Realty Income Corporation (O) Earnings Call Transcript & Summary

Good day, and welcome to the Realty Income conference call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Steve Bakke, Vice President, Capital Markets and Investor Relations. Please go ahead.

Good morning. Welcome to the joint conference call to discuss Realty Income's acquisition of Spirit Realty Capital, which was announced earlier today. Discussing the transaction today will be Sumit Roy, President and Chief Executive Officer at Realty Income; and Jackson Shey, President and Chief Executive Officer at Spirit Realty Capital. During this conference call, we will make certain statements that may be considered forward-looking statements under federal securities law. The company's actual future results may differ significantly from the matters discussed in any forward-looking statements. We will disclose in greater detail the factors that may cause such differences in the company's SEC filings. We will be observing a 2-question limit during the Q&A portion of the call in order to give everyone the opportunity to participate. If you would like to ask additional questions, you may reenter the queue. I will now turn the call over to our CEO, Sumit Roy.

Thanks, Steve. Good morning, everyone, and thank you for joining our call today. As announced this morning, the Boards of Directors of Realty Income and Spirit Realty Capital have unanimously approved an all-stock acquisition of Spirit by Realty Income, which will further position Realty Income as the leading net lease REIT in the world with a pro forma enterprise value of approximately $63 billion. We estimate that the transaction will be over 2.5% accretive to annualized AFFO per share, with the accretion supported by the assumption of approximately $4 billion of debt with a weighted average rate of around 3.5% or roughly 300 basis points below our 10-year secondary bond yield. The accretion for the transaction serves as the foundation for 2024 AFFO per share growth and represents compelling basis with an implied cap rate in the mid-7% area. Upon closing, Realty Income would become the fourth largest REIT in the S&P 500 by enterprise value. We view this transaction as another example of how our unique platform can create shareholder value by capitalizing on our competitive advantages of size and scale to consolidate the fragmented net lease real estate market. Under the terms of the agreement, Spirit shareholders will receive 0.762 shares of Realty Income common stock for every share of Spirit common stock they own. Upon closing of the merger, Realty Income and Spirit shareholders will own approximately 87% and 13%, respectively, of the combined company. This $9.3 billion transaction is expected to be leverage-neutral to Realty Income and requires no additional capital raise to complete the merger, which we view as particularly important given the current market backdrop. To put it in perspective, the size of this transaction eclipses our total investment volume for all of 2022, which was a record year for investments for Realty Income. As a testament to the unique scalability of our business in the real estate industry, we estimate annual G&A synergies of approximately $50 million or approximately $30 million on a cash basis, excluding stock-based compensation. Our ability to absorb over 2,000 properties while achieving material cost savings is a testament to the tireless efforts of our team members who have been instrumental in building a world-class net lease platform. We expect to realize these synergies in the first 12 to 18 months post-closing. This should result in a cash G&A margin of 2.8% on a combined basis and further improve our EBITDA margin, which currently stands at over 95%. Our recent merger with VEREIT has honed our institutional knowledge to efficiently onboard this portfolio, taking full advantage of the scale of our operating platform and the efficiencies provided by our recent investments in technology and process improvement. We expect this transaction to be a credit positive as we expect to enhance our size and scale while maintaining our key credit metrics. We remain committed to our A3 / A- credit ratings together with conservative leverage ratios, and we will continue to target a net debt and preferred equity to EBITDA ratio in the mid 5x area on a run rate basis. Spirit's portfolio is highly complementary to ours and consists of over 2,000 properties with significant overlap in our existing key industries and clients. 14 of the combined company's top 20 clients overlap, allowing Realty Income to reinforce and deepen our relationships with key operating partners. Similar to our portfolio, the Spirit's portfolio is comprised primarily of properties leased to retail clients that offer a nondiscretionary, low price point or service-oriented product to the consumer. As we have proven over decades, these traits in a diversified portfolio result in durability of cash flow during periods of economic uncertainty, further supporting the reliability of our monthly dividend, which will not change as a result of this transaction. In addition to its retail portfolio, over 25% of Spirit's rent is generated from industrial properties, which will result in a modest increase to our industrial concentration from 13% to 15%. Our portfolio diversification is enhanced through this transaction. Our rent concentration to 9 of our current top 10 industries will decrease as will the concentration to 18 of our current top 20 clients. Of note, Cineworld will no longer be a top 20 clients of the combined portfolio and will be replaced by Home Depot. Lifetime Fitness and BJ's warehouse are the only 2 current top 20 clients of Realty Income that will increase in exposure. Spirit's top client Lifetime Fitness represents 4.2% of their rental revenue and has been a close partner of ours for several years. Our exposure to Lifetime will increase from 1.5% to 1.9% of our total portfolio annualized contractual rent, elevating them from our 12th largest client to our eighth largest. This is an example of how relationships that are already strong will be reinforced and deepened as we become an even more prominent partner to our clients, who we view as amongst the most successful, innovative and well-respected companies in the world. The benefit of greater client and industry diversification is that it will extend our runway to grow in our target swim lanes, amplifying our competitive position when we are competing for large-scale transactions. As we have demonstrated over the last year, our scalability as a platform has directly translated to a pipeline of high-profile portfolio and sale leaseback transactions, several of which have been proprietary deals negotiated on a relationship basis. The enhanced size, scale and diversification of the combined portfolio further positions Realty Income as the real estate partner of choice for large-scale net lease transactions, particularly given the current interest rate backdrop. To illustrate this dynamic, giving effect to the closing of the transaction, our portfolio will generate approximately $4.5 billion of annualized rental revenue. For every $1.5 billion of acquisition volume to a single credit or industry, our rent exposure to that creditor industry will increase by approximately 2% compared to around 3% based on our current size. Spirit shareholders will benefit by being part of a larger platform as that same $1.5 billion acquisition would have resulted in a 13% exposure to that credit or industry and would have exceeded their revolving credit facility size by $300 million. We are excited to not only curate new relationships through this transaction, but to deepen existing ones. Our familiarity with many of the industries and clients within Spirit's portfolio provided us with a unique perspective as we underwrote the assets. To supplement our institutional knowledge and experience, we utilized our proprietary predictive analytics tool to layer on another level of review. The rigor of this analysis gives us conviction that the risk-adjusted return potential of this transaction is extremely compelling. We believe we are the natural buyer of this portfolio given our existing footprint and our proven track record of sourcing, underwriting and closing on large-scale transactions. In addition, I'm confident that the experience, talent and dedication of our team members will generate even more value from these assets in the future. We are humbled to continue to grow into a more prominent company within the public company investable universe. Post merger, we expect to enhance our position among the top 200 companies of the S&P 500. After giving effect to the merger agreement's fixed exchange ratio and the 3-month average daily trading volume of Realty Income and Spirit, we estimate the combined company stock could trade over $300 million of value on a daily basis, enhancing our position as 1 of the most actively traded REITs in the S&P 500. Our highly liquid share currency and increasing representation in key benchmark equity indices is expected to create natural demand for the stock through index rebalancing as almost 50% of our shares are currently owned by passive investors. Additionally, more trading volume will only add to our capital markets flexibility, allowing us to further grow our unparalleled capacity to access the capital markets in a highly efficient manner, another competitive advantage amplified through this merger. Our track record of accretive and well-timed acquisitions is reinforced by this transaction, which is the fourth large-scale real estate acquisitions we have completed over the past 12 months and is our third M&A transaction since 2013. We hope to continue demonstrating to the investment community that our growth levers are deep, differentiated from any other real estate sector and distinctive within the net lease sector. Before handing it over to Jackson, my team and I would like to extend our appreciation for the professionalism, responsiveness and collaboration. He and the Spirit Realty team have exemplified throughout the underwriting and diligence period. Together, we are confident that our collective shareholder base will realize immediate value from this transaction from both an earnings accretion perspective as well as a strategic one. Jackson?

Thank you, Sumit. As many of you know, upon my appointment as CEO in 2017, Spirit required an immediate corporate transformation to create the company you see today. Owing to the relentless efforts of our associates and the leadership team, along with the support from our Board of Directors, we've achieved commendable milestones. Our team members met every challenge and completely overhauled Spirit's processes, developing proprietary technology tools and systems that we believe will benefit the combined platform going forward. Our asset management-centric approach allowed us to rapidly sell and spin off over $4 billion of non-core real estate and replace them with high-quality tenants in well-located properties situated in diverse and durable industries. Finally, our BBB rated balance sheet with over $4 billion in below-market fixed-rate debt with well-laddered maturities provides tremendous value in the current high rate environment. Our merger with Realty Income is the culmination of all these efforts. With the Realty merger, Spirit's investors, including common and preferred stockholders and unsecured bondholders will immediately benefit from the improved cost and access to capital, along with Realty's A-rated balance sheet and impressive track record of dividend and earnings growth. I am confident that in the current macro environment being part of a larger and more diversified company with greater and more attractive access to capital will reduce risk and deliver growing cash flows to shareholders. With that, I'll turn it back to Sumit.

Thank you, Jackson. We are grateful for the support of all our stakeholders and are invigorated by the opportunity afforded to us through this transaction. In conclusion, I would like to recap 5 key takeaways to summarize the benefits realized from this transaction. First, this is an AFFO per share accretive transaction as we expect over 2.5% accretion with room for upside given our conservative underwriting. Second, Spirit's portfolio is highly complementary to ours, which augments diversification of industry and client exposure. Third, utilizing Spirit's portable capital stack with below-market debt enhances our implied investment spread on the transaction. Fourth, no new capital will be required to finance the transaction, a positive in today's capital markets environment. And finally, the transaction is leverage neutral, preserving our A3 / A- credit rating and maintaining each of our key leverage ratios. Thank you for your interest in today's exciting announcement, and we will now open it up for questions. Operator?

[Operator Instructions] The first question today comes from Michael Goldsmith from UBS.

Congratulations to everyone involved. Sumit, the first question is just on the size and scale that Realty Income is becoming. You're already the largest player, you're moving up the rankings in terms of size of REIT. So, can you just talk a little bit about how important scale is to you at this point? You also did the VEREIT integration not that long ago. And so you have reached experience on how adding size and scale can impact your platform. So maybe we outline like what you learned from VEREIT and then how you're going to -- how that's going to benefit you going forward?

Michael. Very good questions. If we step back and look at what Realty Income has done over the last 12 months, I think you will find that we've done close to $1 billion transactions -- $4 billion transactions. And what that is an indication of is how the sale-leaseback market globally is becoming more mature and growing. And companies large in size are now thinking of sale leaseback as a potential source of raising capital. And I think some of the transactions that we've talked about that we have shown to the market over the last 4 quarters is a testament to that comment. So size and scale continues to be incredibly important to be a true solution provider to these large companies. And 1 of the examples that we have put out in the investment deck that I think you should be able to find on our website, if we do $1.5 billion sale leaseback, in our current state, that would result in, call it, around 3% of rental concentration. Post this transaction, it will result in only 2%. And that's a 33% diversification benefit that this particular transaction continues to afford us. And I believe that the size of transactions, the solutions required by the market will only continue to increase. And therefore, we keep talking about the benefits of size and scale. I believe that the benefits of size and scale will continue to enhance over the next few years, as sale and leaseback becomes more and more mature as a product. In terms of the integration experience that you referenced, Michael, it is true. We've just come off -- I think it's been about a year now, 1.5 years since we closed on the transaction on VEREIT. VEREIT was obviously a much more complicated transaction because there was a spin that was involved as a precondition to closing, there was integration of systems, there was integration of people. This one is going to be a much simpler transaction of 2,064 assets. And even in terms of system integration, we're going to take a slightly different route, which will make this process a lot faster, a lot more efficient and one that we've obviously got a lot of experience on that we can lean on to make more efficient. And that's the reason why we believe assuming everything goes according to plan, that this transaction will close in the first quarter of next year.

And as my follow-up, this one is for Sumit and both -- Sumit and Jackson both, why does this transaction make sense now? And how much does this current interest rate environment and how interest cost of capital and where cap rates are, how much of that was a catalyst for this deal to get done now?

So Jackson, I'll take it first, and then I'll hand it off to you to share your perspective. Michael, the situation that we find ourselves in, in terms of the capital markets certainly has a role, but that is not the catalyst for doing this particular transaction. Once you see the proxy getting filed, you'll know that these discussions have been ongoing for a while well ahead of this environment that we find ourselves in. But the fact that we do find ourselves in this environment with very high interest rates and access to capital certainly being an issue for some of the companies out there. And cap rates adjusting and the time it takes for cap rates to adjust, the benefits of this particular transaction, I believe, is even more enhanced. The fact that we can generate north of 2.5% accretion without having to rely on the capital markets to finance this transaction, while resulting in a leverage-neutral transaction and being able to assume a balance sheet from Spirit, that is well below market in terms of cost. It's at 3.5%, almost 5 years of tenure. Those are all benefits that I believe is even further enhanced in this environment. But just to be very clear, it wasn't this particular situation that dictated this transaction. We've been in conversations well in advance of what we find ourselves in over the last, call it, 12 months. Jackson?

Yes. Thanks, Sumit. Michael, good question. I'll give you -- I'll answer it more different way for us, and I would agree with a lot of Sumit's comments on this. It was not a knee-jerk decision on our part. But going back to when I got promoted to CEO back in early May 2017, our Board leadership team, as I said earlier in my prepared comments and associates, they have literally relentlessly met each challenge and there were many, which has resulted in this quality company that you see today. And I would tell you that today, our company is operating at the best level since I joined the company. And also, when you look at total shareholder return from when I started Friday's close, we've got a TSR over 50%. So when you look at it, you say, "Oh, that's interesting. " As you know, earlier this year, we designed a business plan that was not reliant on raising new equity or debt capital, which allowed us to showcase the strength and diversity of our real estate and tenant base. And we've continued to outperform our 1% unidentified rent reserves throughout the year. Now in spite of all these accomplishments, Spirit has consistently traded at a discount to the net lease peer group. And when you sort of look at this recent stock market performance, given this increase in long-term interest rates, it's actually interesting that the actual spread between Spirit and Realty Income's equity multiple is narrowed. So in that case, you could say, well, it's made the current environment an ideal time to negotiate a stock for stock transaction, but that wasn't the real reason. I mean, there was other reasons, as Sumit said, we started this conversation earlier. Also, and it's been said many times, Spirit's assumable $4 billion of below market fixed rate debt enables a buyer like Realty Income to generate future meaningful AFFO accretion, which would otherwise not be achievable if they were required to issue new debt today on a long-term basis. And finally, I believe, this is personal opinion, that we believe is the Board that a transaction today with Realty Income could result as a catalyst for them to actually improve their equity multiple rating, which our shareholders will also benefit in. So we -- this -- that's the background of our conversation and decision-making.

The next question comes from Haendel St. Juste with Mizuho.

Good morning. I guess a very early good morning to you, Sumit. Can you add a little bit of color on if there's any provisions to this deal that you can make us aware of perhaps a go-shop breakup fee or color?

Sure. So Haendel, I believe our merger agreement is going to be filed later today, and you'll obviously find all the details. There is a non-solicitation window shop provision that is part of this deal, where people interested could come in within the first 30 days and the window shop provision is for a 45-day period. And then post 45 days, it basically is reliant on a shareholder vote. Obviously, our proxy being filed, which should take about 4 to 6 weeks from today. And then a shareholder vote and then post that, there's the closing. In terms of breakup fees, et cetera, the way it's been structured is that if it's within the window provision, it's 1.75%, which is roughly $93 million. If it happens post that period, it is 3.25%, which is roughly $170 million, maybe $190 million. I don't quite remember the number directly. But it's in that ZIP code. And those are the details around the non-solicitation window shop.

That's helpful. And 1 more. Maybe a bit more on the accretion here. I'm wondering if there's any other potential levers you can pull beyond the 2.5% accretion you've identified, any other -- I know you don't need to sell assets here, but are other assets perhaps that you've also may consider selling anything within the acquired portfolio you might be predisposed to selling like perhaps the office assets when you acquired VEREIT?

Yes. So the good news here, Haendel, is that the number of office assets are very, very few in this particular portfolio, and a lot of them have very long-term leases. If you recall from the VEREIT portfolio as well, we ended up having to keep 6 office portfolios because it was part of CMBS. It is also stated that office is not a long-term strategic hold for us. So we will continue to look to dispose of those office assets if and when the market presents itself, we don't feel a compulsion given how small a portion of our overall portfolio is going to represent. But yes, longer term, it is certainly not core to us. In terms of the accretion number, I just want to be very clear that -- we've obviously gone through all 2,064 assets and have done a bottoms-up analysis, used our analytic tools, used our team to underwrite all of the leases. And we've been conservative and I think appropriately so, given the backdrop that we find ourselves in. And that is the reason why we've been very careful about stating that the accretion is at the -- it's 2.5%, but with the expectation that it will be more than that, given how conservatively we've underwritten this particular portfolio. And what the conservatism comes in terms of reserves that we've taken and to represent basically the current market environment that we find ourselves in. In terms of actual recycling of assets, I don't believe that we will need to go above and beyond our normal recycling, which we've been doing every quarter, and it is a natural part of our asset management operations. So yes, that's how I would answer that question, Haendel.

The next question comes from Brad Heffern with RBC Capital Markets.

I can already hear investors saying that the deal just makes it harder for O to grow going forward. Obviously, some that you already said that the larger you get, the more opportunities that you see, but could you say what you would say to people that are incrementally more concerned about the ability for O to grow in the future post this deal?

Yes, Brad, there's very little I can do about that particular comment outside of continuing to prove every quarter that, look, there is a path for us to grow, and there's a path for us to do it in a way that I don't believe anybody else in our peer group can. And it's, again, goes back to some of the remarks I made in answering a previous question that sale leaseback as a product is certainly maturing. And you don't have to take my word for it. You can just take a look at some of the very large transactions that we've recently announced from the $1.5 billion EG sale leaseback that we closed on, the $900 million CIM portfolio. The close to $950 million Bellagio transaction that we talked about. There are some others that we are looking forward to discussing. We did a $1.7 billion sale leaseback that we closed on in the Encore transaction fourth quarter of last year. These are massive transactions and they require massive capital. And what a lot of folks will find themselves in taking on a particular transaction of this size is running into concentration issues, which is the primary reason why we've given examples of how this is a non-issue for a company our size. And the bigger we become the bigger a solution we can be for this ever-expanding need for capital. And especially at situations like this, like the one that we find ourselves in, where capital costs have increased, debt costs have increased, equity costs have increased, where the sale leaseback product could be viewed much more favorably. Now it is also true that our cost of capital is not what it was. But we've also seen in the past how cap rates do adjust and we are already starting to see elements of that, not white scale, but elements of that percolate through the market where we have transactions coming back to us because we were not willing to transact that given cap rate. So I think, it's a culmination of all of these factors that I believe being our size and scale will allow us to differentiate ourselves and continue to take advantage of our size. We have never viewed it and we don't view it, I know it's a sentiment that is not widely shared across the Board, but we don't view our size and scale as an impediment. In fact, we think of it as a massive advantage. It's 1 of the main reasons why we were able to go into the international markets in 2019. We had 0 investments, fast forward to today, we have $8.5 billion of investments in the international market. I mean all of that, I think, is a testament to size and scale. The fact that we were able to announce this transaction in this market condition, again, is all about size and scale and the balance sheet that comes with it. So we will win them over, Brad. Every quarter, 1 quarter at a time is how I think we're going to have to win this argument.

Okay. Okay. Thank you for the detailed answer on that, Sumit. Does this deal give you any capabilities that you didn't have or you were undersized in before? Obviously, when you did the VEREIT deal, you talked about gaining a team that had more experience in the higher yield strategy that would overlap with Spirit's capabilities. But just wondering if there's anything like that, that comes along with this deal?

I'm sure there will be, Brad. We just -- we haven't had a chance to actually look at some of the tools that Jackson has referenced and talked about with us. That will be the next phase of this project is to actually meet with a wide swath of folks from Jackson's team, evaluate some of the tools that they've created and that they are very proud of as they should be, given the results that they've posted and see if these tools are complementary to what we've already created, and along with the tools also hopefully consider some of the personnel to see if they could help us absorb some of these tools going forward. But it is too early to tell right now as to whether there will be applications or software that we are going to absorb as part of this process. But that journey begins today.

The next question comes from Eric Wolfe with Citi.

You mentioned that the interest on FSC's debt was 200 bps below your bond yields, which would imply like $120 million of extra interest expense at today's rates. Just curious how you thought about this in terms of the long-term accretion on the deal and whether the deal is still accretive on an asset flow basis since I assume that, that topic needs to be taken to market.

Yes. So obviously, this is well below where our bonds are trading today. Our bonds are in the mid-6s, maybe even the high 6s for an A3 / A- rated credit. The average on this 1 is right around 3.5%, and it's got a 5-year tenor. For us, the mark-to-market on this debt is absolutely true value. And though it doesn't filter through AFFO, we have largely focused on AFFO because it's a cash business. And that's not to discount the value that this brings. But obviously, it's an element of the capital stack that does not need to be addressed, assuming that we'll be able to assume all of this debt stack. And if your question, Eric, is what happens 4, 5 years from now when the debt starts to mature. I mean that's an issue that all of us are facing today. It's not unique to us. It's not unique to Spirit is going to be an issue that all companies that have debt that they've raised over the last 5, 10 years, when it comes due, it's going to have then current interest rate environment dictating whether there's value there or dilution there. So for us, for the next 4, 5 years, this is very good capital at well below market rates. And obviously, it helps with immediate accretion to our earnings and the pathway to that value creation is obviously over the next few years. But there's no doubt that the synergies on the G&A side is much more of a permanent value creation opportunity for the business.

That's helpful. And then you mentioned that you were conservative in terms of thinking about the reserves. So wondering if you could share your underwriting around the credit loss for SRC and if there are any sort of exposures that you'd like to sell more quickly? And if so, is that factored into the accretion now?

All of those things have factored into our underwriting, Eric. There's a reason why we keep saying at least 2.5% accretion. But it is also very true what Jackson shared, which was that they keep a 1% reserve and through the first 2 quarters, they haven't had to lean on any reserves. But obviously, our underwriting is more conservative. If you think about it and you look at what the public numbers are and you do your own math, you'll come to that conclusion very quickly, and you'll be able to back into the reserves that we've taken. And it's not reserved as an accounting reserve. It's just credit that we are keeping a close eye on, which will then lead to that next comment that you made about asset recycling. If there's a market and we can get ahead of it, there are certain assets that we will try to reposition. But there isn't any gun to our head, so to speak, which will push us into that asset recycling methodology. So we think we have the time. We believe we are underwriting it conservatively. And as we get more and more comfortable with the assets, some of the newer clients, that's going to dictate what the schedule is going to be in terms of asset recycling going forward.

The next question comes from Wes Golladay with Baird.

I just want to go back, maybe it was Haendel's question about doing something bigger. I mean do you -- is there anything you can do maybe create a fund out of this, maybe do -- obviously, you get a bigger industrial portfolio, having that. Does that do anything for you? Just trying to see what -- how 1 plus 1 can be even more?

I guess, $9.5 billion is not big, however, look, all of those opportunities that you just highlighted Wes, it's certainly on the table. Do we have to rely only on the public markets for equity going forward. Whether or not we did this transaction, that is a question that we often ask ourselves. And the answers are, no, we don't have to only rely on the public markets for equity. And there are other capital sources. There are some blue chip names in our space who have perfected being able to have access to these alternative capital sources. And so this is a natural progression that you will see Realty Income making in terms of diversifying its capital sources, including private sources of capital to help further enhance the platform that we have, actually monetize the platform that we have. So I think that's a legitimate question. It's one that we are asking ourselves every day. And it is one -- I don't have an answer for you today, but it is one that is being contemplated internally.

Got it. And then maybe -- I wouldn't get your view on something we always talk with investors about mark-to-market on debt and how valuable that is to a company, and obviously, there's G&A savings here as well. But I guess if you were to rank those 2, which would be more important in this deal, the mark-to-market or the G&A savings?