Realty Income Q2 2024 Earnings Call Transcript

Quartr
Provided by Quartr
August 6, 2024

There are 12 speakers on the call.

Operator

Good day, and welcome to the Realty Income Second Quarter 20 24 Earnings Conference Call. All participants will be in a listen only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Steve Bauchi, Senior Vice President, Corporate Finance.

Operator

Please go ahead.

Speaker 1

Thank you all for joining us today for Realty Income's 2nd quarter operating results conference call. Discussing our results will be Sumit Roy, President and Chief Executive Officer and Jonathan Pong, Chief Financial Officer and Treasurer. During this conference call, we will make statements that may be considered forward looking statements under federal securities law. The company's actual future results may differ significantly from the matters discussed in any forward looking statements. We will disclose in greater detail the factors that may cause such differences

Speaker 2

in the company's Form 10 Q.

Speaker 1

You 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. If you would like to ask additional questions, you may reenter the queue. I will now turn the call over to our President and CEO, Sumit Roy.

Speaker 2

Thank you, Steve. Welcome, everyone. In the Q2, I'm pleased we were able to deliver strong results as the economy as well as the transaction market navigate today's rate environment. We seek to be real estate partners to the world's leading companies and the diligent efforts of our dedicated team resulted in AFFO per share of $1.06 representing a robust 6% growth compared to last year. Combined with our annualized dividend yield in excess of 5%, our shareholders earned a total operational return of over 11%.

Speaker 2

The power of our global sourcing and acquisition platform was on display this quarter as we deployed capital in the U. S. And Europe across retail, industrial and data center real estate and the real estate backed credit opportunities. In total, we invested $805,800,000 into high quality opportunities at a blended 7.9 percent initial cash yield or an 8.2% straight line yield assuming CPI growth of 2%. Of this, approximately $262,000,000 of volume was invested in the U.

Speaker 2

S. At a 7.6% initial cash yield. The balance of approximately $544,000,000 was invested in Europe at an 8% initial cash yield, including a $377,500,000 investment in a secured note at an 8.1% yield issued by Asda, a leading UK grocery operator. As we discussed in the past, we intend to pursue credit investments selectively and only when it may eventually facilitate access to high quality real estate opportunities as has been the case with ASDA. We also believe these credit investments represent a profitable means for Realty Income to participate in and benefit from the current rate environment.

Speaker 2

Furthermore, from a risk management perspective, we view these credit investments as a prudent natural hedge to the inherent rate exposure as we have on the liability side of our balance sheet. Providing further detail on investments in the quarter, we executed 79 discrete transactions with 55 clients, including 2 new clients across 22 industries. 31% of direct real estate investment volume was allocated to new sale leasebacks. Touching on our sourcing activity, we were pleased that our transaction discipline earlier this year is bearing fruit as this quarter we began to see a greater number of opportunities available at pricing that aligns with our cost of capital. This improvement supported the $200,000,000 increase in transaction volume sequentially and it drove the investment guidance increase to $3,000,000,000 in June, a 50% increase from our prior guidance.

Speaker 2

We believe the higher closed volume paired with investment spreads that are largely consistent with last quarter are signs the transaction market may be moving towards normalization. Investment activity this quarter was funded in large part by adjusted free cash flow, which totaled approximately $200,000,000 in the 2nd quarter. Not having to rely on public equity enhanced the accretive nature of these transactions. The deployment of excess cash flow represents an important contributor to our growth. In fact, we believe we can utilize excess free cash flow together with our portfolio's internal rent growth to deliver an approximate 7% to 8% total operational return annually to shareholders without relying on public equity issuance.

Speaker 2

The portfolio's stabilized internal growth rate has risen in recent years and now stands at approximately 1.5% on an annualized basis, in part because of the expansion of our European platform where many leases are subject to uncapped CPI increases as well as our expansion into the gaming and data center verticals, which where leases often include healthy annual rent escalators. With the benefit of excess free cash flow, 2nd quarter capital deployment activity resulted in investment spread of approximately 293 basis points, which like the Q1 is well above our historical spread of 150 basis points, in part due to the utilization of excess free cash flow. As a reminder, these disclosed investment spreads utilize our short term which measures the estimated year 1 earnings dilution from raising capital on a leverage neutral basis to fund our investment volume. This is different from a higher long term cost of capital which applies a growth premium to our cost of equity to account for the long term return requirements for our investors. While we remain vigilant in today's volatile environment, seeking only the most attractive risk adjusted return opportunities, we will also only utilize external capital opportunistically aiming to augment our growth rate at times when our cost of capital becomes increasingly attractive as compared to prevailing market investment yields.

Speaker 2

An additional source of capital in the Q2 was dispositions. We utilized proprietary predictive analytic tools in combination with the insights of our asset management and research teams to drive the decision to sell 75 properties for total net proceeds of approximately $106,000,000 bringing the year to date total to approximately 202,000,000 dollars For the year, we expect to sell between $400,000,000 $500,000,000 of assets. As we continue to calibrate and hone our predictive analytic tools, advancing our investment thesis on each property in our portfolio, we may be more active on dispositions than in the past. We continue to optimize our portfolio composition and investment returns while broadening our use of organically generated capital to finance growth. Another critical point of differentiation for Realty Income is the strength of our balance sheet underpinned by our low leverage of A3A- credit ratings by Moody's and S and P respectively and our access to capital on a global basis.

Speaker 2

During the Q2 of 2024, the combination of internally generated cash flow and disposition sale proceeds allowed us to fund most of our investment activity without settling any newly issued equity capital, while still maintaining our leverage metrics at or below our long term targets. Shifting to operations, our portfolio continues to generate very solid returns and to perform in a very stable fashion. Occupancy rose to 98.8% as of June 30, a 20 basis point increase from the prior quarter. Additionally, our rent recapture rate across 199 leases was 105.7 percent, totaling approximately $34,000,000 in new annualized cash rent. The size, scale diversification and consistency of performance from our global real estate portfolio continues to provide us with excellent visibility to revenue and is a key reason why we have not had a single year of negative operational return in our 30 years as a public company.

Speaker 2

Managing through periodic store closures is a natural part of our business model and our top tier credit search and asset management teams offer distinct competitive advantages, which have consistently enabled us to optimize value in these situations. To that end, we would like to provide remarks on a few clients that are currently managing through stroke closures or have been in the news due to credit related concerns. Importantly, in the context of our portfolio's size and scale, the aggregate financial exposure of potential loss rent is expected to materially impact our ability to generate the consistent operational returns our shareholders are accustomed to. And it is important to emphasize our recent increase in earnings guidance takes all credit considerations into account. Rite Aid, which represents 30 basis points of our total portfolio analyzed contractual rent as of June 30, 2024 is to emerge from bankruptcy in the Q3.

Speaker 2

Through the remainder of the bankruptcy process, we expect to lose 12 basis points of rent prior to the resolution of assets vacated in the proceedings, which are ultimately re leased or sold. Red Lobster represents 1% of our total portfolio annualized contractual rents And it is currently moving through the bankruptcy process. At present, as publicly stated, Red Lobster is targeting to emerge from bankruptcy in the our in line with our historical portfolio wide average of 84% for client bankruptcy restructurings. Walgreens is considered closing certain stores. Looking out over the next two and a half years, we have leases representing only 26 basis points of our total portfolio annualized contractual rent that will expire over that time.

Speaker 2

Outside of a bankruptcy scenario, which we view as unlikely with Walgreens, these are the only stores Walgreens can legally seize to rent payments on once each lease expires. To provide context on historical capture rates in the drugstore industry, we have managed 166 lease expirations since 2013. 80% of these were renewed that resulted in a blended recapture rate in excess of 100% of prior rent. Dollar Tree, which is investment grade rated announced the potential split of the Family Dollar brand from Dollar Tree. If this were to result in store closings, Family Dollar leases representing only 5 basis points of our total portfolio annualized contractual rent are set to expire between now year end 2026.

Speaker 2

And of course, in the interim, they're obligated to continue paying rent through lease expiration. Our historical recapture results in the Dollar Store Industries have been similarly favorable. We have managed 263 lease expirations since 2013 of which 86% of the clients renewed at a weighted average rate well north of 105%. In case of our theater exposure, we feel the risks have notably diminished in the past 12 months. Cineworld reduced its debt by 4,500,000,000 dollars through its restructuring and AMC recently made improvements to its financial position by extending debt maturities and additional equity issues.

Speaker 2

It is important to note that in total, the rent at risk from Rite Aid, Red Lobster, Walgreens, Dollar Tree as well as at home and Big Lots, which is 11 basis points of rent represents in total only 2.3 percent of our total portfolio annualized contractual rent through year end 2026. And if we achieve the recapture rate in line with our long term average for bankruptcies which is 84%, this suggests only approximately 37 basis points of rent is at risk of seizing or an approximately $0.02 of AFFO per share impact. In addition, if they do take place, advance notice of potential store closures are of incremental value to us because they provide years in many instances to plan the optimal outcome at those locations where the client's plan is to leave while we continue to be paid rent. This $0.02 per share potential impact is manageable and is counterbalanced by the power and stability of our net lease business model, which is underpinned by diversification across more than 15,000 properties, 1500 clients and 8 countries on 2 continents. Hence, we believe it is important to separate the store closing headlines from the manageable impact they have on our financials.

Speaker 2

With that, I would like to turn it over to Jonathan to discuss our Q2 financial results in more detail. Jonathan?

Speaker 3

Thank you, Sumit. Consistency has long been a benchmark by which we manage our business. To that end, we ended the 2nd quarter with leverage at 5.3 times without settling any ATM equity during the quarter. This was the 25th consecutive quarter of leverage at 5.5x or lower, reflecting our commitment to our A3A- credit ratings, which we have had now since 2018. As a reminder, we manage our leverage through the lens of net debt and preferred equity to annualized pro form a adjusted EBITDA.

Speaker 3

During the Q2, we generated approximately 200,000,000 dollars of adjusted free cash flow over $100,000,000 in real estate sales proceeds and approximately $185,000,000 afford unsettled equity sold through the ATM after modest ATM issuance activity subsequent to quarter end, we currently have almost $450,000,000 of unsettled forward equity, which we estimate will be more than sufficient to finance our equity needs for the remainder of 2024 and still remain within our target leverage ratios. Our balance sheet remains healthy with a well staggered debt maturity schedule that allows us to be active should borrowing costs trend lower over the maturity cycle. Last month, we repaid 350,000,000 dollars of maturing public notes, leaving us with only $118,000,000 of maturing mortgage debt for the balance of the year. Our exposure to February debt of $1,600,000,000 remains modest at only 6.3% of total debt principal at quarter end, Our liquidity remains solid with access to approximately $3,800,000,000 of capital at the end of the second quarter inclusive of cash on hand, availability under our $4,250,000,000 revolving credit facility and our outstanding ATM for equity. We remain comfortable with the liability side of the balance sheet and believe we are well positioned to act on larger investment opportunities should they present themselves.

Speaker 3

As Sumit mentioned earlier, we view our credit investments as a natural hedge to the inherent interest rate risk associated with debt maturities we have on our balance sheet. That end, the 6 year GBP 300,000,000 sterling senior secured loan we invested in during the quarter provides us with an attractive 8.1% yield, secured by the solid credit of a UK grocery store operator, while reducing the rate sensitivity on the value of sterling debt we have on the balance sheet maturing in 2,030, which currently totals £504,000,000 From a 2024 earnings guidance perspective, we are reiterating our full year investments guidance at $3,000,000,000 and our AFFO per share guidance of $4.15 to $4.21 which represents 4.5% annual per share growth assuming the midpoint. As a reminder, we increased our guidance on June 4, which included the expectation of collecting the $16,000,000 of lease termination fees that we recognized in the Q2. Offsetting a portion of AFFO tailwinds from termination fees was the recognition of approximately 6 $200,000 of AR reserves from one of our clients in the convenience store industry. Lease termination of fees are excluded in our same store rental revenue calculations, while AR reserves are included, and thus the $6,200,000 of reserves that we recognized on one client in the quarter alongside impacts of our theater portfolio held back our 2nd quarter same store rent growth by approximately 60 basis points, resulting in overall same store growth of 0.2% for the quarter.

Speaker 3

Including this reserve, we continue to expect our full year same store rental revenue growth recovered to close to the 1% level for 2024. With that, I'd like to hand the call back to Sumit for closing remarks.

Speaker 2

Thank you, Jonathan. To conclude our prepared remarks, this year is progressing largely in line with expectations, perhaps even slightly ahead. There are signs the transaction market is beginning to normalize as we find more opportunities to deploy capital into high quality investments, meeting our minimum return requirements. Adjusted free cash flow and dispositions continue to be accretive sources of capital we can use to support future growth. Combined with the stability of our solidly performing client base and the strength of our balance sheet, we believe we are well positioned to deliver attractive risk adjusted returns to shareholders in a variety of economic environments.

Speaker 2

I'd like to now open it up for questions. Operator?

Operator

The first question comes from Michael Goldsmith from UBS. Please go ahead.

Speaker 4

Good afternoon. Thanks a lot for taking my question. The largest component of your investment volume this quarter was the investment in the adds in notes. How should we think about the different investment buckets that you have when it comes to expectations for the back half of the year? Thanks.

Speaker 2

Thank you, Michael. That's correct. We did have a $377,000,000 investment in the opportunistic and we've already highlighted the reasons as to why we did that. What you should expect for the balance of the year for the remaining half of the year is that we are probably going to have the majority of our investments, if not 100% of our estate direct investment. That's what's going to make up the estate, direct investment.

Speaker 2

That's what's going to make up the balance of the remaining 6 months.

Speaker 4

Got it. And then as a follow-up, can you talk a little bit about the opportunities you're seeing in the U. S. Versus European markets outside the loan, you leaned a little bit more to the U. S.

Speaker 4

In the Q2, a reversal from the Q1. So can you talk a little bit about what you're seeing in these markets and the spreads in the U. S. Versus Europe? Thanks.

Speaker 2

Yes. So we had during the Q1, we had said that we're starting to see some green shoots here in the U. S. Where sellers were starting to realize the higher cap rate environment was here to stay. That obviously resulted in an increase in volume in terms of investments here in the U.

Speaker 2

S. In the second quarter. We expect that to continue into the remainder of the year. The volume increase that we saw with regards to sourcing would also attest to that phenomenon. And I think with the backdrop that we are seeing on the cost of capital side, I do think that there will be more transactions that will materialize in the next half, especially here in the U.

Speaker 2

S. The markets in Europe are have been fairly stable. I think the expectations of the interest rate cuts were well understood. And what we saw in the Q1 where we had some opportunistic sellers come to the market and we were the beneficiaries of those transactions. Similar transactions took place in the 2nd quarter and we feel pretty confident that that trend will continue for the remainder of the year, but you should see an increase in volume coming from the U.

Speaker 2

S. And more of the same in markets outside the U. S.

Operator

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

Speaker 5

Yes. Hey, guys. Maybe just going back to the Asda loan, I think you've done some other loans in the past that were pretty sizable. Just kind of how do you think about like the duration risk and just like when you're typically taking the equity stake doing a real estate loan, it's like you would assume that real estate is forever, but for a loan, it's kind of limited duration. Like how does that factor into your underwriting?

Speaker 5

And just like is there a limit maybe on exposure you want to have for lending?

Speaker 2

Yes. So Joshua, we've been very clear with the market that the credit investment side of the business is an addendum to what we are offering our clients. We believe that opportunistically it makes a lot of sense for us to continue to be a partner to our clients such as Astra. And when you look at the investment we made, dollars 377,000,000 at an 8.1% 6 year paper, and you overlay the fact that we have maturing debt close to GBP 600,000,000 coming due in about the same timeframe, this is one of the reasons why we did what we did. Let me put this in perspective in a slightly different way.

Speaker 2

If we were to go out and try to do a sale leaseback on as the real estate today, it would probably be in the mid-6s, maybe even in the slightly inside of that. And so for the same credit, if you're able to get 160, 170 basis points of additional spread over a 6 year period, I think it's and get the same exposure in terms of the credit. It's something that for us made a lot of sense. The other reason is one that we've continued to share with the market around why we have gone down this path of credit We are willing to do 20 year paper sale leasebacks on their real estate. We along the credit.

Speaker 2

We like the credit. And if we can continue to create an even closer relationship by participating higher up on the capital stack, that is something that makes a lot of sense for us. Especially when you take it in the context of we are experiencing the negative impact of higher interest rate environment on our own balance sheet. And if we can offset using this credit investment as a tool, this negative impact that we experience by participating on the asset side by providing credit to some of our clients, then this is a very nice way to hedge this negative impact. Having said all of this, we've also been very clear that credit investment is going to be a point in time.

Speaker 2

This is not a tool that will work in every environment and we don't expect to do credit investments in a very low interest rate environment. And so for all of the reasons that I've just enumerated, it's a wonderful tool to have and thankfully we have the relationships with clients who want us to participate, we would like to participate and it acts as a natural hedge to some of the negative headwinds that we encounter in this environment. So that's why we did what we did.

Speaker 5

Okay. And then maybe just one other question. Just you mentioned the expansion into data centers and gaming. It helps drive internal growth by going into those verticals. I guess are there any other verticals you're looking at or where you think you can get that higher internal growth rate if you're already in that vertical?

Speaker 2

Yes. So the areas that give us that higher internal growth largely are the 2 you've mentioned and the international market. And obviously, this is not a new vertical for us, but industrial does tend to have higher internal growth as well. And the combination of our investments in these areas have resulted in the profile of internal growth changing from circa 1% in our business to 1.5%. And that will continue to be the areas that we focus in, in the future.

Speaker 2

I think this was a question that was asked in a previous call as well. Are there any new verticals that we are looking at? And the answer is no. We have a very well defined total addressable market based on the verticals that we've already articulated to the market and we are very comfortable continuing to play in those specified verticals and there's plenty to be done. So we're very happy with that.

Operator

The next question comes from John Kiehlichowski from Wells Fargo. Please go ahead.

Speaker 3

Hi, thank you. So the amount of IG Tenant as a percentage of acquisitions was 10%, which I believe is your lowest since the Q3 of 2017. Maybe how should we think about that and your appetite to move down the risk curve to generate yields here?

Speaker 2

Yes. I don't necessarily agree with the last comment that you made in your question that, John, but I'll go ahead and answer this question around investment grade representing 10% of our investments in the Q2. We've always been very clear with the market when we've said that we don't target investment grade as a criteria for investment. What we are looking for is, are we generating the right yield for the credit risk that we are taking, for the real estate risk that we are taking, etcetera. And the actual ratings of the client is a byproduct of being able to underwrite appropriate risk adjusted return profiles.

Speaker 2

And if it so happens that we have clients that are investment grade as a result of that risk adjusted return profile that we are targeting, that's great. But it's not something we specifically look for. Case in point, John, if you look at portfolio today, there are so many names in our top 20 that just happened to be non rated. And had they gone through a rating process, they would be investment grade. Companies like Sainsbury's, Treasury Wine Estate, We have grocers like Publix and Trader Joe's that are not rated today and don't constitute an investment grade bucket for us, but if they were to be rated, they would be.

Speaker 2

And so the point I'm trying to make is it's not something that we target, it's a byproduct of our underwriting and we are very comfortable continuing down that path.

Speaker 3

Understood. And then I guess maybe jumping to bad debt here. On the last call, you mentioned the conservative nature of your bad debt number. I don't believe you provided it, but maybe could you talk about where it is today and if there's upside to your guide there? Yes.

Speaker 3

So if you just look at what we disclosed in the footnotes of the income statement on the earnings press release or the supplement, you'll see that we've recognized around $9,000,000 on a year to date basis in bad debt expense. And so looking at that as a percentage of revenue, it is around 70 basis points or so. Now what we've always said is that historically, we've been roughly in the 35 basis point range as a percentage of revenue to bad debt expense. And when you strip out the pandemic, it's closer to 23 basis points. So we're a little bit ahead of that, but a lot of that was related to this $6,000,000 reserve that we did end up taking on 1 C store operator.

Speaker 3

We do not expect the magnitude of that to carry forward into the back half of the year, but there is still a little bit of conservatism there. And I think from our standpoint, even though we feel very good about a lot of these credits, I think in the back half of the year, you can assume that we're assuming something close to what we recognize in the first half.

Operator

The next question comes from Haendel St. Juste from Mizuho. Please go ahead.

Speaker 6

Hey, I guess first question just to follow-up on the Asda loan. I guess, are there any purchase options or agreements attached to the loans? And I guess, I'm assuming these are assets you wouldn't mind owning at some point. And then as part of that, I guess, just want to confirm based on your comments in the call that we should not anticipate you doing more loan deals

Speaker 3

in the second half of

Speaker 6

the year that there's nothing else from that type of activity embedded in the guide? Thanks.

Speaker 2

So, Haendel, yes, the last comment you made is accurate. We are not anticipating doing any credit investments in the second half. But just to be very clear, credit investment is something that we have used opportunistically in the past and we will continue to use opportunistically going forward, but it is not contemplated that we will do any in the second half. Having said that, you're right, this is a secured bond offering. And so it is the security that we have is obviously a lot of the unencumbered real estate that ASSA continues to own.

Speaker 2

You're also correct in assuming that we are very comfortable going along the credit. You might recall in the Q3 of last year, we did a fairly large, I want to say north of $600,000,000 of sale leaseback with Asda. So this is a credit that we are very comfortable with. We like the operators. We like what they're trying to do with their business.

Speaker 2

And this is a way for us to continue to strengthen that relationship going forward. But yes, part of what we are trying to do is in the event they decide to go down the path of doing sale leasebacks, we are going to be 1st in line. There are no guarantees, but we will be 1st in line for those conversations. And that's exactly the type of position we would like to be in going forward with clients such as this.

Speaker 3

Got it. That's helpful.

Speaker 6

Thank you for that. And one more if I may. I was intrigued by your comments on the investing landscape today. It sounds like you're seeing more opportunities to fit your buy box given your improved cost of capital. And that seems like you're willing to be more active if the right opportunity presents themselves.

Speaker 6

But I guess I'm curious if the lower cost of debt and just improving cost of capital more broadly is perhaps allowing some private competition to enter the space. So I'm curious if you're seeing any incrementally new competitors or private equity reentering the landscape here? Thank you.

Speaker 2

Sure. Good question, Haendel. Look, I think it's a little too early, but the reality is that in the event that interest rates do start to come down, private equity that has largely been absent from the market should start to come back in. We are not currently seeing that in the transaction that we are pursuing. We are seeing some institutional capital, I would call them private equity, coming into the market and becoming a bit more aggressive.

Speaker 2

It's not prevalent yet. But yes, if the interest rate environment continues to be positive, I. E. Rate cuts start to materialize, finding private equity as a competitor is certainly something that we should expect. You talked about us becoming more aggressive given our cost of capital having improved, especially over the last couple of weeks.

Speaker 2

That is true. And our cost of capital has improved. But the point I want to keep making, Haendel, is we want to remain very disciplined. We do believe that there will be more transactions that should take place just given the backdrop that we've talked about. But we don't have to do a whole lot to generate the earnings guidance that we've shared with the market.

Speaker 2

And if the market opportunistically produces transaction for us that we feel like makes a lot of sense for our portfolio, we will absolutely be first in line to take advantage of that. And that's the position that we want to be in. And but I don't think the fact that our cost of capital has improved, that's going to be the impetus to go out there and start doing more transactions. I think the materialization of actual transactions that we would like to be successful pursuing, that is going to drive what we do in the second half. And we feel based on everything that we are seeing plus the pipeline that we have, very confident that the investment market will continue to improve.

Operator

The next question comes from Smedes Rose from Citi. Please go ahead.

Speaker 7

Hi, thanks. Just on that, I was just wondering about the transaction activity that you kind of have in your pipeline. I mean, do you see more kind of larger portfolio deals in the offering? Or is it more kind of smaller kind of one off transaction opportunities, any sort of changes since your last quarterly call?

Speaker 2

Smedes, there are some large front actions that will be coming to market in the second half. These are existing clients that we have that we are in constant conversations with as to whether we are lucky enough to win those transactions or whether they end up coming to market is still a bit of a question mark. But we are starting to see those types of conversations taking place and we feel pretty good that the market is going to improve. Our pipeline is largely along the lines of what we've achieved to date on the straight up organic acquisition side. And there aren't any $1,000,000,000 portfolios, if that's what you're thinking, that we have in our pipeline yet.

Speaker 2

But the conversation leads me to believe that there will be larger portfolios coming down, but we'll see.

Speaker 7

Okay. Okay. And then I just wanted to ask you too. I'm sorry if you maybe address this, but the termination fees you received in the quarter, they were related to one particular client or was this just a bunch of fees that happened to come in at once? So I'm just kind of wondering they were related to?

Speaker 3

Yes. Those are related to one particular tenant. And it's really reflective of an agreement that our team was able to reach with them for a handful of assets, not the entire exposure, but just a handful of them.

Operator

The next question comes from Greg McGinnis from Scotiabank. Please go ahead.

Speaker 8

Hey, hope you're doing well. Just hoping to get a little more color on how you're identifying assets for disposition, whether that's tenant credit, renewal risk, geography? Any color would be appreciated.

Speaker 2

So a lot of it is very it's opportunistic. It is an analysis, a very deep analysis that the asset management team takes on looking at assets for existing clients that may not have the right return profile that longer term because the markets have changed or that particular location is not what it used to be. There could be several reasons as to why they get into the disposition list, one of which could be credit as well. And so we are using our predictive analytic tools to help monitor these 15,000 assets that we have at any given point in time and it's coming out with a rating that then suggests that, hey, this one may have a high location risk or low fungibility available to these locations and then we overlay the credit on top of that. And then asset management goes through those and tries to create various different scenarios of what is the economic outcome going to look like under, for instance, a client that may not have any credit issues will pay rent, but at the end, this asset may not have other alternatives available to it outside of a vacant sale.

Speaker 2

And that return profile will be compared with selling it today to see what yields a better outcome. And that's the analysis that the asset management team is undertaking far more directly today than I think we've done in the past. And that's the reason why we've come up with the $400,000,000 to $500,000,000 of assets that we feel like does not necessarily have a long term future in our portfolio. And that's how we come up with the list.

Speaker 8

Okay. Thank you. And then on acquisitions, how should we be thinking about your view on investment spread with improved cost of capital versus what you're actually seeing in the market? The U. S.

Speaker 8

Cap rates were up 70 points quarter over quarter. Is that kind of

Speaker 1

a fair target area?

Speaker 8

Or could we see that start to come back in?

Speaker 2

Greg, as you know, I think I don't see the cap rates moving out from these levels. And in fact, they probably are going to start to come in going forward just given the backdrop that we are all experiencing with better cost of capital, more competitors are going to start to come in, that's going to push it's going to put pressure on the cap rates. So but in terms of spread, which is how we think about business, we are very hopeful of maintaining the spreads that we've achieved thus far. And it could be a combination of our improving cost of capital, despite perhaps a slightly lower cap rate environment. But we are going to be very selective in what it is that we pursue, which is why we have not gone out and increased our acquisition guidance.

Speaker 2

But let's wait and see what happens over the next couple of months. Things are fairly volatile with elections coming up later this year. And obviously, we see what's happening on the geopolitical side. So it is a bit of a volatile period, but having filtered all of that, I think you should expect to see us trying to maintain the spreads that we've achieved thus far.

Operator

The next question comes from Yupul Rana from KeyBanc Capital Markets. Please go ahead. Great.

Speaker 9

Thanks for taking my question. Yes, Sumay, you touched on dispositions already, but I wanted to get your reasoning on providing guidance at this point. And is this product of better visibility or a shift in strategy? You did mention that you do impact expect to be more active on that front than in the past. So you have sold a number of vacant properties already this year, but you still have another 185 more to go.

Speaker 9

So want to get any color on that, that would be helpful.

Speaker 2

Yes. Good question, Upal. You should expect the at the end of it all, half of it to be occupied assets and half of it to be vacant assets. So clearly, the trend for the first half has been more vacant asset sales. So that's going to shift going forward.

Speaker 2

It is a slight shift in our strategy, but part of it is driven by 2 very large M and A deals that we've effectuated over the last two and a half years. And clearly, and we've been very upfront about this, there are assets that we've inherited that it's not a long term strategic hold for us. And so we just want to be more proactive in being able to dispose of these assets. And given the quantum of capital that this particular process can generate for us, I. E, dollars 4,000,000 to $500,000,000 We wanted to be very clear with the market that look, this is going to be a source of capital for us that you may or may not be aware of.

Speaker 2

And so people can appropriately underwrite that source of capital. And when we make statements like we don't have to be out in the equity market, this helps explain that piece. But the strategic rationale is always a constant vigilance on what is it that our portfolio looks like, where has our strategic shifts occurred given everything that we are seeing and being a lot more proactive on the

Speaker 9

transaction market moving towards normalization. What did you transaction market moving towards normalization. What did you mean by that? Did you mean in terms of volume, cap rates, investment spreads, seller sentiment, competition? Maybe if you can give more detail on that, that would be helpful.

Speaker 2

Sure. So obviously a lot of sellers were on the sideline hoping for cap rates to move. We've always talked about the cost of capital is a mark to market variable that's essentially getting marked every second. But cap rates tend to be stickier and when the cost of capital changed as abruptly as it did for a lot of the REIT sector, the sellers were not able to accept that environment. And so they were waiting on the sidelines, expecting things to change.

Speaker 2

But sellers can't wait indefinitely. And we've seen that phenomena play out in the international markets more so than here. And so when that happens, sellers start to creep back into the market after a period of time And the added element that's taking place is there's a little bit more clarity today and I say that and I smile as to where the interest rates are going to go and so obviously the cost of capital side of the equation has changed for a lot of the REITs. And so this is going to allow them to transact on transactions on assets that they would have looked at doing had their cost of capital been better. And so I think it's a movement on the buyer side, it's going to be a movement on the seller side and that's what I mean that this should facilitate more transactions in the second half than it has in the first half.

Operator

The next question comes from Linda Tsai from Jefferies. Please go ahead.

Speaker 10

Yes, hi. The 1% of same store revenue growth you're achieving this year, what does it look like for next year if your Yes. So Linda,

Speaker 4

first of all, there's some moving pieces with this

Speaker 2

year's Yes.

Speaker 3

So Linda, first of all, there's some moving pieces with this year's guidance of approximately 1% on same store. It's a difficult year over year comp because we did have some reserve reversals and deferment payments that we realized last year. Last year, we had 1.9% was our same store number. This year at 2%, you're kind of averaging this year at 1%, you're kind of averaging outside 1.5% level. And so next year, there should be an easing of the difficult comps, but what we've always been framing for investors, especially more recently, is that we are around 1.5% on a contractual rent basis, growth basis and we would expect that to continue next year and beyond.

Speaker 10

Thanks. And then assuming an 84% recapture rate through year end 'twenty six, you only have 0.37 bps or $0.02 of AFFO per share impact at risk. Could that mean that your bad debt outlook in 'twenty five is stable or even less than what we saw this

Speaker 2

year? Linda, the way to think about bad debt is, we start the year expecting a certain percentage of bad debt expense. And in certain years, we either meet those. In a lot of years, we beat them. And in certain other years, like the pandemic year it goes beyond what we had originally gone into the year with.

Speaker 2

I think this is one of those like last year for instance, we were we had positive outcomes on what our initial expectation was, which was I think 40 basis points to 50 basis points of rent. And then all of last year, we not only did not have any bad debt expense, we actually ended up collecting on rents that we had on cash accounting. So that was a positive outcome. This year, this seems to be trending more in line with what we had anticipated at the beginning of the year. And there is some potential upside, but we are not we've still got 5 months left and we'll see how things play out.

Speaker 2

But traditionally, it's been right around that 23% absent the pandemic year and inclusive of the pandemic year, it's been right around 37 basis points, sorry, 37 basis points of rent that's gone has basically been bad debt expense. So do we expect 2025 to be similar? Yes. But we generally don't talk about years well in advance, which is why I'm pointing to what historically has happened at Realty Income.

Operator

The next question comes from Alek Fabian from Baird. Please go ahead.

Speaker 3

Hi, and thanks for taking my question. Kind of to go back to the C store client that's in litigation, do you have that space back and is there already a replacement tenant for that asset?

Speaker 2

We don't, Alec, which is why we are in litigation and which is where the upside comes from. So we've essentially said this year is going to be a resolution year. Once we get those assets back, we are very confident in our ability to find alternative clients in the C store space for those particular locations. So that's where the upside is. And no, we are not expecting to resolve any of that this year.

Speaker 3

Got it. That's helpful. And then maybe for Jonathan, what are you thinking about future debt issuances? What currency is currently most attractive and at what rate can you issue at? Yes, so if we were to sit here today and guess what indicative this might be on 10 year unsecured paper, you're probably looking at the very low fives, call it 5,152 for U.

Speaker 3

S. Dollar and sterling. And then you're probably looking at very low 4s, about 100 basis points tighter in the eurozone. So we always want to have a level of flexibility. I think when you look at how far wide Sterling has treated relative to the dollar over the last few years and now that it's back to parity, we have been leaning more towards the dollar side over the last few years and the optionality is there for us because we do have the currency net investment hedge capacity to be active in the sterling market.

Speaker 3

But obviously the more euro deals that we do and transact on, the greater the ability for us to access 4% paper will be. So these are the kind of things that we think about on a daily basis. A lot of it depends on the currency of the assets that we're bringing on the books. But we're glad that we left quite a bit of capacity

Operator

The next question comes from Spenser Allaway from Green Street Advisors. Please go ahead. Thank you. Maybe just one going back to the transaction market. Can you just comment on where you're seeing the largest bid ask spreads, either across property types or industries?

Speaker 2

For the first half of the year, Spence, it was here in the U. S. That's the reason why our volumes were much lower than what was traditionally seen in what we've done. I think that's starting to compress that bid ask spread, which is the reason why we feel pretty confident that the markets here in the U. S.

Speaker 2

Is going to start to materialize favorably for us. And yes, so that's what we're seeing.

Operator

The next question comes from Ronald Kamdem from Morgan Stanley. Please go ahead.

Speaker 11

Hey, just two quick ones for me. Just one just on the interest cost, can you remind us how much of the guidance this year, the FFO growth, how much of it was a drag just from higher interest expense and so forth? And how are you thinking about sort of the maturities in 2025?

Speaker 3

Yes. So it definitely wasn't much of a drag this year. I mean, luckily for us, we came out and did a debt offering in January, and that was in the very low fives, just above 5. So when you look at it on a year over year basis, not a big difference. We did obviously have a $350,000,000 bond that we did repay.

Speaker 3

So there's a little bit of dilution from that. But I think when you look into 2025 where we've got $1,800,000,000 $1,900,000,000 at 4.2 percent, I just talked about how maybe there's 100 basis points of dilution. If we were to do something like sterling in dollars based off of today's indicative rates, that have no more than about a 50 basis point impact to earnings. So it's obviously come in quite a bit. But obviously, if we have something from a euro standpoint that we can take advantage of, then it will be breakeven for 2025.

Speaker 3

For short term borrowings, yes, it has been a little bit more dilutive because we peaked with the Fed funds rate this year. But I think much better than it was last year where that was close to 2% of growth that was held back solely because of that.

Speaker 11

Great. And then my second question was just on the new growth verticals, specifically just double clicking on sort of data centers and sort of gaming. Obviously, you've got done 2 great deals with 2 great partners. But just wondering as you're thinking about sort of the future deals opportunity, is there sort of any lesson learned, any way that you want to structure it differently maybe that you're thinking about it? Has the opportunity gotten more attractive, less attractive?

Speaker 11

Just trying to get a sense of where we are 12 months, 24 months into this process? Thanks.

Speaker 2

Thanks, Ronald. So on the gaming side, just based on performance of the assets that we have visibility into, it's clearly been a great investment for us. Both the assets that we currently either own 100% or partially own have continued to perform and then the leases that were structured were in our view very favorable leases. It was a fair lease both to the operator and to us And I'm not sure if there's anything there that we would change based on what we've learned over the last 2 years. On the data center side, we've only got one investment that has now come online And we are very excited about continuing to work with our partner, our existing partner and some new partners that we are trying to cultivate within this space.

Speaker 2

Like I've said, the hyperscale business with enterprise clients, it's a massive business and one that I don't think any single or even 3, 4 sources of capital can solve. And we believe that this is a total addressable market that has a place for somebody like us, partnering with the right developers, operators to create our own portfolio that grows from where we are today. And I don't need to go into thesis as to the why, but it's fairly new for us to really reflect on lessons learned. We are still trying to build that particular pipeline up and in time, I'm sure we will share lessons learned. But one of the things that we are very focused on, and this is not necessarily based on our own history, but the history of this particular sector, is to make sure that the rents that we are underwriting to day 1 are rents that can be supported come renewal time, even 10, 15 years out.

Speaker 2

And I think that was one of the lessons that this particular sector had to learn the hard way when they went through renewals and they were taking write downs in the space. But outside of that, make sure that things that can become obsolete are investments that we would want the operator to make and we stay as close and as true to the real estate as we possibly can. That's really the lens through which we are looking at the data center space.

Operator

We have a follow-up question from Linda Tsai from Jefferies. Please go ahead.

Speaker 10

Hi. Thanks for taking my follow-up. Just on the 84% recapture rate, how much does that number move around any given year? And could that actually go down next year if you have a longer run rate for knowing when those closures are going to happen?

Speaker 2

No, the 84% is our historical average through the bankruptcy process. So any client that goes through a Chapter 11 process And if you compare the emerging rent to the pre bankruptcy rent, that recapture rate is 84%. And Linda, if you look at the amplitude within that 84%, if you actually look at individuals, we've had situations where we've collected 70% or 65% of the rent And then there have been situations where we've collected 100% of the rent, pre bankruptcy versus post bankruptcy. So there is variance around this 84%, but that has historically been what we've achieved and that's the number that we are sharing with the market.

Speaker 10

Thanks.

Speaker 2

Thank you.

Operator

This concludes our question and answer session. I would like to turn the conference back over to Soumit Roy for closing remarks.

Speaker 2

Thank you all for joining us today. We look forward to speaking soon and seeing you at conferences in the coming months.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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Earnings Conference Call
Realty Income Q2 2024
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