Realty Income Corporation (O) Earnings Call Transcript & Summary

We appreciate everyone being here for the Realty Income First Quarter Operating Results Conference Call. Presenting our results are Sumit Roy, President and Chief Executive Officer, along with Jonathan Pong, Chief Financial Officer and Treasurer. On this call, we might make statements deemed forward-looking under federal securities law. Actual future results for the company could vary materially from what is covered in any forward-looking statements. The factors behind such differences will be disclosed more thoroughly in the company's Form 10-Q; throughout the Q&A portion, a 2-question cap will be enforced so that all may have a chance to take part. Should you wish to pose further questions, you are welcome to rejoin the queue. At this point I'll hand things over to Sumit Roy, our CEO.

Thanks, Steve. Hello, everyone. The numbers we posted for the beginning of 2024 show how we concentrate on sensible, measured expansion, and they keep proving how steady our worldwide operations and acquisition engine really are. In our view, the case we make to investors is straightforward. We have shown we can produce reliable, positive operational returns no matter how volatile markets get or what shape the economy is in. Roughly 10% is the operational return profile we project for 2024, made up of an anticipated dividend yield near 6% plus AFFO per share growth of about 4.3%, assuming the guidance midpoint — that is what validates the case we make. To sum up what happened in the quarter, a few key points stand out. Number one, diversification. We diversify across geographies, asset types and client relationships; in our view, no other business model in real estate matches ours, since we can choose to expand in various regions by putting money into a wide range of real estate products wherever we find better risk-adjusted returns. In Q1, we deployed $598 million at an initial weighted average cash yield of 7.8%, spread over 3 property types: retail, industrial and data centers. More than half of that total — about $323 million — went into Europe and the U.K. at an 8.2% initial weighted average cash yield. U.S. investment volume stayed modest in the quarter. Out of the $275 million deployed in the U.S. at a 7.3% initial weighted average cash yield, only $16 million went anywhere other than previously committed development takeouts. The tilt toward international volume this quarter proves how many different geographies we weigh when deciding where capital should go. To go a bit further, the quarter's investment activity was made up of 87 discrete transactions, 3 of which exceeded $50 million, which says a lot about how broad our platform is. Whatever growth vertical or new region we pursue, what we ultimately aim for is being a real estate partner to the world's leading companies and making sure the investment result fits the steady risk-return profile of our investments, which have stayed resilient across almost 5 decades as an operating company and 3 decades as a public company. Number two, our portfolio's health is still solid on every key operational metric. We closed the quarter at 98.6% occupancy, matching both the previous quarter and what we had projected. And we turned in another strong leasing quarter, with rent recapture of 104.3% across the 198 leases renewed or re-leased in the quarter. When the quarter ended, tenants on our credit watch list accounted for roughly 5.2% of total portfolio annualized rent, which matches our historical average, and no single client made up more than 1% of total portfolio annualized rent. So we would point to how diversified our portfolio is: it now includes over 1,500 clients across all 50 states, the U.K. and 6 other countries in Western Europe, and all of that helps shield us from possible disruptive interest rate and credit events that might threaten how durable our cash flow is. And lastly, our balance sheet, along with our ability to access capital, keeps serving as a key competitive edge and gives us considerable room to maneuver when it comes to funding the business without relying on outside capital. Once the Spirit merger wrapped up in January, the free cash flow we generate on an annualized basis that's available for investments comes to roughly $825 million; that hands us substantial capacity for organic investment to bankroll our growth plans without having to go to the debt or equity markets to satisfy current investment guidance. I'd point out as well that this figure doesn't include any extra capacity that comes out of our disposition program, which I'll get into later. Even with the capital markets being volatile, we recorded a nominal first year investment spread of more than 340 basis points during the first quarter, far above the roughly 150 basis points spread we've seen historically. What mainly drives these outside spreads is the sizable share of investment volume that gets funded through free cash flow, and since that's a nondiluted capital source, it brings down our nominal first year cost of capital in a meaningful way. To put it plainly, we still make investment decisions grounded in our long-term weighted average cost of capital, which takes into account only our cost of stock for equity and long-term 10-year unsecured debt. That sets the minimum return hurdle we aim to beat across our aggregate investment activity. In every instance, our long-term WACC has come in above our nominal first year cost of capital when it comes to our transactions. It's this long-term oriented underwriting model that fuels our emphasis on buying high-quality real estate, leased to solid operators who lead in their respective industries, since we think these opportunities carry significantly lower residual risk — value risk. Beyond that, to hit our longer-term growth hurdle rates, we're placing growing priority on meaningful contractual rent escalators in our leases, paired with conservative rent coverage metrics that we expect will prove even more resilient across a range of economic cycles. To sum up, activity in the transaction market is still uneven. A lot of potential sellers of real estate are staying on the sidelines because of this uncertain interest rate environment, which gets amplified by mixed inflation-related data over the last 6 months. Sellers are still hesitant to transact, and the breadth and depth of domestic investment opportunities have narrowed as a result. That said, as we've seen in prior cycles, we're still optimistic the market will deliver more opportunities in the second half of the year as the economic outlook becomes clearer. Moving to portfolio operations. As noted earlier, our recapture rate came in at 104.3%, which contributed to same-store rent growth of 0.8% in the first quarter. If you set aside the negative impact from our Sinovel theater portfolio, after the lease amendments were finalized late last year, our same-store portfolio rose 1.4%, mostly consistent with the contractual rent growth built into our portfolio. One of the competitive advantages we hold in the marketplace is our asset management and real estate operations functions, made up of over 80 individuals who we consider among the most talented in the industry. Ever since our 1994 IPO, we've resolved more than 6,000 lease expirations, achieving a blended rent recapture rate of 102.5% — clear evidence of our acquisition underwriting, the quality of our real estate, and the scale of our asset management and real estate operations teams. In the quarter, we disposed of 46 properties, generating total net proceeds of $95.6 million. These recycling efforts stem from a more active investment management initiative. Our proactive approach to dispositions is backed by our proprietary predictive analytics platform; over recent years, we've drawn on the combined efforts of our predictive analytics team, the credit underwriting group, and fundamental input from our asset management group to shape our acquisition strategy. We think the combined advantages of these 3 groups set us apart significantly in the industry, thanks to the volume of data we've collected across our portfolio throughout our long operational history. So now, alongside our acquisition program, we're applying that data to manage the portfolio more proactively and steer our active disposition program. I'll now hand it over to Jonathan, who will provide more detail on the quarter.

Thanks, Sumit. Things have been pretty calm so far this year in the capital markets, after our U.S. dollar bond offering in January brought in $1.25 billion in gross proceeds, with a blended yield to maturity of roughly 5.14%. As we mentioned on our last earnings call, our 2024 financing plan doesn't call for any extra capital to fund our growth and acquisition needs. That's still true under the investment guidance we have right now. Along those lines, we posted another quarter with a net debt and preferred equity, annualized pro forma adjusted EBITDA ratio of 5.5x, which matches our target ratio. In the quarter, we settled about $550 million of equity that had been raised earlier through our ATM program and was outstanding on a forward basis. That leaves us with roughly $63 million of outstanding equity available for future settlements; and together with about $825 million of annualized free cash flow available to us after the Spirit merger, plus the disposition program Sumit mentioned, we think our $2 billion investment guidance for the year can be funded without going to the markets. Our debt maturity schedule for the rest of the year is modest, at approximately $469 million of remaining maturities, excluding $342 million of short-term commercial paper and revolver borrowings and of cash. As always, we aim to keep significant financial flexibility to fund known and identified liquidity, and with about $4 billion of total liquidity available to us and minimal berate debt exposure on the balance sheet, we believe we can refinance these maturities while still retaining significant liquidity headroom and keeping beverage debt exposure well below 10% of our debt capital stack through the rest of the year; with that, I'll hand it back to Sumit for closing remarks.

Thanks, Jonathan. So all in all, we've gotten off to a good beginning this year, and it lines up with what we were expecting. For the rest of the year, the way our earnings should grow stays right in line with the outlook and the earnings guidance we provided back in February. The slower level of activity during the first quarter is a result of how we've allocated capital for a long time, and as cap rates move in response to where rates are now, we'll keep being selective. At the same time, the internal funding levers available to us — free cash flow and capital recycling in particular — let us keep putting money to work at spreads that are comfortably above 200 basis points while keeping leverage neutral. With roughly 4% projected growth in AFFO per share, together with an estimated annualized dividend yield of about 6%, that's why we think our platform gives investors one of the most attractive opportunities available in the S&P 500. With that said, let's open things up for questions.

Could you give us some color on how the pipeline stands right now and what pricing has looked like so far in 2Q? Which areas carry the most weight in that pipeline? I realize the sample is quite small, but yields in Europe during the quarter looked pretty attractive. Is there anything worth calling out there?

Appreciate that, Nate. Good question. What we're observing in the U.S., I'd say, stems mostly from uncertainty over the direction of rates. The timing of when cuts actually arrive remains unclear, and that ties back to the mixed data we've watched unfold across the last 6 months, which is what's driving the uncertainty. In our sector, this shows up as sellers hesitating to transact at levels that reflect today's cost of capital environment. For us, one of the strengths we offer is that we operate across multiple geographies, and right now we're finding notably better risk-adjusted return opportunities in Europe, where the data has been far more consistent, which makes it much more feasible to actually transact with prospective sellers. That largely explains why 54% of the volume showed up in Europe rather than in the U.S. Given that your question focused specifically on the pipeline as it stands and our expectations for the second quarter, my guess is the results will carry a similar tilt. That said, I do think we should begin to see considerably more transactions get done in the second half of the year. I know the team is in active discussions with a number of prospective sellers, though the sticking point tends to be where prospective sellers set their reservation price. Still, we believe that once the picture clears up somewhat regarding what happens with rates and when those possible cuts actually come through, the U.S. transaction market will close the gap.

All right, that helps. Now, may I ask just one more thing regarding tenant credit? Which names are on the watch list at this moment that we ought to be monitoring, and perhaps you could address Red Lobster in particular, since it has been in the headlines lately.

Certainly. Regarding those presently on our watch list, Rite Aid accounts for roughly 31 basis points of rent. That company is still working its way through bankruptcy. We remain quite optimistic that it will come out of bankruptcy before long. That said, as I mentioned, it makes up only a tiny share of our portfolio as a whole. Joanne is another name that was on our — that is on our watch list; it accounts for 4 basis points of rent, and we expect that all 6 leases will be assumed with 100% recapture, simply given how they intend to emerge from bankruptcy. Any other name on our watch list is below 4% among the names presently in bankruptcy. So it is — clearly, it is a very, very small share of our watch list overall. The names not on — not presently in bankruptcy but still drawing considerable attention internally include Red Lobster, which you just brought up. We hold approximately 216 leases; that equals 1.07% of our rent. Cash flow coverage across all 216 assets stands at about 2x, and 201 among those 216 leases are in fact included in a master lease. So I wanted to set out our exposure to Red Lobster before providing some detail on the name itself. In my view, Red Lobster is — it is quite an unusual story. They operate 700 distinct locations; they capture 14% of the casual seafood category. That is extremely difficult to achieve. And the fact that they bring in more than $2 billion in revenue, when viewed on a per unit basis, comes to just about $3.5 million per unit. So the problem isn't top line so much as it is operations. They have been through multiple ownership changes. Clearly, there have also been multiple management changes. And in our view, this is a business that has not been run particularly well. If you examine the balance sheet, is the issue at Red Lobster a balance sheet problem. In our view, it is not. They carry $220 million of debt, and the real question is whether an operator exists who could step in and essentially run this business even at a sensible level of margins. As of today, I don't think they are producing a great deal of EBITDA; even so, our 200 assets carry 2x coverage. That ought to indicate to you that we clearly hold assets that rank among the finest in their portfolio. So if it can be straightened out from an operations standpoint, our belief is that this idea ought to make it, ought to stick around, and ought to perform pretty well, considering the presence they've managed to build. That's how we see it. We're watching it closely. On the rent side, we've brought in every dollar owed to us through May — 100%. So we'll wait and see, though it does happen to sit on our watch list.

Could you share additional specifics about that active disposition initiative you mentioned — for instance, which industries or target volumes are involved, and what method you use to pick properties for recycling?

Absolutely, Greg — that's a fair question. Our goal is to complete somewhere in the neighborhood of $400 million to $500 million in asset sales during this year. Precision is difficult here, since market conditions play a role in how much we get done. We anticipate that occupied sales will split with vacant asset sales at roughly 50 to 50. As everyone saw, during the first quarter, vacant asset sales made up a much larger share. Of the $96 million total, I believe $82 million came from vacant asset sales, while $14 million was occupied. What we're deliberately attempting, though, is to move ahead of certain properties that end up on our watch list. A credit problem isn't always the reason; occasionally it's strictly a real estate matter that our asset management team has determined lacks a long-term position within our overall portfolio. Beyond that, there are particular trends we're noticing — based on conversations with clients and so on — that we want to stay in front of, which also lets us act far more proactively and address situations long before they turn into problems further down the road. Regarding the specific concepts involved, they follow the pattern of what we've already been selling. A portion consists of automotive services. We have some drug stores that, in our view, don't fit the overall strategy. Another portion will be the Cineworld assets — and incidentally, the sale process there is progressing, I'd say, better than we had anticipated. Then there are others that, as I mentioned, aren't central to our overall strategy on the discount store side either, and we want to get ahead of those; those are the pieces that will form what we aim to dispose of during this year.

All right. So that $400 million to $500 million — does that represent the whole initiative? Is it just an initial phase? And when you look at how that stacks up against the acquisitions you're aiming for this year, what could that imply for growth in 2025?

Well, we need to carry out our plan around what we see as the correct portfolio to bring us into 2025 from a position of strength. Our business has expanded via M&A. In the last 2.5, 3 years, there were 2 really big M&A transactions; I think we've been quite transparent that not every one of those assets was central to our long-term strategy. So part of this is mostly about working back toward that core portfolio. Clearly, we have underwritten the effect of 50% of approximately $400 million to $500 million in dispositions being occupied assets. But what you'll see is that a number of these assets are in fact being sold. Consider what we sold or — and I realize it wasn't a large figure, but the occupied assets, we did sell those at a 7% cap rate, cash cap rate, and we're putting that money back to work at 77%. So it's genuinely an accretive disposition strategy that we've managed to carry out at least during the first quarter; so for us, it comes down to building the portfolio we want as we head into 2025 and beyond; and this is an initiative that will be consistently carried out moving forward. Whenever we do sale leasebacks, there's no problem. Whenever we do portfolio transactions on existing leases, we don't always get 100% of what we're after. And so being somewhat more proactive about pruning the assets that aren't central to our overall strategy from the outset is something I think we'll be far more intentional about. But we feel quite good about our capacity to keep growing in spite of the strategy in 2025 and beyond.

This is Daryl calling in for Josh. Could you shed some light on what the current bad debt trend looks like? I'm aware you touched on the watch list. And maybe whether your view has shifted regarding how much bad debt is factored into guidance?

Jonathan Pong here — regarding that bad debt figure, we did report it in the Q1 earnings press release, and the amount we recognized came to roughly $1.4 million. When we consider forward-looking guidance along with downside scenarios, I believe our past statements make it clear that our approach has been very conservative. Sitting here now, it's early May, and there's still a considerable stretch remaining until the year wraps up — that isn't meant to suggest anything seriously worrying. You likely picked up some discussion regarding the watch list, which consists of a number of minor items that, should each one turn out favorably, might collectively matter somewhat, though that's definitely not the scenario we anticipate there. So really, I'd say it's a combination of spirits assets we acquired — ones we've consistently viewed with a bit more caution, and that caution will remain until we're deeper into the year. For our part, we tend to stay quite conservative when it comes to bad debt expense, particularly in the earlier part of the year; and lastly, there are certain identified credits that are even more so.

Sure. So, regarding your second question — considering the cap rates you’re observing in Europe as acquisitions come off — has your thinking or thesis shifted when you consider development and the yield you might achieve from that compared to straightforward acquisitions?

No, Daryl, it really comes down to timing. As older-vintage developments begin to roll off, you’ll start to see that some of the newer projects we’ve committed to better reflect the current cost of capital environment. As a result, the cash cap rate yields we anticipate from that vintage should gradually increase. The thing is, we started our development pipeline 12, 18 months ago. Obviously, some of those assets reflected the environment we were in at that specific time. But even at a 7.2% cash cap yield — which is what our development delivered in the first quarter — that’s still around 150 basis points, 170 basis points of spread. So yes, it’s not quite the $78 million we managed to achieve overall, and certainly not the 8.2% we achieved in Europe. But I just wanted to ensure you’re aware there’s a bit of a lag in the development pipeline, and the developments we’re entering into today much better reflect the current environment.

If we return to those European cap rates, it truly seemed as though that region had trailed America for quite a while when it came to acknowledging the elevated rate setting. I'm grateful that conditions there have been somewhat steadier. Yet has anything else shifted across Europe that is currently producing such appealing cap rates, even though the expense of borrowing is clearly cheaper than in America?

Indeed, Brad, borrowing costs are definitely more favorable in Mainland Europe. That isn't the case in the U.K. I'd suggest stacking them side by side, John. Jonathan is agreeing with a nod. So the major distinction we observe, and the reason prospective sellers are prepared to complete deals at the yields we managed to achieve, comes down to two things. First, certain funds have faced redemption strain and must turn real estate into cash, and they are entirely ready to mirror today's cost of capital conditions since they require that money. Second, and this genuinely benefits us, is that we've built a reputation as the preferred purchaser for these kinds of properties, and they know that the certainty of completion, which matters greatly to these prospective sellers, will be delivered. That standing truly works in our favor whenever we're engaged in such discussions, and someone needs capital soon, and we can finalize these deals at whatever moment we settle on a given price. I believe those 2 elements are what let us do so well in the U.K. and across Europe, and that's how the situation is unfolding. Over here, sadly, you don't encounter comparable strains. Sure, there may be operators open to making a deal. However, if they can afford to hold off, which in America they have far more options, they tend to remain on the sidelines awaiting better conditions so that prospective buyers can eventually secure the cap rates at which they're prepared to transact. So that's how I'd explain the reasons behind our success. One factor is clearly very specific to us, while the other mirrors the broader market.

All right, understood. And moving to Dollar Tree Family Dollar, could you take us back through how the Family Dollar split breaks down? Also, please address whatever effect the store closures could have on you.

Sure. Honestly, I wouldn't describe the effect on our side as outsized. Roughly 3% of our rent comes from Dollar Tree, Family Dollar — that exposure is to Dollar Tree, which clearly is the parent of Family Dollar. Then I'd estimate around 60%, approximately 60%, is Family Dollar, while the remainder consists of either Dollar Tree or the combined banners they operate. Of that 3.3%, there's something like — I'd put it at 3%. That works out to 9 basis points of lease expirations materializing across the coming 2 years, 2.5 years. So regardless of those closures happening, and regardless of certain of those assets appearing on the closing list, the effect on us comes to essentially 9 basis points. And I can tell you our asset management team is already pursuing resolutions, since this sits within the pipeline. Whatever falls outside that could end up closed and stay dark. Rent will still be coming to us; and beyond that, the strain on Family Dollar and Dollar Tree will be far sharper than whatever strain lands on us. We'll be looking to locate a replacement that can come in and assume those leases. And on a case-by-case basis, we've gotten a decent amount of interest in certain of these sites, simply following some of the reporting circulating regarding possible closures and so forth, which leaves us feeling fairly confident in our capacity to resolve the Family Dollar assets. One more point worth adding, perhaps not obvious: Family Dollar locations tend to sit in urban markets and in far more densely populated places compared with Dollar Tree or Dollar General. That makes those sites considerably more appealing to other retail tenants — and the inbound interest we've gotten confirms it. So from our standpoint, this is really no different from finding out far ahead of time that, hey, these specific leases won't be renewed, which gives us room to address certain of them long before the actual lease expiration arrives. That's the way I'd put it.

This is Catherine Graton here with Michael. To start off — you mentioned a bit of this during your opening remarks, but could you perhaps give us a little additional detail on how the cost of free cash flow fits into the way you look at your investment spreads?

Absolutely. That's a wonderful question. From our standpoint, free cash flow represents an enormous benefit. Being able to generate $825 million in free cash flow after all obligations basically gives us capital that can be deployed into many different areas to grow our earnings accretively. Of course, whenever free cash flow is available, we need to determine the optimal way to deploy it. We have options like repurchasing our debt, repurchasing our stock, or continuing to invest accretively; and when we determine that accretive investing is the optimal deployment of that capital — that's an enormous benefit. And in a year when we're pointing to the fact that we have $2 billion of acquisitions, and we're hoping to surpass that, though that figure represents our guidance at present. Having the capacity to fund this business through $825 million of free cash flow, which clearly is nondilutive, while growing our earnings is an enormous benefit; that's our framework for thinking about free cash flow. There is, clearly, an opportunity cost tied to this. But our approach to opportunity cost is asking what the optimal deployment of this capital is. And from our perspective, even in the current environment, with the platform we possess, and with the diversification advantages that come from being able to invest across many asset types in many geographies, we keep identifying accretive deployment of this particular cash flow; and I believe, clearly, another element we examine is the long-term overall return profile. And that's what we measure against our long-term WACC, meaning our cost of equity, that 65%, and our cost of debt, which is 35%. And regarding the cost of equity — incidentally, we have a few pages covering this in our investor deck. It's mostly determined by the CAPM model and the dividend growth model. And I think we average the two to arrive at our effective long-term cost of equity along with the long-term cost of debt, weighted 65%, 35%. And every investment we make must reach that hurdle rate and surpass that hurdle rate before we proceed. So that's essentially our framework for thinking about cost of capital and how we specifically approach free cash flow, which clearly we regard as an enormous benefit for us.

Understood. My follow-up concerns the development side. Should we anticipate a pickup in yields from your development projects as 2024 moves along, or perhaps even heading into 2025?

Yes, we do. Every fresh development we undertake — and I believe this same point came up from someone else — ought to better mirror where the cost of capital stands right now. As you're aware, many of these projects carry a certain lag time. So the deals closing at present sit in that lower 7% ZIP code. What ought to come through across the coming few quarters, though, is that cash cap rate keeping its climb toward considerably higher levels, mirroring the present cost of capital.

My first question has to do with the European deals you completed during the quarter and what those assets yield. Could you expand on the types of built-in rent escalations those properties carry? What portion consisted of conventional single-tenant net lease arrangements as opposed to assets with multiple tenants? The reason I ask is that the duration struck me as somewhat short.