Good day, and welcome to the Realty Income First Quarter 2017 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ms. Janine Bedard. Please go ahead.
Thank you all for joining us today for Realty Income's Q1 2017 operating results conference call. Discussing our results will be John Chase, Chief Executive Officer Paul Muir, Chief Financial Officer and Treasurer and Sue McRoy, President and Chief Operating Officer. During this conference call, we will make certain statements that may be considered to be 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 will be observing a 2 question limit during the Q and A portion of the call in order to give everyone the opportunity to participate. I will now turn the call over to our CEO, John Case.
Thanks, Janine. Welcome to our call today. We're pleased to begin the year with a successful quarter achieving AFFO per share growth of nearly 9%. We completed $371,000,000 of acquisitions, maintained high portfolio occupancy of 98.3 percent and raised $1,500,000,000 of permanent and long term capital at favorable pricing. Our balance sheet strength positions us to continue pursuing the highest quality net lease properties in the marketplace, while securing attractive returns and investment spreads given our sector leading cost of capital.
Let me hand it over to Paul to provide additional detail on our financial results. Paul? Thanks, Todd.
I'll provide some highlights for a few items in our financial results for the quarter, starting with the income statement. Interest expense decreased in the quarter by $1,400,000 to $59,300,000 This decrease is primarily driven by the recognition of a $1,300,000 non cash gain on interest rate swaps during the quarter, which caused a decrease in net liability and lowered our interest expense. As a reminder, we do exclude the impact of non cash swap gains or losses to calculate AFFO. Interest expense this quarter was also impacted by the recording of approximately 1 month of $2,300,000 of preferred dividend as interest expense. Since the redemption notice for our preferred stock was issued before quarter end, we were required to reclassify the preferred stock as a liability at that time and then recognize about a month of preferred dividends as interest expense.
Our G
and A as a percentage of total rental and other revenues was only 4.7% for the quarter as we continue to have the lowest G and A ratio in the net lease REIT sector. Our non reimbursable property expenses as a percentage of total rental and other revenues was 2.7% in the Q1. We tend to experience slightly higher property expenses in the Q1, but we continue to expect non reimbursable property expenses as a percentage of total rental and other revenues to be in the 1.5% to 2% range for all of 2017. Funds from operations or FFO per share was $0.71 for the quarter versus $0.68 a year ago. FFO per share was impacted by a $13,400,000 or $0.05 per share noncash redemption charge related to the unamortized original issuance costs associated with our preferred F shares.
Excluding this noncash charge, FFO per share would have been $0.76 for the quarter. Adjusted funds from operations or AFFO or the actual cash we have available for distribution as dividends was $0.76 per share, representing an 8.6% increase over the year ago period. Briefly turning to the balance sheet. We've continued to maintain our conservative capital structure. As John mentioned, year to date, we have raised approximately $1,500,000,000 of well priced long term capital to fund our acquisition activity and retire over $400,000,000 of high coupon preferred stock.
Our senior unsecured bonds now have a weighted average remaining maturity of 8.1 years, and our fixed charge coverage ratio is now 4.5x. Other than our credit facility, the only variable rate debt exposure we have is on to $38,000,000 of mortgage debt. Our overall debt maturity schedule remains in good shape with about $276,000,000 of debt coming due later this year, and our maturity schedule is very well laddered thereafter. And finally, our overall leverage remains modest with our debt to EBITDA ratio standing at approximately 5.5x. In summary, we have low leverage, excellent liquidity and continued access to attractively priced equity and debt capital.
Now let me turn the call back over to John.
Thanks, Paul. I'll begin with an overview of the portfolio, which continues to perform well. Occupancy based on the number of properties was 98.3%, unchanged from last quarter and up 50 basis points from a year ago. We expect our occupancy to remain at approximately 98% in 2017. During the quarter, we released 49 properties to existing and new tenants, recapturing approximately 104% of expiring rent, which is above our long term average.
This quarter was the 3rd consecutive quarter of leasing recapture rates above 100%. Since our listing in 1994, we have re leased or sold nearly 2,400 properties with leases expiring, recapturing approximately 99% of rent from those properties that were re leased. This compares favorably to the companies in our sector who also report this metric. Our same store rent increased 1.6% during the quarter, primarily due to higher percentage rent. 90% of our leases continue to have contractual rent increases.
Our portfolio continues to be diversified by tenant, industry, geography and to a certain extent property type, which contributes to the stability of our cash flow. At the end of the quarter, our properties were leased in 250 commercial tenants in 47 different industries located in 49 states in Puerto Rico, 80% of our rental revenues from our traditional retail properties. The largest component outside of retail is industrial properties, about 13% of rental revenue. Walgreens remains our largest tenant at 6.8 percent of rental revenue and drugstores remain our largest industry at 11.1% of rental revenue. We remain comfortable with the momentum in the drugstore industry and continue to view our exposure favorably given the industry's attractive demographic tailwinds, non discretionary nature and continued growth from in store pharmacy pickup.
Additionally, Walgreens and CVS, our top 3 drugstore tenants, have generated 15 consecutive quarters of positive same store pharmacy sales growth. During the quarter, we added Kroger to our top 20 tenants, representing 1.2% of our annualized rental revenue. We're pleased with our Kroger locations and the addition of this high quality investment grade rated grocery chain, which we view as one of the better operators in the industry. We continue to have excellent credit quality in the portfolio with 45% of our annualized rental revenue generated from investment grade tenants. The store level performance of our retail tenants also remain sound.
Our 4 wall rated average rent coverage ratio for our retail properties remains 2.8x and the median is 2.7x. Moving on to acquisitions briefly before handing it over to Sumit. We completed $371,000,000 in acquisitions during the quarter and we continue to see a steady flow of opportunities that meet our investment parameters. During the quarter, we sourced $10,800,000,000 in acquisition opportunities. We remain delivered in our investment strategy, acquiring only 3% of the amount sourced.
Our selectivity reflects our focus on quality. We continue to expect to complete $1,000,000,000 of acquisitions in 2017. As a reminder, this estimate primarily reflects our typical Flow business and does not account for any unidentified large scale transactions. Now let me hand it over to Sumit to discuss acquisitions and dispositions. Thank you, John.
During the Q1 of 2017, we invested $371,000,000 in 60 properties located in 18 states at an average initial cash cap rate of 6.1% and with a weighted average lease term of 16.4 years. On a revenue basis, approximately 68% of total acquisitions are from investment grade tenants. 98.7% of the revenues are generated from retail and 1.3% are from industrial. These assets are leased to 20 different tenants in 13 industries. Some of the most significant industries represented are grocery stores, automotive services and motor based computerships.
We closed 11 discrete transactions in the Q1. The transaction flow continues to remain healthy. We sourced approximately $11,000,000,000 in the Q1. Of these opportunities, 50% of the volume sourced were portfolios and 46% or more than $5,000,000,000 were one off assets. Investment grade opportunities represented 28% for the Q1.
Of the $331,000,000 in acquisitions closed in the Q1, 23% were one off transactions. As to pricing, cap rates continued to remain flat in the Q1 with investment grade properties trading from around 5% to high 6% cap rate range and non investment grade properties trading from high 5% to low 8% cap rate range. Our investment spreads relative to our weighted average cost of capital remained healthy, averaging 195 basis points in the Q1, which were well above our historical averages. We define investment spreads as initial cash yield less our nominal 1st year weighted average cost of capital. Regarding distributions, during the Q1, we sold 14 properties for net proceeds of $31,200,000 at a net cash cap rate of 8.3% and realized an unlevered IRR of 9.8%.
In conclusion, we remain confident in reaching our 2017 acquisition target of approximately $1,000,000,000 and disposition volume between $75,000,000 $100,000,000 With that, I'd like to hand it back to John.
Thanks, Sumit. We were very active on the capital markets front in the quarter. We issued approximately $800,000,000 in common equity at an average price to investors of approximately $62 per share. Additionally, with the highest credit rating in the net lease sector, we issued $700,000,000 in fixed rate unsecured debt with a weighted average term of 18.3 years and a yield of 4.1%. Our credit spreads remain among the lowest in the REIT industry and our leverage continues to decline with net debt to total market cap of approximately 26% and debt to EBITDA of approximately 5.5x.
We currently have approximately $1,500,000,000 available on our $2,000,000,000 line of credit. This provides us with ample liquidity and flexibility as we grow the company. Last month, we increased the dividend for the 91st time in the company's history. The current annualized dividend represents a 6% increase over 1 year ago. We've increased our dividend every year since company's listing in 1994, growing the dividend at a compound average annual rate of just under 5%.
We're proud to be one of only 5 REITs in the S and P High Yield Dividend Aristocrats Index. Our dividend represents an AFFO payout ratio of 83.5% based on the midpoint of our 2017 guidance. To wrap it up, we've had another good start to the year. Our portfolio remains healthy, our growth prospects are attractive and our balance sheet remains in excellent shape. We continue to be well positioned to capitalize on the highest quality acquisition opportunities in our sector leading cost of capital and financial flexibility.
These strengths of our business should continue to position us to generate dependable dividends over time. At this time, I would like to open it up for questions. Operator?
Thank We will go first to Vikram Malhotra with Morgan Stanley.
Thanks for taking my questions. So first one, I noticed over the last maybe quarter or so and maybe you've done this to 'sixteen, you can get more exposure to larger boxes, Walmart neighborhoods, which are maybe in the 40,000 square foot range and in the Kroger's, which are maybe slightly larger. Can you maybe just walk us through sort of what makes you comfortable with exposure to big boxes and any trends you may be seeing in your own portfolio in preparing and contrasting to smaller exposure, smaller boxes?
Yes, sure, Vikram. The majority of our retail big boxes that we own are leased to tenants with service non discretionary or low price point components to their business. So we're comfortable with those. Only about 1% of our properties, about 50 big boxes, are boxes that are leased to tenants that don't meet those investment parameters that are selling discretionary goods. But those tenants, many of them are strong discount merchandisers that are doing very well.
So we're comfortable with larger boxes. On the grocery side, you mentioned, that's a business we like quite a bit. 95% of grocery sales in brick and mortar locations. And we're aligned with some of the top operators in the country and the top regional operators there. So that's an area where we're comfortable owning big boxes.
And you'll see some properties that are in that 40,000 up to even 65,000, 70000 square feet range.
Okay, that's helpful. And then just second question and just a follow on. Just in terms of the watch list and the rent the overall rent coverage, any changes in the watch list? And just in that coverage, can you maybe give us a range of what the range of the rent coverage is?
Well,
I think it's more important to look at the median. I mean, we have coverages that are close to 1 and we have coverages that are at 4 times. Our median for the whole portfolio is 2.7 times and our average is 2.8 times. You mentioned the watch list. The watch list has remained in the low 1% area.
It's still there, not a material change. Our retail tenants have seen their sales grow at approximately 3% over the last year. So we're pleased with that as well. And then in terms of the tenants outside of our top 20, our coverages on those tenants is actually higher, notably higher than it is for our overall portfolio. And I think that's important to note.
Just because the tenant is not in that top 20, doesn't mean they're not a strong tenant.
And we'll go next to Joshua Dennerlein with American College.
Hey, guys. I'm just curious, quarter coming on your top 20 list, is that from an acquisition this quarter? Or was it like were all 11 stores bought in 1Q? Or was it just kind of hovering below the surface for a while and then you just added a property or 2?
We added several properties this quarter, which pushed them up to 1.2% of revenues and knocked Home Depot out of the top 20. So it was not a single large portfolio. It was a smaller portfolio.
Okay.
And then I know the Rite Aid Walgreens merger seems like it's kind of hitting some hiccups. If it does go through, do you expect that there'll have to be any asset sales by the new combined company?
Right now, the FTC is asking Walgreens to sell up to 1200 assets via the acquisition. It's expected to close in July. There have been some rumors that it may be blocked by the FTC. If it were to move forward, we've looked at our exposure in terms of asset closures and we only have 15 Rite Aid's that are within 2 mile radius of a Walgreens. And even if they were, to another retailer such as Fred's, which is being mentioned, our credit would remain Walgreens.
And the average lease term for our Rite Aid properties is just under 10 years. So we still have that credit. So we think it will be a non event for us.
And we'll take our next question from Nick Joseph with Citi.
Thanks. Curious, what you're seeing in terms of pricing and financials between portfolio deals and individual properties? Sure. On an individual asset, we're seeing them trade anywhere from 25 to 100 basis points below, cap rates 25 to 100 basis points below where we'd see them trade in a portfolio. So there's still a notable difference.
There's a premium cap rate for portfolios. And then just for leverage, you talked about it hasn't trended down. Do you expect to maintain the current leverage levels because it could continue to trend down? Or should we expect leverage to
move up from here?
I think we're going to maintain this level. This is a level that we're comfortable with and gives us sufficient flexibility to operate the business.
And we'll go next to Collin Mings with Raymond James.
Hey, thank you. Just as it relates
to the watch list, last quarter, I believe you indicated that the below average credit bucket was about 6% of revenues. Any change to that?
Or has anything slipped maybe from one of
the top 2 categories in the average bucket?
No, it's still holding just a shade above 6%. So there's been no material change to that.
Okay. Then just on the same store revenue, can you discuss what really drove the jump in the same store revenues related to car dealerships and sporting goods markets? Was there what's going on as far as just the lease terms and the bumps with those?
It's really percentage rents was the primary driver and they came in early in the year and gave us higher than expected same store rent growth, not higher than expected, but higher than expected what we expect for the full year, which is still around 1% to 1.2%. So it was higher in the Q1, primarily due to that percentage rent.
And we'll take our next question from Michael Knaud with Green Street Advisors.
Given the continued pursuit of higher quality properties within your business, just curious when you combine that with if we get 1031s going away and that impacted that market, wouldn't that potentially uniquely open up that avenue to you as a new opportunity somewhat with your external growth platform. Just curious how
you think about that and integrate that into
your thinking with higher quality properties?
Well, I do think that if the 1031 buyers go away, that there'll be more opportunity to play in those assets. They treat it at levels that we think don't necessarily make sense. So we really haven't been a player on the sell side or the buy side in the 1031 market. But if that were to occur, I think you're right, Michael. I think that we could see some acquisition opportunities as a result of that if we were to step in there.
And what would be your do you have any ballpark estimate you'd be willing to share publicly of where those type of assets, the pricing would come up to in terms of cap rate?
No. I think it's premature at this point. I don't want to speculate on where that pricing might be and where it would go if they were to actually get rid of 1031 exchanges in the new tax package.
And we'll go next to Haendel St. Juste with Mizuho.
Hey, I guess
it's still good morning out there.
Can you talk a bit about your what you're seeing in the corporate sale leaseback market and your appetite for larger corporate lead type of transactions?
Yes. This is Sumit. We continue to see a healthy flow of sale leaseback opportunities on the corporate side. This is something that we touched on even in our last call. The quality of discussions, the number of discussions have continued to trend up over the years and it's no different this quarter vis the last year.
Okay. And on the 711, the big corporate leaseback to corporate transaction, curious, the convenience store is something that a number of your peers have seen to be moving in the opposite direction. So curious as to your comfort level with that type of transaction here while others seem to be different to you?
We're focused on the highest quality convenience stores like a 711, Couche Tard, Circle K, who are both in our top 20. We want 3,000 square feet or more where they have a significant inside store. 70% of the store sales are generated by customers not buying gas. So, the emphasis is really on convenience. These are great locations and good markets run by solid operators.
So, we're still bullish on the C Star industry and it's our 2nd largest industry today and I think it will continue to be one of our top industry investments. We are selling some smaller kiosks and smaller store convenience store operations. So we are focusing on the top tier and highest quality C Stores.
We'll go next to Michael Carroll with RBC Capital Markets. Yes, thanks. John, can you talk
a little bit about your underwriting standards and how, if it has at all changed with the current concerns in the retail space right now?
We continue to be very selective as is evidenced by our 3% acquisition ratio relative to what we sourced in those last quarter. We've run anywhere from 3% to 7% in the last several quarters. So, our investment parameters continue to be quite tight on the retail side. We're investing in service, non discretionary and low price point businesses that compete in all economies effectively and better compete with e commerce. So I think we remain selective and cautious and we're very judicious with our exercising use of our cost of capital, which is the lowest in the sector.
Sumit, anything to add there? No. No. Are there any specific profit types or industries
that you're shifting away from or you're starting
to focus more on given, I guess, the current environment?
Well, I think it's really summed up by what I said. What we're focusing on are service, non discretionary and low price point retailers and businesses. So you look at drug stores, fee stores, dollar stores, grocery stores, QSRs. Those are all areas that we continue to focus on. And if an asset and tenant don't meet the definition, don't meet our investment parameters and investment strategy, we're not going to pursue it.
And we'll go next to Dan Donlen with Ladenburg Thalmann.
Thank you and good afternoon, good morning. Just wanted to talk a little bit about your exposure to childcare and education. Just looking at Slide 17, it looks like that has continued to decline annually since 2012. So I'm just curious how you see that trend in the 5 years? It seems to be
a portion of the market that
your peers continue to invest in. So I'm just curious if it's going to turn back up or you're now comfortable with your current exposure?
We're comfortable with our current exposure. If anything, it will stay where it is or maybe trend down just slightly. We haven't been big on education or schools for a variety of reasons we discussed in the past. And childcare, we've seen some of those companies over the years struggle
a bit.
Some of our tenants and locations actually are doing quite well and those are the ones we intend to hold. But it's a business where demographics within a neighborhood can change over time. And what you thought you had when you bought the asset 20 years ago is much different than what you end up with 20 years later. And those are assets that where we've seen changes in demographics and more challenging situations we've sold over the years, which has decreased our exposure.
Okay. That's helpful. And then as far as the cap rates going forward, I know you've kind of been at this low 6 percent level. We've seen a nice tick up in the treasury. Is your expectation or maybe hope that we should start to see that lift, just kind of given the treasury yield?
Well, it's certainly our hope. And it's our expectation that if capital cost and treasury prices actually for a sustained period of time hold at a higher level, we would certainly expect cap rates to increase as well. Cap rates have always followed the cost of capital. When our cost of capital was 10%, we were buying assets at caps of 11.5%. So there's always a lag period though.
Bond prices and yields, bond yields can move $10 in a day or greater than that. That just doesn't happen in the real estate market. The cap rates are a bit more sticky and they lag by a quarter or 2. And you need to see some more stability of interest rates at a certain level just because they tick up to the 10 year ticks up to 2.70 per week and back down and holds for several weeks and then it ends up within a few days back to $2.30 that's not really going to drive cap rates. You're going to need to see rates stay at a sustained higher level.
And then you'll see with the lag period, cap rates move.
And we'll go next to Jason Belcher with Wells Fargo.
Hi. I guess first on your lease expirations in
the quarter, just wondering how much you all spent in CapEx to reten at those leases year?
Yes. For retenanting in the Q1, we had CapEx of right at about 2,500,000 dollars And that was primarily most of that was an expansion for an industrial tenant, where we received an 11 percent yield on the incremental invested capital and the tenant extended their lease term by a factor of 2 times. So when we have those opportunities, we would like to deploy capital with those sort of returns and qualitative results as well. So looking forward, we'll continue to have some of that. It won't be a huge number, but I wouldn't be surprised if we have other quarters right at the same amount or even a little bit higher.
Great. That makes sense. And secondly, can you just touch on your investment grade tenant mix?
I know that ticked down a little bit
in the quarter. How happy are you with where that is currently? And is there a hot deal level where you'd like to see that shake out going forward? We don't have a target for investment grade. We went from 47% to 45%.
That's primarily a result of Diageo completing their exit on our lease on the wineries and vineyards in Napa Valley and Treasury Wine Estates picking up that lease now that they've bought those operations from Diageo. Treasury is the largest vendor, publicly traded vendor in the world. It has a market cap of about 9,000,000,000. It's not rated. Its credit metrics in terms of debt to EBITDA are actually stronger than Diageo's.
It's not as large of a company as Diageo, but we're very comfortable with that investment. We're comfortable with our tenants in the top 20 and outside the top 20, both investment grade and non investment grade. So I think you'll continue to see the investment grade number kind of fluctuate. If the Rite Aid Walgreens merger happens, it will pick up about 1.8%. But it will ebb and flow in general area, I think.
Our acquisitions in the Q1 were about 67%, 68% investment grade. So as long as we continue to stay at that level, we'll slowly pull it up. But it's not something we do consciously. It's sort of gravy to get that investment grade rated tenant and a really good property underwritten conservatively.
That concludes the question and answer portion of Realty Income's conference call. I will now turn the call over to Sean Case for his closing remarks.
Thanks, Tracy, and thanks to everyone for joining us today. We look forward to speaking with all of you soon. I'm sure we'll be seeing some of you at NAREIT in June, if not before then. Have a good afternoon.