Realty Income Corporation (NYSE:O) Q1 2024 Earnings Call Transcript

Realty Income Corporation (NYSE:O) Q1 2024 Earnings Call Transcript May 7, 2024

Realty Income Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, and welcome to the Realty Income Q1 2024 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would like now to turn the conference over to Mr. Steve Bakke, Senior Vice President of Corporate Finance. Please go ahead.

Steve Bakke: Thank you all for joining us today for Realty Income’s first quarter operating results conference call. Discussing our results will be Sumit Roy, President and Chief Executive Officer; and Jonathan Pong, Chief Financial Officer and Treasurer. During this conference call, we will make 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. You’ll disclose in greater detail the factors that may cause such differences in the company’s Form 10-Q. We will be observing a two-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.

Sumit Roy: Thank you, Steve. Welcome, everyone. Our results for the start of 2024 illustrate our focus on thoughtful, disciplined growth and continue to demonstrate the consistency of our global operating and acquisition platform. We believe our value proposition to investors is a simple one. Our demonstrated ability to generate consistent positive operational returns regardless of market volatility and economic environment. Our projected 2024 operational return profile of approximately 10%, which comprises an anticipated dividend yield close to 6% and AFFO per share growth of approximately 4.3%, assuming the midpoint of guidance is a validation of our value proposition. To summarize the results from the quarter, we would highlight several key takeaways.

First, diversification. Diversification by geography, asset types and client relationships. We believe our business model is unique in the real estate sector as we have optionality to grow in different regions with investments in a multitude of real estate products where we see superior risk-adjusted returns. During the first quarter, we invested $598 million at an initial weighted average cash yield of 7.8% across three property types: retail, industrial and data centers. Over half of this volume representing approximately $323 million was invested in Europe and the U.K. at an 8.2% initial weighted average cash yield. Investment volume in the U.S. was modest during the quarter. Of the $275 million of U.S. volume, which was invested at a 7.3% initial weighted average cash yield all but $16 million was invested in previously committed development takeouts.

This quarter’s bias towards international volume is a testament to the diversity of geographies we consider to allocate capital. To further elaborate, our investment volume during the quarter consisted of 87 discrete transactions with three transactions over $50 million, which speaks to the breadth of our platform. Our ultimate focus with any growth vertical or new region is to serve as a real estate partner to the world’s leading companies and to ensure the investment outcome matches the consistent risk return profile of our investments, which have proven resilient over almost five decades as an operating company and three decades as a public company. Second, the health of our portfolio remains solid across all key operational metrics. We finished the quarter with occupancy of 98.6% consistent with the prior quarter and our projections.

And we delivered another strong leasing quarter with rent recapture of 104.3% on the 198 leases that we renewed or re-leased during the quarter. At quarter end, our list of tenants on the credit watch list comprise approximately 5.2% of total portfolio annualized rent, which is in line with our historical average and with no individual client representing more than 1% of our total portfolio annualized rent. Consequently, we would highlight the diversification of our portfolio, which today consists of over 1,500 clients in all 50 states, the UK and six other countries in Western Europe, all of which helps insulate us from potential disruptive interest rate and credit events that could impact the durability of our cash flow. Finally, our balance sheet and access to capital continues to represent a major competitive advantage and affords us significant flexibility to fund our business without the need for external capital.

After the Spirit merger closed in January, our annualized free cash flow available for investments is approximately $825 million. This provides us significant organic investment capacity to finance our growth plans without being required to tap into the debt or equity markets to meet current investment guidance. I would also note this also excludes any additional capacity generated by our disposition program, which I will discuss later. In spite of volatility in the capital markets, we posted a nominal first year investment spread of over 340 basis points in the first quarter, which is well above our historical spread of around 150 basis points. The primary driver of these outside spreads is the significant portion of investment volume funded to free cash flow, which by virtue of being a non-diluted source of capital, meaningfully reduces our nominal first year cost of capital.

To be clear, our investment decisions remain based on our long-term weighted average cost of capital, which considers only our cost of stock for equity and long-term 10-year unsecured debt. This establishes the minimum return hurdle we seek to exceed across our aggregate investment activity. In all cases, our long-term WACC has exceeded our nominal first year cost of capital with respect to our transactions. This long-term oriented underwriting model is what drives our focus on acquiring high-quality real estate, leased to solid operators who are leaders in their respective industries, because we believe these opportunities have significantly lower residual risk — value risk. In addition, to reach our longer-term growth hurdle rates, we are increasingly prioritizing meaningful contractual rent escalators in our leases with conservative rent coverage metrics that we believe will be even more resilient through a variety of economic cycles.

In summary, activity in the transaction market remains uneven. Many potential sellers of real estate remain sidelined, given this uncertain interest rate environment, which is amplified by mixed inflation related data over the last six months. Sellers remain reluctant to transact and the breadth and depth of domestic investment opportunities have compressed as a result. However, as experienced in prior cycles, we remain optimistic that the market will provide more opportunities in the second half of the year as the economic outlook becomes clearer. Turning to portfolio operations. As previously mentioned, our recapture rate was 104.3%, contributing to same-store rent growth of 0.8% in the first quarter. Excluding the negative impact from our Sinovel theater portfolio, following the lease amendments finalized late last year, our same-store portfolio was up 1.4%, largely in line with the contractual rent growth embedded in our portfolio.

One of our competitive advantages in the marketplace is our asset management and real estate operations functions, consisting of over 80 individuals who we believe are among the most talented in the industry. Since becoming a public company in 1994, we have now resolved over 6,000 lease expirations at a blended rent recapture rate of 102.5%, which is a testament to our acquisition underwriting, quality of our real estate and the scale of our asset management and real estate operations teams. During the quarter, we sold 46 properties for total net proceeds of $95.6 million. Our recycling efforts are a function of a more active investment management initiative. Our active decision-making on dispositions is supported by our proprietary predictive analytics platform.

In recent years, we have harnessed the collective contributions of our predictive analytics team, the credit underwriting group, and the fundamental input from our asset management group to inform our acquisition strategy. We believe the combined benefits of these three groups provide us a significant differentiation in the industry as a result of the quantum of data we have gathered across our portfolio over our long operational history. So now in addition to our acquisition program, we are using the data to more proactively manage the portfolio and guide our active disposition program. I will now turn it over to Jonathan, who will add further color to the quarter.

Jonathan Pong: Thank you, Sumit. It’s been a quiet start to the year on the capital markets front, following our January US dollar bond offering, which raised $1.25 billion in gross proceeds at a blended yield to maturity of approximately 5.14%. As introduced in our prior earnings call, our financing strategy for 2024 does not require incremental capital to finance our growth and acquisition needs. This continues to be the case at our current investment guidance. To that end, we had another quarter with a net debt and preferred equity, annualized pro forma adjusted EBITDA ratio of 5.5 times, that’s in line with our target ratio. During the quarter, we settled approximately $550 million of equity previously raised through our ATM program, and which was outstanding on a forward basis.

This leaves us with approximately $63 million of outstanding equity available for future settlements. And when combined with approximately $825 million of annualized free cash flow available to us following the Spirit merger, and the disposition program that Sumit referenced, our $2 billion investment guidance for the year is one, we believe can be funded without having to tap the markets. Our debt maturity schedule for the remainder of the year is modest, with approximately $469 million of remaining maturities, excluding $342 million of short-term commercial paper and revolver borrowings and of cash. As always, we look to maintain significant financial flexibility to fund known and identified liquidity and with approximately $4 billion of total liquidity available to us and minimal variability debt exposure on the balance sheet, we believe we can refinance these maturities while still retaining significant liquidity headroom and keeping ydebt exposure well below 10% of our debt capital stack through the balance of the year.

With that, I’ll turn it back over to Sumit for closing remarks.

Sumit Roy: Thank you, Jonathan. In summary, the year is off to a solid start that is in line with expectations. Our earnings growth profile for the balance of the year remains consistent with our outlook and earnings guidance we gave in February. The tempered pace of activity in the first quarter reflects our long-standing capital allocation discipline, and we will remain selective as cap rates adjust to the current rate environment. In the meantime, the levers we can exercise from an internal funding standpoint, in particular, free cash flow and capital recycling, allow us to continue investing at spreads well over 200 basis points on a leverage-neutral basis. Our approximately 4% AFFO per share projected growth rate, paired with our estimated annualized dividend yield of approximately 6% is why we believe our platform offers one of the most compelling investment opportunities in the S&P 500. With that, I would like to open it up for questions.

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Q&A Session

Operator: We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Nate Crossett with BNP. Please go ahead.

Nate Crossett: Hey, good afternoon. I was wondering if you could just talk about the current pipeline what does pricing look like so far into 2Q? Where is the pipeline weighted? And I know it’s this most sample size, but pretty attractive yields in Europe in the quarter. Is there anything to note there?

Sumit Roy: Thanks, Nate. Good question. I think what you’re seeing here in the U.S. is largely a confusion around where the rates are going. When will the rate cuts materialize and it’s a function of what we’ve seen play out over the last six months in terms of mixed data that is causing this confusion. And the way it’s manifesting in our space is this reluctance of sellers to transact at what is reflective of the cost of capital environment today. And so for us, this is one of the advantages we bring to the table is we play in multiple geographies. And we are seeing much better risk-adjusted return opportunities in Europe today, where the data has been a lot more consistent, and therefore, the ability to transact with potential sellers much more real.

And that’s kind of the reason why you’ve seen 54% of the volume manifest itself in Europe versus here in the US. And I suspect, because your question was very specific around the current pipeline and what we think will happen in the second quarter, I suspect it will be a similar slant to the results. But I do believe that the second half of the year, we should start to see a lot more transactions materialize. I know that the team is actually in conversations with multiple potential sellers, but the disconnect happens to be where that reservation price is for potential sellers. But we do believe that once the environment becomes a little clearer in terms of what’s going to happen with rates and when will those potential rate cuts come to fruition, I think the transaction market in the US will catch up.

Nate Crossett: Okay. That’s helpful. And then if I could just ask one on the tenant credit side. What’s on the watchlist right now that we should be tracking and maybe you could speak to Red Lobster, specifically because that’s been in the news recently

Sumit Roy: Sure. So the ones that we currently have on our watchlist, Rite Aid, that represents about 31 basis points of rent. It’s still going through bankruptcy. We are very hopeful that it will emerge from bankruptcy soon. But like I said, it’s a very small portion of our overall portfolio. Joan is another one that was on our — is on our watchlist. That represents 4 basis points of rent and our expectation is that all six leases are going to be assumed at 100% recapture, just given the way they’re planning on emerging from bankruptcy. Every other name that’s on our watchlist is sub-4% in terms of names that are currently in bankruptcy. So it’s a — it’s obviously a very, very small portion of our overall watchlist. The ones that are not on — not currently in bankruptcy but continue to garner a fair amount of interest here internally, is Red Lobster, the one that you just mentioned.

We have about 216 leases. It represents 1.07% of our rent. The cash flow coverage that we have across all 216 assets is right around two times and 201 of these 216 leases happen to be part of a master lease. So I just wanted to frame our exposure to Red Lobster, before I go into some color around the name itself. I think of Red Lobster is — it’s a pretty strange story. They have 700 unique locations. They garner 14% of the casual seafood concept. That is a very hard thing to do. And the fact that they generate north of $2 billion in revenue, if you look at it on a per unit basis, that’s just right around $3.5 million per unit. So it’s not a top line issue, as much as it is an operations issue. They’ve gone through several changes in terms of ownership.

Obviously, there have been several changes in terms of management. And this is a business that, in our opinion, hasn’t been very well run. If you look at the balance sheet, is it a balance sheet issue at Red Lobster. In our opinion, it’s not. They have $220 million of debt and this is really a question of, is there an operator out there that could come in and basically manage this business even to a reasonable level of margins. Today, I don’t believe they’re generating a whole lot of EBITDA. But having said that, our 200 assets has two times coverage. So that should tell you that we obviously have assets that are some of the best assets in their portfolio. And so if this can be operationally rightsized, we believe that this is a concept that should come out, and should survive and do quite well, given the footprint that they’ve been able to establish.

So, that’s our view. We are keeping a close eye on it. As far as rents are concerned, we’ve collected 100% of the rents due to us as of May. So, it’s a wait and see, but it does happen to be on our watch list.

Operator: The next question comes from Greg McGinniss of Scotiabank. Please go ahead.

Greg McGinniss: Hey Sumit. Are you able to provide more details on the active disposition program you’re talking about maybe in terms of targeted volumes industries or how you’re identifying assets for recycling?

Sumit Roy: Sure. Good question, Greg. So, what we are hoping to achieve is circa $400 million to $500 million of asset dispositions this year. We can’t be very precise around it because part of it is a function of the market. We expect that the occupied sales and the vacant asset sales is going to be approximately 50/50. Obviously, in the first quarter, it was disproportionately vacant asset sales. I think $82 million of the $96 million was vacant asset sales, $14 million were occupied. But what we are trying to do is intentionally get ahead of some of these assets that happen to be on our watch list. And not always is it being driven by a credit issue. It’s — sometimes it is purely a real estate issue that our asset management team has concluded, does not have a long-term position in our overall portfolio.

And then there are certain trends that we are seeing that we want to try to get ahead of based on client conversations, et cetera, that is also going to allow us to be a lot more proactive and get ahead of situations, well in advance of it becoming an issue downstream. In terms of the actual concepts themselves, it is along the lines of what we have been selling. Some of it is automotive services. There are some drug stores that we believe are not part of the overall strategy. Some of it is going to be the Cineworld assets that, by the way, the sale process is going, I would say, ahead of what our expectations were. And then some that are perhaps not, like I said, core to what our overall strategy is on the discount store side as well that we want to try to get ahead of.

So, those are the components that will make up what we want to try to get disposed of this year.

Greg McGinniss: Okay. And is that $400 million to $500 million the kind of entirety of the program? Is that a first step? And then how are you thinking about as that compares to the level of acquisitions that you’re targeting this year, what that might mean for growth in 2025?

Sumit Roy: Look, we’ve got to execute our plan based on what we believe is the right portfolio that’s going to take us into 2025 in a position of strength. We have grown our business through M&A. There have been two very large M&A deals done in the last two and a half, three years. We’ve been, I believe, very open about not all of those assets have been core to our long-term strategy. And so some of this is largely a function of trying to get back to that core portfolio. We have obviously underwritten the impact of 50% of circa $400 million to $500 million in dispositions being occupied assets. But what you’ll find is some of these assets are actually being sold. Look at what we sold or — and I know it wasn’t a big number, but the occupied assets, we actually sold them at a 7% cap rate, cash cap rate and we are reinvesting it at 77%.

So it is actually an accretive disposition strategy that we’ve been able to implement at least for the first quarter. So for us, it’s about creating the portfolio that we want to go into 2025 and beyond with. And this is a program that will consistently be executed on going forward. When we are doing sale leasebacks, it’s not an issue. When we’re doing portfolio transactions on existing leases, not always do we get 100% of what we want. And so being a bit more proactive around culling the assets that is not core to our overall strategy upfront is something that I think we are going to be a lot more intentional about. But we feel very good about our ability to continue to grow despite the strategy in 2025 and beyond.

Operator: The next question comes from Joshua Dennerlein of Bank of America. Please go ahead.

Unidentified Analyst : Hi. Good afternoon. This is Farrell [ph] on behalf of Josh. I was wondering if you could clarify how bad debt is currently trending. I know you made some comments on the watch list. And perhaps if that has changed at all in your outlook of how much bad debt is baked into guidance?

Jonathan Pong: Hey, Farrell, on the bad debt number, so we did disclose in the earnings press release for Q1, it was about $1.4 million that we actually recognized. As we think about forward-looking guidance and downside scenarios. I think we’ve been pretty clear in the past that we’ve been extremely conservative. I think when you sit here today, it’s early May, it’s a long time to go before the end of the year — it’s not to say that there’s any major concerns. I think you heard some talk about the watch list and it’s a bunch of small little things that if everything when a yes, maybe could have some impact, but it’s certainly not our expected scenario on that front. And so I think it’s really a mix of spirits assets that we did acquire that we’ve always been a little bit more cautious on, and we’ll continue to be cautious until we get further into the year.

I think for us, we’re always pretty conservative as it relates to bad debt expense, especially early in the year. And then finally, there’s some identified credits that even more or coating on.

Unidentified Analyst : Great. And second question about given the cap rates that you’re seeing in Europe with coming off of acquisitions, has your thought process or thesis change when you’re thinking about development and the yield you can get off that versus these straight-up acquisitions.

Sumit Roy: No, it’s a matter of timing, Farrell as the older vintage developments start to roll off, you’ll start to notice that some of the newer developments that we’ve entered into are more reflective of the current cost of capital environment and therefore, the cash cap rate yields that we are expecting on that vintage should creep up. It’s just that we entered into our development pipeline 12, 18 months ago. And some of those assets obviously were more reflective of the environment that we were in at that particular point in time. But even at a 7.2% cash cap yield, which is what our development is — that closed in the first quarter yielded is still circa 150 basis points, 170 basis points of spread. So yes, it’s not quite the 7.8% that we were able to achieve on the overall and certainly not 8.2% that we were able to achieve in Europe.

But that — I just wanted to make sure that you are aware that there is a bit of a lag on the development pipeline and the developments that we are entering into today is much more reflective of the environment today.

Operator: The next question comes from Brad Heffern of RBC Capital Markets. Please go ahead.

Brad Heffern: Yes, thanks. Hi everybody. Going back to the European cap rates, it really felt like that market has lagged the US for a long time in terms of recognizing the higher rate environment. I appreciate the outlook has been a bit more stable over there. But is there anything else that’s changed in Europe that’s now generating these attractive cap rates despite the cost of debt obviously being lower than the US.

Sumit Roy: Yes, Brad, what the cost of debt is certainly lower in Mainland Europe. It’s not lower in the UK. I would say trying on top of each other, John. Jonathan is nodding. So the big difference that we see and why potential sellers are willing to transact at the yields that we were able to realize, they’re twofold. One, there are funds that have had redemption pressures where they need to monetize real estate, and they are more than willing to reflect what the current cost of capital environment is because they need the capital. And the second, which works really in our favor is the fact that we have established ourselves as the go-to buyer of these types of assets and recognizing that the surety of close, which is very important for these potential sellers is going to be met.

And that reputation really does accrue to our benefit, when we are sort of having these conversations, and somebody requires capital near term, and we have the ability to close on these transactions as and when we agree on a particular price. I think it’s those 2 factors that’s allowing us to be very successful in the UK and in Europe, and is how it’s playing out. Here, unfortunately, you don’t have similar pressures. Yes, there could be operators that might be willing to transact. But if they have any ability to wait, which in the US, they have a lot more alternatives, they are sort of standing on the sidelines, waiting for the environment to improve for potential buyers to then be able to get the cap rates that they’re willing to transact in.

So I think that’s how I would frame, why we are being successful. One of the reasons is obviously very idiosyncratic to us and the other is it’s a reflection of the market.

Brad Heffern: Okay. Got it. Thank you for that. And then on Dollar Tree Family Dollar, can you remind us what the Family Dollar split is? And talk about any impact that you might have from the closures?

Sumit Roy: Yes. Look, I don’t think that the impact for us is going to be disproportionate. We have about 3% of our rent that is Dollar Tree, Family Dollar exposed to Dollar Tree, which obviously is the owner of Family Dollar. And I would say about 60%, circa 60% is Family Dollar and the rest of it is either Dollar Tree or the dual banners that they have. There’s about, I want to say 3% of the 3.3%. So that’s nine basis points of lease expirations over the next two years, 2.5 years that will materialize. So even if there are these closures and even if some of these assets are named on the closing list, our impact is basically nine basis points. And I can assure you that our asset management team is already working on resolutions given that it is part of the pipeline.

Anything beyond that will potentially be closed and will remain dark. We are still going to collect rent. And let me tell you that the pressure on Family Dollar and Dollar Tree is going to be a lot more acute than it is on us to try to find a substitute to step in and take over these leases. And just episodically, there’s a fair amount of interest in some of these locations that we’ve received just along the lines of some of the news that’s out there about potential closings, et cetera that we feel pretty good about our ability to resolve the Family Dollar assets. The one thing I’ll add, which may not be apparent, Family Dollar tends to be in urban areas and in much more densely populated areas than Dollar Tree or Dollar General. And so the attractiveness of those locations to alternative retail clients is a lot more, and that’s borne out by the fact that we have received inbound.

So for us, this is no different than learning well in advance that, hey, these particular leases are not going to get renewed and it gives us time to work on some of these leases well in advance of the actual lease expiration. So that’s how I would frame it.

Operator: Our next question comes from Michael Goldsmith with UBS. Please go ahead.

Unidentified Analyst: Hi. This is Katherine Grey [ph] on with Michael. Thanks for taking my questions. My first is, you touched on this a bit at the opening, but how are you thinking about — if you could maybe just provide some more color, how you’re thinking about the cost of free cash flow within the context of your investment spreads?

Sumit Roy: Sure. That’s a great question. For us, free cash flow is a massive advantage. The ability to raise $825 million of free cash flow post all obligations is essentially capital that we can use to invest across a variety of areas to accretively grow our earnings. Obviously, when we have free cash flow, we have to figure out what is the best use of that free cash flow. We could buy back our debt, we could buy back our stock, we could continue to invest accretively. And when we find that investing accretively is the best possible use of that capital — that is a massive advantage. And in a year where we are highlighting the fact that we have $2 billion of acquisitions, and we hope we do better than that, but that’s our current guidance.

Being able to finance this business with $825 million of free cash flow, which is obviously non-dilutive in nature and grow our earnings is a massive advantage. That’s how we think about our free cash flow. There is obviously opportunity cost associated with this. But the way we think about opportunity cost is what’s the best use of this capital. And for us, even in this environment, given the platform that we have, and given the diversification benefits of being able to invest across multiple asset types, across multiple geographies, we are continuing to find accretive use of this particular cash flow. And I think, obviously, one of the other things that we do look at is what is the long-term overall return profile. And that is what we compare to our long-term WACC, which is our cost of equity, that 65% and our cost of debt that is 35%.

And the cost of equity — and by the way, we have a few pages on this in our investor deck. It’s largely driven by the CAPM model and the dividend growth model. And I think we take the average of the two to come up with our cost effective long-term cost of equity and the long-term cost of debt and it’s 65%, 35% weighted. And all of our investments need to meet that hurdle rate and exceed that hurdle rate for us to move forward. So that’s really how we think about our cost of capital and how we specifically think about the free cash flow, which obviously we view as a massive advantage to us.

Unidentified Analyst: Got it. Thanks so much for the color. And my second question is on the development piece. So do you expect to see an acceleration of yields for your development projects as we progress through 2024 or even into 2025?

Sumit Roy: We do. Any new development that we are entering into, and I think somebody asked this question as well, we should — it should be more reflective of the current cost of capital environment. And so as you know, a lot of these developments, they do have a bit of a lag time. And so what you’re seeing close today is in that lower 7% ZIP code. But what you should see translate over the next few quarters is to see that cash cap rate continuing to trend much higher, reflecting the current cost of capital.

Operator: Our next question comes from Anthony Paolone of JP Morgan. Please go ahead.

Anthony Paolone: Thanks. First question relates to the Europe acquisitions in the quarter and the yields there. Can you talk a bit more about what kinds of embedded rent bumps are included in that? How much was maybe traditional net lease versus maybe multi-tenant assets? Because it looked like duration was a little bit on the shorter side.