Good day, and welcome to the Realty Income 4th Quarter 2016 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ms. Janine Bedard, Vice President. Please go ahead, ma'am.
Thank you all for joining us today for Realty Income's 4th quarter 2016 operating results conference call. Discussing our results will be John Case, Chief Executive Officer Paul Muir, 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 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 ks.
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, and welcome to our call today. We are pleased to report an excellent Q4, which concluded a solid year for our company across all areas of the business. We completed a record high volume of high quality property acquisitions, accessed the capital markets at favorable pricing and terms and actively managed the portfolio to maximize value. As a result, AFFO per share during the Q4 increased 10.3% to $0.75 which contributed to 2016 AFFO per share growth of 5.1% to $2.88 As announced in yesterday's press release, we are introducing our AFFO per share guidance for 2017 of $3 to $3.06 as we anticipate another attractive year of earnings growth. Now let me hand it over to Paul to provide additional detail on the financials.
Thanks, John. I'll provide highlights for a few items in our financial results for the quarter year, starting with the income statement. Interest expense decreased in the quarter by $3,000,000 to $49,000,000 and decreased in 2016 by $13,000,000 to $220,000,000 This decrease is partly due to a lower average outstanding debt balance over the past year as we have primarily sold common equity for our capital needs over the last 2 years to repay outstanding bonds and mortgages. Our October bond offering of $600,000,000 was the first large debt offering we had completed in over 2 years. The decrease in interest expense was also driven by the recognition of noncash gains on interest rate swaps during the quarter year, which caused a decrease in net liability and lowered our interest expense.
As a reminder, we do exclude the impact of noncash swap gains or losses to calculate our AFFO. Our G and A as a percentage of total rental and other revenues was only 4.9% for the quarter and year as we continue to have the lowest G and A ratio in the net lease REIT sector. We project G and A to remain approximately 5% in 2017. Our non reimbursable property expenses as a percentage of total rental and other revenues was 1.9% in 2016. This was slightly higher than 2015 due to higher carrying costs associated with some vacant properties.
We expect non reimbursable property expenses as a percentage of total rental and other revenues to remain in the 1.5% to 2% range for 2017. Provisions for impairment were $20,700,000 in 2016 on 32 sold properties, 6 properties held for sale and 2 properties held for investment. We have increased our property sales activity a little with $90,500,000 in sales in 2016 $75,000,000 to $100,000,000 of sales expected in 2017. Briefly turning to the balance sheet. We've continued to maintain our conservative capital structure.
In 2016, we've raised approximately $573,000,000 of common equity capital. In fact, over the last 2 years, approximately 70% of the capital we have raised has been common equity, and our balance sheet remains very flexible. Our senior unsecured bonds have a weighted average remaining maturity of 6.6 years, and we have approximately $900,000,000 available under our $2,000,000,000 revolving credit facility. Other than our credit facility, the only variable rate debt exposure we have is on just $38,000,000 of mortgage debt. Our overall debt maturity schedule remains in very good shape with only $278,000,000 of debt coming due in 2017, and our maturity schedule is well laddered thereafter.
Finally, our overall leverage remains modest with our debt to EBITDA ratio standing at approximately 5 point seven times. In summary, we have low leverage, excellent liquidity and continued access to attractively priced equity and debt capital, both of which remain well priced financing options today. Let me turn the call now back over to John.
Thanks, Paul. I'll begin with an overview of the portfolio, which continues perform well. Occupancy based on the number of properties was 98.3%, unchanged from last quarter. We expect our occupancy to remain at approximately 98% in 2017. During the year, we released 186 properties to existing and new tenants, recapturing 105 percent of the expiring rent, which is well above our long term average.
Since our listing in 1994, we have re leased or sold more than 2,300 properties with leases expiring, recapturing approximately 98% of rent on those properties that were re leased. This compares favorably to the handful of net lease companies who also report this metric. We remain active in our asset management efforts as we look to enhance the returns on our existing properties as well. Our same store rent increased 0.9% during the quarter and 1.2% in 2016, which is generally consistent with the run rate we expect for our portfolio in 2017. 90% of our leases continue to have contractual rent increases, so we remain pleased with the growth we were able to achieve from our properties.
Approximately 75% of our investment grade leases have rental rate growth that averages about 1.3%. Our portfolio continues to be diversified by tenant, industry, geography and to a certain extent, property type, all of which contributes to the stability of our cash flow. At the end of the quarter, our properties were leased to 248 commercial tenants in 47 different industries located in 49 states and Puerto Rico. 79% of our rental revenue is from our traditional retail properties. The largest component outside of retail is industrial properties at about 13% of rental revenue.
Walgreens remains our largest tenant at 7% of rental revenues and drugstores remain our largest industry at 11.4% of rental revenue. During the Q4, we added 2 new tenants to our top 20, including 711, which represents 1.8% of our annualized rental revenue and Home Depot, which represents 1.1% of our annualized revenue. We are pleased with these additions as both of these tenants are investment grade rated best in class operators in their respective industries with excellent real estate locations and strong store level metrics. We continue to have excellent credit quality in the portfolio with 47% of our annualized rental revenue generated from investment grade rated tenants. The store level performance of our retail tenants also remain sound.
Our weighted average rent coverage ratio for our retail properties remains 2.8x on a 4 wall basis and the median remains 2.7x. Moving on to acquisitions. We completed $1,860,000,000 in property level acquisitions in 2016, of which $786,000,000 was completed during the Q4. Both of these amounts were record high volumes for our company and were completed at investment spreads relative to our nominal 1st year weighted average cost of capital that well exceed our historical average. We continue to see a steady flow of opportunities that meet our investment parameters.
In 2016, we sourced $28,500,000,000 in acquisition opportunities. We remain disciplined in our investment strategy, acquiring less than 7% of the amount sourced, which is consistent with our average since 2010. Our selectivity reflects our focus on quality. Our distinct cost of capital advantage allows us to consistently grow earnings while adding the highest quality investment opportunities to our portfolio. Given the pipeline we are seeing today, we are introducing 2017 acquisitions guidance of approximately $1,000,000,000 As a reminder, this estimate reflects our typical flow business and does not account for any unidentified large scale transactions.
I'll hand it over to Sumit to further discuss our acquisitions and dispositions.
Thank you, John. During the Q4 of 2016, we invested $786,000,000 in 2.79 properties located in 27 states at an average initial cash cap rate of 6.1% and with a weighted average lease term of 14.3 years. On a revenue basis, approximately 84% of total acquisitions are from investment grade tenants. 94% of the revenues are generated from retail and 6% are from industrial. These assets are leased to 27 different tenants in 21 industries.
Some of the most significant industries represented are convenience stores, financial services and discount grocery stores. We closed 24 discrete transactions in the 4th quarter and the average investment per property was approximately 2,800,000 dollars During 2016, we invested $1,860,000,000 in 505 properties located in 40 states at an average initial cash cap rate of 6.3 percent and with a weighted average lease term of 14.7 years. On a revenue basis, approximately 64% of total acquisitions are from investing rate tenants. 86% of the revenues are generated from retail and 14% are from industrial. These assets are leased to 51 different tenants in 28 industries.
Some of the most significant industries represented are convenience stores, drug stores and financial services. Of the 85 discrete transactions closed during 2016, buy transactions were above 50,000,000 dollars Transaction flow continues to remain healthy. We sourced more than $5,000,000,000 in the 4th quarter. During 2016, we sourced $28,500,000,000 in potential transaction opportunities. Of these opportunities, 61% of the volume sourced were portfolios and 39% or approximately $12,000,000,000 were one off assets.
Investment grade opportunities represented 26% for the 4th quarter. Of the $786,000,000 in acquisitions closed in the 4th quarter, 30% were 1 off transactions. As to pricing, cap rates remained flat in the 4th quarter with investment grade properties trading around 5% to high 6% cap rate range and non investment grade properties trading from high 5 percent to low 8 percent cap rate range. Our investment spreads relative to our weighted average cost of capital were healthy, averaging 2 14 basis points in the 4th quarter, which were well above our historical average spreads. We define investment spreads as initial cash yield less our nominal 1st year weighted average cost of capital.
Our disposition program remained active. During the quarter, we sold 26 properties for net proceeds of $34,400,000 at a net cash cap rate of 7% and realized an unlevered IRR of 8.5%. This brings us to 75 properties sold during 2016 or $87,600,000 at a net cash cap rate of 7.3% and an unlevered IRR of 8.5%. In conclusion, we had an exceptional year in 2016 regarding acquisitions as well as dispositions. We look forward to achieving our 2017 acquisition target of approximately 1,000,000,000 dollars and disposition volume between $75,000,000 $100,000,000 With that, I'd like to hand it back to John.
Thanks, Soumit. As Paul mentioned, 2016 was an active year for our capital markets activities. We issued $573,000,000 in common equity at an average price of approximately $61 per share, reflecting the lowest cost of equity raised in any year in our company's history. Additionally, with the highest credit rating in the net lease sector, we issued $600,000,000 10 year fixed rate unsecured debt at a yield of 3.15%, the lowest yield for debt we have issued with this term in our company's history. Our 10 year credit spread, which has narrowed by over 20 basis points since the offering, is now amongst the lowest in the entire REIT industry.
Our leverage remains low with debt to total market cap of approximately 28% and debt to EBITDA of 5.7 times. We currently have approximately $1,100,000,000 outstanding on our $2,000,000,000 line of credit, which can be expanded to $3,000,000,000 at our option. This provides us with ample liquidity and flexibility as we continue to grow our company. Last month, we increased the dividend for the 90th time in the company's history. The current annualized dividend represents a 6 percent increase over the prior year.
We have 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%. Our AFFO payout ratio is 83.5%, which is a level we are quite comfortable with. To wrap it up, we are pleased with our performance in 2016 and remain quite optimistic for 17. As demonstrated by our sector leading EBITDA margins of approximately 93%, we continue to realize the efficiencies associated with our size and the economies of scale in the net lease business. Our portfolio remains healthy and we continue to see an ample volume of acquisition opportunities that allows us to consistently grow earnings.
The net lease acquisition environment remains a very efficient marketplace, and we believe we are best positioned to capitalize on the highest quality opportunities given our sector leading cost of capital, access to capital and balance sheet flexibility. At this time, I would now like to open it up for questions. Operator?
Thank We'll take our first question from Vinik Khanna with Capital One Securities.
Can you just regarding the credit facility and understanding that you can spend it by 1,000,000,000 dollars What are your sort of plans for the $1,100,000,000 that's sitting on it now? Would you consider tapping the preferred market or is pricing significantly better in the 10 year, 30 year bond market?
Well, Vinit, we have a tremendous amount of a tremendous amount of financial flexibility right now, as I said in the opening comments. And at the appropriate time, we'll take a look at all forms of capital that are available to us and that would include unsecured debt, equity as well as hybrid capital and make a decision as to what makes the most sense at that time to term out some of the line. But in terms of leverage right now with a debt to EBITDA of 5.7 times, we're well within our targeted ranges and feel very comfortable about where the balance sheet is.
Okay, great. And then just sort of looking at the transaction market, have you guys seen any changes in sort of portfolio premiums or discounts? And I mean, it sounds like there are a handful of portfolios in the Q4, including the large convenience store 1. So maybe you could talk about sort of the trends there?
Sure. The premiums right now are for one off assets. On the portfolio side, especially when you get to the higher quality product and large investment dollars, there's substantially less competition because there are not very many players who can execute, if any, in the public sector who can execute on that type of transaction. So what we are experiencing right now are cap rates on one off transactions that are 25 basis points to 75 basis points lower than where they are on the larger portfolio transactions.
Great. Thank you.
Thank you. We'll take
our next question from Joshua Dennerlein with Bank of America Merrill Lynch.
Hey, guys. Question in guidance, what are you budgeting for CapEx in 2017?
Yes. For CapEx, recurring CapEx in 2017, we're budgeting $5,500,000
Okay. And is that kind of the standard run rate going forward or is that an uptick or?
It hops around. In 2016, it was 1 point $5,000,000 and 20.15, it was $8,500,000 So really, it's driven by timing on those recurring CapEx and the requirements fluctuate year to year. So there's not really a smooth run rate, but I'd say in general, it's going to be somewhere between 2% to 8% over the next few years. And this year, we're projecting 5.5%.
Okay. Thanks. And then where are you seeing the best opportunities across asset types and tenant types in the market right now?
I'd say, it's pretty broad right now. It's consistent with what we were seeing last year, where some of our larger, more attractive industries were seeing product from tenants in those industries. And whether it be C stores,
QSRs,
some theater opportunities, some fitness opportunities. It really is quite broad. And I can't say there's one particular industry that's driving the opportunities on the investment side that we're seeing currently. But we do have a good flow of a good flow of opportunities as we mentioned in the opening remarks.
And we will take our next question from Michael Knot with Green Street Advisors.
Hey, guys. Obviously, you're blessed with a very attractive cost of capital, particularly on the equity side, debt side also, but on the equity side. I'm just curious, given your record level of acquisitions that you reported last night at one of the lower yields, combined with the markets, pretty favorable reaction this morning. Curious if that has any bearing on your thoughts on where you go and where you position yourself on the quality spectrum in terms of acquisitions? It seems like you've focused more on the higher quality side here lately with better cost capital.
Just curious if today's reaction gives you any pause on that?
Well, no, I think given our distinct cost of capital advantage, we're able to focus on the highest quality net lease properties and investments out there. And this is a very efficient market. And as you go out on the risk and yield spectrum, you're going to be taking on issues that you don't take on the higher quality. And with our unique position, we're certainly able to achieve IRRs that exceed our hurdle rates and spreads, initial spreads relative to our 1st year nominal weighted average cost of capital that are much wider than what they have been historically. So we plan to maintain that quality focus and we think it's paying off and we think the market is respecting that.
Okay, thanks. And then other question for me would just be curious if you can talk about the occupancy tiny reduction you expect in 2017. Is there any particular credit issues that you're seeing generally across a couple of different types of industries? Or is it just pretty normal course of business?
Just normal. We've been in this 98% plus or minus range, and it's hard to get it down to 1 tenth of a percentage point in terms of prediction. So in our model, we modeled approximately 98%. The portfolio, there are no material issues in the portfolio right now. We feel quite good about its health.
And 98% is not indicative of any downturn on the portfolio front.
And we'll take our next question from Nick Joseph with Citi.
Thanks. John, you mentioned the premium on the one off assets and not portfolios. So is it fair to assume that you do exceed your 2017 acquisition guidance that it could be more meaningful because it'd be driven by those portfolio deals? Yes. Yes.
I think that's fair to say, Nick. Okay. And then just, I guess, along that line, in terms of potential M and A in the space, just wondering if you have any updated thoughts, just given multiple disparity amongst the group? No, I don't. I don't like to speculate on any potential or theoretical M and A activity.
So I don't really have any thoughts to share publicly on that front.
And we'll take our next question from Vikram Malhotra with Morgan Stanley.
Hi. This is Landon Parikh on for Vikram. Just to start off, I was wondering if you could touch base on the 711 portfolio you purchased, just the process there as well as the underlying lease characteristics? Yes. Well, we're subject to CA.
So I can't get into specific details on that portfolio, but what I can do is kind of talk about what we look for when we do a C store transaction. So again, we're focused on quality, really a best in class operator with high quality real estate, store sizes that are at least 3,000 square feet because that's where these C stores drive their profits and that's where their margins are. We want to be in properties that are reflective of market rents and replacement costs, and we want good coverages. And having a great credit is icing on the cake. And we prefer to be with best in class operators.
Kushtard, Circle K is another one of our top 20 tenants. That's what we like. We're actually selling some C stores right now. And these are the ones we're selling are a contrast of what I just described. We don't have a lot of them, but they're non strategic and that the store sizes are 500 square feet or less.
They're more kiosks, regional. The locations are inferior and certainly the credits are inferior to someone like a 711. So and we don't really experience a lot of competition, certainly from the public sector on those types of transactions, because again, going back to our cost of capital advantage and our ability to execute and clear our hurdles and drive earnings through these types of investments. Okay. And could you give any sense of pricing relative to what you did on average for the quarter or where the coverage levels are on average compared to your existing portfolio?
Do the coverage levels on those types of transactions exceed our average for our overall portfolio? I can't release specifics on that front. So given the fact that we're subject to a CA. Okay. Thank you very much.
We'll take our next question from Michael Carroll with RBC Capital.
Yes, thanks. John, how would you characterize the competitive landscape today? And has that changed over the past few quarters? Not materially. I mean, when we're looking at the higher quality investments that we've been talking about some on today's call, we don't see as many public companies, if any, there.
We see institutional capital being run by institutional investment managers that are familiar and experts in the net lease sector. So when you when we go out a bit on the yield and a little bit out on the risk spectrum, we start to bump into some of the other public and private REITs that are out there that are in the net lease space, plus we see some mortgage REITs and sometimes some private equity capital. That's been consistent for the last few quarters, if not the last year and a half. So no real discernible changes on that front. Okay.
And then can you give us some color on the planned dispositions that you have in your guidance? What's the main reason for these sales? And are they vacant or stabilized assets? It's a mix. So we're guiding to $75,000,000 to $100,000,000 in dispositions this year.
That's really comprised of the kiosk lower quality legacy C Stores and some casual dining opportunities as well as some daycare properties that are no longer consistent with our investment strategy that we're moving out. Some are vacant and some are leased. It's probably fifty-fifty, somewhere in that neighborhood. With what we the $90,000,000 we did last year, those are also non strategic sales. And on the leased assets, which were about half of what we sold, we achieved cap rate in the low 7s.
So that gives you an idea of the market where we can sell non strategic assets in the low sevens. Our overall unlevered IRR on all of our sales, including our vacant properties, was 8.5 percent. And again, these are non strategic investments that we're selling.
Thanks.
Thank you.
We'll take our next question from Daniel Donlin with Ladenburg Thalmann.
Thank you
and good afternoon. Just had a quick question on you guys used to talk about a metric called the ARPS score and just curious if you guys still use that and kind of what's that showing in terms of tenant health now versus maybe what it did at this time last year, given the weakness seen with many bricks and mortars retailers in the Q4, I'm just kind of curious if that has ticked up or what's going on there?
Yes. We've converted from a Darth to an S and P approach in terms of credit. So the DARTH days are behind us. But I can talk about the categories from a credit perspective. We have really 4 categories from a tenant credit and it's excellent, above average, average and below average.
And the low average are the weaker credits and they represent about 6% of our revenues. But our watch list, the list from which we sell is in the low ones. And that watch list combines both the credit and the quality of the real estate. So there's some very high quality real estate in that 6% below average credit bucket that we wouldn't mind getting back and selling or releasing. And so we're fine holding on to that.
The trends have been pretty consistent there. The watch list has been hovering in the low ones and the below average credit has been in the 7s. And I'll tell you, you've been following us for a long time. If you go back 8 years ago and you looked at our top 20 tenants, the average rating would be kind of double B minus. You flash forward to today.
And
at the
end of 2016, the average rating of our top 20 tenants is a solid BBB. So we've made real good progress over the years and upgrading the credit profile and we feel good about where the portfolio stands, Dan. Okay. I appreciate it.
And then just kind of curious on the lower cap rate, if you could comment on kind of maybe what percentage of acquisitions maybe in the Q4 or even 2016 were direct sale leasebacks. But I'm wondering if the low cap rates is more or less a function of you trying to engineer higher rent coverage ratios versus kind of versus just simply paying a low cap rate. So any commentary on that would be helpful.
Yes. Well, on the sale leaseback, 75% of the activity in the Q4 was sale leaseback and for the year it was about 60%. And we don't financially engineer transactions. We want to underwrite market rents. We could reduce those rents and show higher cap rates, but that gives you risk on the residual and long term risks.
So we've always avoided that. And we don't mind announcing an initial yield of 6.1% like we did in the Q4 when we're buying the sort of quality assets that we're buying. We're still making, as I said, great spreads well above our historical average. And on our IRRs, we're exceeding notably our hurdles there. So what we see done in the industry is some players dressing up their yields by buying assets that have rents that are well above market.
And in the long run, it's our opinion that that's just not a value creating exercise.
Okay. Thanks.
Thank you.
We'll take our next question from Jeremy Metz with UBS.
Hey, guys. Just one quick one. You had the 409,000,000 of preferred with a coupon of a little over 6.6%. I believe it just became callable last week. So given the coupon versus where you're buying assets and call it the low 6% range, it would seem like redeeming this would clearly seem to make sense.
Can you just give us your thoughts around this and what if anything is baked into guidance?
We're going to take a look at this coming out of the call in the next few weeks and determine what's appropriate for the company and the shareholders. We've made no definitive decisions on that.
Okay. So nothing in guidance then?
No. Okay. Thanks.
This concludes the question and answer portion of Realty Income's conference call. I would now turn the call over to John Case for concluding remarks.
Okay. Thank you, Kyle, and thanks for everyone to everyone for joining us today. And I know we'll be visiting a number of our investors who were on call today in less than 2 weeks at the Citi conference. We look forward to that. And again, thanks for your participation and have a good afternoon.
And this does conclude today's conference call. Thank you all for your participation and you may now disconnect.