$O Realty Income Q4 2023 Earnings Conference Call

Thank you, Steve. Welcome everyone. Our fourth quarter and 2023 full year results demonstrate the unique platform value that Realty Income has built, which differentiates us as a real estate partner to the world's leading companies. During the year, we accomplished several milestones which illustrate the benefits bestowed to us by our size, scale, and relationships. First, we set an annual high in property level investment volume, closing on over $9.5 billion in high quality, diversified investments across eight different countries and through 271 discrete transactions at a weighted average cash yield of 7.1%. The year was punctuated with a particularly active fourth quarter as we closed on $2.7 billion of investments at a weighted average cash yield of 7.6%. Our fourth quarter activity included a $527 million sale-leaseback transaction with the Catalan, one of the world's leading investment grade rated sporting goods retailers, and included properties located in Germany, France, Spain, Italy, and Portugal. Despite a volatile capital markets environment, we achieved an investment spread of approximately 115 basis points in the fourth quarter and approximately 120 basis points in 2023. We were able to achieve these spreads without sacrificing our focus on the quality of real estate or security of cash flow, which is a testament to our experienced team and the merits that sophisticated sellers see in transacting with our platform. Second, during the year we established a presence in the data center sector through a build-to-suit development joint venture with Digital Realty, and we incubated new relationships with blue chip partners such as Blackstone and the EG Group through large-scale investments, including the $950 million investment for a 21.9% stake in the Bellagio and the $1.5 billion sale-leaseback involving primarily Cumberland Farms convenience stores. Third, and in addition to the achievements noted above, we also announced the $9.3 billion merger with Spirit Realty Capital in an all-stock transaction in October, which closed subsequent to year end on January 23rd. These accomplishments contributed to our 2023 AFFO per share of $4.00, representing an approximately 7% total operational return for the year, and importantly, together with the Spirit merger, set us up to deliver a compelling earnings growth backdrop in 2024. We believe that the close of the Spirit merger last month, along with meaningful debt and equity capital raising activity completed at attractive prices in December and January that Jonathan will describe in more detail, leave us well positioned to deliver robust growth in 2024. We have initiated an AFFO per share guidance range of $4.13 to $4.21 per share for 2024, which represents an annual growth rate of 4.3% at the midpoint. We believe we can achieve this growth rate without the selling of additional public equity inclusive of our dividend. This positions us to deliver a total operational return of more than 10% at the midpoint of the guidance range based on the trading price of our common stock as of February 20th, 2024. In addition to the $9.3 billion Spirit merger, we're also providing 2024 acquisitions guidance of approximately $2 billion, which is expected to be fully funded via a combination of our portfolio's internally generated cash flow now exceeding $800 million after dividend payments on an annualized basis, as well as approximately $605 million of unsettled ATM proceeds and our $3.7 billion of cash and unutilized availability on our revolving credit facility as of year end. While we continue to source and review high quality investment opportunities, we remain highly selective, deploying capital only into attractive risk-adjusted return opportunities that meet both our near-term and long-term investment spread requirements. Of our $2 billion initial investment volume forecast, approximately half is expected to come in the form of development financing, the vast majority of which is already identified. To reiterate, our favorable return profile in 2024 carries very little execution risk from an investment standpoint, allowing us the flexibility to remain patient, disciplined, and opportunistic from a capital deployment standpoint. That said, as we demonstrated during the height of the pandemic, our platform affords us the opportunity to pivot quickly back into growth mode should market conditions change. While we intend to remain disciplined in our investments to ensure appropriate risk-adjusted returns for our investors, we continue to highlight why we are best positioned to capitalize on compelling opportunities over the long term. First, the opportunity to consolidate the fragmented net lease real estate market is vast. We estimate a $14 trillion total addressable market in the US and Europe across traditional net lease and emerging verticals like data centers and gaming. Second, we have firmly demonstrated our capabilities deploying capital, having invested $9 billion or more including public M&A in each of the last three years since exiting the pandemic year of 2020. Over this time, we have generated annualized AFFO per share growth of approximately 6%, and we have provided a total operational return to stockholders of approximately 10% per year. Looking to 2024 and beyond, we are on track to achieve similar capital deployment and AFFO per share growth objectives this year, and we are particularly energized by the prospect to participate meaningfully in verticals like data centers and gaming, where we are seeing opportunities to earn healthy initial yields with attractive contractual rent escalators. Third, the Spirit merger deepens our ability to access capital markets through increased trading volume in our publicly listed stock, which has averaged more than $400 million of daily trading volume since the Spirit transaction was announced. This places us in the top 150 of S&P 500 companies and is more than seven times the net lease peer average over the same time frame, leaving us even better situated to fund our business in a highly efficient and non-disruptive manner through our ATM equity program. Fourth, our real estate portfolio is becoming increasingly diversified over time and consists of properties leased to relationship clients representing some of the world's leading companies in their respective industries. Diversified exposure to these clients reinforces the stability of our platform and accordingly our growing monthly dividend payments. Finally, the power of our platform is a crucial differentiator as we leverage our expertise across ownership of over 15,400 properties globally inclusive of the Spirit portfolio. Our experience managing over 5,900 lease outcomes since 1996 provides learnings that feed into analytic AI tools that provide actionable insights, enabling us to more accurately identify acquisition opportunities and to maximize the value of our existing holdings. Continuing with our key operational results from the fourth quarter, investment volume of approximately $2.7 billion was allocated to high quality investments at a weighted average cash yield of approximately 7.6%. We completed $1.1 billion of total investment volume internationally at a weighted average cash yield of 7.8%. Investments were made across 49 distinct transactions, including 29 sale-leaseback transactions equating to $884 million of volume. Our full year investment activity was $9.5 billion, of which 35% was derived internationally, serving as a testament to the value of our investment platform's global footprint. Included in fourth quarter volume was a loan we made to Asda Stores in the UK at a 10.9% yield. The loan is backed by ownership interests in properties containing grocery stores and supermarkets and was extended as part of a sale-leaseback transaction with Asda. In addition, fourth quarter volume included our previously announced $650 million of preferred equity investment in the Bellagio JV with Blackstone, which earns an 8.1% yield. Similar to the loan investment in Asda, the Bellagio preferred equity investment was paired with investment in high quality real estate. For both investments, our ability to offer a broader suite of capital solutions to clients granted us access to high quality net lease real estate investments at superior risk-adjusted returns than we could have otherwise achieved. These transactions serve as templates for future sale-leaseback transactions. Also in the fourth quarter, we made our initial investment in a data center development JV with Digital Realty. The initial $200 million investment represents an 80% equity investment in the venture and is expected to generate a 6.9% initial cash yield, 2% annual rent escalators, and a long-term triple net lease with an S&P 100 investment grade client upon completion. Turning to portfolio operations, same store rent grew 2.6% in the fourth quarter and 1.9% for the year, benefiting in part from lower net bad debt expense compared to the prior year. On a normalized basis, our contractual rent growth approximates 1.5% on an annual basis based on the current composition of our portfolio. This amount is up over 50 basis points from just five years ago and is a result of an intentional push by our team to generate enhanced organic growth. We remain committed to walking this growth rate higher over time through our deliberate underwriting strategy. Our diligent asset management efforts led to a recapture rate of 103.6% during the quarter and 104.1% for the year, excluding the impact of the C World bankruptcy. At year end, occupancy was 98.6%, a 20 basis point decline from the prior quarter as a result of expected client move outs. I will now turn it over to Jonathan, who will add further color to the quarter.

Thank you, Jonathan. Before concluding, I would like to extend my immense gratitude to Ron Merriman for his valued service to Realty Income on our board of directors the past 19 years. Ron's leadership, guidance, and mentorship have been invaluable, and we all owe our sincere thanks. I would also like to extend a warm welcome to Jeff Jacobson, who will be joining our board. I'm thrilled for all of us at Realty Income to benefit from Jeff's perspective as a former CEO of one of the world's premier global real estate asset management firms, LEL Investment Management, and in his current role as the chairman of the board of Cadillac Fairview Corporation. In conclusion, our results in 2023 underscore the multiple avenues of growth at our disposal in the global commercial real estate industry, including through one-off and portfolio acquisitions, multiple asset types, corporate sale-leasebacks, development and joint venture partnerships, and via public M&A opportunities. The depth of our platform, team, and relationships enable us to leverage some or all of these sourcing avenues concurrently as opportunities arise. In 2023, we completed five transactions greater than $500 million in size, and two of which were greater than $1 billion excluding the Spirit merger. These are transactions that Realty Income was uniquely positioned to execute given our size, scale, and access to capital globally. These distinct competitive advantages support us in serving as real estate partner to the world's leading companies at an unparalleled scale. Moreover, we believe that serving as capital provider to a diverse spectrum of clients who are leaders in their respective industries furthers our core mission to deliver dependable monthly dividends that grow over time. We will now open it up for questions.

Thank you for that question, Michael. It's a lot of what you just said. If you look at the market today and you look at the cap rate environment, the adjustments that we have seen has not been commensurate with the movement in the cost of capital. And we are coming out with a business plan that basically says okay, these two variables that we don't control are not going to be part of how we deliver the 4.3% growth and north of 10% total return growth, and that's the reason for the numbers that we have shared with you. If the cap rates were to adjust, we will be first in line to take advantage of that. If the interest rate environment were to start to go down, which would then have an impact on our cost of capital, i.e., lower cost of capital, we would be first in line to react. We wanted to come out with a business plan that had no reliance on the capital markets on the funding side, and come up with a number which we all believe very, very confidently that we will be able to meet, if not exceed, if the environment were to change, i.e., interest rate environment were to start to go down, etc., which would have a positive impact on our cost of capital. I do believe that a lot of the conversations that we are having, it's not the conversations that have dried up, it's the expectation in the market around what the reservation price needs to be that needs to move. And that can happen either through the movement of cap rates or through our cost of capital getting better. And right now we feel very confident in saying the plan that we have has very little to no risk, and we can deliver a 10-plus percent return without having to be aggressive in the market. And that really is the thesis around what we've come out with.

So Michael, the reason I believe that cap rates haven't moved is because of the volatility in the market. If there was certainty that this cost of capital environment is going to remain at these elevated levels for the next three years, guess what, cap rates will adjust, will move, and there will be more willingness on the part of the seller to transact today. We had the ten-year at 4.2 towards the end of last year, it dropped down to 3.75 in January, and then it's back up to 4.2. In that sort of environment, you have sellers that are saying, we expect the Fed to start cutting interest rates later in the year, I think I can hold off another six to seven months, so why transact in this environment today? And I think that's the reason why we have hesitation and lack of widespread movement in cap rates that one would expect if people were to buy into the fact that this cost of capital environment has been permanently impaired. So I think in the scenario that you've sort of dictated, if that were to be the norm and if everybody were to accept that for the next three years the cost of capital environment is not going to change, I do think transactions are going to come back, I do think cap rates will move much more than they have done so, and yes, we'll be the ones first in line to take advantage of that.

Thank you, Michael.

Yeah, the vast majority of the pipeline are takeouts, Josh. So this is really entering into a forward contract. We are not deploying capital as the asset is being developed. And once it's developed and the certificate of occupancy is received, we are essentially buying the asset at that point, and obviously rent is commencing at that point. So that's how one should think about the development pipeline.

Yeah, it's just yet another tool that is available to us to drive growth, Josh. That's how we think about development. We have existing client relationships, they have aggressive plans of expansion, they come to us and they say, hey, we're working with this developer, would you be interested in getting slightly higher yields than what the market would dictate if this asset were available today? And would you lend your balance sheet to help us expand? And that is part of how we are building out our development pipeline, because the expectation is that the yield one can generate through development should be superior to what one could get in the transaction market if that asset were fully operational today. That was the thesis. Now, obviously you might see that some of the yields that we have posted on these developments were slightly lower than what we were able to get on the acquisitions market, and this is largely a function of how quickly the cost of capital environment changed and the adjustments that did take place on the cap rate side. But on the way down on the cost of capital side, this will also manifest itself as a positive to what the markets are going to be. So for instance, the types of transactions we are entering into today on the development side will be reflective of the yield environment today, and if the cost of capital were to improve, let's say a year from now to a year and a half from now when these assets get delivered, there will be a positive spread that you should see on the development deals versus the at that time cap rates that are transacting in the market. So this is really yet another tool. This will never be a dominant part of our business, but it is certainly a tool that if we want to view ourselves as the real estate partners to leading operators, this is a tool that we want to also provide to our clients to help them grow their business.

So Josh, I think I tried to hint that on the last conversation when somebody asked about what you're seeing, what's happening. There are portfolio deals out there. There are large transactions out there. But the challenge is that the bid-ask spread is still wide. And we are not going to be the ones that are going to be aggressive in trying to close that gap. We are going to be patient. We are going to be disciplined. And we are going to wait for the market to come to us. And we believe that over time, it will. And when it does, we will be ready to deploy capital. But we are not going to force it. We are not going to stretch for yield. We are not going to take on risk that we don't understand. And that is the philosophy that has served us well over the years, and we are going to continue to stick to it.

Driving the movement in the market, I can tell you that we are continuing to have a multitude of conversations with our clients where there is a disconnect on the price at which they are willing to transact. That's where the disconnect is. It's not that suddenly we are not talking to our clients. In fact, one of our largest clients we spoke with a couple of weeks ago, and the conversation sort of ended with their expectation of cap rates versus what we would need to generate the kind of spreads that would allow us to do the transaction. That's the type of conversations we're having. Clearly, if you look at what we did last year, more than five transactions were above $500 million in size, two of which were above a billion dollars. That's what we can deliver, what we can bring to the table, and that's what our clients need: big solutions to big problems. So yes, when the spigots open and this reservation price is met by our cost of capital, we will be able to take advantage and build out our pipeline just like we did the last three years.

Hi Nate. I'm not going to start giving you cap rates on assets that we have closed in the first quarter. Suffice it to say that there have been transactions that we have closed on in the first quarter. It is reflective of some of the comments that we've made. There has been movement in cap rates. You'll see that when we report our first quarter numbers, but the movement in cap rates is not as widespread as we would like to see. It's not reflective of the changes that have occurred in the cost of capital side. But yes, our flow business is ongoing, and we are being a lot more selective about making sure that our spreads are not being compromised just to create volume. We have the advantage of coming into this year with a business plan that allows us to do that. With regards to occupancy, we have mentioned that it's going to be about 98%. A lot of these were expected vacancies. We generally tend to guide to this low 98% occupancy. Part of what makes our business slightly different from some of our other peers is we actually like to hold on to some of our vacant assets given the ability to reposition these assets and create more economic value. Over the last six quarters, we were hovering around that 99%, which was unusual for us. But we are very comfortable if we believe that we can generate more economic value which supersedes the holding cost of some of these vacant assets by repositioning them. The way to think about how we run our business is the normalized level of occupancy should be in this 98.5% zip code. The 1.5% is vacancy that we need to be able to execute on the plans that I've just laid out.

That's a great question, Brad. I will tell you that even in Europe, the volume of transactions is a lot lower, again because of this disconnect between buyers and sellers and what each requires to perpetuate a transaction. However, having said that, we are seeing pockets of opportunities, especially in the UK, where we feel like even in this environment transactions can get done. That, along with the fact that at least in Europe our cost of debt is significantly lower by 110 to 120 basis points, we are continuing to look for opportunities. But the volume being low is not just unique to the US; it is across the geographies that we play in.

Good morning, Haendel. Thank you for your question. A couple of points. I've heard a few comments around free cash flow. We are going to generate north of $800 million in free cash flow. If you think about our $2 billion of acquisition guidance, this represents 40% of the total volume, and on a leverage-neutral basis it represents 60% of the total capital. So to be able to generate 200 basis points on free cash flow, you can actually do deals at 2% cap rates and still generate 200 basis points, but obviously that's not how we think about our business. By the way, the 200 basis points that we were able to achieve about three years ago, two and a half years ago, that was in an environment where our cost of capital was massively different than what it is today. Being able to generate 200 basis points was not that difficult. On average, from the time we've been tracking spread, we have always said that the average spread has been 150 basis points. We also want to make it clear that there will be times like last year, the fourth quarter and all of last year, where we did 120 basis points. When you build up a pipeline with a certain backdrop with regards to your cost of capital and the cap rates you're entering into a contract in, by the time you close, if your cost of capital environment changes and you're permanently financing it at that point in time, that's precisely what happened all of last year. We had a very robust pipeline, and we were entering into contracts with the expectation of not necessarily 200 basis points but certainly 150 basis points, and sometimes well north of that. But by the time we actually permanently finance the transaction, the cost of capital environment was different. Just to make another point, if you actually look at the cost of permanent financing that we ultimately effectuated in 2023, what we locked in in terms of spread was closer to 140 basis points. It was 136 basis points, I think, much closer to the average that we have since we've been tracking this particular metric. But I just want to make sure that if the expectation is that in any transaction we enter into we're going to try to lock in 200 basis points, that's not how we think about pursuing transactions. We also use a barbell strategy where there might be transactions that are precisely the right investment for us, and if it only creates 100 basis points, we believe that on a risk-adjusted return basis that is the right profile for that investment. We are comfortable doing that particular investment, but then we will always try to balance it with transactions that have a 200 basis point profile. But that volatility, that spectrum of spreads in this volatile environment, is very difficult to predict, which is why we've come out with the plan that we have, which even in this environment we can still deliver 10% without having to rely on the acquisition market.

The integration is going very well. We closed on the transaction on the 23rd. We are still very excited about the portfolio. We've absorbed as part of this transaction, we've hired eight people from Spirit on a permanent basis, and we have seven people on a temporary basis that are helping us through the integration process over the next 6 to 9 months. In terms of the actual portfolio itself, we have not been surprised. Now that we control this asset and the portfolio of clients that we are exposed to, we have not been negatively surprised on any front. There have been some positive surprises in terms of resolutions to certain clients where the outcome has been slightly more positive. But I will caution that it is still too early to tell, and that is part of the reason why we were very conservative in our underwriting and what we shared with the market. We felt very comfortable in terms of delivering, but we've also said that it was conservative and there happens to be upside, which we hope plays out. If that's the case, we will share that information with you on the road.

What we can share with you, Haendel, is the range that we have shared with you accommodates for any level of credit loss that the Spirit portfolio and or our portfolio would generate.

It's all of those things, Spencer. I think you've been following us for a while. We're constantly looking for ways to grow our portfolio, and we're constantly looking at non-traditional ways to grow our earnings. That will continue to be a massive focus of ours in 2024. You're absolutely right. Part of having to absorb an additional 2,000 assets with 400 new clients, not all new clients but 400 clients coming from Spirit, there's going to be a fair amount of asset and capital recycling that we would like to also engage in. That is something that the team is very much focused on, trying to take advantage of the time that we have to focus on playing a little bit of defense rather than offense. But having said all of that, I do believe that this acquisitions environment can change and can change very quickly. The rest of the team, the investment team, continues to stay in front of the clients, continues to have conversations, continues to be creative about how we could potentially be a solution to our clients. Despite the guidance of $2 billion, I can tell you there is going to be a lot of work, perhaps even more so this year than last year, in terms of creating the right tools, creating the right efficiencies, all of the things that we had to put a little bit on the back burner given the robustness of the investment environment over the last three years. I think all of that will manifest itself in a much more scalable business, and we'll be happy to share some of that as and when we put it to use and actually start to realize some of the scale benefits.

We are not waiting on a particular date. There is obviously a priority of assets that we have identified that we don't believe to be core to our overall portfolio. Those are already in the market. And then we are culling through the rest of the portfolio to continue to add to our capital recycling program for 2024. So there isn't a particular target date, but we'll be happy to share with you more on this front during the first quarter earnings, when we'll have assumed control of this portfolio for about two months and 10 days.

Sure, Smedes. Your intuition is accurate. In the retail space here in the US, when you start to talk to investment grade clients on the retail side, on retail boxes that enter into long-term leases, it is very difficult to get them to give you what one would consider to be market growth rates. The ones that tend to be triple B, triple B minus, and sub-investment grade, those are the clients that you can help drive internal growth. But let me be very clear that the 50 basis points of increase was not by going lower in the credit cycle on the retail side, but was expanding into other asset types which have a different growth profile than what retail assets do. Some of the steps that we took: we obviously went into industrial in a big way. Industrials tend to have, even with investment grade clients, and at one point virtually all of our clients were investment grade on the industrial side, that's no longer the case as we've matured as a company, but they too tended to give 2% to 2.5% growth. So that was one of the drivers of the change in growth profile. The second was going into new asset types like data centers, like gaming. Those do also tend to have a higher internal growth profile. And the biggest driver of all of this is really the international business, where we do find a lot of growth even on the retail side with investment grade clients. You might recall that our first transaction was a half a billion dollar sale-leaseback with one of the largest grocers in the UK, and that had a growth profile that far superseded the profile that one can get here in the US. So it's a combination of all of these factors: different asset types, international, which has allowed us to grow our internal growth from approximately 1% to approximately 1.5%. That will continue to be a major focus of our business: how do we take this profile and grow it by another 50 basis points, perhaps more, so that this reliance on external acquisitions continues to be minimized.

I think one of our comments was that you should expect to see a higher number than the $116 million that we accomplished in 2023. As to the actual number, we will be in a position to share that with you during our first quarter earnings call in May.

Eric, the way we think about the credit business is how can we be a one-stop shop for our clients. Clients with whom we've done traditional sale-leaseback business that have a need to continue to grow their real estate portfolio, and if there is a disconnect, which we kind of saw last year, where what you could get in terms of a sale-leaseback in terms of yield versus playing in a much more secured position on a balance sheet and yet get 300, maybe even more basis points of yield on investments, it's a win-win for us as well as for our clients. They would much rather do business with somebody that they understand and that they have a relationship with, and we can offer more of these products to them and enhance the economics on our transactions. That's really what's going to drive the credit side of our business. Having said that, it's across the board. I think we've talked about doing a credit investment on the gaming side with Blackstone. We've talked about doing an investment on one of the largest grocers in the UK again. These are the types of examples that you should continue to see. But we are going to be very selective in terms of who we lend to, given that that is not a core element of our business.

We don't have it identified on the non-development side, which was $1.2 billion. Some of it is identified, but a lot of it is discussions that we are having both here in the US and in the international markets. If you look at what we did last year, 35% of everything we did was in the international market, 65% was here locally. That could change because it is such a small number. Based on the discussions today, there could be a lot more on the international side than here, but it's too early to tell. If you look at the history, it's largely been in that 30% to 40% international and 60% to 70% US, and that's what we would expect under a normalized situation.

Thank you all for joining us today. We look forward to seeing many of you at upcoming investor conferences in the spring. Thanks. Bye.