Realty Income Corporation (NYSE:O) Q3 2023 Earnings Call Transcript

Realty Income Corporation (NYSE:O) Q3 2023 Earnings Call Transcript November 7, 2023

Operator: Good day, and welcome to the Realty Income Third Quarter 2023 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 now like to turn the conference over to Tyler Grant, Investor Relations. Please go ahead.

Tyler Grant: Thank you all for joining us today for Realty Income’s third quarter operating results conference call. Discussing our results will be Sumit Roy, President and Chief Executive Officer; and Jonathan Pong, Senior Vice President, Head of Corporate Finance. During this conference call, we will make statements that may be considered forward-looking statements under federal securities laws. 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 Form 10-Q. We’ll 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, Tyler, and welcome, everyone. We are proud of the solid execution we’ve delivered on our strategy in the third quarter and maintain a favorable outlook for our business. Our One Team at Realty Income continues to work diligently toward delivering strong results to our clients and stakeholders. The resilience, tenacity and range of our One Team has been impressive, culminating in the signing of the merger agreement with Spirit Realty, which we announced last week. This followed a quarter in which we invested $2 billion in high-quality acquisitions, raised over $2 billion in long-term and permanent capital, re-leased 284 properties at a 106.9% recapture rate, supporting an increase to our 2023 AFFO per share guidance range, which now stands at $3.98 to $4.01.

I would like to thank our One Team for their leadership efforts and dedication on behalf of all of whom we serve. Our third quarter results demonstrate the consistency of our earnings profile through varying economic environments and the attractive internal growth of our high-quality real estate portfolio, while highlighting the capabilities of our One Team and platform. Notwithstanding the challenging capital markets backdrop, AFFO per share grew 4.1% from last year to $1.02 per share. Combined with our dividend, we are pleased to have delivered an annualized total operational return up approximately 9%. As announced last week, we entered into a definitive merger agreement with Spirit Realty in an all-stock transaction valued at $9.3 billion.

The deal is expected to be immediately accretive to AFFO per share on a leverage-neutral basis without requiring any external capital to fund the merger. The accretion from the transaction once completed creates the foundation for AFFO per share growth in the coming year and puts us in a unique situation where we’ve had good visibility to an attractive forward earnings growth rate potential two months prior to the start of the new year. Given that that of course remains a fair amount of uncertainty in the capital markets environment, the accretion from the Spirit transaction is made more compelling given the lack of capital markets risk we are absorbing to effectuate this outcome. In fact, we believe our conservative underwriting of the portfolio provides for meaningful upside potential to our headline accretion expectations.

We believe Spirit’s portfolio is complementary to ours and we help to further diversify our industry, client and property concentrations. We expect our increased size diversification, trading liquidity and overall presence in the market will enable us to access the capital markets even more efficiently, while also improving our ability to digest larger deals without creating concentration issues within our portfolio. We are excited about the attractive cost basis, earnings accretion and enhanced ability to buy in bulk that will be effectuated through this transaction. I would like to express great appreciation for the Spirit and Realty Income teams, given their hard work and collaboration, which enabled us to successfully progress the transaction.

In the third quarter, we invested approximately $2 billion in high-quality real estate investments, leased to a diversified group of clients at a 6.9% initial cash yield. $1.4 billion of this total was derived from the international business at a 6.9% yield. Investments in the quarter were made across 132 discrete transactions. I would highlight that our volume include 34 sale-leaseback transactions for $1.3 billion of volume and six deals that were greater than $50 million in size. This demonstrates that both the corporate sale leaseback and larger transaction initiatives remained advantageous for us during the quarter. A testament to our ability to source, negotiate and close on transactions that are less trafficked amongst other net lease companies both public and private.

Our investment activity year-to-date is $6.8 billion, with investments in international markets representing approximately one-third of this total. Investment spreads realized during the quarter were over 100 basis points when calculating our WACC on a leverage-neutral basis and using the cost of equity and debt actually executed during the quarter. This is a decline of 30 basis points from last quarter, which is a result of the significant increase in the cost of capital – felt across the capital markets in a short amount of time. To put it into context, the average 10-year yield increased by approximately 55 basis points from Q2 to Q3. Following the sharp changes in the public debt and equity markets during the quarter, the private market cap rates have not adequately adjusted.

Accordingly, we believe that it is particularly important to be disciplined and patient allocators of capital and ensuring that we are appropriately compensated for the capital we provide. We are confident in our ability to source and allocate capital and scale and with efficiency and we are deeply focused on delivering attractive risk-adjusted returns to our shareholders. Given the level of transactions completed in the first three quarters of the year, combined with an outlook for narrowed investment spreads, we are modestly increasing our investment guidance to approximately $9 billion for 2023, which excludes the Spirit transaction that is anticipated to close in 2024. This increased target reflects deals that we already had in the closing pipeline prior to the recent surge in our cost of capital.

With the sharp recent changes in cost of capital, we remain highly selective in pursuing new investment opportunities and will assertively hold the line on entering into any new transactions unless we can be assured of generating ample spreads to our cost of capital. From an operating perspective, our portfolio continues to be healthy and performed well. At the end of the quarter occupancy was 98.8%. This is down slightly from last quarter’s historically high occupancy level of 99% and it is a result of expected client move-outs. Rent recapture rates across 284 new and renewed leases was 106.9%. This outcome is better than our historical average of 102.3% and results in year-to-date rent recapture of 104.3% on 661 new and renewed leases. I would highlight that since 1996 we have managed over 5,300 lease expirations.

And the improving recapture rates in recent years is a testament to our asset management expertise and the unparalleled historical data we have at our disposal. This competitive advantage enhances the quality of our asset management decisions through unique insights gleaned from our proprietary data analytics platform. Our credit watchlist represents 2.5% of our annualized base rent as of the end of the quarter. This is a decline of 120 basis points from the second quarter and is primarily the result of removing Cineworld from the watch list following our amendment, which became effective on October 1. We recovered 60% of prior base rent on our 41 locations without any capital contributions. Importantly we also negotiated the ability to recover rent through percentage rent agreements which could give us the ability to recapture a total of 70% of prior rent based on our internal estimates of performance.

Finally with the reinvestment of certain asset sales we expect to recapture a total of approximately 85% of prior rent. Same-store rent grew at an elevated rate of 2.2%. We continue to generate increasing higher average rent escalators within the portfolio due to our commitment to investing in leases with stronger rent escalators, particularly, in international markets where we have a relatively outsized number of leases with uncapped inflation escalators. The better-than-expected same-store rent growth in the quarter has enabled us to raise our full year guidance to approximately 1.5%. With that I would like to turn the call over to Jonathan.

Jonathan Pong: Thank you, Sumit. Discipline and a commitment to our A3/A minus- credit ratings continue to be our priorities from a balance sheet management perspective. During the third quarter our net debt to annualized pro forma adjusted EBITDA and fixed charge coverage ratios each fell by 10% to 5.2 times and 4.5 times, respectively. In the third quarter we issued $886 million of equity primarily through our ATM program while ending the quarter with $749 million of unsettled forward equity outstanding. Combined with cash on hand with $344 million, the net availability on our credit facility of $3.4 billion we ended the quarter with $4.5 billion of liquidity. As we look forward to future capital raising needs we continue to have rate protection on $1 billion of notional value to hedge against a rising 10-year yield.

We purchased this protection in the form of a derivative instrument called a swaption corridor, which effectively limits our rate exposure on a future note issuance at an option premium below the cost of a regular way vanilla option. We purchased this option in late March when a 10-year yield was in the 3.5% area. And as of quarter end the net value of the swaptions had a mark-to-market value of approximately $25 million. As Sumit mentioned previously, the Spirit transaction provides us with the opportunity for meaningful earnings accretion in the coming years. From a balance sheet perspective, the Spirit team has done a great job in curating a well-laddered debt maturity schedule, which limits our future refinancing risk in any given year.

As we have experienced throughout the company’s history, the global rate environment provides both headwinds and tailwinds in any given year, which is why the assumption of balance fixed rate debt stack that is spread fairly ratably from 2025 through 2032 and provides us with extended financial benefits with manageable refinancing risk. When giving effect to the combined debt maturity stack, we estimate that there will not be a year when more than 12% of our total fixed rate debt comes due. Similar to the complementary real estate portfolio, Spirits debt stack is also a good fit with our existing maturity schedule, and we expect the continued debt stack or the combined debt stack to remain well laddered giving us numerous opportunities to engage in opportunistic liability management exercises when — and economically advantageous to do so.

When I finally I would like to thank all of our team members who have worked so incredibly hard in helping to support this transaction, and we will continue to be integral as we move towards close and integration. With that, I would like to turn it back to Sumit.

Sumit Roy : Thank you, Jonathan. In conclusion as further demonstrated in the quarter, Realty Income has a well-established growth-focused business model that provides stable and predictable cash flows to fund the payout of our monthly dividend. We believe the platform we have created, evolved and refined is not easily replicable. We have a long history of prudently allocating capital that is complemented by our industry-leading capital leasing abilities that we used to invest across properties that fall within our well-defined investment criteria. The results of our efforts have produced our net lease portfolio that consists of more than 13,200 properties diversified across property types industries, geographies and clients.

We’re excited for the future of our business. Our anticipated acquisition of Spirit provides a solid building block for growth, as we head into 2024 and our existing portfolio continues to perform well. As such we find ourselves in a favorable position to produce high single or low double-digit operational returns, while offering the same stability that has defined this platform for decades. At this time we can open it up for questions. Operator?

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Q&A Session

Operator: We will now begin the question-and-answer session. [Operator Instructions] The first question today comes from Joshua Dennerlein with Bank of America. Please go ahead.

Joshua Dennerlein: Yeah. Hey, guys. Thanks for the time. Maybe just going back to some of the opening remarks on the re-leasing the spreads. Just curious what drove that historically better than or the re-leasing spread is better than the historical run rate? And then just how should we think about that going forward?

Sumit Roy: Yeah. Great question, Josh. A lot of this was driven by our non-retail re-leasings. And you can see the breakout I think we provide that in the supplemental, it was closer to 140% in terms of re-leasing spreads. It was also largely driven by this one very large industrial distribution center that we released to a new client. If you looked at just the retail side of the equation that was closer to 104% which is still slightly better than average. And I think a lot of this is really what I said in my opening remarks, the more assets we control the kind of conversations that we can enter into with our clients is a different one. One of the largest renewals was Circle K and where we looked at 100 of their assets and we’re able to enter into long-term lease discussions at very favorable rates.

And that is what makes this platform so unique. The fact that we do control so many assets for some of these clients, the discussion we can have where, if there is an asset that’s not performing well we are more than willing to give them a rent haircut, but make that more than up across the portfolio and come up with a win-win situation for both parties. And again, it’s all about size and scale, but I’d be remiss, if I don’t compliment the asset management team, the predictive analytics team that continues to refine the models and give scores on each asset, which gives the asset management team the confidence to then go in and negotiate knowing that these are assets that are performing well and therefore warrant an increase. So I think it’s a combination of all of those factors Joshua that we were able to realize 106.9% re-leasing spreads.

Joshua Dennerlein: Appreciate that color. Maybe just stepping back, how do you think about like your strategy? Is it something you want to lean into or you can try to get assets that get better internal growth going forward? Just curious.

Sumit Roy: Yeah. Obviously, what this is implying Josh is that, if there are assets that we believe based on some of the things that I just shared with you that we can do better than the current in-place rent. We are going to take a bit of a different stance and try to take control of those assets, especially if the existing client is looking for a rent haircut et cetera. Which obviously we may have a bit of a negative drag on occupancy levels, because we want to take control and despite our best efforts sometimes when you take control, there’s a bit of a lag time between getting this new client into this building at that elevated rents. But for us, the bottom line is going to be about creating better economics on rent recapture and at a small expense on the occupancy side, if that’s what’s going to be needed to do that.

So going forward, you will see us continue to push this strategy and continue to show to the market that we do have a differentiated asset management platform.

Joshua Dennerlein: Got it. Thanks for the time.

Sumit Roy: Thank you, Josh.

Operator: The next question comes from Nate Crossett with BNP. Please go ahead.

Nate Crossett: Hey good afternoon. Maybe you could just talk about the current pipeline. What do the yields look like right now? And then also how big is the Spirit pipeline? What do those yields look like?

Sumit Roy: Yes, I’m not going to speak to Spirit because it’s not a transaction that we’ve closed on yet. So, I’ll speak very much to the pipeline that we have made. And as you can tell we obviously have a very healthy pipeline. We just increased the acquisitions to approximately $9 billion, which is an increase from where we were at the end of the third quarter. And again these are very similar to what we showed you in the third quarter. If you look at some of the largest transactions we did they were with grocery operators in the UK, it was ASDA and Morrisons, both names that we like and we’re able to get these very large transactions as I believe was close to a $900 million transaction. Morrisons slightly smaller closer to $170 million sale-leaseback.

Both of these were sale-leasebacks and done purely on a negotiated basis. That type of transaction is what you’re going to see when we get those over the finish line in the fourth quarter. Those are the types of transactions that we have in our pipeline today. Some of the comments I’ve made around cap rates moving but not moving commensurate with our cost of capital movement remains true. The other piece that I will overlay is the fact that some of these transactions that we have in our pipeline were created six to nine months ago. And so people may have questions, how come you were only able to get a 6.9% cash cap rate which by the way if you look at it on a straight-line basis it’s almost 8.1% and just given the inherent growth in these leases and to make it equivalent to some of the other data that is shown by some of our peers.

Has the growth profile that we are targeting but potentially is not reflective? Which was obviously shown in the spreads that we were able to recapture 105 basis points, which is about 30 basis points inside of what we did in the second quarter. And that goes to the point I’m making is that cap rates though adjusting are adjusting much, much more slowly than our cost of capital. And so this is a time where going forward we are going to be hyper selective. But the makeup of the fourth quarter will be very similar. You should see a movement in cap rates in the right direction, i.e. higher cap rates and more reflective of when these transactions were essentially came on to the pipeline which started to reflect the more rapid movement in our cost of capital.

So, that’s what you should see. It’s obviously fairly healthy. But thankfully we’ve raised a fair amount of capital through the ATM et cetera already.

Nate Crossett: Okay, that’s helpful. Just one on the Bellagio I just wanted to ask like what is your appetite to do investments where you don’t own the asset 100%. whether it’s a JV or a loan? And is there anything in the pipeline that is a JV?

Sumit Roy: Off the top of my head, outside of the Bellagio transaction, I don’t believe we have a JV structure in the pipeline. Similar to the way we structured the Bellagio transaction, we do tend to have JVs with developers where they hold on to a small stake in the development while developing the assets, et cetera, but we generally tend to be the takeout on the back end. But I don’t think Nate and correct me if I’m wrong, that you meant those types of JVs. You were talking about more permanent JV structures like the one that we’ve entered into with Bellagio. I don’t believe we have one like that. There is one — there are products out there by the way, that do lend themselves to this JV structure. There are asset classes that require a tremendous amount of capital, where we will be more than forthcoming about entering into a JV just given the sheer amount of capital required.