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Good day, everyone and welcome to the Realty Income First Quarter 2018 Operating Results Conference Call. Today’s conference is being recorded.
At this time, I would like to turn the conference over to Janeen Bedard, Senior Vice President. Please go ahead, ma’am.
Thank you all for joining us today for Realty Income’s first quarter 2018 operating results conference call. Discussing our results will be John Case, Chief Executive Officer; Paul Meurer, Chief Financial Officer and Treasurer; and Sumit Roy, President and Chief Operating Officer.
During this conference call, we will make certain statements that may be considered to be forward-looking statements under federal securities laws. The company’s actual future results may differ significantly from the matters discussed in any forward-looking statements. We will disclose in greater detail the factors that may cause such differences in the company’s Forms 10-Q. We will be observing a two-question limit during the Q&A portion of the call in order to give everyone the opportunity to participate.
I will now turn the call over to our CEO, John Case.
Thanks, Janeen and welcome to our call today. We're pleased to begin the year with another successful quarter. During the first quarter, we invested $510 million in high quality property acquisitions and now over 50% of our rental revenue was generated from investment grade rated tenants. Our focus on quality is also reflected in our portfolio occupancy, which is 98.6%, our highest quarter en occupancy in more than 10 years. We reached this occupancy level, while achieving our seventh consecutive quarter of positive recapture spreads on properties released. We remain confident in the outlook for our business and are reiterating our 2018 AFFO per share guidance of $3.14 to $3.20, which represents annual growth of about 3% to 5%.
Let me hand it over to Paul now to provide some additional detail on our financial results. Paul?
Thanks, John. I will provide highlights for a few items in our financial results for the quarter, starting with the income statement. Interest expense in the quarter was flat despite a higher outstanding debt balance. This was largely due to the $2.3 million preferred dividend expense we recognized in the comparative quarter a year ago when we announced the redemption of our Series F preferred stock. Additionally, we recognized the larger interest rate swap gain this quarter, which has the effect of decreasing interest expense.
Our G&A, as a percentage of total rental and other revenues, was 5.1% for the quarter. We continued to have the lowest G&A ratio in the net lease REIT sector and we project G&A to remain approximately 5% in 2018. Our non-reimbursable property expenses, as a percentage of total rental and other revenues, was 1.7% for the quarter and we expect non-reimbursable property expenses to remain in the 1.5% to 2% range in 2018.
Funds from operations or FFO per share was $0.79 for the quarter, representing 11.3% increase over the first quarter of 2017. Note that in the first quarter of last year, we recognized a $13.4 million non-cash charge related to the early redemption of our Series F preferred stock. As a reminder, our reported FFO does follow the NAREIT redefined FFO definitions. Adjusted funds from operations or AFFO or the actual cash we have available for distribution as dividends, was also $0.79 per share for the quarter, representing a 3.9% increase.
Briefly turning to the balance sheet, we've continued to maintain our conservative capital structure. In early April, we issued $500 million in seven-year fixed rate unsecured bonds at a yield of 3.96%. The offering allowed us to term out our borrowings on our revolving credit facility and they fit nicely in our debt maturity schedule as we had no other maturities in 2025. Pro forma for the bond offering, the weighted average maturity of our bond is approximately 9.5 years, which is nearly three years longer than it was at the start of 2017.
Our overall debt maturity schedule remains in excellent shape with less than $80 million of debt coming due the remainder of this year and only $21 million coming due in 2019 outside of our revolver and our maturity schedule is very well latter thereafter. Our overall leverage remains modest. Our pro forma debt to EBITDA, assuming the annualized impact of our first quarter acquisitions, is currently 5.6 times and our fixed charge coverage remains healthy at 4.6 times.
So, in summary, we continue to have low leverage, excellent liquidity and strong coverage metrics. Now, let me turn the call back over to John.
Thanks, Paul. I’ll begin with an overview of the portfolio, which continues to perform well. As I mentioned earlier, occupancy based on the number of properties was 98.6%, an increase of 30 basis points versus the year ago period. We expect occupancy to be just north of 98% for 2018. During the quarter, we re-leased 55 properties, recapturing just over 100% of the expiring rent, which is consistent with our long-term average. Since our listing in 1994, we have re-leased or sold nearly 2700 properties with leases expiring, recapturing 100% of rent on those properties that were re-leased.
Going to dispositions, we continue to selectively sell properties that no longer meet our investment criteria. During the quarter, we sold $14 million of non-strategic assets, achieving an unlevered IRR of 7.3% and a cap rate or leased property sales of 6.6%. We’re increasing in our estimate for dispositions from $75 million to $100 million to approximately $200 million for 2018.
Our same store rental revenue increased 1% during the quarter, which is consistent with our projected run rate for 2018. Approximately 90% of our leases continue to have contractual rent increases. Our portfolio continues to be diversified by tenant and history, geography and to a certain extent property type, which contributes to the stability of our cash flow. At the end of the quarter, our properties re-leased to 254 commercial tenants in 47 different industries located in 49 states in Puerto Rico.
81% of our rental revenue is from our traditional retail properties. The largest component outside of retail is industrial properties at about 13% of rental revenue. Walgreens remains our largest tenant at 6.7% of rental revenue and in the first quarter, drugstores was our largest industry at 10.5% of rental revenue. We're pleased with the strength of our portfolio, which continues to perform well, especially relative to other types of retail portfolios, which had faced more significant challenges due to e-commerce pressures.
Within our retail portfolio, over 90% of our rent comes from tenants with a service, non-discretionary and/or low price point component to their business. We believe these characteristics allow our tenants to compete more effectively with e-commerce and operate successfully in a variety of economic environments. These factors have been particularly relevant in today's retail climate where the vast majority of recent US retailer bankruptcies have been in industries that do not possess these characteristics.
We continue to have excellent credit quality in the portfolio with over half of our annualized rental revenue generated from investment grade rated tenants. This represents the highest investment grade exposure in our portfolio’s history. The store level performance of our retail tenants also remains sound. The weighted average rent coverage ratio for retail properties is 2.8 times on a four wall basis, while the median is 2.6 times. Our watch list remains in the low 1% range as a percentage of rent, which is also consistent with our levels of the last few years.
Moving on to acquisitions, we completed $510 million in acquisitions during the quarter at a 6.2% cap rate. Virtually, all in the QSR and C-store industries. As a reminder, we disclose cash cap rates as opposed to GAAP cap rates. We estimate our GAAP acquisition cap rates would be about 0.5% higher. We were pleased with the quality of our first quarter acquisitions as 85% of the rental revenue generated from these investments is from investment grade rated tenants.
During the quarter, we completed a significant sale leaseback transaction with 7-Eleven who is now our fifth largest tenant, representing approximately 3.5% of rent. 7-Eleven is the top global convenience store operator and provides very strong credit with an S&P rating of AA-. We previously partnered with 7-Eleven for their first sale leaseback transaction in 2016 and are pleased to continue the relationship. This transaction was done on a off-market basis and reflects the benefits afforded to us due to our size, as we are the only net lease REIT able to execute on an investment of this scale without creating tenant and history concentration issues. These properties are newer vintage and located in highly trafficked markets with significant population density. The average size of these properties is in excess of 4000 square feet and about two-thirds of the properties operate a quick service restaurant concept within the convenience store.
In addition to the quality of the real estate, we are pleased with the structure of this transaction, which carries an average lease term of 16 years and rent growth well in excess of our portfolio average with rents in lined with market rents. Overall, we continue to see a steady flow of opportunities that meet our investment parameters. During the quarter, we sourced 9.5 billion in acquisition opportunities. We remain selective in our investment strategy, acquiring 5% of the amount sourced. Our investment spreads in the first quarter move closer to our historical average as a result of the high quality of the properties and the strong credit profile of the tenants as well as higher capital costs. Given the continued strength in our investment pipeline in the current market environment, we continue to estimate 2018 acquisition volume to be $1 billion to $1.5 billion.
I'll hand it over to Sumit to discuss our acquisitions in a bit more detail now. Sumit?
Thank you, John. During the first quarter of 2018, we invested 510 million in 174 properties located in 27 states at an average initial cash cap rate of 6.2% and with a weighted average lease term of 14 years. On revenue basis, approximately 85% of the total acquisitions are from investment grade tenants. 100% of the revenues are generated from retail. These assets are leased to 16 different tenants in 12 industries.
Some of the most significant industries represented are convenience stores and quick service restaurants. We closed 10 discrete transactions in the first quarter. Transaction flow continues to remain healthy of the opportunity source during the first quarter, 54% for portfolios and 46% or approximately 4.4 billion were one-off assets. Investment grade opportunities represented 23% for the first quarter. Of the 510 million in acquisitions closed in the first quarter, 5% were one-off transactions.
As to pricing cap rates, we’re essentially unchanged in the first quarter. Investment grade properties trading from around 5% to high 6% cap rate range and non-investment grade properties trading from high 5% to low 8% cap rate range. Our investment spreads relative to our weighted average cost of capital were healthy, averaging approximately 130 basis points in the first quarter, which were just under our historical average spreads. We define investment spreads as an initial cash yield, less our nominal first year weighted average cost of capital.
As John mentioned, during the quarter, we sold 14 properties for net proceeds of 13.8 million at a net cash cap rate of 6.6% and realized an unlevered IRR of 7.3%. In conclusion, we look forward to achieving our 2018 acquisition target and revise disposition volume of approximately 200 million. John?
We continue to monitor the capital markets to fund our business. The pricing of our April bond offering, which Paul referenced reflects the benefits of having the highest credit rating in the net lease sector. We're well positioned to fund our growth for the remainder of the year as a result of our conservative balance sheet management over recent years. We have no bond maturities until 2021 and our senior unsecured notes and bonds have a weighted average remaining term of approximately 9.5 years. We currently have about $1.3 billion available on our $2 billion line of credit.
In March, we increased the dividend for the 96th time in our company’s history. Our current annualized dividend represents a 4% increase over the year ago period. We have increased our dividend every year since the company's listing in 1994, growing the dividend at a compound average annual rate of 4.7%. We’re proud to be one of only five REITs in the S&P High Yield Dividend Aristocrats Index.
To wrap it up, we are pleased with our company's performance to start the year and remain optimistic for the remainder of 2018. Our real estate portfolio, acquisitions pipeline and balance sheet remain healthy, contributing to favorable risk adjusted earnings growth for our shareholders.
At this time, I would like to open it up for questions. Operator?
[Operator Instructions] We’ll take our first question now from Nick Yulico with UBS.
I guess first off, just a question on the disposition guidance going up. Can you talk a little bit more about what you're looking to sell?
Sure. Just like last year, when initially we guided the dispositions for the year, 75 million to 100 million, we did the same thing this year, but as the year goes along, we uncover opportunities to sell non-strategic assets and we've had a couple of conversations that have led us to believe we think we're going to be closer to 200 million in dispositions. The types of assets are non-strategic. There's a casual dining portfolio included in that and some additional Piazzi stores and a few other types, but they're largely non-strategic and they're factored in to our guidance, even though they're a bit dilutive.
Okay. And then second question is on industrial. You've previously talked about looking to grow that exposure. I'm wondering how much of the pipeline build as you looked at in the first quarter was industrial and with the M&A that's happened in that sector of late, how is the pricing there for us that's been affected, affecting your ability to still be able to buy industrial? Can you make deals work versus where you see your cost of capital?
Yeah. That's a good question, Nick. About 20% of the transactions we sourced in the first quarter were industrial properties and even though the 10-year treasury has risen by 50 basis points this year more or less, we've seen industrial cap rates continue to tick down by roughly 25 basis points. So it's been quite challenging for us to grow that part of the business and that's why none of our acquisitions in the first quarter were industrial properties.
That being said, given the activity in that sector, it does reinforce the views we have regarding the strength of that portfolio, just under $3 billion on our balance sheet. So we're pleased to have it, but at these pricing levels, it would be challenging to grow significantly, given our current cost of capital.
We’ll move and take our next question from Karin Ford with MUFG Securities.
You’ve talked about how you could fund your investment guidance with cash flow, leverage capacity and dispositions. You’re off to a fast start here, it sounds like the pipeline is good. How are you thinking about expanding that guidance and using the ATM and/or equity issuance now you’re once again trading above NAV?
Well, Karin, the acquisitions are lumpy. So that's the word we've used to describe them. We've quarters at 700 to 800 million and quarters at 200 million to 300 million. We can't really extrapolate of one quarter and that's what we did change our guidance for acquisitions. We’re still guiding to 1 billion to 1.5 billion for the year at this point.
As far as capital raising, yes, we could fund our growth this year. Our estimated growth without coming to the equity markets through disposition proceeds, routine cash flow and debt, the balance sheet is in great shape right now. However, we will look at all capital opportunities, including equity and when we need to raise capital, we will use the appropriate form in the form that makes the most sense for the company.
My second question is going back to the M&A question earlier. Do you think that the Gramercy deal earlier this week was driven by the unique aspects of GPT’s industrial real estate or do you take anything away with respect to the privatization prospects for triple net real estate generally.
Well, I think industrial was the flavor of the day. We've seen a lot of competition for those types of properties. I think Gramercy did a good job, I know, Gordon, we know Gordon well, solid company. We competed frequently with them, winning our fair share and losing some on property acquisitions. They put together a nice portfolio just as we have. I think that the Blackstone transaction is driven more by the fact that Gramercy is industrial rather than you it's a net least company. I think that addresses your question.
And next, we’ll move on to Nick Joseph with Citi.
It’s Michael Bilerman here with Nick. So just, if I think about G&A load, the last call it four years or so, you’ve consistently run at this sort of 5% of revenue line in terms of G&A relative to revenues and your asset base has grown almost $5 billion over that time. How should investors think about, at what point you may or maybe you won't ever see further G&A leverage within the organization, as you continue to put out capital every year.
Yeah. So, we have held at 5%, which we've been pleased with in terms of G&A as a percent of revenues. I think we'll be able to hold that level for the foreseeable future and perhaps bring it down a bit more. Paul, you want to elaborate on that?
Yeah. Some of the additions of personnel over the past couple of years as we enter new property types and expanded the portfolio were necessary and we've invested in, I think, personnel and systems, which put us in good position to kind of support continued growth of the company without significant additions on the G&A side. So we're feeling kind of that curve coming, where I think a little bit more leverage will occur and we could see that number ticked down. Yes, for this year though and the near term is still around 5%.
How do you think about the right organizational structure for a net lease company? I think with Mark's announcement, have a CEO, President, and COO, CIO, a Chief Strategy Officer, I guess it’s going to be a CSO, CFO, and then a number of Executive Vice Presidents that feed into that. Just from the -- I recognize you’re a big company. It just seems like a lot of heads for a net lease company in their senior suite where you haven't been able to get that G&A leverage as you've grown pretty meaningfully.
Well, we've got the lowest in the sector and over time, it has come down and we probably hear more comments as to why don't you continue to broaden your skill set and deepen your skillset, given the efficiency of the company. We don't have any positions right now that are not critical positions to the management of the company. So with Mark’s addition, I think we'll be in a place where we've got our full complement of skillsets and it will be, I think, we'll be taking care of at the executive and any level following that.
I’d cite that most of our peers I think are closer to 10% in terms of G&A load as a percent of revenues.
Next, we’ll move on to Jason Belcher with Wells Fargo.
Hi. Just wanted to ask about this headline I saw this morning about Sears partnering with Amazon to sell and install car tires, it’s another retail sector that I think most people yesterday would have felt was fairly well insulated from pressures of online retail. Just wondering is this something that you've heard anything about from your auto parts and service tenants, something they’ve sort of seen coming down the line or would this be more in the unexpected disruption bucket? And then if you could just remind us what your exposure is to the auto parts and service sectors please?
Yeah. So to the tire services sector, 2.4% of our rental revenues are represented by tires, the tire service. And then on top of that, we have about another 4% in automotive parts and automotive service and that's an area we've been fine with. We haven't received any immediate feedback from our clients on the Sears transaction as of yet, but that's a business that we like and that certainly is benefits from the trend of automobile miles driven continuing to increase in this country. So all vehicles will need tires, regardless of whether they're gas or EDV. Sumitomo is the parent of TBC and is a very strong company with an A- rating and stands behind those leases for TBC.
And next we’ll move on to Vikram Malhotra with Morgan Stanley.
I just wanted to dig in a bit more on the new position announced in the terms of the Chief Strategy Officer. I believe this is the first time you've sort of created this role. So I’m wondering if you can give us a sense of what his role would be and does this signal perhaps you looking at this sector viewer exposed to maybe in a different matter to changing the strategy say for over the next ten years, does it signal you looking at potentially bigger portfolios or maybe even strategic M&A?
Well, it doesn't change our strategy. We believe that as the company has grown in size to be a $21 billion company with 5300 properties in 47 different industries, 49 states that it made sense to have a -- we've become more complex as well, but it made sense to have a executive level position dedicated to strategy. We'll continue to oversee our research and credit effort and continue to sit on the investment community and Neil’s background is very well suited for this position. He'll work with the rest of the executive team, me and the board in formulating strategy going forward and I think it will be a more efficient process. So we're glad to have Neil in that role and he will do well, given the successes he had in the Chief Investment Officer role, but it does not signal any change in strategy for us. It's just a response to the growth we've had and that increasing diversification of our portfolio that we've had since 2010 when we were just a $4.5 billion company and today, we're $21 billion company.
And just in terms of sort of the portfolio itself, you do have the concentration now in two main sectors, convenience stores and drugstores, maybe just give us some thoughts of where you'd like that to be over the next few years.
Well, we're comfortable having strong sectors such as those be in that low double digit percentage of rent range. So, next quarter, we'll see C-stores, drugstores would be somewhere around 11% of rental revenues. We're comfortable with those levels. That being said, at times, we opportunistically sell some of the tenants within those categories, properties, when we have strong bids and that's a very liquid market for assets in those two industries and we often acquire a large sale leaseback transactions and did a 25 to 75 basis point cap rate, higher than what you see in the one-off market. So it's a good way for us to drive value, raise money and manage exposure, but we're comfortable with those levels, given the strength of those industries.
Next, we’ll move on to John Massocca with Ladenburg Thalmann.
Given the increase in the disposition guidance and the fact that you expected to be maybe more strategic, generally speaking, what would you expect the mix on dispositions to be this year between vacant and occupied assets?
In the first quarter, it was – of the 13 assets, three were occupied, 10 were vacant. I do see a shift in that in order for us to get to the 200 million as John alluded. We are having discussions on the casual dining side and a vast majority of those are going to be occupied assets.
And then it’s a little bit of a blast in the past, but can you give us a quick update on the former Gander assets, did you sell any of these properties in 1Q 18 or leasing of them?
Sure. So we owned initially -- I think it was nine Ganders and they represented less than 0.5% of our revenues. So it wasn't a significant tenant for us. At this point, we resolved six of the nine, three were re-leased at recapture rates just under 90%, the expiring rent. So we were pleased with those and then we are selling, have sold and have under contract to sell three more properties and then the remaining three we're in discussions on in terms of leasing with national and regional tenants. So that's where we stand on that and we're pleased with the outcome so far.
This concludes the question-and-answer portion of Realty Income’s conference. I will now turn the call back over to John Case for concluding remarks.
Okay. Well, thank you. We appreciate everyone joining us today and we look forward to speaking with you in a few weeks at ICSC and NAREIT. Thanks again for joining the call.
Thank you. This concludes our conference call for today, everyone. Thank you all for your participation. You may now disconnect.