Good day, 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. Janeen Bedard . Please go ahead.
Thank you all for joining us today for Realty Income's First Quarter 2017 Operating Results Conference Call. Discussing our results will be John Case, Chief Executive Officer, Paul Meurer, Chief Financial Officer and Treasurer, and Sumit Roy, 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 law. The company's actual future results may differ significantly from the matters discussed in any forward-looking statements. We will disclose in greater detail the factors that may cause such differences in the company's 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. I will now turn the call over to our CEO, John Case.
Thanks, Janeen. 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 million of acquisitions, maintained high portfolio occupancy of 98.3%, and raised $1.5 billion 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, John. 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 $1.4 million to $59.3 million. This decrease is primarily driven by the recognition of a $1.3 million non-cash gain on interest rate swaps during the quarter, which caused a decrease in that 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 one month of $2.3 million 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, then recognize about a month of preferred dividend as interest expense.
Our G&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&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 first quarter. We tend to experience slightly higher property expenses in the first quarter, but we continue to expect non-reimbursable property expenses as a percentage of total rental and other revenues to be in the one and a half 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 $13.4 million, or $0.05 per share non-cash redemption charge related to the unamortized original issuance cost associated with our Class F preferred shares.
Excluding this non-cash 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 $1.5 billion of well-priced long-term capital to fund our acquisition activity and retire over $400 million 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 just $38 million of mortgage debt.
Our overall debt maturity schedule remains in very good shape, with about $276 million of debt coming due later this year, and our maturity schedule is very well-laddered thereafter. 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 re-leased 49 properties to existing and new tenants, recapturing approximately 104% of expiring rent, which is above our long-term average. This quarter was the third 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 on those properties that were re-leased. It 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 to 250 commercial tenants in 47 different industries, located in 49 states and Puerto Rico. 80% of our rental revenue is 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% 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 two 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 remains sound. Our four-wall weighted 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 million in acquisitions during the quarter and continue to see a steady flow of opportunities that meet our investment parameters. During the quarter, we sourced $10.8 billion in acquisition opportunities.
We remain deliberate 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 billion of acquisitions in 2017. As a reminder, this estimate primarily reflects our typical flow of 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 first quarter of 2017, we invested $371 million 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 vehicle dealerships. We closed 11 discrete transactions in the first quarter. The transaction flow continues to remain healthy. We sourced approximately $11 billion in the first quarter. Of these opportunities, 54% of the volume sourced were portfolios, and 46%, or more than $5 billion, were one-off assets. Investment-grade opportunities represented 28% for the first quarter.
Of the $371 million in acquisitions closed in the first quarter, 23% were one-off acquisitions. As to pricing, cap rates continued to remain flat in the first quarter, 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 first quarter, which were well above our historical averages. We define investment spreads as initial cash yield less our nominal first-year weighted average cost of capital. Regarding dispositions, during the first quarter, we sold 14 properties for net proceeds of $31.2 million 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 billion and disposition volume between $75 million and $100 million. 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 million 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 million 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 5.5 times. We currently have approximately $1.5 billion available on our $2 billion 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 one year ago. We've increased our dividend every year since the 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 five REITs in the S&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 given our sector-leading cost of capital and financial flexibility. These strengths of our business should continue to position us to generate dependable dividends that grow over time.
At this time, I would like to open it up for questions. Operator?
Thank you. If you would like to ask a question, please signal by pressing star one on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Please limit your questions to two. Again, please press star one to ask a question. We'll pause for just a moment to allow everyone an opportunity to signal for questions. We'll go first to Vikram Malhotra with Morgan Stanley.
Thanks. Thanks for taking my questions. First one, I've noticed over the last maybe quarter or so, and maybe you've done this through 2016, a bit more exposure to larger boxes, Walmart neighborhoods which are maybe in the 40,000 sq ft range, and then the Krogers, 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 trend you may be seeing in your own portfolio and comparing and contrasting to the smaller exposure, smaller boxes?
Yeah, 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. 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. Those tenants, many of them are strong discount merchandisers that are doing very well. We're comfortable with the larger boxes. On the grocery side, you mentioned that's a business we like quite a bit. 95% of grocery sales occur in brick-and-mortar locations. We're aligned with some of the top operators in the country and the top regional operators there. That's an area where we're comfortable owning big boxes.
You'll see some properties that are in that 40,000 up to even 65,000, 70,000 sq ft range.
Okay. That's helpful. Just second question, and just to follow on, just in terms of the watch list, and the overall rent coverage, any changes in the watch list? Just in that coverage, can you maybe give us what the range of the rent coverage is?
Well, I think it's more important to look at the median. We have coverages that are close to one, and we have coverages that are at four times. Our median for the whole portfolio is 2.7x , and our average is 2.8x . 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. 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. I think that's important to note. Just because a tenant's not in that top 20 doesn't mean they're not a strong tenant.
We'll go next to Joshua Dennerlein with BofA Merrill Lynch.
Hey, guys. Just curious, with the Kroger coming on your top 20 list, was that from an acquisition this quarter, or was it like were all 11 stores bought in 1 Q, or was it just kind of hovering below the surface for a while, then just added a property or two ?
We added several properties this quarter, which pushed them up to 1.2% of revenues, and knocked Home Depot out of the top 20. It was not a single large portfolio. It was a smaller portfolio.
Okay. 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 1,200 assets via the acquisition. It's expected to close in July. There've 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, we only have 15 Rite Aids that are within a two-mile radius of a Walgreens. Even if they were to relet to another retailer such as Fred's, which is being mentioned, our credit would remain Walgreens. The average lease term for our Rite Aid properties is just under 10 years. We still have that credit. We think it'll be a non-event for us.
We'll take our next question from Nick Joseph with Citi.
Thanks. Curious what you're seeing in terms of pricing differentials between portfolio deals and individual properties.
Sure. On an individual asset, we're seeing them trade anywhere from the cap rate's 25 to 100 basis points below where we'd see them trade in a portfolio. There's still a notable difference. There's a premium cap rate for portfolios.
Okay. Just for leverage, you said that it has been trended down. Do you expect to maintain the current leverage levels? Do you think it could continue to trend down, or should we expect leverage to move up from here?
Nick, 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.
We'll go next to Collin Mings with Raymond James .
Hey, thank you. Just as it relates to the watchlist, last quarter, I believe you indicated that the below-average tenant credit bucket was about 6% of revenues. Any change to that, or has anything slipped maybe from one of the top two categories to the average bucket?
No, it's still holding at just a shade above 6%. There's been no material change to that.
Okay. Just on the same-store revenues, can you discuss what really drove the jump in the same-store revenues, and it related to car dealerships and sporting good properties? 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. They came in early in the year and gave us higher than expected same-store rent growth. Not higher than expected, but higher than what we expect for this full year, which is still around 1% to 1.2%. It was higher in the first quarter, primarily due to that percentage rent.
We'll take our next question from Michael Knott with Green Street Advisors.
Hey, guys. 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.
I do think that if the 1031 buyers go away, that there'll be more opportunity to play in those assets. They traded at levels that we think don't necessarily make sense. We really haven't been a player on the sell side or the buy side in the 1031 market. 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.
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.
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 what you're seeing in the corporate sale-leaseback market and your appetite for larger corporate lease type of transactions?
Yeah. 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 on 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-à-vis to last year.
Okay. On the 7-Eleven, to bring corporate leaseback to corporate transaction, curious, the convenience stores, something that a number of your peers have seemed to be moving in the opposite direction of. Curious as to your comfort level with that type of transaction here while others seem to be taking a different view.
We're focused on the highest quality convenience stores like a 7-Eleven, Couche-Tard, Circle K, who are both in our top 20. We want 3,000 sq ft or more where they have a significant inside store. 70% of the store sales are generated by customers not buying gas. The emphasis is really on convenience. These are great locations and good markets run by solid operators. We're still bullish on the C-store industry. It's our second largest industry today, and I think it'll continue to be one of our top industry investments. We are selling some smaller kiosk and smaller convenience store operations. We are focusing on the top tier and the highest quality C-stores.
As a reminder, if you would like to ask a question, please press star one on your telephone keypad. Again, please limit your questions to two. We'll go next to Michael Carroll with RBC Capital Markets.
Yeah, 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 the last quarter. We've run anywhere from 3% to 7% in the last several quarters. 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. 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?
Nope.
No.
Are there any specific property types or industries that you're shifting away from or you're starting to focus more on given, I guess, the current environment?
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. You look at drugstores, C stores, dollar stores, grocery stores, QSRs. Those are all areas that we continue to focus on. 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.
We'll go next to Dan Donlan 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. I'm just curious how you see that trending in the next five years. It seems to be a portion of the market that your peers continue to invest in. I'm just curious if it's going to trend back up or you're comfortable with your current exposure?
Dan, we're comfortable with our current exposure. If anything, it'll 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've discussed in the past. 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. 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. Those are assets 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. As far as the cap rates going forward, you've kind of met this low 6% level. We've seen a nice tick up in the 10-year 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. 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%. There's always a lag period, though. Bond prices and yields, bond yields can move 10 basis points 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 two. You need to see some more stability of interest rates at a certain level.
Just because the 10-year ticks up to 270 for a week and back down and holds for several weeks, and then it ends up within a few days back to 230, that's not really going to drive cap rates. You're going to need to see rates stay at a sustained higher level. You'll see, with a lag period, cap rates move.
We'll go next to Jason Belcher with Wells Fargo.
Oh, hi. I guess first, on your lease expirations in the quarter, just wondering how much you all spent in CapEx to retenant those leases that rolled over in Q1 and how much you expect to spend for retenanting over the balance of the year?
Yeah. For retenanting in the first quarter, we had CapEx right at about $2.5 million. Most of that was an expansion for an industrial tenant, where we received an 11% yield on the incremental invested capital, and the tenant extended their lease term by a factor of two times. When we have those opportunities, we would like to deploy capital with those sort of returns and qualitative results as well. 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. Yeah, that makes sense. 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 an ideal level where you'd like to see that shake out going forward?
Yeah. 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, Treasury Wine Estates picking up that lease now that they bought those operations from Diageo. Treasury is the largest publicly traded vintner in the world. It has a market cap of about $9 billion. 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. I think you'll continue to see the investment-grade number kind of fluctuate.
If the Rite Aid-Walgreens merger happens, it'll tick up about 1.8%, but it'll ebb and flow in this general area, I think. Our acquisitions in the first quarter were about 67%, 68% investment grade. 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 John Case for concluding remarks.
Thanks, Tracy, 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.
This does conclude today's conference. Thank you for your participation. You may now disconnect.