital, we have the ability to achieve spreads above what we have historically delivered. Now, with international markets beginning to show a bit more positive movement for us on the cap rate side, that is what gives me the confidence to state that we have continued momentum in the business.

Appreciate that. For my next question, it seems an office has been established by you in Amsterdam. Could you share a bit about what advantages that brings? Should we take it to mean that additional international deals are coming, or does it let you source deals more effectively across Europe? Do any tax benefits come along with having an office in that location? Thank you.

Yes. What made it necessary for us to set up a Netherlands office was mostly a result of the structure we have put in place, which gives us the flexibility to keep expanding in international markets. When I say international markets, I mainly mean the U.K. and Western Europe. A substance question largely drove this — you know, whether we have or need employees located in Amsterdam so that this tax structure we've managed to create, the one providing us that flexibility, can be satisfied. That is mostly what has driven, you know, a couple of hires we've brought on. The bulk of other hires will stay in the U.K. and possibly in some of those other countries once we start hitting a core size in terms of our portfolio. Yes. That is what truly drove opening a Netherlands office and bringing on a few folks who can assist us in managing our international business.

Thanks. A few of your competitors have suggested that U.S. cap rates might be nearing their peak. Are you observing the same thing during the second quarter? And on the other side, in Europe, you noted that cap rates didn't begin shifting until Q4 or Q1 of 2023. Do you believe there's still additional room there, and that this could serve as a tailwind for you compared with peers? The point of my question isn't to claim that European cap rates will rise above the 7/6. I realize those one-off deals may not occur each quarter. Is the direction you're witnessing in Europe upward, and could that improve your spread versus peers?

Yeah. Thanks for asking, Harsh. I won't go as far as claiming that we're seeing cap rates rise even more in international markets than they have in the U.S. Just consider where our 10-year bonds stand. They're practically stacked right on top of each other; those benefits exist now just as they did 12 months ago. I don't anticipate outsized movement in either region. Could we encounter circumstances, though, unique ones that emerge largely because of what you called idiosyncratic issues? Yes, that might generate additional cap rates. As a market overall, I don't foresee a significantly greater advantage in either market when it comes to cap rates. You're correct. You put it well that cap rate movement happened more slowly in Europe than in the U.S., but I believe they've mostly closed the gap. Similar to some of our competitors, it's reasonable to say we haven't witnessed ongoing cap rate expansion compared with what we've gone through over the past, say, 1.5 months, 2 months. That doesn't mean cap rates couldn't keep shifting. There's simply a great deal of uncertainty in today's market regarding banks. The moment we begin to think the banking crisis is behind us, another name surfaces. As you're aware, many of these regional banks served as the lifeblood for financing developers and other local real estate operators. Might those circumstances reappear in the form of forced sales, where we could benefit, which would then affect cap rates? Yes, that's possible. That's why I'm reluctant to declare that cap rate movements have finished and will stay at today's level. I'd say that, much like what other companies in our space have seen, we've gone through something of a leveling off when it comes to cap rates. That said, I'm not convinced the story here is fully finished.

Understood. That provides useful context. In the last few calls, you've brought up how income-producing sales of vacant properties have been climbing over recent quarters, while every asset sale involved vacant buildings. You indicated this would essentially become business as usual — when that represents the highest and best use for those properties, and we can deploy the proceeds more productively by acquiring something accretive, that's what you'll pursue. Could you help us understand who the potential buyers for these properties are? Has demand for these properties shifted in any way across the last few years, and how does it compare with the pre-COVID period?

Harsh, that's a difficult one to answer. What we're seeing is that every asset has a price. If you're ready to accept a price, then essentially you can sell a property. Everything we got done during the first quarter consisted of vacant sales, since that was the only thing we truly had to deal with. The unlevered IRR came in around 6%, below what we've historically seen, mostly because of one or two assets we simply wanted off our books, since we believed the long-term outlook — or even the short-term outlook, for that matter — didn't warrant keeping them. Looking back, the norm has been a high single-digit unlevered IRR, which translates into a double-digit levered return profile; that's what we've typically achieved, and I believe we can return to that level. As for who the buyers are in this market, I'd say the majority of those looking to purchase these assets are people who intend to run their operations from them. They aren't seeking a lease arrangement. They want ownership and control of the property. These are generally not institutional-quality purchasers but rather local purchasers who plan to operate a business at that site and wish to hold the real estate for that purpose. That describes the buyer profile. Previously, we would also have included developers in the pool — naturally, developers continue to poke around. Since the debt markets have become somewhat more difficult, demand from that category of prospective buyers may have softened a bit. As I see it today, owner-operators account for the bulk of activity driving the sale process.

Hey, good afternoon.

Hi, Greg.