Realty Income Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
August 3, 2023

There are 15 speakers on the call.

Operator

Afternoon, and welcome to the Realty Income Second Quarter 2023 Earnings Conference Call. All participants will be in 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 Bakke, Vice President of Capital Markets and Investor Relations.

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 Christy Kelly, Executive Vice President, Chief Financial Officer Treasurer and Jonathan Pong, Senior Vice President, Head of Corporate Finance. 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 in the company's Form 10 Q. We will be observing a 2 question limit during the Q I will now turn the call over to our CEO, Sumit Roy.

Speaker 2

Thank you, Steve. Welcome, everyone. We successfully executed on our strategy in the Q2 and continue to see momentum across the business. I would like to sincerely thank our ONE team, whose focus and commitment continue to propel our business forward, serving all our clients and stakeholders. We believe the strength of our platform and quality of our real estate portfolio were evident in the quarter's results.

Speaker 2

Despite the challenging interest rate environment, AFFO per share grew 3.1% from last year to $1 per share. Combined with our dividend, we are pleased to have delivered a total operational return of over 8% On a trailing 12 month basis, delivering stable and consistent growth is foundational to our mission at Realty Income. Underlying this growth, our team continues to source and invest in high quality properties at accretive spreads to our cost of capital, While partnering with our clients who are leaders in non discretionary, low price point and service oriented industries. Partnering with industry leaders across over 13,000 properties in a diversified real estate portfolio offers us durability of cash flows that results in the predictable nature of our revenues, earnings and dividend payments. Our investment activities remain robust As we continue to demonstrate that size and scale are unique advantages in the sale leaseback and portfolio transaction markets.

Speaker 2

In the Q2, we closed an approximately $3,100,000,000 of high quality real estate investments, which brings our year to date investment activity to over $4,700,000,000 Cap rates in our acquisitions appear to have stabilized after a meaningful adjustment period to a higher Though in select situations, we continue to find unique opportunities to source and close on larger transactions, where our relationships, Platform and access to capital allow us to take advantage of more favorable terms. Our 2nd quarter initial cash lease yield of 6.9% represents a 120 basis point increase Compared to the Q2 of 2022 and resulted in a realized investment spread of approximately 133 basis points When calculating our WACC on a leverage neutral basis, using the cost of equity and debt raised in the quarter. In addition to closing our $1,500,000,000 U. S. Convenience store acquisition from the EG Group, we remained active internationally during the Q2, Closing on $416,000,000 of investments at an initial cash lease yield of 7.1%.

Speaker 2

This international activity includes the addition of a new geographic vertical in Ireland, where we acquired 2 properties for $54,000,000 At healthy cash yield. Given the transaction velocity we have achieved in the first half of the year, We are increasing our outlook for investments to over $7,000,000,000 for 2023. Year to date, We have acquired 15% of source investment volume compared to an average of 7% over the last 5 years. In today's more constrained environment for capital, we have found the size and scale of our platform have become increasingly meaningful differentiators As we seek accretive growth opportunities. Shifting to operations, our portfolio continues to perform is our highest occupancy at the end of a reporting period in over 20 years.

Speaker 2

Additionally, our rent recapture rates increased from last to 103.4 percent across 201 new and renewed leases, bringing the year to date recapture rate to 102.7 percent across 377 new or renewed leases executed in the period. As further testament to the stability of our portfolio and the leading clients with whom we partner, our client watch list declined from last quarter and now represent less than 4% of our annualized rental revenue. This is the lowest level in the last 5 years. Finally, our same store rental revenue increased 2.0% in the quarter, a tangible result of our purposeful decision to seek investment opportunities with higher internal growth characteristics as well as the benefit of uncapped CPI based rent escalators presently Present in nearly 30% of the leases in our growing international portfolio. Our efforts to increasingly pursue leases With meaningful contractual rent escalators has helped contribute to a portfolio with contractual rent growth at approximately 1.5% per annum As of the Q2, or 2% annual growth on a levered basis.

Speaker 2

Before turning it over to Kristie, I would like to recognize the tremendous value she has brought to Realty Income, first as a Board member and then as Chief Financial Officer. The leadership and counsel through a very active period for our company has left a lasting positive mark. As well, I would also like to congratulate Jonathan on his upcoming promotion to CFO. Kristi?

Speaker 3

Thank you, Sumit. It's an honor to serve our colleagues, Board and stakeholders during this exciting time at Realty Income. As we previously announced at the end of this year, I will be retiring as CFO and passing our CFO baton to Jonathan Pong, Who is our current Senior Vice President, Head of Corporate Finance. Jonathan has been with the company for the last 9 years And brings significant experience to the role, having overseen our Capital Markets, Investor Relations, FP and A and derivatives functions during his time here. Over the last two and a half years since joining the management team, We have worked closely together as part of a planned succession and Jonathan is well positioned to carry the torch moving forward.

Speaker 3

With that, I would like to hand the call over to Jonathan to go over the financial results from our quarter.

Speaker 4

Thank you, Christy. I would be remiss without acknowledging your many contributions to the company and its stakeholders during your tenure. I'm grateful for your guidance, support and leadership, all of which has laid the foundation for excellence as our business continues to evolve. Over my 9 year tenure in Realty Income, we have experienced significant growth in new industry verticals, geographies and property types. However, we've continued to view a reliable growing dividend and a well capitalized balance sheet as critical components for our business.

Speaker 4

To that end, we finished the 2nd quarter with healthy leverage as measured by net debt to annualized pro form a adjusted EBITDA of 5.3 times our fixed charge coverage ratio remains solid at 4.6. We are once again active issuers of equity capital via the ATM, Raising approximately $2,200,000,000 in the aggregate during the 2nd quarter, dollars 651,000,000 of unsettled forward equity As our platform has advanced and grown over time, our investment spread business has been supported by access to a wide range of Last month, we added another capital source to our inventory raising €1,100,000,000 Through our debut public offering of euro denominated unsecured bonds. This dual tranche offering resulted in a weighted average tenure of 9 years weighted average annual yield to maturity of 5.08%. Establishing a presence in the euro unsecured bond market allowed us to Our fixed income investor base and generate a natural hedge for a year denominated earnings and access a source of debt capital That was priced approximately 60 basis points inside of indicative U. S.

Speaker 4

Dollar bond pricing at the time of Proceeds from the offering effectively repaid short term borrowings on our multi currency revolver and commercial paper programs which had a combined balance of $990,000,000 at quarterend. Combined with $254,000,000 of cash on hand at quarterend and the 650,000,000 Our forward equity previously mentioned, we believe we are well capitalized with significant liquidity heading into the Q3. Finally, from an earnings outlook perspective, the midpoint of our 2023 AFFO per share guidance is unchanged. Though we are narrowing the guidance range to 3.96 The 401 representing approximately 1.8% growth at the midpoint. With that, I would like to turn the call back over to Sumit.

Speaker 2

Thank you, Jonathan. As our second quarter results illustrate, our company is well positioned to provide consistent results in a variety of economic environments And to grow through a variety of different acquisition channels. The optionality we have to toggle between different sources of capital is also a competitive advantage As it broadens our reach of investors and oftentimes provides a lower cost of capital alternative to the public U. S. Dollar market.

Speaker 2

Looking at the S and P 500 constituents within our addressable market, we count approximately 300 firms With $1,600,000,000,000 of owned real estate, to quantify the near term opportunity, which is available to us as sale leaseback capital providers, This group has approximately $1,200,000,000,000 of debt, representing 34% of the group's outstanding debt capital Maturing between 20242027. Meanwhile, corporate bond deals have risen anywhere between 240 and 400 basis points from the 2021 average to today. This compares to 140 basis point increase in initial cash lease yields For Realty Income's investments over the same timeframe, making our capital solutions even more competitively priced On a relative basis than in the past. Because of this cost of capital convergence and because of the many benefits sale leaseback financing provides, Including the elimination of maturity risk, we believe there is a more compelling case to be made than ever for corporates to look to sale leaseback financing To replace maturing debt. As the attractiveness of sale leaseback financing accelerates for corporates with looming debt maturities and elevated debt costs, We believe our growth opportunities will continue to expand on a sustainable basis.

Speaker 2

At this time, we can open it up for questions. Operator?

Operator

And our first question will come from Nate Crossett of BNP Paribas. Please go ahead.

Speaker 5

Hey, good afternoon. Congrats, Jonathan and Christy. Maybe just a question on guidance. Maybe you could just unpack, you guys increased acquisition volume guidance At the midpoint, on AFFO remained the same, maybe you can just kind of go over the puts and takes there? And then also what are you guys assuming for kind of cap rates in your guidance?

Speaker 5

I think we're down 10 basis points in the quarter. What's kind of the outlook of the pipeline right now?

Speaker 2

So Nate, I'll take your second question And then I'll hand it off to Jonathan to talk about puts and takes with regards to the earnings guidance. With regards to the cap rate, we are Assuming the cap rate to be within the zip code that we've announced in the Q2 and in the Q1. That's where we believe where the cap rates have settled down. Opportunistically, there are situations that we could enter into where we could drive those cap rates higher. But for modeling purposes, I would request that you keep it within these zip codes that we've announced in the 1st and second quarter.

Speaker 2

Jonathan?

Speaker 4

Hey, Nate. On the guidance question, I would first of all say the midpoint of our guide is the same as it was at And so when you think about how we put guidance together, there's a lot of puts and takes that we look at the beginning of the year, we visit every quarter. We know that on a probability weighted basis, not all of the takes are going to happen, not all the puts are going And so when you think about acquisition guidance increasing 2 quarters now, that was a scenario that we had at the start of the year, but there's always going to be puts and takes that could offset that a bit. I think the biggest one for us has been short term interest rates. When you look at what was implied back in January, February, the SOFR forward curve, you compare that to what it's implying today, About a 40 basis point increase.

Speaker 4

And so that alone is about a $0.01 per share for our business in the back half of the year. So I would say that and there's also some other things that we always look at that maybe we're taking a slightly more conservative view on over the second Half of the year appropriately, but we feel very good about being more or less accurate from what we came out at the start of the year.

Speaker 5

Okay, that's helpful. Maybe just one on the debt rates are much lower in Europe. You did that recent bond deal. Can you just like talk about how much you could kind of theoretically raise over there to kind of take advantage of the better cost of capital? Are there any like hindrances like in terms of size?

Speaker 4

Yes. We're not going to go crazy and have Significantly more liabilities denominated in one currency relative to the assets we have denominated in that same currency, especially when it's foreign denominated. And so for us, when we're going out and issuing in various currencies, we're thinking about the income statement FX risk that we might have and we're using the natural interest expense in that currency to serve as a hedge. If we don't have that, there's not a lot of reason for us to go out and do that type of issuance. We also know that we have a very active acquisition pipeline across all currencies.

Speaker 4

We know that we're going to need the capital at some point, really denominated in dollars, sterling or euros. So That's how we think about it. It was a 60 basis point pickup relative to comparable U. S. Dollar.

Speaker 4

But for us, it's really about Diversification. And so you can expect us to utilize everything in our toolkit going forward. But I think we are all set on the euro side, at least for the near term.

Operator

The next question comes from Greg McGinnis of Scotiabank, please go ahead.

Speaker 6

Hey, good afternoon. As always, I'm interested in any larger portfolio deals. And we appreciate your opening remarks regarding the size of the Potentially addressable S and P 500 market. Have you noticed any material uptick in sale leaseback interest from those companies at this point? Or is that still A developing potential.

Speaker 2

I guess we have to post one of these large transactions per quarter. And I think we've done that. If you look at what we've done in the 4th Quarter of last year, that's when we closed on the gaming asset, which was $1,700,000,000 You look at the large portfolio deal we did in the Q1, it was a CIM transaction that was circa 900,000,000 And in the Q2, we've announced the $1,500,000,000 and closed the $1,500,000,000 EG Group transaction. And look, the reason why we are sharing all of this data, it's to help support what we are seeing develop in our pipeline and the conversations that we are having currently. Now how much of that gets translated to close transactions?

Speaker 2

Time will tell. But clearly, we are very optimistic and that is one of the main drivers of why we have increased our guidance by another $1,000,000,000 in terms of acquisitions. So we just feel like I wish our cost of capital was slightly better, but in terms of actual transactions, We feel like the pipeline is robust and it's largely a function of what is happening in the debt capital market.

Speaker 6

Okay. What are your thoughts on increasing maybe the level of tenant debt investments to push earnings growth higher and offset some

Speaker 2

of that cost of capital, it's

Speaker 6

not exactly where you want it.

Speaker 2

Well, we think of ourselves as an investment company. And Greg, so where we invest on the capital stack It's always available for debate within the four walls of Realty Income. And Wherever we feel like we can quantify the risk and underwrite The benefits of doing a sale leaseback versus doing a direct loan to one of our clients, we are going to go down the path of Whichever yields the best risk adjusted return. So yes, we haven't done one of those, up for discussion and it's one that we have been discussing with my colleagues here at Realty Income.

Operator

The next question comes from Brad Heffern of RBC Capital Markets. Please go ahead.

Speaker 7

Yes. Thank you, operator. Hi, everybody. Sumit, can you give your updated thoughts on how you feel about the theater business broadly right now? Obviously, AMC recently reported its best week, but then you have the strikes which will theoretically start affecting things at some point And the release schedule isn't back to normal.

Speaker 7

So are you feeling worse at this point or better given the recent strength?

Speaker 2

Yes. So Brad, I've always stated this about the theater business that it is largely a function of content. And as long as the content continues to develop and it goes back to levels that it was pre pandemic, which was Circa 70, 75 big tent type releases, we're going to get back to levels pretty close To the revenue levels that we had in 2019. And anytime you have situations like the one that you've just described, where you have Strike, it does obviously put a little bit of a breaker in terms of The ability of studios to continue to release those big tent movies. The good news in today's environment versus the last time there was a strike, which lasted if I remember correctly from for about 4 months, the good news today is we've got a lot more studios beyond the big four That are releasing big budget movies and I'd put Amazon and Netflix in the mix there.

Speaker 2

But yes, all else being equal, a strike is not a Good thing. Do I see this having a near term impact? I don't think so because a lot of these movies have already Being completed and it's just a question of staging the release. But longer term, it could have a disruption on how many of these movies get And so we are watching this closely. I believe there's a meeting on Friday, where the studios are getting together with the writers And the actors and all of that and my hope is that there's a resolution soon and but yes, it is a situation that we are monitoring closely.

Speaker 2

My expectation, if it is anything like what it was last time, this should resolve itself in the next couple of months. Okay.

Speaker 7

I appreciate that. And then can you give your expectations for the Senate World sites that were rejected and maybe talk through some of the opportunities with those, whether it's Just typical releasing or if there's a development opportunity for any of them?

Speaker 2

Yes. So Brad, I'm not going to give go into the of the Cineworld situation just because we haven't quite penned the contract yet. What I will say is that any of the potential economic outcomes have been completely reflected In our updated earnings guidance. So that's how I'm going to leave it with the Cineworld situation. And I'll just add something to stuff that I've already talked about in the past.

Speaker 2

There will be a few assets that we expect to get back and we have already started to look at what are the alternatives at those Particular sites and the gamut runs from complete Redevelopment of the site to an alternative use, I. E. Industrial to situations where we have a retailer coming And talking about potentially just taking the asset as is, even though they're not movie theater operators, To potentially reentitling the asset for an alternative use and selling it, I. E, creating more value for ourselves. And the last bucket will be just selling the asset as is.

Speaker 2

So All of those various permutations are being considered on the handful of assets that we expect will get rejected through

Operator

of Mizuho. Please go ahead.

Speaker 8

Hey, I guess it's still good morning out there. First of all, congratulations again Jonathan and to Christi. Sume, I'd like to go back to a conversation we've had in the past on iGrade. You continue to source deals here with a lower share of And I know in the past you've talked about that your experience in acquiring higher yielding assets and you're focused on generating the best risk adjusted returns. But this quarter particularly had a big drop, but it continues the trend of having below average iGRADE.

Speaker 8

So I guess, is this a dynamic that we should just expect to Can you going forward as the new norm? How should we think about the share of iGrade going forward? Thank you.

Speaker 2

Sure. Thank you for that question, Haendel. So just to continue to reiterate the point, we are not targeting investment grade. What we are targeting are opportunities that yield the best risk adjusted return. If it so happens that it is an investment grade client, And so be it.

Speaker 2

But ultimately, it's the economic profile of that investment that's going to dictate as to whether or not we are going to invest. Today, truth be told, we are looking at some of these investment grade opportunities and cannot pencil The risk adjusted returns. We are finding far more value in areas where we are looking at sub investment grade tenants, We're willing to give us a return profile that is commensurate with the inherent risk in that particular opportunity. And that's what's driving the approximately 26% year to date investment grade Closings that we've done and it's closer to 18%, I think, for the Q2. But that's how we think about the world.

Speaker 2

And the other thing I'd just point out is, just to make it equivalent because I have seen some of these cap rates being reported and there's a bit of a mix match. When we're talking about a 6.9% cash lease yield, if you layer in the straight line, We're talking about an additional 100 basis points. And I've seen certain reports that are sort of conflating these two numbers. So just to make it apples to apples, our straight line yields are closer to 7.9% On $3,100,000,000 worth of acquisitions. That's where we are seeing the value with, I would argue much better growth profile and clearly that's represented in the 100 basis points of increase when compared to cash yields.

Speaker 2

So That's how you should think about us, Hanel. And if it just so happens that this dynamic were to shift and Suddenly, investment grade was to go back to our 40%, 45% that we have in our portfolio, then that will be it. But it's not something that we target and you shouldn't expect us to be targeting that number going forward.

Speaker 8

That's really helpful. I appreciate the color there. And one more, I guess wanted to get your updated thoughts on investing in gaming assets I know in the past you've talked about having an interest. I'm curious if you're seeing anything out there today that would interest you, what type of returns or incremental spreads you require there? And specifically, your potential or your level of interest in a potential Bellagio trade?

Speaker 8

Thank you.

Speaker 2

Sure. So again, I'm not going to talk about specifics, but I'll repeat what I've said in the past about our desire to grow our Gaming vertical, we are obviously looking at many opportunities and thankfully it's a fairly robust environment today for gaming. And yes, in terms of how we're going to view these opportunities, it's along the lines of how I answered the previous question. So That's what you should expect from us for this particular vertical.

Operator

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

Speaker 9

Yes. Hey, guys. Thanks for the time. I just I saw your cap rates on looks like domestic acquisitions is like a 6.8 And then for developments, it was like a 6.9%, 10 basis point spread seems kind of small. So just is that a function of kind of when deals were Straka or just the risk profile with tenants are just something that you're seeing broadly in the market?

Speaker 2

Yes, very good Question, Joshua. As you know, when you enter into transactions that have a long duration associated with it, which is what Development by its very definition is going to have. It does become a function of when were those transactions entered into And what's the duration of that build out period? And so what you might have noticed is, If you're tracking our development yields over the last few quarters, you've noticed a marked increase In those cash yields on developments, it's largely a function of when did we strike those. So things that you're starting to see filtered through In the Q2, which has a similar yield to what you saw on the domestic side, it's largely a function of us having entered into those transactions Over the last 2 to 3 quarters, when we were anticipating a much higher interest rate environment and therefore being able to Work with our clients to get that yield reflected in the development cycle.

Speaker 2

And you should continue to see that Trends slightly higher looking into the next few quarters as Some of the older generation development opportunities start to sort of Get fully developed and are become cash paying opportunities. So I think just keep a close eye on that and that's the trend you should see manifest itself over the next few quarters.

Speaker 9

Okay. All right. That makes sense. And then I think Jonathan might have answered this, but just wanted to clarify. The top end of guidance, Looks like you took down $0.02 Was it just the interest rate environment that's pushing down put downward pressure on that top range or Anything else in there?

Speaker 9

Just curious given you bumped acquisition guidance a bit, so.

Speaker 4

Hey, Josh. To address that, Sumit brought it up earlier, the impact of what we felt was the greatest The Cineworld resolution of that impact is now better known to us. And going into the quarter, it was something There was a range of possibilities that we built into the high end and the low end. And so with a greater sense of confidence now where that's Trending, we felt that it was appropriate to take the high end down by $0.02 in addition to bringing the low end up by 0.02

Operator

The next question comes from Michael Goldsmith of UBS. Please go ahead.

Speaker 10

Good afternoon. Thanks a lot for taking my question. Jonathan, you've been with Realty Income for a while and I think you're developing reputation for Creative Solutions from a financing perspective, but as you move into the CFO seat, is there anything different that Is there anything different you would think about doing in their new position or different approaches To what Realty is doing overall? Thanks.

Speaker 4

Thanks, Michael. Appreciate the question. I would say, Look, what's made Realty Income so successful over the years regardless of what we've done, what verticals we've established, it's Commitment to a fortress balance sheet and that's the one thing that is going to Sacrosbank to us for as long as we're in existence in these seats. And so we're not going to sacrifice things like The A3 minuteus credit rating that we worked very hard to get, we're not going to sacrifice the trust of fixed income community that now spans Across 3 other currencies and so you're going to see us continue to focus on low leverage, Plenty of liquidity and we're going to be very predictable from that standpoint. I think going forward, Given the added complexity of the business, the volume, the transaction volume that we see, the different countries that we're in and We'll continue to be in.

Speaker 4

I think it's really more of a focus on more of the internal operations now. The external The side of things, I think we're pretty well established. We're going to continue to be creative. But I think it's about building and continuing this momentum on the internal platform that we've created, which we think is a differentiator in the net lease industry and frankly in the real estate industry.

Speaker 10

Thanks for that. And Sumit, you mentioned your size and scale competitive advantage at least twice, if not 3 times on the call. Do you feel like your Competitive advantage is growing. Are you seeing fewer bidders on some of the larger deals out there? Is that GAAP and the strength of the size and scale, is that improving and widening Versus peers?

Speaker 2

Thanks. Thanks for the question, Michael. I might have actually said it 4 times. I'm not Sure. I just believe in it so much.

Speaker 2

And it's really not something that we believe. It's what we are hearing. When we are engaging in these conversations with clients who are big clients, who have big questions that they're trying to answer, It's the fact that who gets invited to the table. And when we see that we are the only REIT in the net lease space at the table Competing against private sources of capital, that in itself gives us continued confidence that we are playing a game That is very different from some of our smaller peers. And we want to be that.

Speaker 2

We want to be the real estate partners of choice for the S and P 500 names. We want to be The first name that is considered when folks think about they have the ability to write big checks, They have the ability to stand by what it is they say. Their reputation speaks for itself and their ability to close is bar none. And when we hear those comments from clients who work with us and more recently with some of our new clients who've Being added to our registry, it gives us continued confidence to say that our scale and size It's being appreciated within this space.

Operator

The next question comes from Eric Wolf of Citi. Please go ahead.

Speaker 11

Thanks. Just wanted to follow-up on Greg's question. When you look at your S and P peers, just curious what percentage would you say are receptive to the sale leaseback And how has that changed versus a couple of years ago? Just trying to understand how your adjustable market has changed? And for those that Perhaps aren't as receptive.

Speaker 11

What's the typical pushback?

Speaker 2

I can't give you percentages, Eric, but what I can point to Just look at some of the larger transactions we've done and who have we done it with. And they're all first time sale leaseback candidates, right? Think about wind. They were they've never done a sale leaseback before and they chose to do it with us. Think about EG Group.

Speaker 2

They've never done a sale leaseback before. Their best chance of doing a sale leaseback was when they actually ended up being the winners on the Cumberland Farms Portfolio, this was 3, 4 years ago and they chose not to do it at that time. And so part of the reason why I believe that Sale leaseback as a product is maturing is certainly driven by the capital markets environment that we find ourselves in And suddenly finding that sale leaseback as an alternative to raise capital is Quite beneficial visavis compared being as we were traditionally being compared to the debt capital markets, Especially for names that are lower investment grade or sub investment grade candidates. And so I believe that that will continue and there will be other transactions that we hope to get over the finish line that we can Speak to, that will again be first time candidates. And yes, we feel like that, that will continue to grow.

Speaker 11

That's helpful. And then you look at the 10 year or whatever interest rate you want to look at and it's up pretty meaningfully over the last Couple of weeks. When you see moves like this, and then how quickly will you adjust your pricing on future acquisitions or potentially even retrade recent deals? Just trying to understand how sort of real time capital market volatility changes return on those?

Speaker 2

Yes. So Eric, I'm going to have Jonathan talk a little bit about things that we try to do to anticipate What I'll call unanticipated movements in 10 years, Okay. We'll talk about a hedging strategy that we have in place. But I just want to make one point very clear. Our cost of capital gets mark to market pretty much by the second.

Speaker 2

That's not how cap rates move. There is absolutely a lag time how sticky these movements, these upward movements in the cost of capital. People have a different opinion about how sticky that is and that drives their view around what cap rates should be. And it does take time for people to adjust to a higher cost of capital environment. And if there's a lot of volatility that makes that adjustment period that much more difficult.

Speaker 2

So yes, we've seen movements on the tenure from In cap rates to reflect this movement in 10 years, unless we see that this 4.74.17, God forbid, 4.17, 4.2 become a more sustainable rate. But then what do we do from a balance sheet To sort of anticipate those situations, I'll have Jonathan speak to that.

Speaker 4

Thanks, Sumit. We've been very active on the hedging front, both For FX, which I alluded to earlier, but also on the interest rate front, if you look at the 10 Q from the Q1, you'll see that we actually Purchased swaptions, which really go out until January next year and that protects us against rising rates and the tenure. The reason why we chose $1,000,000,000 the reason why we went out to January is because we do have some debt maturities coming up around $1,000,000,000 $1,100,000,000 In the Q1 of next year, we put those hedges in place in late March, early April. And so as you might imagine, it's Pretty healthily in the money right now. So from that standpoint, we've taken out the primary balance sheet risk and or refi risk that we have Coming up over the next 6 to 9 months, but we're always going to look for opportunities where we We want to be proactive.

Speaker 4

We can't time the market, but what we can do is mitigate the exposure that we have to potential risk. And Yes, that's something that we've done now twice and the first time we did it was in the middle of the pandemic and we were able to monetize that Ford started to swap at a $72,000,000 gain. We're not always going to be so fortunate, but that's how we're thinking about managing risk.

Operator

The next question comes from Wes Golladay of Baird. Please go ahead.

Speaker 1

Hey, everyone. Can you talk about what's going on in the UK? It looks like volume was low. I'm just curious if this is a function of just low deal volume is it just pricing, just lagging still over there?

Speaker 2

Yes. Neil needs to work a little bit harder, I think. It really is a timing issue, Wes. We had some great momentum towards the end of last year, Driven by pressures that funds were experiencing on the redemption side and it created some amazing opportunities for us. That momentum continued into the Q1.

Speaker 2

2nd quarter was still very healthy. We did about 420 1,000,000 which is a big number, but it's just it got dominated by what we did on the U. S. Side, Largely driven by the $1,500,000,000 If you take that $1,500,000,000 away and you look at what We've done we were at $1,600,000,000 of which the European, the international business represented, I would say trying to do a quick math right around 30%. So and that's generally been where The international business has contributed.

Speaker 2

But look, I'm very excited about that business and It's more to come.

Speaker 1

Okay. It sounds good. And yes, good job, Neil. That's actually good volume once adjusted. I guess next question is more bigger picture.

Speaker 1

I'm kind of curious what your opinion would be, what is the bigger risk to net lease? Would The inflation and potentially having this price escalators were to be tenant credit at this point of the cycle? I

Speaker 2

would think it's Tenant credit, you'll have to look at all of the various different net lease businesses and take a view Where do you see the credit risk largely driven by these inflationary pressures, the persistence of those inflationary pressures, Which then obviously is resulting in this higher interest rate environment. I think that's going to sort of filter through And it will impact net lease businesses, net lease companies differently depending on the makeup of where their exposure lies. For me, one of the advantages that we have is do we can we perfectly match Inflation with the inherent growth rates that we have, we can't. So there's always going to be a bit of a mismatch. But Have we, and now I'm talking about Realty Income, done a much better job of growing the inherent growth profile Of our leases, the answer is a categorical yes.

Speaker 2

Today, and I think it was part of my prepared remarks, Our overall portfolio, if you were to do nothing, will grow by 1.5% and on a levered basis closer to 2%. Some of it is actually benefited from non capped CPIs that we've been able to get on 1 third of the assets that have CPI growth rates built into them in the international markets. And those have contributed greatly to increasing our inherent growth rate. So it's never going to be perfectly matched, but the risk of not having a perfectly matched Growth rate inherited in your leases is somewhat muted versus credit risks that could translate into Much bigger impact on your overall business.

Operator

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

Speaker 12

Hey, just Two quick ones, staying on the tenant credit risk. So I see occupancy 99, Need an EBITDAR, it looks like it ticked up 2.8 versus 2.7 last quarter, and I know that's reported with a lag, but still pretty interesting. And I think in your opening comments, you mentioned that basically the watches was the lowest sort of ever. So things are certainly feeling pretty good. But As you sort of look forward, when you hear stuff like student loans starting again or property insurance in Florida, Just sort of curious how does your team sort of stress test that or think about that, what the potential impact could have on the tenant side?

Speaker 12

Thanks.

Speaker 2

Yes. Good question, Ronald. And just to clarify, it was in the last 5 years that I said that our credit watch list is In the 3s, it's the lowest it's been in the last 5 years. Those are very good questions. What is it when student Loans get instituted back again and discretionary income falls, what are the first things to go?

Speaker 2

It's going to be discretionary spend, And if you look at the portfolio that we've created that largely consists of Non discretionary, low price point, service oriented businesses, these are things that will be the last to go. Could they be impacted? Of course, they can. But when you have discretionary income that is getting compressed, Those are not going to be the types of businesses that will get impacted first. And that's how we've Constituted our portfolio of assets is being very much focused on what are the industries That are going to be a lot more resilient under economic conditions like the one that we are facing today.

Speaker 2

So it is not by luck that we find ourselves with a credit watch list that is circa 3.7%. It is by design. And that's how we run our business, Ronald.

Speaker 12

Great. And then my second one was just, so going back to guidance a little bit, and taking a step back thinking about this year, just What are the sort of the big 2 or 3 sort of comp issues that the guidance was facing this year? I think you hit on 1, which is the interest costs Sort of headwind, right, for this year, but presumably that's not going to be an issue for 'twenty four because the comps just is not as tough. Was there anything else sort of one time or unique to this year? It could be property tax, it could be whatever that we should be mindful for '23, that maybe does not sort of happen again in 'twenty four?

Speaker 4

Hey, Ron, it's Jonathan. I'll say I'll expand on what I said earlier regarding short term rates. We talked about the impact to the back Half of this year, but when you really zoom out and you look at year over year versus all of 2022 versus 2023, It's even a greater impact. It's closer to $0.07 or $0.08 which based off the midpoint of our guide is about 2%. And so you take that out and on a normalized basis, the volume that we're doing, everything that we're doing from a portfolio to asset management standpoint, We're trending closer to a 5% number year over year if you were at 3.1% this quarter.

Speaker 4

The Q1 did have a little bit of a tougher comp. If you recall, the Q1 of 2022, we did have a Significant reserve reversal in theater industry. So that's why the Q1 was a little bit flat, second quarter Outside of rates, it's getting back more towards a normalized level. So back half of the year, I think you'll continue to see some difficult On the sulfur front and given that we do have even 8%, 10% exposure to variable rates, Just given the magnitude of the move, that's going to be the biggest difference.

Operator

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

Speaker 3

Hi, Christy, sad to see

Speaker 13

you go. You have Great perspective and Jonathan well deserved. Congratulations to you both. Just going back to your comment regarding the stickiness of Cap rates, the investment spread of 133 basis points, how does that vary between international and domestic investments? And

Speaker 2

The headline cap rates that we are registering, I think the international business was 20 basis points higher. So that should answer your question, Linda. But again, this is going to be very much a product by product, opportunity by opportunity discussion In terms of what is the actual spread that we are going to realize and is there an advantage between the domestic markets and the international markets? I think the advantages are very different. Here in the U.

Speaker 2

S. Market, there's clearly more competition, there are more players. In the international markets, we don't experience that. The U. S.

Speaker 2

Market, however, is a much more mature Sale leaseback market and so there are more opportunities that one can participate in. Whereas I would say the international market is Still in the nascent stages of off sale leaseback as a viable product. It is maturing, but it is behind the curve. And for us, what we want to try to do is position ourselves in both these markets and work from Our points of strength that allows us to then win transactions, Our average has been 150 basis points of spread from the time we've been tracking Spreads and Q1, it was 200 basis points based on realized Capital that we raised to actually help finance our business. This quarter based on again the same method, It's 133 basis points.

Speaker 2

So if you average out year to date, it's still north Of what our 150 basis points historical average has been. But it's very difficult, Linda, to tell Going forward, you're going to have one geography that is going to dominate The spread versus another. It's very much opportunity driven.

Speaker 13

Got it. And then I think you said 30% of your international leases have uncapped CTI, what is the nature of those tenants that are open to that versus the other 70% of leases that don't have uncapped?

Speaker 2

Yes. Linda, let me be a bit more precise. Of the international leases that have CPI As the driver of internal growth, 1 third or 30% of them are uncapped. So not all of our leases in the international markets have CPI drivers of internal growth. So I just want to make that clarification.

Speaker 2

And again, it is very much a function of the market. A market that is used to seeing CPI growth as the metric for In their leases, they're far more receptive to continuing to see that. Now there has been some pushback given just the Sheer magnitude of inflation that's being experienced in some of these markets, and we are trying to be commercial about that. But it's very difficult suddenly to go to a client here who happens to be an investment grade client and say, sorry, we want CPI growth, you're not going to get that. So, yes, we see we tend to see more uncapped CPI growth In the international markets than we do here.

Speaker 2

And yes, but that too is evolving.

Operator

The next question comes from Harsh Himani of Green Please go ahead.

Speaker 14

Thank you. Sumit, you mentioned that in the past sourcing, What you close is roughly 7% of what you've sourced and this quarter it was closer to 15%. Do you worry at all if the net lease transaction market sort of continues to remain illiquid and Equity income, you're closing $5,000,000,000 to $7,000,000,000 annually that you might not have the luxury to be as selective as you were in the past Maybe you have to execute on your 2nd or 3rd best idea. How are you thinking about that looking over the next 12 months?

Speaker 2

Well, the good news Harsh is that we haven't gone to executing on our second or third best ideas yet. We are very fortunate. Let me shed some light on this 15% closing rather than what we've traditionally done, which is 7% to 10%. What is skewing this is clearly the $1,500,000,000 transaction that we closed on in the second But it's not reflected in the denominator, in the sourcing volume of $15,000,000,000 We had sourced that asset, I would Probably in the Q4 of last year. So that's where the mismatch occurs.

Speaker 2

In some ways, The sourcing volume is much more real time. What did we see? And there is generally a lag between When we engage in a conversation, I. E, when it is sourced versus when does that particular transaction get over the finish line or closes. And I think that lag sometimes does create this mismatch.

Speaker 2

So if we were to sort of take away the 1.5 And then look at the $1,600,000,000 that we ended up closing in a year that in a quarter where we Source $15,000,000,000 $16,000,000,000 that's still 10%. So, I think that's probably the way to think about This mismatch that we saw in the Q2.

Speaker 14

Okay. That's helpful. And then the 1.6 $1,000,000,000,000 that you provided that there's $1,600,000,000,000 of commercial real estate on S and P 500 company balance sheet. How much of that Is real estate that you would actually want to have in your portfolio? So I imagine you're not actively acquiring office assets.

Speaker 14

Could you share how much of that is maybe retail, gaming, etcetera that you might go after?

Speaker 2

Yes. That's a great question, And we did that when we talk about $4,000,000,000,000 here in the U. S. And $8,000,000,000,000 in Europe. And just to be also super Clear about this particular statistics that we shared in the prepared remarks.

Speaker 2

It does not include other real estate companies. It does not include certain sectors like Finance companies, banks, energy companies, etcetera, etcetera, these are operating businesses that have assets. And an easy way to think about it is, let's assume that half of it is office. Let's assume that another 20% of it is Something that we wouldn't want, even if it is 20% or 30% of this $1,600,000,000,000 that is a massive number. And the point is that these are companies that are going to have to refinance their debt, This $1,200,000,000,000 of debt over the next 3 years, it's maturing over the next 3 years and sale leaseback Should be a conversation that is appealing to them, especially given the cost of doing a sale leaseback today in this environment versus The cost of refinancing that a lot of these companies are going to experience, that's really the point.

Speaker 2

Thank you all for joining us today. We're looking forward to seeing many of you at the various conferences this fall. Have a good rest of your summer. Bye bye.

Operator

The conference is now concluded. Thank you for attending today's presentation and you may now disconnect.

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Earnings Conference Call
Realty Income Q2 2023
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