Realty Income Corp

NYSE:O

Good day, and welcome to the Realty Income Fourth Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note today's event is being recorded.

I would now like to turn the conference over to Steve Bakke, Senior Vice President of Corporate Finance. Please go ahead, sir.

Thank you all for joining us today for Realty Income's Fourth Quarter Operating Results Conference Call. Discussing our results will be Sumit Roy, President and Chief Executive Officer; and Jonathan Pong, Chief Financial Officer and Treasurer.

During this conference call, we will make statements that may be considered forward-looking statements under federal securities law. The company's actual future results may differ significantly from the matters discussed in any forward-looking statements. We will disclose in greater detail the factors that may cause such differences in the company's Form 10-K. We will be observing a 2-question limit during the Q&A portion of the call in order to give everyone the opportunity to participate. If you would like to ask additional questions, you may reenter the queue.

I will now turn the call over to our CEO, Sumit Roy.

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 8 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 Decathlon, 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 Farm 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 23. These accomplishments contributed to our 2023 AFFO per share of $4 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 here in 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 20, 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 meets 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 U.S. 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 3 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 7x the net lease peer average over the same timeframe, leaving us even better situated to fund our business in a highly efficient and nondisruptive 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 119 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 platforms and global footprint. Included in fourth quarter volume was a loan we made to assets stores in the U.K. 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 and 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 that Bellagio preferred equity investment was spared with investment in high-quality real estate. For both investments, our ability to offer a broadened suite of capital solutions to clients granted us access to high-quality net lease real estate investments at superior risk-adjusted returns that we could have otherwise achieved. These transactions serve as templates for future serve 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 5 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 Cineworld 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, Sumit. We completed an active quarter in the capital markets during the fourth quarter, raising $1.6 billion of equity at a weighted average price of $56.25, including activity subsequent to year-end, we currently have approximately $605 million of outstanding forward equity available to finance a portion of our equity needs in 2024.

When combined with over $800 million of annual free cash flow available to us following the Spirit merger, we have the ability to finance all of our equity needs for our $2 billion investments guidance without having to tap into the public equity markets for the remainder of 2024. And this is before any capital recycling opportunities through asset sales, which we expect to be north of the $116 million volume we achieved in 2023.

As Sumit mentioned earlier, our AFFO per share guidance midpoint implies 4.3% annual growth and assumes only $2 billion of investment volume with almost half are we accounted for in our development pipeline. From a debt capital market standpoint, we derisked our 2024 maturity schedule through approximately $2.2 billion of bond issuance activity and a 45-day spend. Beginning with our GBP 750 million sterling notes offering in December and culminating in our USD 1.25 billion offering that closed last month.

Combined, the 2 offerings blend to a weighted average tenant of approximately 10.2 years and weighted average yield to maturity of approximately 5.5%. Near-term, these 2 offerings allow us to fund our business given our current investment outlook without needing to tap into the debt capital markets in 2024, which we believe was a prudent approach given the persistent instability that has permeated the capital markets over the last 2 years. There are also longer-term strategic considerations that dictated this approach.

Following our debut Euro offerings in the summer of 2023, we believe these offerings also support our steadfast desire to maintain investor diversification across our multicurrency debt complex, while pocketing future debt repayment risk in years with meaningful capacity.

Last month, we also exercised the first of 2 1-year extension options available to us on our $1.1 billion multicurrency term loan that we established in January of 2023. In conjunction with the extension, we entered into a 2-year floating to fixed interest rate swap that effectively locked in a fixed rate of approximately 4.85%. On this principle through its maturity date in January 2026. In conjunction with the closing of the Spirit merger, we also assumed $1.3 billion of term loan debt from Spirit as well as $1.3 billion in existing floating to fixed interest rate swaps, which resulted in an effective weighted average fixed rate of 3.9% on that debt.

Of this term loan principle, $800 million matures in 2025 and $500 million matures in 2027. Moving on to key credit metrics at year-end. We finished the year with net debt to annualized pro forma EBITDA of 5.5x in line with our targeted leverage ratio. And this excludes the $605 million of outstanding forward equity, we currently have available to us. Our fixed charge coverage finished the year at 4.7x, which was a high watermark for us in 2023. And benefiting from higher investment yields in the fourth quarter and less and lower-cost short-term borrowings outstanding.

In 2024, we do anticipate an increase of $45 million in annualized noncash interest expense we expect to recognize from the amortization of below-market debt on the Spirit that we assumed. Note that this noncash interest expense adjustment does lower annual FFO per share run rate by approximately $0.05 per share, but is not reflected in AFFO thus explaining the primary reason why our initial FFO and AFFO guidance ranges are more closely bound than in 2023.

We would note that purchase price accounting adjustments are ongoing for the merger and thus, straight-line rent and FAS 141 adjustments from the merger are likely to push FFO higher once finalized, and we will adjust our FFO guidance at that time. Of course, these are noncash adjustments that do not impact AFFO.

Looking forward, I would like to reiterate Sumit's opening comments about our lack of reliance on the capital markets to fund our growth in 2024. From a liquidity perspective, we view our near-term capital availability as a strength following our bond deal last month. We head into the rest of 2024 with approximately $4 billion of liquidity available at year-end, variable rate debt representing less than 5% of our total debt capital stack and no capital markets execution risk to fund our growth for the remainder of 2024.

With that, I'll turn it back over to Sumit for closing remarks.

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 him 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 LaSalle 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 5 transactions greater than $500 million in size and 2 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 a 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.

[Operator Instructions] Today's first question comes from Michael Goldsmith with UBS.

First question is just on the acquisition guidance. You're starting the year with $2 billion of acquisitions. It sounds like you have visibility into half of them. So really like the execution risk for the year is only for $1 billion. So what has to change in order for that number to kind of move higher through the year? Is it interest rates? Is it opportunities that come to you? Is it your ability to do deals kind of like what you've done with the Bellagio with preferred equity or along with Asda to get it done. Like how should we think about the potential for upside for that number and that number will be higher through the year?

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 2 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 environments 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 were to start to go down, et cetera, which would have a positive impact on our cost of capital. I do believe that a lot of the conversations that we are having. So 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's really the thesis around what we've come out with.

No. That's helpful, Sumit. And then if we think about -- as my follow-up question, not to be -- we still have a lot to get through with '24. So this question isn't necessarily specific to '25, but just like the philosophy of if the environment stays kind of in a similar-ish range than where it is right now, where you just there isn't a lot of deals getting done. The transaction market remains kind of murky, you've driven. You've locked in growth for '24 through an acquisition, how would you think about -- how would you think about navigating through a multi -- a potentially multiyear kind of murky environment. Yes, exactly. Like how do you plan on navigating through a multiyear murky environment, if that was the case?

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, hey, this cost of capital environment is going to remain at these elevated levels for the next 3 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 tenure at a 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 rate later in the year. I think it can hold off another 6 to 7 months. So why transact in this environment today? And I think that's the reason why we have hesitation and lack of this widespread movement in cap rates that one would expect if people were to bind to the fact that this cost of capital environment has been permanently impaired.

So I think in this scenario that you've sort of dictated, if that were to be the norm and if everybody were to accept that, that, hey, for the next 3 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.

And our next question comes from Joshua Dennerlein with BOA Merrill Lynch.

I appreciate the time. Just wanted to -- I had a question on the development funding. How do we think about the NOI from that development funding coming online? Do you only get NOI or return once the project is finished? Or do you get like a return as the money is kind of drawn down for that development?

Josh, this is Jonathan. One way to think about it because the answer is really going to vary depending on the lease. But if we're doing a development takeout, obviously, we put the funds down when the project is done, we get those assets and the rent starts and there's really no lag.

If it's a development build-to-suit we're funding along the way a little bit more nuance associated with that, where you're not quite getting the economics that we are entitled to as we put this funding out. However, from an accounting standpoint, the way that it flows through to the income statement is through essentially our cost of short-term debt. And so from a modeling perspective, the most clean way to do it, in my view, would be to just assume when you see us developing and deploying capital, that's when the yield begins because in most cases, that's going to be the case.

Yes, 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 assets 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.

And I appreciate all that color. Maybe one more on development. I guess just how do we think about development as kind of like when you look across like your appetite to acquire new assets, like how do you think about like development? Is this something you're going to lean into more? There are better yields on developments versus just straight-up acquisitions. Just kind of curious.

Yes. 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 are 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 in 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.

The transactions we are entering into today on the development side, we'll have 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 1.5 years from now, when these assets get delivered, there will be a positive spread that you should see on the development yields 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.

Got it. And if I can sneak one more in. Sorry about that. Does your -- I know your guide is only $2 billion, but when you think about your broader pipeline, are there a lot of portfolio deals out there? Like bigger transactions out there? I know they take a while to close. Just kind of curious.

So Josh, I think I tried to hint that on the last conversation when somebody asked about what are you seeing, what's 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's a disconnect is what is the price at which they are willing to transact. And that's where the disconnect is.

So it's not that suddenly we are not talking to our clients. We, in fact, one of our largest clients, we spoke with them a couple of weeks ago and where the conversation sort of ended was their expectation of cap rates versus what it is that we could -- what it is that we would need to be able to generate the kind of spreads that would allow us to do the transaction. And that's where -- that's the type of conversations we're having.

And clearly, if you look at what we did last year, more than 5 transactions were above $500 million in size, 2 of which were above $1 billion in size. That's what we can deliver. That's what we can bring to the table. And that's what our clients need are big solutions to big problems. And so yes, when the spigots open and this reservation price is going to be met by our cost of capital, we will be able to take advantage of and build out our pipeline just like we did the last 3 years.

And our next question comes from Nate Crossett with BNP.

Just one on the pipeline ex development. I'm just curious if you've closed on anything so far in Q1? And if so, what was the pricing on that? And then my second question is the occupancy guide was a bit below current levels. So maybe you can just give us a little color on that? And what's on the watch list right now that we should be tracking?

Nate. So 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. So -- 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. And 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 above 98%. A lot of these were expected at lease expiration, these were expected vacancies.

And we have -- we generally tend to sort of guide to this low 98% occupancy. Part of what makes our business slightly different from perhaps what you see with the other -- with 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. I know that for a long time over the last 6 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 it, et cetera, we are very comfortable doing so. So the way to think about how we run our business is the normalized level of occupancy should be in this 98.5% ZIP code. This 1.5% is vacancy that we need to be able to execute on the plans that I've just laid out.

And our next question today comes from Brad Heffern with RBC Capital Markets.

Sumit, can you talk about the relative attractiveness of Europe right now versus the U.S.? It seems like you don't think anything is all that attractive overall, but at least in Europe, you have the better cost of debt?

Yes, 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 U.K., where we feel like even in this environment, transactions can get done.

And so that, along with the fact that at least in Europe, our cost of debt is significantly lower by 110, 120 basis points. We are continuing to look for opportunities. But the volume being low is not just unique to the U.S. It is across the geographies that we play in.

Okay. And then, Jonathan, I thought there might be more of a reduction in G&A as a percent of revenue this year than what the guidance suggested just given the additional revenue from Spirit was coming with not much additional G&A. So is there anything else going on that's keeping that figure from declining more?

Brad, there's always going to be a fair amount of conservatism sitting here in mid-February on line items like that. We did have quite a bit of growth from a resource standpoint in the back half of 2023, you're going to see the full annualized effect of that. And it's still too early to tell on the synergies front with Spirit, what ultimately is going to be achievable, but in the first month or so less than that of ownership, everything is trending to better than we expected from a synergy standpoint.

And as a reminder, on a cash basis, we expected $30 million of synergies off of a $40 million cash G&A load annualized. So we're hopeful, but look, we're trying to create a platform. We're trying to refine certain areas of the business, but we're really trying to resource with everything going on, all of our groups to create this moat, if you will, that can persist for a long time. So with that comes a little bit of investment in things like technology and in people. So that's really the driver of that.

And our next question today comes from Haendel St. Juste with Mizuho.

Good morning out there. I guess my first question is on the investment spreads here. I think you guys previously outlined expectations for a minimum of 200 basis point spread on new investments versus your cost of capital, which is well above, I guess, what you saw last year. So I guess I'm curious, one is the 200 basis points still kind of your minimum required spread? And if so, how do you achieve that today given where your cost of capital is -- appears to be somewhere in the [ 6 ]? And if that requires using some of your free cash flow, how are you thinking about the required return for that portion of your capital as well?

Haendel, thank you for your question. So 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, this represents 60% of the total capital.

So to be able to generate 200 basis points on free cash flow is actually you can do deals at 2% cap rates and still generate 200 basis points. But obviously, that's not how we think about our business. And by the way, the 200 basis points that we were able to achieve, I would say now about 3 years ago, 2.5 years ago, that was in an environment where our cost of capital was massively different than what it is today. And being able to generate 200 basis points was not that difficult.

On average, from the time we've been tracking spreads, 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 and the fourth quarter of last year and all of last year where we did 120 basis points, where when you build up a pipeline with a certain backdrop with regards to your cost of capital and the cap rates that you're entering into a contract in. And 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. And 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.

So 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 that 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 bar build 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 or that spectrum of spreads in this volatile environment is very difficult to predict, which is why we are -- we've come out with the plan that we have, which -- even in this environment, we can still deliver north of 10% without having to rely on the acquisition market.

I appreciate that. I just want to be clear, it sounds like 200 basis points is not the absolute minimum that you're seeking, which I think is a little different for what I think we had talked about a few months ago. But my next question, I guess, is on what's embedded in the guide here regarding credit loss and the integration of the Spirit portfolio? Can you touch on that a little bit?

The integration is going very well. We've 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 8 people from Spirit on a permanent basis. And we have 7 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 by -- 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 and say 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. And if that's the case, we will share that information with you down the road.

Got it. Got it. But are you able to quantify within the guide for potential credit loss or any added color on that?

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.

Our next question comes from Spenser Allaway with Green Street Advisors.

Given the dearth of deal volume right now, especially compared to recent years, what is the highest and best use of time right now? So I know you have a massive portfolio but outside of routine asset management. I'm just curious at this quiet period, if you will, is a good opportunity to underwrite new geographies or property types?

It's all of those things, Spenser. I mean -- I think you've been following us for a while. We are constantly looking for ways to grow our portfolio and we are constantly looking at nontraditional ways to growing our earnings. And 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 and 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 the offense.

But having said all of that, I do believe that this acquisitions environment can change and can change very quickly. And so 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. And so 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've sort of had to put a little bit on the back burner given the robustness of the investment environment that we've had over the last 3 years. So 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.

Okay. Great. And do you guys have a target date for when you'd like to get through the kind of the spare portfolio in terms of pegging some potential disposition candidates and things of that nature? Do you guys have to get a target date when you want to get through the portfolio?

We are not waiting on a particular date. There's 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 2 months and 10 days.

Our next question comes from Smedes Rose with Citi.

I wanted to go back to something you mentioned in your opening remarks where you were talking about being able to put in more growth opportunities into your leases? I think you mentioned it's up 50 basis points versus 5 years ago? And as you speak to, I guess my question is, I'm wondering, does the quality or sort of the credit quality of the client vary by the ability to push through higher escalators? It sort of feels like the higher quality or higher credit would have more bargaining power on their side to resist those kinds of changes. But I'd just be interested in kind of if you could just maybe talk about that a little more.

Sure. Smedes, your intuition is accurate. In the retail space here in the U.S., when you start to talk to investment-grade clients on the retail side, on retail boxes, that enter into long-term leases, et cetera. It is very difficult to get them to give you what one would consider to be market growth rates. And so it's the ones that tend to be BBB, BBB- 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. So what were 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, I think 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%, 2.5% growth. So that was one of the drivers of the change in the growth profile. The second was going into new asset types like data centers, like gaming. Those do also tend to have 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.

So you might recall that we had -- our first transaction was a $0.5 billion sale-leaseback with one of the largest grocers in the U.K., and that had a growth profile that far superseded the profile that one can get here in the U.S. 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%, and that will continue to be a major focus of our business is to 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.

Okay. That's super helpful. And then I just wanted to quickly ask you, I think you kind of touched on this, but you said you're going to recycle capital, more than $160 million that you did in 2023. And that's just because you probably have sort of more noncore assets identified with the Spirit acquisition. So that would -- that's what's sort of taking that number up maybe relative to where it's been historically or?

Yes. 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.

And our next question comes from Eric Borden with BMO Capital Markets.

I'm just curious if you could talk about the potential opportunities you're seeing today as it relates to the credit lending platform. And what are the different types of tenant credit in industries that you're targeting today?

So 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 yields 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.

And 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 in the gaming side with Blackstone. We've talked about doing an investment on one of the largest grocers in the U.K.

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.

That's helpful. And then I just wanted to ask one question on the free cash flow. On the $800 million plus of expected free cash flow for 2024, does that guidance include the potential income generated from holding cash in a money market account?

Eric, it includes everything. So in our AFFO guidance, first of all, all of those outcomes, if we're sitting on cash like we have been, where we're relentless and trying to get as much as we possibly can while it's there. So that flows through to AFFO. And then you have to deduct obviously, for the dividend, that in effect is the free cash flow.

And our next question today comes from Linda Tsai with Jefferies.

Can you just take us through some puts and takes regarding the high and low end of your AFFO per share guidance?

Linda, so on the low end at $4.13, it's a fairly draconian scenario. You almost have to believe that short-term rates are going to continue to push higher, which we have -- we don't have a crystal ball, but crazy things have happened.

It also assumes that there's essentially a shutdown of acquisitions and so you can assume that the $2 billion is something significantly less than that. From the credit loss perspective, I think that's also something that we put in a very, very conservative number that we don't think is likely at all of happening, but it is something that is included from a bad debt perspective. There's also some certain cost elements, things like leasing commissions, things like property expenses that are not reimbursed in G&A. You always want to plan for some negative surprises there.

And then in terms of the high end, it contemplates a scenario where the macro environment and the cost of capital environment improves, and we are able to do quite a bit more in terms of investment volume. It also suggests that spreads stay in that 150 and up range. Bad debt expense is something that is closer aligned to where we've historically been as a company, which has been close to 40 basis points of rent when you include the pandemic. Outside of the pandemic, we're probably closer to 25 basis points.

And it probably would assume a better outcome for some identified credits that we have in the combined portfolio that naturally, we took a very, very draconian stance on as we're building up the base case for guidance. And it also assumes that the mix of our short-term rates, whether it's in euro commercial paper, whether it's in sterling denominated revolver borrowings or whether it's in U.S. CP, which tends to comprise our [indiscernible] exposure, it assumes that the mix is tilted maybe a little bit more towards the European side. Right now, indicative ECP rates would be in the low 4% range. U.S. indicative rates would be in the mid-5s and then you have sterling at 6%, not on the CP side, but on the revolver side. So these are all the variables that have to hit on the low and high end in order for us to reach those scenarios.

Really helpful. And then just my second question is in your pipeline right now, what percentage is domestic versus international?

Well, we don't have -- it's unidentified on the nondevelopment side, which was $1.2 billion. Some of it is identified, but a lot of it is discussions that we're having both here in the U.S. and in the international markets. And 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, Linda. If you look at the history, it's largely been in that 30% to 40% international and 70% to 60%, 60% to 70% U.S. And that's what we would expect under normalized situation.

And our next question comes from [ Alex Fagan ] with Baird.

So I have one on income taxes. So for the full year, the year-over-year increase in 2023 was about 15%. And the midpoint of guidance is implying about a 35% year-over-year increase in 2024. Can you provide some more color on what is driving that large increase in income taxes?

Alex, this is really a function of the international business. So the way that we're taxed on that income, it's primarily in the U.K. First of all, as a U.S. domiciled company as the 100% owner of the U.K., but we are subject to some withholding taxes there. Now what we've done to combat that is we have intercompany loan interest expense and other ways that we can lower taxable income, where the effective tax rate on that NOI is around 11%.

But the growth that you see year-over-year is really just a function of the growing platform and portfolio that we have abroad, which is now north of USD 9 billion. So it shouldn't be a surprise that as the U.K. grows in particular, you see that line item for income tax start to increase year-over-year. It's something that we obviously take into account in our underwriting and investment committee it's a factor, obviously, in our long-term IRR underwriting, which is really what dictates the investment decision in most cases. And so it's a known cost that is fully built in to this business model.

Thank you. This concludes the question-and-answer session. I'd like to turn the conference back over to Sumit Roy for any closing remarks.

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

Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.