This conference call transcript was computer generated and almost certianly contains errors. This transcript is provided for information purposes only.EarningsCall, LLC makes no representation about the accuracy of the aforementioned transcript, and you are cautioned not to place undue reliance on the information provided by the transcript.
spk01: Good afternoon and welcome to the Realty Income Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on your telephone keypad. To withdraw your question, please press star then 2. 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. Please go ahead.
spk05: Thank you all for joining us today for Realty Income's second 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 and 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 10Q. 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. 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.
spk09: Thank you, Steve. Welcome, everyone. We successfully executed on our strategy in the second quarter 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. 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 RealtyIncome. 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. In the second quarter, we closed on approximately $3.1 billion of high-quality real estate investments, which brings our year-to-date investment activity to over $4.7 billion. Cap rates in our acquisitions appear to have stabilized after a meaningful adjustment period to a higher interest rate environment, 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 second quarter initial cash lease yield of 6.9% represents a 120 basis point increase compared to the second quarter of 2022 and resulted in a realized investment spread of approximately 133 basis points when calculating our WAC on a leverage neutral basis using the cost of equity and debt raised in the quarter. In addition to closing our 1.5 billion US convenience store acquisition from the EG Group, we remained active internationally during the second quarter, closing on $416 million of investments at an initial cash lease yield of 7.1%. This international activity includes the addition of a new geographic vertical in Ireland where we acquired two properties for $54 million at healthy cash yields. Given the transaction velocity we have achieved in the first half of the year, we are increasing our outlook for investments to over $7 billion for 2023. Year-to-date, we have acquired 15% of source investment volume compared to an average of 7% over the last five 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, and we ended the quarter with occupancy of 99%, the third consecutive quarter at that level. This matches our highest occupancy at the end of a reporting period in over 20 years. Additionally, Our rent recapture rates increased from last quarter to 103.4% across 201 new and renewed leases, bringing the year-to-date recapture rate to 102.7% 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 five 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 second quarter, or 2% annual growth on a levered basis. Before turning it over to Christy, 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. Her 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. Christy?
spk00: 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 nine years and brings significant experience to the role. Having overseen our capital markets, investor relations, FP&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. With that, I would like to hand the call over to Jonathan to go over the financial results from our quarter.
spk07: 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 nine-year tenure at 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. To that end, we finished the second quarter with healthy leverage as measured by net debt to annualized pro forma adjusted EBITDA of 5.3 times, and our fixed charge coverage ratio remains solid at 4.6. We're once again active issuers of equity capital via the ATM, raising approximately $2.2 billion in the aggregate during the second quarter. $651 million of unsettled forward equity remains outstanding as of today. As our platform has advanced and grown over time, our investment spread business has been supported by access to a wide range of products in the capital markets. Last month, we added another capital source to our inventory, raising 1.1 billion euros through our debut public offering of euro-denominated unsecured bonds. This dual-trunch offering resulted in a weighted average tenor of nine years and a weighted average annual yield to maturity of 5.08%. Establishing a presence in the Euro unsecured bond market allowed us to diversify our fixed income investor base and generate a natural hedge for Euro denominated earnings and access a source of debt capital that was priced approximately 60 basis points inside of indicative US dollar bond pricing at the time of execution. Proceeds from the offering effectively repaid short-term bonds on a multi-currency revolver and commercial paper programs, which had a combined balance of $990 million at quarter end. Combined with $254 million of cash on hand at quarter end and the $650 million of forward equity previously mentioned, we believe we are well capitalized with significant liquidity heading into the third quarter. Finally, from an earnings outlook perspective, the midpoint of our 2023 AFO per share guidance is unchanged. though we're narrowing the guidance range to 396 to 401, representing approximately 1.8% growth at the midpoint. With that, I would like to turn the call back over to Sumit.
spk09: 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 US dollar market. Looking at the S&P 500 constituents within our addressable market, we count approximately 300 firms with $1.6 trillion of owned real estate. To quantify the near-term opportunity which is available to us as sale-leaseback capital providers, this group has approximately $1.2 trillion of debt, representing 34% of the group's outstanding debt capital, maturing between 2024 and 2027. Meanwhile, corporate bond yields have risen anywhere between 240 and 400 basis points from the 2021 average to today. This compares to a 140 basis point increase in initial cash lease yields for realty incomes investments over the same time frame. 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. At this time, we can open it up for questions. Operator?
spk01: We will now begin the question and answer session. To ask a question, you may press star, then 1 on your telephone keypad, If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble the roster. And our first question will come from Nate Crossett of BNP Paribas. Please go ahead.
spk03: Hey, good afternoon, and congrats to Jonathan and Christy. Maybe just a question on guidance. Maybe you could just unpack, you know, you guys increased acquisitions and volume guidance with the midpoint. On ASFO 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? I think we're down 10 basis points in the quarter. what's kind of the outlook of the pipeline right now.
spk09: So, Nate, I'll take your second question first 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 second quarter and in the first quarter. 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 first and second quarter. Jonathan?
spk07: Hey, Nate. On the guidance question, I would first of all say the midpoint of our guide is the same as it was at the start of the year. You know, when you think about how we put guidance together, there's a lot of puts and takes that we look at at the beginning of the year, revisit every quarter. We know that on a probability weighted basis, not all of the takes are going to happen and not all the puts are going to happen. And so when you think about, you know, acquisition guidance increasing two quarters now, that was, you know, a scenario that we had expected at the start of the year, but there was always going to be you know, 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. And so that alone is about a penny 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.
spk03: Okay, that's helpful. Maybe just one on the debt rates are much lower in Europe. We 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?
spk07: Yeah, you know, we're not going to go, you know, crazy and have, you know, 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, you know, 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. We know that we're going to need the capital at some point, really denominated in dollars, sterling, or euros. That's how we think about it. It was a 60 basis point pickup relative to comparable US dollar. 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.
spk01: The next question comes from Greg McGinnis of Scotiabank. Please go ahead.
spk02: 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&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?
spk09: 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 fourth quarter of last year, that's when we closed on the gaming asset, which was $1.7 billion. You look at the large portfolio deal we did in the first quarter, it was a CIM transaction. That was circa $900 million. And, you know, in the second quarter, we've announced the 1.5 billion and closed the 1.5 billion 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 closed transactions? 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 billion dollars in terms of acquisitions. So we just feel like, you know, 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.
spk02: Okay. What are your thoughts on increasing maybe the level of tenant debt investments to push earnings growth higher and offset some of that cost of capital that's not exactly where you want it?
spk09: Well, we think of ourselves as an investment company. And Greg, so where we invest on the capital stack is 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, but it is certainly up for discussion, and it's one that we have been discussing with my colleagues here at Realty Income.
spk01: The next question comes from Brad Heffern of RBC Capital Markets. Please go ahead.
spk13: Yeah, thank you, Opera. Hey, everybody. Simit, 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. So are you feeling worse at this point or better given the recent strength?
spk09: Yeah, 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 Ten 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 a 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, for about four 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. But yeah, 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 been 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 released. 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. But yes, it is a situation that we are monitoring closely. But my expectation, if it is anything like what it was last time, this should resolve itself in the next couple of months.
spk13: Okay, I appreciate that. And then can you give your expectations for the Cineworld 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?
spk09: Yeah, so Brad, I'm not going to go into the details of the Cineworld situation just because we haven't quite, you know, 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. That's how I'm going to leave it with the Cineworld situation. I'll just add something to stuff that I've already talked about in the past. 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 in and talking about potentially just taking the asset as is, even though they're not movie theater operators, to potentially re-entitling 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. So all of those various permutations are being considered on the handful of assets that we expect will get rejected through this process, but I'm not going to go into any more detail than that.
spk01: The next question comes from Handel St. Just of Mizuho. Please go ahead.
spk04: Hey, I guess it's still good morning out there. First of all, congratulations again to Jonathan and to Christy. Suman, 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 iGrade than historically. And I know in the past you've talked about that your experience in acquiring higher-yielding assets and your focus on generating the best risk-adjusted returns, But this quarter, particularly, we had a big drop, but it continues the trend of having below average I-grade. So, I guess, is this a dynamic that we should just expect to continue going forward? Is this a new norm? How should we think about the share of I-grade going forward? Thank you.
spk09: Sure. Thank you for that question, Handel. 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, then so be it. 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 who are 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 second quarter. But that's how we think about the world. And the other thing I'd just point out is, you know, just to make it equivalent because I have seen some of these cap rates being reported and there's a bit of a mixed match. You know, 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, you know, 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 $3.1 billion 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. So that's how you should think about us, Handel. 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'll be it. But it's not something that we target, and you shouldn't expect us to be targeting that number going forward.
spk04: That's really helpful. I appreciate the color there. And one more. I guess I wanted to get your updated thoughts on investing in gaming assets today. I know in the past you've talked about having an interest. I'm curious if they'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. Thank you.
spk09: 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 verticals. You know, 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.
spk01: The next question comes from Joshua Dennerlein of Bank of America. Please go ahead.
spk15: Hey, guys. Thanks for the time. I saw your cap rates on domestic acquisitions was like a 6.8, and then for developments it was like a 6.9. base point spread seems kind of small. Is that a function of kind of when deals are struck or just the risk profile of the tenants or just something that you're seeing broadly in the market?
spk09: Yeah, 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, you know, 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 second quarter, 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 two to three 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. And you should continue to see that, you know, trends slightly higher, you know, looking into the next few quarters as some of the older, you know, generation development opportunities start to sort of, you know, get fully developed and are, you know, 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. Okay. All right.
spk15: That makes sense. Um, and then I think Jonathan might've answered this, but just wanted to clarify the top end of guidance. Looks like you took down two cents. Was it just the interest rate environment that's pushing down, uh, put down with pressure on that top range or anything else in there? Just, just curious, given, uh, acquisition guidance, uh, a bit. So,
spk07: Hey, Josh. To address that, Sumit brought it up earlier, the impact of what we felt was the greatest uncertainty out there, the CINAHL resolution, that impact is now better known to us. And going into the quarter, it was something where 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 of where that's
spk12: trending uh we felt that it was appropriate to take the high end down by two cents in addition to bringing the low end up by two the next question comes from michael goldsmith of ubs please go ahead 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 a reputation for creative solutions from a financing perspective, but as you move into the CFO seat, is there anything different that you would think about doing in your new position or different approaches to what Realty is doing overall? Thanks.
spk07: Thanks, Michael. Appreciate the question. I would say, look, what's made a Realty income so successful over the years regardless of what we've done what verticals we've established. It's you know commitment to a Fortress balance sheet, and that's the one thing that is going to be sacrosanct to us For you know as long as you know we're in existence in these seats And so we're not going to sacrifice things like the a3 minus credit rating that we worked very hard to get we're not going to sacrifice you know, the trust of fixed income community that now spans, you know, across three of the currencies. And so you're going to see us continue to, you know, focus on low leverage, plenty of liquidity, and, you know, we're going to be very predictable from that standpoint. I think going forward, you know, given the added complexity of the business, the volume, the transaction volume that we see, the different countries that we're in and will continue to be in, I think it's really more of a focus on more of the internal operations now. The external 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.
spk12: Thanks for that. And Sumit, You mentioned your size and scale as a competitive advantage at least twice, if not three 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 gap and the strength of the size and scale, is that improving and widening versus peers?
spk09: Thanks for the question, Michael. I might have actually said it four times. I'm not sure. I just believe in it so much. 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 read in the NetLease 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. We want to be the real estate partners of choice for the S&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 been added to our registry, it gives us continued confidence to say that our scale and size you know, is being appreciated within this space.
spk01: The next question comes from Eric Wolf of Citi. Please go ahead.
spk11: Thanks. Just wanted to follow up on Greg's question. When you look at your S&P peers, just curious, what percentage would you say are receptive to the sale-leaseback conversation, and how has that changed versus a couple years ago? Just trying to understand how your addressable market has changed. And for those that perhaps aren't as receptive, what's the typical pushback?
spk09: I can't give you percentages, Eric, but what I can point to is 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 Wynn. They've never done a sale leaseback before, and they chose to do it with us. Think about EG Group. They'd 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 three, four 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 vis-a-vis, 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 yeah, we feel like that that will continue to grow.
spk11: 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 weeks. When you see moves like this, 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 holders.
spk09: Yeah. So, Eric, I'm going to have Jonathan talk a little bit about, you know, things that we try to do to anticipate what I'll call, you know, 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. You know, our cost of capital gets marked to market pretty much by the second. That's not how cap rates move. You know, there is absolutely a lack time. How sticky these movements, these upward movements in the cost of capital, you know, people have a different opinion about how sticky that is. And that drives their view around, you know, what cap rates should be. And it does take. you know, 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. So, you know, yes, we've seen movements on the 10-year from 386 to 417, 418 today within a matter of days. You're not going to see a 30 basis point movement in cap rates to reflect this movement in 10 years unless we see that this 4.7, 4.17, God forbid 4.7, 4.17, 4.2 become a more sustainable rate. But then what do we do from a balance sheet perspective to sort of anticipate those situations? I'll have Jonathan speak to that.
spk07: 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. you know, look at the 10Q from the first quarter, you'll see that we actually, you know, purchased some swaptions, which really go out until January of next year, and that protects us against rising rates on the 10-year. The reason why we chose a billion, the reason why we went out to January is because we do have some debt maturities coming up of around a billion, billion one in the first quarter of next year. We put those hedges in place in late March, early April, And so as you might imagine, you know, it's pretty healthily in the money right now. So, you know, from that standpoint, we've taken out, you know, the primary balance sheet risk or refi risk that we have coming up over the next, you know, six to nine months. But we're always going to look for opportunities where, you know, we see a risk, we want to be proactive, we can't time the market, but what we can do is mitigate the exposure that we have to potential risk. And so You know, that's something that we've done now twice, and, you know, the first time we did it was in the middle of the pandemic, and we were able to monetize that forward-started swap at a $72 million gain. We're not always going to be so fortunate, but that's how we're thinking about managing risk.
spk01: The next question comes from Wes Galladay of Baird. Please go ahead.
spk14: 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, or is it just pricing just lagging still over there?
spk09: Yeah. 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 first quarter. Second quarter was still very healthy. We did about 420 million, which is a big number, but it got dominated by what we did on the US side, largely driven by the 1.5 billion. If you take that 1.5 billion away, and you look at what we've done, we were at 1.6 billion, of which the European, the international business represented, I would say, trying to do quick math, right around 30%. And that's generally been where the international businesses contributed. But look, I'm very excited about that business, and there's more to come.
spk14: Okay, it sounds good. And yeah, good job, Neil. That's actually good volume once adjusted. I guess next question is more bigger picture. I'm kind of curious what your opinion would be. What is the bigger risk to net lease? Would it be inflation and potentially having mispriced escalators? Or would it be tenant credit at this point of the cycle?
spk09: I would think it's tenant credit. You know, you'll have to look at all of the various different net lease businesses and and take a view on 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 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. 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 one-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 inherent in your leases is somewhat muted versus credit risks that could translate into much bigger losses. impact on your overall business.
spk01: The next question comes from Ronald Camden of Morgan Stanley. Please go ahead.
spk06: Hey, just two quick ones. Staying on the tenant credit risk, so I see occupancy 99, median EBITDA 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 comment, 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, you know, student loans starting again or, you know, 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 it have on the tenant side? Thanks.
spk09: Yeah, good question, Ronald. And just to clarify, it was in the last five years that I said that our credit watch list is in the threes. It's the lowest it's been in the last five 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? It's going to be discretionary spend, right? 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. 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.
spk06: 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 two or three sort of comp issues that the guidance was facing this year? I think you hit on one, which is the interest costs sort of headwind, right, for this year. But presumably that's not going to be an issue for 24 because the comp just is not as tough. But was there anything else sort of one-timey or unique to this year? It could be property tax, you know, it could be whatever that we should be mindful of for 23 that maybe does not sort of happen again in 24.
spk07: Hey, Ron, it's Jonathan. I'll say, you know, 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 seven or eight cents, 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 you know, from a portfolio to asset management standpoint, you know, we're trending closer, you know, to a 5% number year over year, if you were at 3.1% this quarter. The first quarter did have a little bit of a tougher comp. If you recall the first quarter of 2022, we did have a significant reserve reversal in the theater industry. So that's why the first quarter was a little bit flat second quarter. you know, outside of rates, you know, is getting back more towards a normalized level. So, back half of the year, I think, you know, you'll continue to see some difficult bumps on the SOFR front. And given that we do have even, you know, 8%, 10% exposure to variable rates, just given the magnitude of the move, that's going to be the biggest difference.
spk01: The next question comes from Linda Tessai of Jefferies. Please go ahead.
spk08: Hi, Christy, sad to see 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 where would you see investment spreads in those two categories trending?
spk09: Yeah, if you actually follow the you know, 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, you know, between the domestic markets and the international markets I think the advantages are very different. Here in the U.S. market, there's clearly more competition, there are more players. In the international markets, we don't experience that. The U.S. 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 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 first quarter, 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. 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 you You know, going forward, you're going to have one geography that is going to dominate, you know, the spread versus another. It's very much opportunity driven.
spk08: Got it. And then I think you said 30% of your international leases have uncapped CPI. What is the nature of those tenants that are open to that versus the other 70% of leases that don't have uncapped?
spk09: Yeah, Linda, let me be a bit more precise. Of the international leases that have CPI as the driver of internal growth, one-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. And again, it is very much a function of the market. a market that is used to seeing CPI growth as the metric 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 you know, 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, yeah, we tend to see more uncapped CPI growth in the international markets than we do here. And, yeah, but that too is evolving.
spk01: The next question comes from Harsh Himani of Green Street. Please go ahead.
spk10: 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, you know, at realty income you're closing $5 to $7 billion annually, that you might not have the luxury to be as selective as you were in the past and maybe you have to execute on your second or third best idea? How are you thinking about that, you know, looking over the next 12 months?
spk09: Well, the good news, Harsh, is that we haven't, gone to executing on our second or third best ideas yet. We're very fortunate. Let me shed some light on this 15% closing rather than what we've traditionally done, which is this 7% to 10%. What is skewing this is clearly the $1.5 billion transaction that we closed on in the second quarter, but it's not reflected in the denominator, in the sourcing volume of $15 billion. We had sourced that asset, I would say, probably in the fourth quarter of last year. So that's where the mismatch occurs 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, you know, does create this mismatch. So if we were to sort of take away the 1.5 and then look at, you know, the 1.6 billion that we ended up closing in a year that, you know, in a quarter where we, you know, sourced 15, 16 billion, that's still 10%. So I think that's probably the way to think about this mismatch that we saw in the second quarter.
spk10: Okay, that helps. And then the $1.6 trillion that you provided, that there's $1.6 trillion of commercial real estate on S&P 500 company balance sheets. 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. Could you share how much of that is maybe retail, gaming, et cetera, that you might go after?
spk09: Yeah, that's a great question, Harsh. And we did that when we talk about $4 trillion here in the U.S. and $8 trillion in Europe. And just to be also super clear about this particular statistics that we shared in the prepared remarks, it does not include other real estate companies. It does not include certain sectors like finance companies, banks, energy companies, et cetera, et cetera. 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 $1.6 trillion, that is a massive number. And the point is that these are companies that are going to have to refinance their debt this $1.2 trillion of debt over the next three years. It's maturing over the next three 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.
spk01: This concludes our question and answer session. I would like to turn the conference back over to Samit Roy for any closing remarks.
spk09: 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.
spk01: The conference is now concluded. Thank you for attending today's presentation and you may now disconnect.
Disclaimer