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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC  20549

 

FORM 10-Q

 

x Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended June 30, 2016, or

 

o Transition report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934

 

Commission File Number 1-13374

 

 

REALTY INCOME CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Maryland

 

33-0580106

 

 

(State or Other Jurisdiction of
Incorporation or Organization)

 

(IRS Employer Identification
Number)

 

 

11995 El Camino Real, San Diego, California 92130

(Address of Principal Executive Offices)

 

Registrant’s telephone number, including area code: (858) 284-5000

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x   No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x

Accelerated filer o

Non-accelerated filer o

Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o   No  x

 

There were 258,569,373 shares of common stock outstanding as of July 21, 2016.

 



Table of Contents

 

 

REALTY INCOME CORPORATION

 

 

 

Index to Form 10-Q

 

 

 

 

 

June 30, 2016

 

 

 

 

 

PART I.

FINANCIAL INFORMATION

Page

Item 1:

Financial Statements

 

 

 

 

 

Consolidated Balance Sheets

2

 

Consolidated Statements of Income

3

 

Consolidated Statements of Cash Flows

4

 

Notes to Consolidated Financial Statements

5

 

 

 

Item 2:

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

 

 

Forward-Looking Statements

19

 

The Company

20

 

Recent Developments

23

 

Liquidity and Capital Resources

26

 

Results of Operations

31

 

Funds from Operations Available to Common Stockholders (FFO)

38

 

Adjusted Funds from Operations Available to Common Stockholders (AFFO)

39

 

Property Portfolio Information

40

 

Impact of Inflation

47

 

Impact of Recent Accounting Pronouncements

47

 

Other Information

47

 

 

 

Item 3:

Quantitative and Qualitative Disclosures About Market Risk

48

 

 

 

Item 4:

Controls and Procedures

49

 

 

 

PART II.

OTHER INFORMATION

 

 

 

 

Item 2:

Unregistered Sales of Equity Securities and Use of Proceeds

50

 

 

 

Item 6:

Exhibits

50

 

 

 

SIGNATURE

 

54

 

-1-



Table of Contents

 

PART 1. FINANCIAL INFORMATION

 

Item 1.   Financial Statements

 

REALTY INCOME CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

June 30, 2016 and December 31, 2015

 

(dollars in thousands, except per share data)

 

 

 

2016

 

2015

 

ASSETS

 

(unaudited)

 

 

 

Real estate, at cost:

 

 

 

 

 

Land

 

$

3,436,504

 

$

3,286,004

 

Buildings and improvements

 

9,403,441

 

9,010,778

 

Total real estate, at cost

 

12,839,945

 

12,296,782

 

Less accumulated depreciation and amortization

 

(1,841,790

)

(1,687,665

)

Net real estate held for investment

 

10,998,155

 

10,609,117

 

Real estate held for sale, net

 

9,991

 

9,767

 

Net real estate

 

11,008,146

 

10,618,884

 

Cash and cash equivalents

 

20,443

 

40,294

 

Accounts receivable, net

 

87,166

 

81,678

 

Acquired lease intangible assets, net

 

1,063,045

 

1,034,417

 

Goodwill

 

15,220

 

15,321

 

Other assets, net

 

55,411

 

54,785

 

Total assets

 

$

12,249,431

 

$

11,845,379

 

 

 

 

 

 

 

LIABILITIES AND EQUITY

 

 

 

 

 

Distributions payable

 

$

54,023

 

$

50,344

 

Accounts payable and accrued expenses

 

130,024

 

115,826

 

Acquired lease intangible liabilities, net

 

256,512

 

250,916

 

Other liabilities

 

41,191

 

53,965

 

Line of credit payable

 

512,000

 

238,000

 

Term loans, net

 

318,981

 

318,835

 

Mortgages payable, net

 

496,348

 

646,187

 

Notes payable, net

 

3,620,275

 

3,617,973

 

Total liabilities

 

5,429,354

 

5,292,046

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock and paid in capital, par value $0.01 per share, 69,900,000 shares authorized, 16,350,000 shares issued and outstanding as of June 30, 2016 and December 31, 2015, liquidation preference $25.00 per share

 

395,378

 

395,378

 

Common stock and paid in capital, par value $0.01 per share, 370,100,000 shares authorized, 257,954,902 shares issued and outstanding as of June 30, 2016 and 250,416,757 shares issued and outstanding as of December 31, 2015

 

8,105,229

 

7,666,428

 

Distributions in excess of net income

 

(1,699,966

)

(1,530,210

)

Total stockholders’ equity

 

6,800,641

 

6,531,596

 

Noncontrolling interests

 

19,436

 

21,737

 

Total equity

 

6,820,077

 

6,553,333

 

Total liabilities and equity

 

$

12,249,431

 

$

11,845,379

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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Table of Contents

 

REALTY INCOME CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME

 

For the three and six months ended June 30, 2016 and 2015

 

(dollars in thousands, except per share data) (unaudited)

 

 

 

Three months ended

 

Six months ended

 

 

 

June 30,

 

June 30,

 

 

 

2016

 

2015

 

2016

 

2015

 

REVENUE

 

 

 

 

 

 

 

 

 

Rental

 

$

260,056

 

$

241,431

 

$

516,857

 

$

476,554

 

Tenant reimbursements

 

11,112

 

11,607

 

20,217

 

21,570

 

Other

 

(129

)

822

 

1,081

 

2,604

 

Total revenue

 

271,039

 

253,860

 

538,155

 

500,728

 

 

 

 

 

 

 

 

 

 

 

EXPENSES

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

110,342

 

101,101

 

218,275

 

199,138

 

Interest

 

57,409

 

58,680

 

118,088

 

117,148

 

General and administrative

 

13,985

 

12,609

 

26,304

 

25,471

 

Property (including reimbursable)

 

14,671

 

14,937

 

29,776

 

28,914

 

Income taxes

 

953

 

628

 

1,917

 

1,702

 

Provisions for impairment

 

6,269

 

3,230

 

8,192

 

5,317

 

Total expenses

 

203,629

 

191,185

 

402,552

 

377,690

 

 

 

 

 

 

 

 

 

 

 

Gain on sales of real estate

 

8,658

 

3,675

 

10,948

 

10,893

 

 

 

 

 

 

 

 

 

 

 

Net income

 

76,068

 

66,350

 

146,551

 

133,931

 

 

 

 

 

 

 

 

 

 

 

Net income attributable to noncontrolling interests

 

(253

)

(263

)

(493

)

(581

)

 

 

 

 

 

 

 

 

 

 

Net income attributable to the Company

 

75,815

 

66,087

 

146,058

 

133,350

 

Preferred stock dividends

 

(6,770

)

(6,770

)

(13,540

)

(13,540

)

 

 

 

 

 

 

 

 

 

 

Net income available to common stockholders

 

$

69,045

 

$

59,317

 

$

132,518

 

$

119,810

 

 

 

 

 

 

 

 

 

 

 

Amounts available to common stockholders per common share:

 

 

 

 

 

 

 

Net income:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.27

 

$

0.26

 

$

0.53

 

$

0.52

 

Diluted

 

$

0.27

 

$

0.25

 

$

0.53

 

$

0.52

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

253,375,546

 

232,403,586

 

251,792,989

 

228,932,782

 

 

 

 

 

 

 

 

 

 

 

Diluted

 

253,973,745

 

232,886,185

 

252,390,707

 

229,378,784

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

-3-



Table of Contents

 

REALTY INCOME CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

For the six months ended June 30, 2016 and 2015

 

(dollars in thousands) (unaudited)

 

 

 

2016

 

2015

 

CASH FLOWS FROM OPERATING ACTIVITIES

 

 

 

 

 

Net income

 

$

146,551

 

$

133,931

 

Adjustments to net income:

 

 

 

 

 

Depreciation and amortization

 

218,275

 

199,138

 

Amortization of share-based compensation

 

6,552

 

5,362

 

Non-cash rental adjustments

 

(5,279

)

(4,939

)

Amortization of net premiums on mortgages payable

 

(1,855

)

(3,824

)

Amortization of deferred financing costs

 

4,384

 

6,509

 

Loss on interest rate swaps

 

7,886

 

1,958

 

Gain on sales of real estate

 

(10,948

)

(10,893

)

Provisions for impairment on real estate

 

8,192

 

5,317

 

Change in assets and liabilities

 

 

 

 

 

Accounts receivable and other assets

 

6,946

 

1,778

 

Accounts payable, accrued expenses and other liabilities

 

(19,277

)

(12,627

)

Net cash provided by operating activities

 

361,427

 

321,710

 

CASH FLOWS FROM INVESTING ACTIVITIES

 

 

 

 

 

Investment in real estate

 

(618,340

)

(924,541

)

Improvements to real estate, including leasing costs

 

(2,934

)

(2,470

)

Proceeds from sales of real estate

 

35,020

 

30,455

 

Collection of loans receivable

 

12,457

 

-

 

Restricted escrow deposits for Section 1031 tax-deferred exchanges and pending acquisitions

 

(17,291

)

21,313

 

Net cash used in investing activities

 

(591,088

)

(875,243

)

CASH FLOWS FROM FINANCING ACTIVITIES

 

 

 

 

 

Cash distributions to common stockholders

 

(298,581

)

(258,277

)

Cash dividends to preferred stockholders

 

(13,540

)

(13,540

)

Borrowings on line of credit

 

2,244,000

 

957,000

 

Payments on line of credit

 

(1,970,000

)

(750,000

)

Principal payments on mortgages payable

 

(181,333

)

(79,291

)

Proceeds from term loans

 

-

 

250,000

 

Proceeds from common stock offerings, net

 

383,525

 

276,430

 

Redemption of preferred units

 

-

 

(6,750

)

Distributions to noncontrolling interests

 

(747

)

(848

)

Debt issuance costs

 

-

 

(10,204

)

Proceeds from dividend reinvestment and stock purchase plan

 

5,806

 

208,033

 

Proceeds from At-the-Market (ATM) program

 

44,565

 

-

 

Other items, including shares withheld upon vesting

 

(3,885

)

(4,131

)

Net cash provided by financing activities

 

209,810

 

568,422

 

Net (decrease) increase in cash and cash equivalents

 

(19,851

)

14,889

 

Cash and cash equivalents, beginning of period

 

40,294

 

3,852

 

Cash and cash equivalents, end of period

 

$

20,443

 

$

18,741

 

 

For supplemental disclosures, see note 16.

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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Table of Contents

 

REALTY INCOME CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

June 30, 2016

 

(unaudited)

 

1.                                        Management Statement

 

The consolidated financial statements of Realty Income Corporation (“Realty Income”, the “Company”, “we”, “our” or “us”) were prepared from our books and records without audit and include all adjustments (consisting of only normal recurring accruals) necessary to present a fair statement of results for the interim periods presented. Readers of this quarterly report should refer to our audited consolidated financial statements for the year ended December 31, 2015, which are included in our 2015 Annual Report on Form 10-K, as certain disclosures that would substantially duplicate those contained in the audited financial statements have not been included in this report.

 

At June 30, 2016, we owned 4,646 properties, located in 49 states and Puerto Rico, containing over 79.0 million leasable square feet.

 

2.                  Summary of Significant Accounting Policies and Procedures and Recent Accounting Pronouncements

 

A.  The accompanying consolidated financial statements include the accounts of Realty Income and other entities for which we make operating and financial decisions (i.e., control), after elimination of all material intercompany balances and transactions.  We consolidate entities that we control and record a noncontrolling interest for the portion that we do not own.  Noncontrolling interest that was created or assumed as part of a business combination was recognized at fair value as of the date of the transaction (see note 10).  We have no unconsolidated investments.

 

B.  We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended. We believe we have qualified and continue to qualify as a REIT. Under the REIT operating structure, we are permitted to deduct dividends paid to our stockholders in determining our taxable income.  Assuming our dividends equal or exceed our taxable net income, we generally will not be required to pay federal corporate income taxes on such income. Accordingly, no provision has been made for federal income taxes in the accompanying consolidated financial statements, except for federal income taxes of our taxable REIT subsidiaries. The income taxes recorded on our consolidated statements of income represent amounts paid by Realty Income for city and state income and franchise taxes.

 

C.  We recognize an allowance for doubtful accounts relating to accounts receivable for amounts deemed uncollectible. We consider tenant specific issues, such as financial stability and ability to pay rent, when determining collectability of accounts receivable and appropriate allowances to record.  The allowance for doubtful accounts was $1.5 million at June 30, 2016 and $429,000 at December 31, 2015.

 

D.  We assign a portion of goodwill to our applicable property sales, which results in a reduction of the carrying amount of our goodwill. In order to allocate goodwill to the carrying amount of properties that we sell, we utilize a relative fair value approach based on the original methodology for assigning goodwill.  As we sell properties, our goodwill will likely continue to gradually decrease over time. Based on our analyses of goodwill during the second quarters of 2016 and 2015, we determined there was no impairment on our existing goodwill.

 

E.  In May 2014, the Financial Accounting Standards Board, or FASB, issued ASU 2014-09, Revenue from Contracts with Customers.  This ASU outlines a comprehensive model for companies to use in accounting for revenue arising from contracts with customers, and will apply to transactions such as the sale of real estate. This ASU is effective for interim and annual periods beginning after December 15, 2017.  We have not yet adopted this topic and do not expect it to have a material impact on our consolidated financial statements.

 

In February 2015, FASB issued ASU 2015-02, which amends Topic 810, Consolidation.  This ASU amended the criteria used to evaluate whether an entity is a variable interest entity, or VIE, resulting in the conclusion that all limited partnerships are considered VIEs, unless substantive kick-out rights or participating rights exist.  We adopted this ASU during the quarter ended March 31, 2016 and evaluated our applicable entities. The evaluation did not result in changes to our conclusions regarding consolidation of these entities (see note 10).

 

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Table of Contents

 

In April 2015, FASB issued ASU 2015-03, which amends Topic 835, Other Presentation Matters. The amendments in this ASU require that debt issuance costs be reported on the balance sheet as a direct reduction of the face amount of the debt instrument they relate to, and should not be classified as a deferred charge, as was previously required under the Accounting Standards Codification. We adopted this ASU during the quarter ended March 31, 2016 and, as a result, reclassified deferred financing costs from other assets, net, to the applicable debt caption on the December 31, 2015 balance sheet.

 

In February 2016, FASB issued Topic 842, Leases, which amended Topic 840, Leases.  Under this amended topic, the accounting applied by a lessor is largely unchanged from that applied under Topic 840, Leases. The large majority of operating leases should remain classified as operating leases, and lessors should continue to recognize lease income for those leases on a generally straight-line basis over the lease term. The amendments included in this topic are effective, on a retrospective or modified retrospective basis, for interim and annual periods beginning after December 15, 2018.  We have not yet adopted this topic and are currently evaluating the impact this amendment will have on our consolidated financial statements.

 

In March 2016, FASB issued ASU 2016-09, which amends Topic 718, Compensation – Stock Compensation.  The FASB issued this ASU to simplify several aspects of the accounting for share-based payment transactions, including classification of awards as either equity or liabilities, estimation of forfeitures, and classification on the statement of cash flows. The ASU is effective for interim and annual periods beginning after December 15, 2016, and early adoption is permitted. We early adopted this ASU during the quarter ended March 31, 2016 and it did not have a material impact on our consolidated financial statements.

 

3.                                     Supplemental Detail for Certain Components of Consolidated Balance Sheets

 

A.                 Acquired lease intangible assets, net, consist of the following

 

June 30,

 

December 31,

 

(dollars in thousands) at:

 

2016

 

2015

 

Acquired in-place leases

 

   $

1,121,112

 

   $

1,056,715

 

Accumulated amortization of acquired in-place leases

 

(310,141

)

(264,399

)

Acquired above-market leases

 

327,050

 

304,548

 

Accumulated amortization of acquired above-market leases

 

(74,976

)

(62,447

)

 

 

   $

1,063,045

 

   $

1,034,417

 

 

 

 

June 30,

 

December 31,

 

B.                 Other assets, net, consist of the following (dollars in thousands) at:

 

2016

 

2015

 

Restricted escrow deposits

 

21,074

 

4,179

 

Prepaid expenses

 

13,694

 

14,258

 

Credit facility origination costs, net

 

8,734

 

10,226

 

Notes receivable issued in connection with property sales

 

5,448

 

17,905

 

Impounds related to mortgages payable

 

2,701

 

5,860

 

Corporate assets, net

 

2,502

 

2,313

 

Other items

 

1,258

 

44

 

 

 

   $

55,411

 

   $

54,785

 

 

C.                Distributions payable consist of the following declared

 

June 30,

 

December 31,

 

distributions (dollars in thousands) at:

 

2016

 

2015

 

Common stock distributions

 

   $

51,657

 

   $

47,963

 

Preferred stock dividends

 

2,257

 

2,257

 

Noncontrolling interests distributions

 

109

 

124

 

 

 

   $

54,023

 

   $

50,344

 

 

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Table of Contents

 

D.               Accounts payable and accrued expenses consist of the

 

June 30,

 

December 31,

 

following (dollars in thousands) at:

 

2016

 

2015

 

Notes payable - interest payable

 

   $

61,486

 

   $

61,486

 

Property taxes payable

 

14,990

 

13,354

 

Mortgages, term loans, credit line - interest payable and interest rate swaps

 

14,261

 

6,813

 

Accrued costs on properties under development

 

8,865

 

9,976

 

Other items

 

30,422

 

24,197

 

 

 

   $

130,024

 

   $

115,826

 

 

E.                 Acquired lease intangible liabilities, net, consist of the

 

June 30,

 

December 31,

 

following (dollars in thousands) at:

 

2016

 

2015

 

Acquired below-market leases

 

   $

302,342

 

   $

288,412

 

Accumulated amortization of acquired below-market leases

 

(45,830

)

(37,496

)

 

 

   $

256,512

 

   $

250,916

 

 

F.                 Other liabilities consist of the following

 

June 30,

 

December 31,

 

(dollars in thousands) at:

 

2016

 

2015

 

Rent received in advance

 

   $

29,743

 

   $

42,840

 

Security deposits

 

6,586

 

6,418

 

Capital lease obligations

 

4,862

 

4,707

 

 

 

   $

41,191

 

   $

53,965

 

 

4.                                     Investments in Real Estate

 

We acquire land, buildings and improvements necessary for the successful operations of commercial tenants.

 

A.           Acquisitions During the First Six Months of 2016 and 2015

During the first six months of 2016, we invested $662.9 million in 153 new properties and properties under development or expansion with an initial weighted average contractual lease rate of 6.5%. The 153 new properties and properties under development or expansion are located in 34 states, will contain approximately 3.5 million leasable square feet, and are 100% leased with a weighted average lease term of 14.8 years. The tenants occupying the new properties operate in 23 industries and the property types are 77.6% retail and 22.4% industrial, based on rental revenue.  None of our investments during 2016 caused any one tenant to be 10% or more of our total assets at June 30, 2016.

 

The $662.9 million invested during the first six months of 2016 was allocated as follows: $163.0 million to land, $428.9 million to buildings and improvements, $85.0 million to intangible assets related to leases, and $13.3 million to intangible liabilities related to leases and other assumed liabilities. We also recorded mortgage premiums of $692,000. There was no material contingent consideration associated with these acquisitions.

 

The properties acquired during the first six months of 2016 generated total revenues of $8.0 million and net income of $3.8 million during the six months ended June 30, 2016.

 

Of the $662.9 million we invested during the first six months of 2016, $300.7 million of the purchase price allocation is based on a preliminary measurement of fair value that is subject to change.  The allocation for these properties represents our current best estimate of fair value, and we expect to finalize the valuations and complete the purchase price allocations in 2016. During the first six months of 2016, we finalized the purchase price allocations for $195.4 million invested in the fourth quarter of 2015.  There were no material changes to our consolidated balance sheets or income statements as a result of these purchase price allocations being finalized.

 

In comparison, during the first six months of 2015, we invested $931.2 million in 166 new properties and properties under development or expansion with an initial weighted average contractual lease rate of 6.4%. The 166 new properties and properties under development or expansion, were located in 35 states, contained approximately 4.2 million leasable square feet and were 100% leased with a weighted average lease term of 17.5 years. The tenants occupying the new properties operated in 16 industries and the property types are 92.1% retail and 7.9% industrial, based on rental revenue.

 

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The $931.2 million invested during the first six months of 2015 was allocated as follows: $184.2 million to land, $697.4 million to buildings and improvements, $64.0 million to intangible assets related to leases, $5.8 million to other assets, net, and $20.2 million to intangible liabilities related to leases and other assumed liabilities. There was no contingent consideration associated with these acquisitions.

 

The properties acquired during the first six months of 2015 generated total revenues of $10.0 million and net income of $4.9 million for the six months ended June 30, 2015.

 

The estimated initial weighted average contractual lease rate for a property is generally computed as estimated contractual net operating income, which, in the case of a net leased property, is equal to the aggregate base rent for the first full year of each lease, divided by the total cost of the property.  Since it is possible that a tenant could default on the payment of contractual rent, we cannot provide assurance that the actual return on the funds invested will remain at the percentages listed above.

 

In the case of a property under development or expansion, the contractual lease rate is generally fixed such that rent varies based on the actual total investment in order to provide a fixed rate of return.  When the lease does not provide for a fixed rate of return on a property under development or expansion, the estimated initial weighted average contractual lease rate is computed as follows: estimated net operating income (determined by the lease) for the first full year of each lease, divided by our projected total investment in the property, including land, construction and capitalized interest costs. Of the $662.9 million we invested during the first six months of 2016, $61.7 million was invested in 27 properties under development or expansion with an estimated initial weighted average contractual lease rate of 7.1%. Of the $931.2 million we invested during the first six months of 2015, $30.4 million was invested in 30 properties under development or expansion with an estimated initial weighted average contractual lease rate of 9.3%.

 

B.           Acquisition Transaction Costs

Acquisition transaction costs of $85,000 and $298,000 were recorded to general and administrative expense on our consolidated statements of income during the first six months of 2016 and 2015, respectively.

 

C.           Investments in Existing Properties

During the first six months of 2016, we capitalized costs of $3.7 million on existing properties in our portfolio, consisting of $277,000 for re-leasing costs, $246,000 for recurring capital expenditures and $3.2 million for non-recurring building improvements.  In comparison, during the first six months of 2015, we capitalized costs of $2.5 million on existing properties in our portfolio.

 

D.           Properties with Existing Leases

Of the $662.9 million we invested during the first six months of 2016, approximately $411.2 million was used to acquire 51 properties with existing leases.  In comparison, of the $931.2 million we invested during the first six months of 2015, approximately $209.8 million was used to acquire 34 properties with existing leases. The value of the in-place and above-market leases is recorded to acquired lease intangible assets, net on our consolidated balance sheets, and the value of the below-market leases is recorded to acquired lease intangible liabilities, net on our consolidated balance sheets.

 

The values of the in-place leases are amortized as depreciation and amortization expense.  The amounts amortized to expense for all of our in-place leases, for the first six months of 2016 and 2015, were $45.7 million and $43.5 million, respectively.

 

The values of the above-market and below-market leases are amortized over the term of the respective leases, including any bargain renewal options, as an adjustment to rental revenue on our consolidated statements of income. The amounts amortized as a net decrease to rental revenue for capitalized above-market and below-market leases for the first six months of 2016 and 2015 were $4.2 million and $3.7 million, respectively.  If a lease was to be terminated prior to its stated expiration, all unamortized amounts relating to that lease would be recorded to revenue or expense, as appropriate.

 

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The following table presents the estimated impact during the next five years and thereafter related to the amortization of the acquired above-market and below-market lease intangibles and the amortization of the in-place lease intangibles for properties held for investment at June 30, 2016 (in thousands):

 

 

 

Net increase

 

Increase to

 

 

 

(decrease) to

 

amortization

 

 

 

rental revenue

 

expense

 

2016

 

$

(4,270

)

$

48,008

 

2017

 

(8,495

)

94,899

 

2018

 

(8,247

)

92,404

 

2019

 

(7,257

)

81,720

 

2020

 

(6,584

)

75,916

 

Thereafter

 

39,291

 

418,024

 

 

 

 

 

 

 

Totals

 

$

4,438

 

$

810,971

 

 

5.                                     Credit Facility

 

In June 2015, we entered into a $2.0 billion unsecured revolving credit facility, or our credit facility, which replaced our $1.5 billion credit facility that was scheduled to expire in May 2016. The initial term of our credit facility expires in June 2019 and includes, at our option, two six-month extensions. Our credit facility has a    $1.0 billion accordion expansion option.  Under our credit facility, our investment grade credit ratings as of June 30, 2016 provide for financing at the London Interbank Offered Rate, commonly referred to as LIBOR, plus 0.90% with a facility commitment fee of 0.15%, for all-in drawn pricing of 1.05% over LIBOR. The borrowing rate is subject to an interest rate floor. We also have other interest rate options available to us under our credit facility. Our credit facility is unsecured and, accordingly, we have not pledged any assets as collateral for this obligation.

 

At June 30, 2016, credit facility origination costs of $8.7 million are included in other assets, net on our consolidated balance sheet.  This balance includes $9.1 million of credit facility origination costs incurred during 2015 as a result of entering into our credit facility. These costs, as well as a portion of the costs incurred as a result of entering into our previous credit facilities, are being amortized over the remaining term of our credit facility.

 

At June 30, 2016, we had a borrowing capacity of $1.49 billion available on our credit facility (subject to customary conditions to borrowing) and an outstanding balance of $512.0 million, as compared to an outstanding balance of $238.0 million at December 31, 2015.

 

The weighted average interest rate on outstanding borrowings under our credit facility was 1.4% during the first six months of 2016 and 1.3% during the first six months of 2015 under our previous $1.5 billion credit facility. At June 30, 2016, the weighted average interest rate on borrowings outstanding was 1.5%.  Our credit facility is subject to various leverage and interest coverage ratio limitations, and at June 30, 2016, we remain in compliance with the covenants on our credit facility.

 

6.                                     Term Loans

 

In June 2015, in conjunction with entering into our credit facility, we entered into a $250 million senior unsecured term loan maturing on June 30, 2020.  Borrowing under this term loan bears interest at the current one month LIBOR, plus 0.95%.  In conjunction with this term loan, we also entered into an interest rate swap which effectively fixes our per annum interest rate on this term loan at 2.67%.

 

In January 2013, in conjunction with our acquisition of American Realty Capital Trust, Inc., or ARCT, we entered into a $70 million senior unsecured term loan maturing January 21, 2018.  Borrowing under this term loan bears interest at the current one month LIBOR, plus 1.2%.  In conjunction with this term loan, we also entered into an interest rate swap which effectively fixes our per annum interest rate on this term loan at 2.15%.

 

Deferred financing costs of $1.2 million incurred in conjunction with the $250 million term loan and $303,000 incurred in conjunction with the $70 million term loan are being amortized over the remaining terms of each respective term loan.  The net balance of these deferred financing costs, which was $1.0 million at June 30, 2016, and $1.2 million at December 31, 2015, is included within term loans, net on our consolidated balance sheets.

 

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7.                           Mortgages Payable

 

During the first six months of 2016, we made $181.3 million in principal payments, including the repayment of eight mortgages in full for $161.5 million.  Additionally, we assumed mortgages totaling $32.5 million, excluding net premiums.  The assumed mortgages are secured by the properties on which the debt was placed.  Approximately $9.7 million of the assumed mortgages are considered non-recourse debt with limited customary exceptions for items such as solvency, bankruptcy, misrepresentation, fraud, misapplication of payments, environmental liabilities, failure to pay taxes, insurance premiums, liens on the property, violations of the single purpose entity requirements, and uninsured losses, and the remaining $22.8 million of the assumed mortgages are non-recourse debt without such exceptions.  We expect to pay off our mortgages as soon as prepayment penalties make it economically feasible to do so.

 

During the first six months of 2016, aggregate net premiums totaling $692,000 were recorded upon the assumption of a mortgage with an above-market interest rate. Amortization of our net premiums is recorded as a reduction to interest expense over the remaining term of the respective mortgages, using a method that approximates the effective-interest method. These mortgages contain customary covenants, such as limiting our ability to further mortgage each applicable property or to discontinue insurance coverage without the prior consent of the lender. At June 30, 2016, we remain in compliance with these covenants.

 

During the first six months of 2015, we made $79.3 million in principal payments, including the repayment of five mortgages in full for $75.6 million.  No mortgages were assumed during the first six months of 2015.

 

We did not incur any deferred financing costs on our mortgages assumed in 2016. The balance of our deferred financing costs, which are classified as part of mortgages payable, net, on our consolidated balance sheets, was $442,000 at June 30, 2016 and $553,000 at December 31, 2015. These costs are being amortized over the remaining term of each mortgage.

 

The following is a summary of all our mortgages payable as of June 30, 2016 and December 31, 2015, respectively (dollars in thousands):

 

 

 

 

 

Weighted

 

Weighted

 

Weighted

 

 

 

Unamortized

 

 

 

 

 

 

 

Average

 

Average

 

Average

 

 

 

Premium

 

 

 

 

 

 

 

Stated

 

Effective

 

Remaining

 

Remaining

 

and Deferred

 

Mortgage

 

 

 

Number of

 

Interest

 

Interest

 

Years Until

 

Principal

 

Finance Costs

 

Payable

 

As Of

 

Properties(1)

 

Rate(2)

 

Rate(3)

 

Maturity

 

Balance

 

Balance, net

 

Balance

 

6/30/16

 

129

 

5.0%

 

4.3%

 

4.2

 

$

488,870

 

$

7,478

 

$

496,348

 

12/31/15

 

183

 

4.9%

 

4.1%

 

3.6

 

$

637,658

 

$

8,529

 

$

646,187

 

 

 (1) At June 30, 2016, there were 38 mortgages on 129 properties, while at December 31, 2015, there were 44 mortgages on 183 properties.  The mortgages require monthly payments, with principal payments due at maturity.  The mortgages are at fixed interest rates, except for five mortgages on 14 properties totaling $58.3 million at June 30, 2016, including net unamortized discounts.  At December 31, 2015, four mortgages on 13 properties totaling $51.1 million, including net unamortized discounts, were at variable interest rates.  After factoring in arrangements which limit our exposure to interest rate risk and effectively fix our per annum interest rates, our variable rate mortgage debt includes three mortgages totaling $22.6 million at June 30, 2016, and two mortgages totaling $15.5 million at December 31, 2015.

 

(2) Stated interest rates ranged from 2.3% to 6.9% at June 30, 2016, while stated interest rates ranged from 2.0% to 6.9% at December 31, 2015.

 

(3) Effective interest rates ranged from 2.3% to 8.8% at June 30, 2016, while effective interest rates ranged from 2.2% to 8.9% at December 31, 2015.

 

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The following table summarizes the maturity of mortgages payable, excluding net premiums of $7.9 million and deferred finance costs of $442,000, as of June 30, 2016 (dollars in millions):

 

Year of Maturity

 

Principal

 

2016

 

$

4.8

 

2017

 

149.7

 

2018

 

15.5

 

2019

 

26.3

 

2020

 

82.4

 

Thereafter

 

210.2

 

 

 

 

 

 

Totals

 

$

488.9

 

 

 

8.                           Notes Payable

 

Our senior unsecured notes and bonds consist of the following, sorted by maturity date (dollars in millions):

 

 

 

June 30,

 

December 31,

 

 

 

2016

 

2015

 

5.950% notes, issued in September 2006 and due in September 2016

 

$

 275

 

$

275

 

5.375% notes, issued in September 2005 and due in September 2017

 

175

 

175

 

2.000% notes, issued in October 2012 and due in January 2018

 

350

 

350

 

6.750% notes, issued in September 2007 and due in August 2019

 

550

 

550

 

5.750% notes, issued in June 2010 and due in January 2021

 

250

 

250

 

3.250% notes, issued in October 2012 and due in October 2022

 

450

 

450

 

4.650% notes, issued in July 2013 and due in August 2023

 

750

 

750

 

3.875% notes, issued in June 2014 and due in July 2024

 

350

 

350

 

4.125% notes, issued in September 2014 and due in October 2026

 

250

 

250

 

5.875% bonds, $100 issued in March 2005 and $150 issued in June 2011, both due in March 2035

 

250

 

250

 

Total principal amount

 

3,650

 

3,650

 

Unamortized original issuance discounts and deferred financing costs

 

(30

)

(32

)

 

 

$

 3,620

 

$

3,618

 

 

The following table summarizes the maturity of our notes and bonds payable as of June 30, 2016, excluding unamortized original issuance discounts and deferred financing costs (dollars in millions):

 

Year of Maturity

 

Principal

 

2016

 

$

275

 

2017

 

175

 

2018

 

350

 

2019

 

550

 

2020

 

-

 

Thereafter

 

2,300

 

 

 

 

 

 

Totals

 

$

3,650

 

 

As of June 30, 2016, the weighted average interest rate on our notes and bonds payable was 4.7% and the weighted average remaining years until maturity was 6.0 years. In September 2016, we expect to repay our $275 million 5.95% notes.

 

 

9.                           Equity

 

A.           Issuance of Common Stock

In May 2016, we issued 6,500,000 shares of common stock.  After underwriting discounts and other offering costs of $12.1 million, the net proceeds of $383.5 million were used to repay borrowings under our credit facility.

 

In April 2015, we issued 5,500,000 shares of common stock.  After underwriting discounts and other offering costs of $1.4 million, the net proceeds of $276.4 million were used to repay borrowings under our credit facility.

 

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B.           Dividend Reinvestment and Stock Purchase Plan

Our Dividend Reinvestment and Stock Purchase Plan, or the DRSPP, provides our common stockholders, as well as new investors, with a convenient and economical method of purchasing our common stock and reinvesting their distributions. The DRSPP also allows our current stockholders to buy additional shares of common stock by reinvesting all or a portion of their distributions. The DRSPP authorizes up to 26,000,000 common shares to be issued.  During the first six months of 2016, we issued 98,585 shares and raised approximately $5.8 million under the DRSPP.  During the first six months of 2015, we issued 4,335,580 shares and raised approximately $208.3 million under the DRSPP.  From the inception of the DRSPP through June 30, 2016, we have issued 12,798,447 shares and raised approximately $587.4 million.

 

We pay for a majority of the plan-related fees related to our DRSPP.  Additionally, our DRSPP includes a waiver approval process, allowing larger investors or institutions, per a formal approval process, to purchase shares at a small discount, if approved by us. During the first six months of 2016, we did not issue shares under the waiver approval process. During the first six months of 2015, we issued 4,239,477 shares and raised $203.7 million under the waiver approval process.  These shares are included in the total activity for the first six months of 2015 noted in the preceding paragraph.

 

C.           At-the-Market (ATM) Program

In September 2015, we established an “at-the-market” equity distribution program, or our ATM program, pursuant to which we can offer and sell up to 12,000,000 shares of common stock. The shares of common stock may be sold to, or through, a consortium of banks acting as our sales agents either by means of ordinary brokers’ transactions on the NYSE at prevailing market prices or at negotiated prices.  During the first six months of 2016, we issued 710,000 shares and raised approximately $44.6 million under the ATM program.

 

10.                    Noncontrolling Interests

 

In January 2013, we completed our acquisition of ARCT.  Equity issued as consideration for this transaction included common and preferred partnership units issued by Tau Operating Partnership, L.P., or Tau Operating Partnership, the consolidated subsidiary which owns properties acquired through the ARCT acquisition.  We and our subsidiaries hold a 99.4% interest in Tau Operating Partnership, and consolidate the entity.

 

In June 2013, we completed the acquisition of a portfolio of properties by issuing common partnership units in Realty Income, L.P.  The units were issued as consideration for the acquisition.  At June 30, 2016, the remaining units from this issuance represent a 0.9% ownership in Realty Income, L.P.  We hold the remaining 99.1% interests in this entity and consolidate the entity.

 

A.                         Neither of the common partnership units have voting rights. Both common partnership units are entitled to monthly distributions equal to the amount paid to common stockholders of Realty Income, and are redeemable in cash or Realty Income common stock, at our option, and at a conversion ratio of one to one, subject to certain exceptions.  Noncontrolling interests with redemption provisions that permit the issuer to settle in either cash or common stock, at the option of the issuer, were evaluated to determine whether temporary or permanent equity classification on the balance sheet was appropriate.  We determined that the units meet the requirements to qualify for presentation as permanent equity.

 

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The following table represents the change in the carrying value of all noncontrolling interests through June 30, 2016 (dollars in thousands):

 

 

 

Tau Operating

 

Realty Income, L.P.

 

 

 

 

 

Partnership units(1)

 

units(2)

 

Total

 

Carrying value at December 31, 2015

 

$

13,410

 

$

8,327

 

$

21,737

 

Reallocation of equity

 

491

 

52

 

543

 

Redemptions

 

-

 

(2,606

)

(2,606

)

Distributions

 

(378

)

(353

)

(731

)

Allocation of net income

 

128

 

365

 

493

 

Carrying value at June 30, 2016

 

$

13,651

 

$

5,785

 

$

19,436

 

 

(1)           317,022 Tau Operating Partnership units were issued on January 22, 2013 and remained outstanding as of June 30, 2016 and December 31, 2015.

(2)           534,546 Realty Income, L.P. units were issued on June 27, 2013, 331,364 units were outstanding as of December 31, 2015, and 228,182 remain outstanding as of June 30, 2016.

 

B.                         The Tau Operating Partnership preferred units were recorded at fair value as of the date of acquisition.  Since they were redeemable at a fixed price on a determinable date, we initially classified them in other liabilities on our consolidated balance sheets.  Payments on these preferred units were made monthly at a rate of 2% per annum and were included in interest expense.  In January 2015, we redeemed all 6,750 Tau Operating Partnership preferred units for $1,000 per unit, plus accrued and unpaid distributions.

 

C.                         During the first quarter of 2016, we adopted ASU 2015-02, which amends Topic 810, Consolidation.  This ASU amended the criteria used to evaluate whether an entity is a variable interest entity, or VIE, resulting in the conclusion that all limited partnerships are considered VIEs, unless substantive kick-out rights or participating rights exist.  Accordingly, we determined that both Tau Operating Partnership and Realty Income, L.P. are VIEs. We have also concluded that we are the primary beneficiary of these VIEs, based on our controlling financial interests.  We evaluated the minority unitholder rights noting that they do not hold substantive kick-out rights or participating rights. Below is a summary of selected financial data of consolidated VIEs for which we are the primary beneficiary included in the consolidated balance sheets at June 30, 2016 and December 31, 2015 (in thousands):

 

 

 

June 30, 2016

 

December 31, 2015

 

Net real estate

 

$

3,013,607

 

$

3,033,180

 

Total assets

 

3,497,988

 

3,529,667

 

Total debt

 

232,443

 

389,105

 

Total liabilities

 

325,276

 

478,955

 

 

11.                              Fair Value of Financial Instruments

 

Fair value is defined as the price that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The disclosure for assets and liabilities measured at fair value requires allocation to a three-level valuation hierarchy. This valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. Categorization within this hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

 

We believe that the carrying values reflected in our consolidated balance sheets reasonably approximate the fair values for cash and cash equivalents, accounts receivable, escrow deposits, loans receivable, line of credit payable, term loans and all other liabilities, due to their short-term nature or interest rates and terms that are consistent with market, except for our notes receivable issued in connection with property sales, mortgages payable and our senior notes and bonds payable, which are disclosed as follows (dollars in millions):

 

 

 

Carrying value per

 

Estimated fair

 

At June 30, 2016

 

balance sheet

 

value

 

Notes receivable issued in connection with property sales

 

$

5.4

 

$

5.7

 

Mortgages payable assumed in connection with acquisitions, net

 

496.3

 

499.2

 

Notes and bonds payable, net

 

3,620.3

 

3,945.7

 

 

 

 

Carrying value per

 

Estimated fair

 

At December 31, 2015

 

balance sheet

 

value

 

Notes receivable issued in connection with property sales

 

$

17.9

 

$

19.4

 

Mortgages payable assumed in connection with acquisitions, net

 

646.2

 

651.5

 

Notes and bonds payable, net

 

3,618.0

 

3,828.1

 

 

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The estimated fair values of our notes receivable issued in connection with property sales and our mortgages payable have been calculated by discounting the future cash flows using an interest rate based upon the relevant Treasury yield curve, plus an applicable credit-adjusted spread.  Because this methodology includes unobservable inputs that reflect our own internal assumptions and calculations, the measurement of estimated fair values related to our notes receivable and mortgages payable is categorized as level three on the three-level valuation hierarchy.

 

The estimated fair values of our senior notes and bonds payable are based upon indicative market prices and recent trading activity of our senior notes and bonds payable. Because this methodology includes inputs that are less observable by the public and are not necessarily reflected in active markets, the measurement of the estimated fair values, related to our notes and bonds payable, is categorized as level two on the three-level valuation hierarchy.

 

We record interest rate swaps on the consolidated balance sheet at fair value. At June 30, 2016, interest rate swaps valued at $11.8 million were included in accounts payable and accrued expenses on the consolidated balance sheet.  The fair value of our interest rate swaps are based on valuation techniques including discounted cash flow analysis on the expected cash flows of each swap, using both observable and unobservable market-based inputs, including interest rate curves.  Because this methodology uses observable and unobservable inputs, and the unobservable inputs are not significant to the fair value measurement, the measurement of interest rate swaps is categorized as level two on the three-level valuation hierarchy.

 

12.                              Gain on Sales of Real Estate

 

During the second quarter of 2016, we sold 16 properties for $24.5 million, which resulted in a gain of $8.7 million.  During the first six months of 2016, we sold 27 properties for $35.5 million, which resulted in a gain of $10.9 million.

 

During the second quarter of 2015, we sold five properties for $8.2 million, which resulted in a gain of $3.7 million. During the first six months of 2015, we sold 14 properties for $30.5 million, which resulted in a gain of $10.9 million.

 

13.                              Impairments

 

We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. A provision is made for impairment if estimated future operating cash flows (undiscounted and without interest charges) plus estimated disposition proceeds (undiscounted) are less than the current book value of the property. Key factors that we utilize in this analysis include projected rental rates, estimated holding periods, historical sales and releases, capital expenditures and property sales capitalization rates. If a property is classified as held for sale, it is carried at the lower of carrying cost or estimated fair value, less estimated cost to sell, and depreciation of the property ceases.

 

During the second quarter of 2016, we recorded total provisions for impairment of $6.3 million on five sold properties and six properties classified as held for sale in the following industries: one in the automotive service industry, eight in the restaurant-casual dining industry, one in the restaurant-quick service industry and one among the industries we classify as “other.” For the first six months of 2016, we recorded total provisions for impairment of $8.2 million on 11 sold properties, six properties classified as held for sale, and one property classified as held for investment in the following industries: one in the automotive parts industry, one in the automotive service industry, one in the convenience store industry, one in the furniture store industry, one in the health and fitness industry, ten in the restaurant-casual dining industry, one in the restaurant-quick service industry and two among the industries we classify as “other.”

 

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In comparison, for the second quarter of 2015, we recorded total provisions for impairment of $3.2 million on three sold properties and two properties classified as held for investment in the following industries: one in the health and fitness industry, three in the restaurant-casual dining industry, and one among the industries we classify as “other.” For the first six months of 2015, we recorded total provisions for impairment of $5.3 million on five sold properties, two properties classified as held for investment, and one property disposed of other than by sale in the following industries: one in the health and fitness industry, six in the restaurant-casual dining industry, and one among the industries we classify as “other.”

 

14.     Distributions Paid and Payable

 

A.                       Common Stock

 

We pay monthly distributions to our common stockholders.  The following is a summary of monthly distributions paid per common share for the first six months of 2016 and 2015:

 

Month

 

2016

 

2015

 

 

 

 

 

 

 

January

 

$

0.1910000

 

$

0.1834167

 

February

 

0.1985000

 

0.1890000

 

March

 

0.1985000

 

0.1890000

 

April

 

0.1990000

 

0.1895000

 

May

 

0.1990000

 

0.1895000

 

June

 

0.1990000

 

0.1895000

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

1.1850000

 

$

1.1299167

 

 

At June 30, 2016, a distribution of $0.1995 per common share was payable and was paid in July 2016.

 

B.      Class F Preferred Stock

Dividends of $0.138021 per share are paid monthly in arrears on the Class F preferred stock.  During each of the first six months of 2016 and 2015, we paid six monthly dividends to holders of our Class F preferred stock totaling $0.828126 per share, or $13.5 million, and at June 30, 2016, a monthly dividend of $0.138021 per share was payable and was paid in July 2016.  We are current in our obligations to pay dividends on our Class F preferred stock.

 

15.   Net Income per Common Share

 

Basic net income per common share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during each period. Diluted net income per common share is computed by dividing net income available to common stockholders, plus income attributable to dilutive shares and convertible common units, for the period by the weighted average number of common shares that would have been outstanding assuming the issuance of common shares for all potentially dilutive common shares outstanding during the reporting period.

 

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The following is a reconciliation of the denominator of the basic net income per common share computation to the denominator of the diluted net income per common share computation.

 

 

 

Three months ended

 

Six months ended

 

 

 

June 30,

 

June 30,

 

 

 

2016

 

2015

 

2016

 

2015

 

Weighted average shares used for the basic net income per share computation

 

253,375,546

 

232,403,586

 

251,792,989

 

228,932,782

 

Incremental shares from share-based compensation

 

281,177

 

165,577

 

280,696

 

128,980

 

Weighted average partnership common units convertible to common shares that were dilutive

 

317,022

 

317,022

 

317,022

 

317,022

 

Weighted average shares used for diluted net income per share computation

 

253,973,745

 

232,886,185

 

252,390,707

 

229,378,784

 

Unvested shares from share-based compensation that were anti-dilutive

 

-

 

115,789

 

1,978

 

107,539

 

Weighted average partnership common units convertible to common shares that were anti-dilutive

 

280,498

 

419,546

 

305,272

 

429,988

 

 

16.     Supplemental Disclosures of Cash Flow Information

 

Cash paid for interest was $105.6 million in the first six months of 2016 and $114.6 million in the first six months of 2015.

 

Interest capitalized to properties under development was $212,000 in the first six months of 2016 and $266,000 the first six months of 2015.

 

Cash paid for income taxes was $3.4 million in the first six months of 2016 and $3.1 million in the first six months of 2015.

 

The following non-cash activity is included in the accompanying consolidated financial statements:

 

A.     During the first six months of 2016, we assumed mortgages payable to third-party lenders of $32.5 million, and recorded $692,000 of net premiums. There were no assumed mortgages payable for the first six months of 2015.

 

17.     Segment Information

 

We evaluate performance and make resource allocation decisions on an industry by industry basis. For financial reporting purposes, we have grouped our tenants into 47 activity segments. All of the properties are incorporated into one of the applicable segments. Because almost all of our leases require the tenant to pay operating expenses, rental revenue is the only component of segment profit and loss we measure.

 

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The following tables set forth certain information regarding the properties owned by us, classified according to the business of the respective tenants (dollars in thousands):

 

 

 

June 30,

 

December 31,

 

Assets, as of:

 

2016

 

2015

 

Segment net real estate:

 

 

 

 

 

Apparel

 

$

177,482

 

$

180,175

 

Automotive service

 

130,310

 

129,068

 

Automotive tire services

 

242,893

 

247,200

 

Beverages

 

295,585

 

297,724

 

Child care

 

50,965

 

52,391

 

Convenience stores

 

711,270

 

723,092

 

Dollar stores

 

1,139,394

 

1,158,948

 

Drug stores

 

1,406,370

 

1,386,387

 

Financial services

 

250,145

 

254,022

 

General merchandise

 

258,546

 

195,030

 

Grocery stores

 

326,362

 

331,565

 

Health and fitness

 

826,981

 

839,872

 

Health care

 

218,243

 

220,018

 

Home improvement

 

290,763

 

268,974

 

Motor vehicle dealerships

 

195,624

 

137,315

 

Restaurants-casual dining

 

558,588

 

421,235

 

Restaurants-quick service

 

504,888

 

466,802

 

Sporting goods

 

159,223

 

141,287

 

Theaters

 

370,275

 

371,617

 

Transportation services

 

772,749

 

686,041

 

Wholesale club

 

446,060

 

452,563

 

27 other non-reportable segments

 

1,675,430

 

1,657,558

 

Total segment net real estate

 

11,008,146

 

10,618,884

 

 

 

 

 

 

 

Intangible assets:

 

 

 

 

 

Apparel

 

45,951

 

48,116

 

Automotive service

 

18,861

 

19,131

 

Automotive tire services

 

12,367

 

13,202

 

Beverages

 

2,409

 

2,538

 

Convenience stores

 

15,107

 

15,843

 

Dollar stores

 

54,040

 

56,420

 

Drug stores

 

190,449

 

189,631

 

Financial services

 

32,157

 

34,626

 

General merchandise

 

49,764

 

41,301

 

Grocery stores

 

40,747

 

42,823

 

Health and fitness

 

64,731

 

65,037

 

Health care

 

27,585

 

29,950

 

Home improvement

 

43,536

 

42,630

 

Motor vehicle dealerships

 

23,852

 

13,182

 

Restaurants-casual dining

 

22,625

 

9,392

 

Restaurants-quick service

 

34,724

 

32,612

 

Sporting goods

 

16,061

 

11,871

 

Theaters

 

15,748

 

17,673

 

Transportation services

 

103,884

 

92,602

 

Wholesale club

 

34,469

 

36,215

 

Other non-reportable segments

 

213,978

 

219,622

 

 

 

 

 

 

 

Goodwill:

 

 

 

 

 

Automotive service

 

445

 

448

 

Automotive tire services

 

863

 

865

 

Child care

 

4,999

 

5,034

 

Convenience stores

 

2,008

 

2,009

 

Restaurants-casual dining

 

2,175

 

2,215

 

Restaurants-quick service

 

1,075

 

1,082

 

Other non-reportable segments

 

3,655

 

3,668

 

Other corporate assets

 

163,020

 

176,757

 

Total assets

 

$

12,249,431

 

$

11,845,379

 

 

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Three months ended

 

Six months ended

 

 

 

June 30,

 

June 30,

 

Revenue

 

2016

 

2015

 

2016

 

2015

 

Segment rental revenue:

 

 

 

 

 

 

 

 

 

Apparel

 

$

4,879

 

$

4,932

 

$

9,754

 

$

9,863

 

Automotive service

 

4,814

 

4,795

 

9,491

 

9,116

 

Automotive tire services

 

7,220

 

7,280

 

14,484

 

14,370

 

Beverages

 

6,404

 

6,328

 

12,809

 

12,656

 

Child care

 

4,845

 

4,863

 

9,937

 

9,884

 

Convenience stores

 

22,789

 

22,557

 

45,653

 

45,073

 

Dollar stores

 

22,728

 

21,943

 

45,324

 

43,890

 

Drug stores

 

28,638

 

25,885

 

57,059

 

48,483

 

Financial services

 

4,252

 

4,263

 

8,565

 

8,528

 

General merchandise

 

4,301

 

3,842

 

8,560

 

7,866

 

Grocery stores

 

7,408

 

7,527

 

15,054

 

14,882

 

Health and fitness

 

21,545

 

17,396

 

42,849

 

33,411

 

Health care

 

4,049

 

4,016

 

8,065

 

8,032

 

Home improvement

 

6,099

 

5,506

 

12,153

 

10,684

 

Motor vehicle dealerships

 

5,595

 

3,945

 

9,809

 

7,760

 

Restaurants-casual dining

 

10,633

 

9,463

 

20,468

 

18,912

 

Restaurants-quick service

 

12,482

 

9,620

 

25,276

 

19,982

 

Sporting goods

 

5,316

 

4,878

 

9,872

 

8,577

 

Theaters

 

12,708

 

12,286

 

26,157

 

24,476

 

Transportation services

 

13,752

 

12,251

 

26,842

 

25,202

 

Wholesale club

 

9,369

 

9,341

 

18,738

 

18,683

 

27 other non-reportable segments

 

40,230

 

38,514

 

79,938

 

76,224

 

Total rental revenue

 

260,056

 

241,431

 

516,857

 

476,554

 

Tenant reimbursements

 

11,112

 

11,607

 

20,217

 

21,570

 

Other revenue

 

(129)

 

822

 

1,081

 

2,604

 

Total revenue

 

$

271,039

 

$

253,860

 

$

538,155

 

$

500,728

 

 

18.     Common Stock Incentive Plan

 

In 2012, our Board of Directors adopted and stockholders approved the Realty Income Corporation 2012 Incentive Award Plan, or the 2012 Plan, to enable us to motivate, attract and retain the services of directors and employees considered essential to our long-term success. The 2012 Plan offers our directors and employees an opportunity to own our stock or rights that will reflect our growth, development and financial success. Under the terms of the 2012 plan, the aggregate number of shares of our common stock subject to options, restricted stock, stock appreciation rights, restricted stock units and other awards, will be no more than 3,985,734 shares. The 2012 Plan has a term of ten years from the date it was adopted by our Board of Directors.

 

The amount of share-based compensation costs recognized in general and administrative expense on our consolidated statements of income was $3.9 million during the second quarter of 2016, $2.8 million during the second quarter of 2015, $6.6 million during the first six months of 2016 and $5.4 million during the first six months of 2015.

 

A.   Restricted Stock

 

During the first six months of 2016, we granted 169,539 shares of common stock under the 2012 Plan. These shares generally vest over a five-year service period, except for the annual grant of shares to our Board of Directors, totaling 28,000 shares, of which 20,000 shares vested immediately and 8,000 shares vest annually, in equal parts, over a three year service period.

 

As of June 30, 2016, the remaining unamortized share-based compensation expense related to restricted stock totaled $18.0 million, which is being amortized on a straight-line basis over the service period of each applicable award. The amount of share-based compensation is based on the fair value of the stock at the grant date. We define the grant date as the date the recipient and Realty Income have a mutual understanding of the key terms and condition of the award, and the recipient of the grant begins to benefit from, or be adversely affected by, subsequent changes in the price of the shares.

 

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B.    Performance Shares and Restricted Stock Units

 

During the first six months of 2016, we granted 58,569 performance shares, as well as dividend equivalent rights, to our executive officers. The performance shares are earned based on our TSR performance relative to select industry indices as well as achievement of certain operating metrics, and vest 50% on the first and second January 1 after the end of the three year performance period, subject to continued service.

 

During the first six months of 2016, we also granted 11,098 restricted stock units that vest over a five year service period and have the same economic rights as shares of restricted stock.

 

As of June 30, 2016, the remaining share-based compensation expense related to the performance shares and restricted stock units totaled $5.6 million.  The fair value of the performance share was estimated on the date of grant using a Monte Carlo Simulation model. The performance shares are being recognized on a tranche-by-tranche basis over the service period. The amount of share-based compensation for the restricted stock units is based on the fair value of our common stock at the grant date. The restricted stock units are being recognized on a straight-line basis over the service period.

 

19.     Commitments and Contingencies

 

In the ordinary course of business, we are party to various legal actions which we believe are routine in nature and incidental to the operation of our business. We believe that the outcome of the proceedings will not have a material adverse effect upon our consolidated financial position or results of operations.

 

At June 30, 2016, we had commitments of $1.4 million for re-leasing costs, recurring capital expenditures, and non-recurring building improvements. In addition, as of June 30, 2016, we had committed $32.2 million under construction contracts, which is expected to be paid in the next twelve months.

 

20.     Subsequent Events

 

In July 2016, we declared the following dividends, which will be paid in August 2016:

 

·     $0.1995 per share to our common stockholders and

·     $0.138021 per share to our Class F preferred stockholders.

 

In July 2016, we also declared a dividend of $0.2015 per share to our common stockholders, which will be paid in September 2016.

 

In July 2016, we issued 602,269 common shares pursuant to our ATM program, at a weighted average price of $68.43, receiving proceeds of $40.6 million.

 

Item 2.              Management’s Discussion and Analysis of Financial Condition and Results of Operations

FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q, including the documents incorporated by reference, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act of 1934, as amended. When used in this quarterly report, the words “estimated”, “anticipated”, “expect”, “believe”, “intend” and similar expressions are intended to identify forward-looking statements. Forward-looking statements include discussions of strategy, plans, or intentions of management. Forward-looking statements are subject to risks, uncertainties, and assumptions about Realty Income Corporation, including, among other things:

 

·     Our anticipated growth strategies;

·     Our intention to acquire additional properties and the timing of these acquisitions;

·     Our intention to sell properties and the timing of these property sales;

·     Our intention to re-lease vacant properties;

·     Anticipated trends in our business, including trends in the market for long-term, net leases of freestanding, single-tenant properties; and

·     Future expenditures for development projects.

 

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Future events and actual results, financial and otherwise, may differ materially from the results discussed in the forward-looking statements. In particular, some of the factors that could cause actual results to differ materially are:

 

·     Our continued qualification as a real estate investment trust;

·     General business and economic conditions;

·     Competition;

·     Fluctuating interest rates;

·     Access to debt and equity capital markets;

·     Continued volatility and uncertainty in the credit markets and broader financial markets;

·     Other risks inherent in the real estate business including tenant defaults, potential liability relating to environmental matters, illiquidity of real estate investments, and potential damages from natural disasters;

·     Impairments in the value of our real estate assets;

·     Changes in the tax laws of the United States of America;

·     The outcome of any legal proceedings to which we are a party or which may occur in the future; and

·     Acts of terrorism and war.

 

Additional factors that may cause risks and uncertainties include those discussed in the sections entitled “Business”, “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K, for the fiscal year ended December 31, 2015.

 

Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date that this quarterly report was filed with the Securities and Exchange Commission, or SEC.  While forward-looking statements reflect our good faith beliefs, they are not guarantees of future performance. We undertake no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date of this quarterly report or to reflect the occurrence of unanticipated events. In light of these risks and uncertainties, the forward-looking events discussed in this quarterly report might not occur.

 

THE COMPANY

 

Realty Income, The Monthly Dividend Company®, is an S&P 500 real estate company with the primary business objective of generating dependable monthly cash dividends from a consistent and predictable level of cash flow from operations. Our monthly dividends are supported by the cash flow from our property portfolio. We have in-house acquisition, portfolio management, asset management, credit research, real estate research, legal, finance and accounting, information technology, and capital markets capabilities. Over the past 47 years, Realty Income has been acquiring and managing freestanding commercial properties that generate rental revenue under long-term net lease agreements.

 

Realty Income (NYSE: O) was founded in 1969, and listed on the New York Stock Exchange, or NYSE, in 1994.  We elected to be taxed as a real estate investment trust, or REIT, requiring us to distribute dividends to our stockholders aggregating at least 90% of our taxable income (excluding net capital gains).

 

We seek to increase earnings and distributions to stockholders through active portfolio management, asset management and the acquisition of additional properties.

 

Generally, our portfolio and asset management efforts seek to achieve:

 

·     Contractual rent increases on existing leases;

·     Rent increases at the termination of existing leases, when market conditions permit;

·     Optimum exposure to certain tenants and markets through re-leasing vacant properties and selectively selling properties;

·     Maximum asset-level returns on properties re-leased and/or sold;

·     Optimum value of the existing portfolio by enhancing individual properties, pursuing alternative uses, and deriving ancillary revenue; and

·     Investment opportunities in new asset classes for the portfolio.

 

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At June 30, 2016, we owned a diversified portfolio:

 

·     Of 4,646 properties;

·     With an occupancy rate of 98.0%, or 4,551 properties leased and 95 properties available for lease;

·     Leased to 246 different commercial tenants doing business in 47 separate industries;

·     Located in 49 states and Puerto Rico;

·     With over 79.0 million square feet of leasable space; and

·     With an average leasable space per property of approximately 17,010 square feet; approximately 11,620 square feet per retail property and 220,560 square feet per industrial property.

 

Of the 4,646 properties in the portfolio, 4,624, or 99.5%, are single-tenant properties, and the remaining are multi-tenant properties. At June 30, 2016, of the 4,624 single-tenant properties, 4,530 were leased with a weighted average remaining lease term (excluding rights to extend a lease at the option of the tenant) of 9.8 years.

 

Investment Philosophy

We believe that owning an actively managed, diversified portfolio of commercial properties under long-term, net leases produces consistent and predictable income. A net lease typically requires the tenant to be responsible for monthly rent and certain property operating expenses including property taxes, insurance, and maintenance. In addition, tenants of our properties typically pay rent increases based on: (1) increases in the consumer price index (typically subject to ceilings), (2) fixed increases, or (3) additional rent calculated as a percentage of the tenants’ gross sales above a specified level. We believe that a portfolio of properties under long-term, net leases generally produces a more predictable income stream than many other types of real estate portfolios, while continuing to offer the potential for growth in rental income.

 

Diversification is a key component of our investment philosophy.  We believe that diversification of the portfolio by tenant, industry, geography, and to a certain extent, property type leads to more predictable investment results for our shareholders by reducing vulnerability that can come with any single concentration.  Our investment efforts have led to a diversified property portfolio that, as of June 30, 2016, consisted of 4,646 properties located in 49 states and Puerto Rico, leased to 246 different commercial tenants doing business in 47 industries. Each of the 47 industries represented in our property portfolio individually accounted for no more than 11.0% of our rental revenue for the quarter ended June 30, 2016.  Since 1970, our occupancy rate at the end of each year has never been below 96%.  However, we cannot assure you that our future occupancy levels will continue to equal or exceed 96%.

 

Investment Strategy

Our investment strategy is to act as a source of capital to regional and national tenants by acquiring and leasing back their real estate locations. When identifying new properties for investment, we generally focus on acquiring the real estate tenants consider important to the successful operation of their business. We generally seek to acquire real estate that has the following characteristics:

 

·     Properties that are freestanding, commercially-zoned with a single tenant;

·     Properties that are in significant markets or strategic locations critical to generating revenue for regional and national tenants (i.e. they need the property in which they operate in order to conduct their business);

·     Properties that we deem to be profitable for the tenants and/or can generally be characterized as important to the successful operations of the company’s business;

·     Properties that are located within attractive demographic areas relative to the business of our tenants, and have good visibility and easy access to major thoroughfares;

·     Properties with real estate valuations that approximate replacement costs;

·     Properties with rental or lease payments that approximate market rents; and

·     Properties that can be purchased with the simultaneous execution or assumption of long-term, net lease agreements, offering both current income and the potential for future rent increases.

 

We seek to invest in industries in which several, well-organized, regional and national tenants are capturing market share through their selection of prime locations, service, quality control, economies of scale, strong consumer brands, and advertising. In addition, we frequently acquire large portfolios of single-tenant properties net leased to different tenants operating in a variety of industries.  We have an internal team dedicated to sourcing such opportunities, often using our relationships with various tenants, owners/developers, and advisers to uncover and secure transactions.  We also undertake thorough research and analysis to identify what we consider to be appropriate property locations, tenants, and industries for investment. This research expertise is instrumental to uncovering net lease opportunities in markets where we believe we can add value.

 

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In selecting potential investments, we look for tenants with the following attributes:

 

·     Tenants with reliable and sustainable cash flow;

·     Tenants with revenue and cash flow from multiple sources;

·     Tenants that are willing to sign a long-term lease (10 or more years); and

·     Tenants that are large owners and users of real estate.

 

From a retail perspective, our investment strategy is to target tenants that have a service, non-discretionary, and/or low price point component to their business.  We believe these characteristics better position tenants to operate in a variety of economic conditions and to compete more effectively with e-commerce.  As a result of the execution of this strategy, over 90% of our annualized retail rental revenue at June 30, 2016 is derived from tenants with a service, non-discretionary, and/or low price point component to their business.  From a non-retail perspective, we target industrial properties leased to Fortune 1000, primarily investment grade rated companies.  We believe rental revenue generated from businesses with these characteristics is generally more durable and stable.

 

After applying this investment strategy, we pursue those transactions where we can achieve an attractive investment spread over our cost of capital and favorable risk-adjusted returns.

 

Underwriting Strategy

We believe the principal financial obligations for most of our tenants typically include their bank and other debt, payment obligations to suppliers, and real estate lease obligations. Because we typically own the land and building in which a tenant conducts its business or which are critical to the tenant’s ability to generate revenue, we believe the risk of default on a tenant’s lease obligation is less than the tenant’s unsecured general obligations. It has been our experience that tenants must retain their profitable and critical locations in order to survive.  Therefore, in the event of reorganization, they are less likely to reject a lease of a profitable or critical location because this would terminate their right to use the property. Thus, as the property owner, we believe that we will fare better than unsecured creditors of the same tenant in the event of reorganization. If a property is rejected by the tenant during reorganization, we own the property and can either lease it to a new tenant or sell the property. In addition, we believe that the risk of default on real estate leases can be further mitigated by monitoring the performance of the tenants’ individual locations and considering whether to proactively sell locations that are weaker performers.

 

In order to be considered for acquisition, properties must meet stringent investment and credit requirements. The properties must generate attractive current yields and the tenant must meet our credit criteria. We have established a four-part analysis that examines each potential investment based on:

 

·     Overall real estate characteristics, including property value and comparative rental rates;

·     Industry, company, market conditions, and credit profile;

·     Store profitability for retail locations, if profitability data is available; and

·     The importance of the real estate location to the operations of the tenants’ business.

 

Prior to entering into any transaction, our research department conducts a review of a tenant’s credit quality.  The information reviewed may include reports and filings, including any public credit ratings, financial statements, debt and equity analyst reports, and reviews of corporate credit spreads, stock prices, market capitalization, and other financial metrics.  We conduct additional due diligence, including additional financial reviews of the tenant and a more comprehensive review of the business segment and industry in which the tenant operates.  We continue to monitor our tenants’ credit quality on an ongoing basis by reviewing the available information previously discussed, and providing summaries of these findings to management.  We estimate that approximately 44% of our annualized rental revenue comes from properties leased to investment grade rated companies or their subsidiaries.  At June 30, 2016, our top 20 tenants represent approximately 54% of our annualized revenue and eight of these tenants have investment grade credit ratings or are subsidiaries of investment grade rated companies.

 

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Asset Management Strategy

The active management of the property portfolio is an essential component of our long-term strategy. We continually monitor our portfolio for any changes that could affect the performance of our tenants, our tenants’ industries and the locations in which we have invested. We also regularly analyze our portfolio with a view towards optimizing its returns and enhancing its overall credit quality.

 

We regularly review and analyze:

 

·     The quality of the underlying real estate locations;

·     The performance of the various industries of our tenants; and

·     The operation, management, business planning, and financial condition of our tenants.

 

We have an active asset management program that incorporates the sale of assets when we believe the reinvestment of the sale proceeds will:

 

·     Generate higher returns;

·     Enhance the credit quality of our real estate portfolio;

·     Extend our average remaining lease term; or

·     Decrease tenant or industry concentration.

 

At June 30, 2016, we classified 13 properties with a carrying amount of $10.0 million as held for sale on our balance sheet. For 2016, we intend to continue our active disposition efforts to further enhance our real estate portfolio and anticipate $50 to $75 million in property sales in 2016.  We intend to invest these proceeds into new property acquisitions, if there are attractive opportunities available. However, we cannot guarantee that we will sell properties during 2016 at our estimated values or be able to invest the property sale proceeds in new properties.

 

Impact of Real Estate and Credit Markets

In the commercial real estate market, property prices generally continue to fluctuate. Likewise, during certain periods, the U.S. credit markets have experienced significant price volatility, dislocations, and liquidity disruptions, which may impact our access to and cost of capital. We continually monitor the commercial real estate and U.S. credit markets carefully and, if required, will make decisions to adjust our business strategy accordingly.

 

RECENT DEVELOPMENTS

 

Increases in Monthly Dividends to Common Stockholders

We have continued our 47-year policy of paying monthly dividends.  In addition, we increased the dividend four times during 2016.  As of July 2016, we have paid 75 consecutive quarterly dividend increases and increased the dividend 87 times since our listing on the NYSE in 1994.

 

 

 

Month

 

Month

 

Dividend

 

Increase

 

2016 Dividend increases

 

Declared

 

Paid

 

per share

 

per share

 

1st increase

 

Dec 2015

 

Jan 2016

 

$

0.1910

 

$

0.0005

 

2nd increase

 

Jan 2016

 

Feb 2016

 

$

0.1985

 

$

0.0075

 

3rd increase

 

Mar 2016

 

Apr 2016

 

$

0.1990

 

$

0.0005

 

4th increase

 

Jun 2016

 

Jul 2016

 

$

0.1995

 

$

0.0005

 

5th increase

 

Jul 2016

 

Sep 2016

 

$

0.2015

 

$

0.0020

 

 

The dividends paid per share during the first six months of 2016 totaled approximately $1.185, as compared to approximately $1.130 during the first six months of 2015, an increase of $0.055, or 4.9%.

 

The monthly dividend of $0.1995 per share represents a current annualized dividend of $2.394 per share, and an annualized dividend yield of approximately 3.5% based on the last reported sale price of our common stock on the NYSE of $69.36 on June 30, 2016. In July 2016, our Board of Directors declared a 1% increase in our monthly dividend to $0.2015 per share beginning in September 2016. The new monthly dividend amount represents an annualized dividend of $2.418 per share. Although we expect to continue our policy of paying monthly dividends, we cannot guarantee that we will maintain our current level of dividends that we will continue our pattern of increasing dividends per share, or what our actual dividend yield will be in any future period.

 

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Acquisitions During the Second Quarter of 2016

During the second quarter of 2016, we invested $310.3 million in 57 new properties and properties under development or expansion, with an estimated initial weighted average contractual lease rate of 6.3%. The 57 new properties and properties under development or expansion are located in 22 states, will contain approximately 1.7 million leasable square feet and are 100% leased, with a weighted average lease term of 13.5 years.  The tenants occupying the new properties operate in 14 industries and the property types are 68.0% retail and 32.0% industrial, based on rental revenue.

 

Acquisitions During the First Six Months of 2016

During the first six months of 2016, we invested $662.9 million in 153 new properties and properties under development or expansion, with an initial weighted average contractual lease rate of 6.5%. The 153 new properties and properties under development or expansion are located in 34 states, will contain approximately 3.5 million leasable square feet, and are 100% leased with a weighted average lease term of 14.8 years. The tenants occupying the new properties operate in 23 industries and the property types are 77.6% retail and 22.4% industrial, based on rental revenue.  During the first six months of 2016, none of our real estate investments caused any one tenant to be 10% or more of our total assets at June 30, 2016.

 

The estimated initial weighted average contractual lease rate for a property is generally computed as estimated contractual net operating income, which, in the case of a net leased property, is equal to the aggregate base rent for the first full year of each lease, divided by the total cost of the property.  Since it is possible that a tenant could default on the payment of contractual rent, we cannot provide assurance that the actual return on the funds invested will remain at the percentages listed above.

 

In the case of a property under development or expansion, the contractual lease rate is generally fixed such that rent varies based on the actual total investment in order to provide a fixed rate of return.  When the lease does not provide for a fixed rate of return on a property under development or expansion, the estimated initial weighted average contractual lease rate is computed as follows: estimated net operating income (determined by the lease) for the first full year of each lease, divided by our projected total investment in the property, including land, construction and capitalized interest costs. Of the $662.9 million we invested during the first six months of 2016, $61.7 million was invested in 27 properties under development or expansion with an estimated initial weighted average contractual lease rate of 7.1%.  We may continue to pursue development or expansion opportunities under similar arrangements in the future.

 

Portfolio Discussion

Leasing Results

At June 30, 2016, we had 95 properties available for lease out of 4,646 properties in our portfolio, which represents a 98.0% occupancy rate based on the number of properties in our portfolio.  Since December 31, 2015, when we reported 71 properties available for lease out of 4,538 and a 98.4% occupancy rate, we:

 

·     Had 120 lease expirations (including leases rejected in bankruptcy);

·     Re-leased 75 properties; and

·     Sold 21 vacant properties.

 

Of the 75 properties re-leased during the first six months of 2016, 58 properties were re-leased to existing tenants, eight were re-leased to the same tenants without vacancy, and nine were re-leased to new tenants after a period of vacancy.  The annual rent on these 75 leases was $9,889,000, as compared to the previous rent on these same properties of $9,578,000, which represents a rent recapture rate of 103.2%.

 

At June 30, 2016, our average annualized rental revenue was approximately $13.44 per square foot on the 4,551 leased properties in our portfolio.  At June 30, 2016, we classified 13 properties with a carrying amount of $10.0 million as held for sale on our balance sheet.  The expected sale of these properties does not represent a strategic shift that will have a major effect on our operations and financial results.

 

Investments in Existing Properties

In the second quarter of 2016, we capitalized costs of $2.4 million on existing properties in our portfolio, consisting of $86,000 for re-leasing costs, $174,000 for recurring capital expenditures, and $2.2 million for non-recurring building improvements.  In the second quarter of 2015, we capitalized costs of $1.1 million on existing properties in our portfolio.

 

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In the first six months of 2016, we capitalized costs of $3.7 million on existing properties in our portfolio, consisting of $277,000 for re-leasing costs, $246,000 for recurring capital expenditures, and $3.2 million for non- recurring building improvements.  In the first six months of 2015, we capitalized costs of $2.5 million on existing properties in our portfolio.

 

As part of our re-leasing costs, we typically pay leasing commissions and sometimes provide tenant rent concessions.  Leasing commissions are paid based on the commercial real estate industry standard and any rent concessions provided are minimal. It is not customary for us to offer significant tenant improvements on our properties as tenant incentives. We do not consider the collective impact of the leasing commissions or tenant rent concessions to be material to our financial position or results of operations.

 

The majority of our building improvements relate to roof repairs, HVAC improvements, and parking lot resurfacing and replacements. The amounts of our capital expenditures can vary significantly, depending on the rental market, tenant credit worthiness, the lease term and the willingness of tenants to pay higher rents over the terms of the leases.

 

Capital Raising

During the quarter ended June 30, 2016, Realty Income issued 6,747,127 common shares at a weighted average price of $61.06, receiving net proceeds of $399.6 million. During the six months ended June 30, 2016, Realty Income issued 7,308,585 common shares at a weighted average price of $61.03, receiving net proceeds of $433.2 million. In July 2016, Realty Income issued 602,269 common shares at a weighted average price of $68.43, receiving net proceeds of $40.6 million.

 

Net Income Available to Common Stockholders

Net income available to common stockholders was $69.0 million in the second quarter of 2016, compared to $59.3 million in the second quarter of 2015, an increase of $9.7 million.  On a diluted per common share basis, net income was $0.27 in the second quarter of 2016, compared to $0.25 in the second quarter of 2015, an increase of $0.02, or 8.0%.

 

Net income available to common stockholders was $132.5 million in the first six months of 2016, compared to $119.8 million in the first six months of 2015, an increase of $12.7 million. On a diluted per common share basis, net income was $0.53 in the first six months of 2016, as compared to $0.52 in the first six months of 2015, an increase of $0.01, or 1.9%.

 

The calculation to determine net income available to common stockholders includes impairments, gains from the sale of properties and/or fair value adjustments on our interest rate swaps. These items vary from period to period based on the timing of property sales and can significantly impact net income available to common stockholders.

 

Gains from the sale of properties during the second quarter of 2016 were $8.7 million, as compared to gains from the sale of properties of $3.7 million during the second quarter of 2015.  Gains from the sale of properties during the first six months of 2016 and 2015 were $10.9 million.

 

Funds from Operations Available to Common Stockholders (FFO)

In the second quarter of 2016, our FFO increased by $17.1 million, or 10.7%, to $176.6 million, compared to $159.5 million in the second quarter of 2015.  On a diluted per common share basis, FFO was $0.70 in the second quarter of 2016 and $0.69 in the second quarter of 2015, an increase of $0.01, or 1.4%. FFO for the quarter ended June 30, 2016 was impacted by a non-cash loss of $2.1 million, or $0.01 per share, resulting from fair value adjustments on our interest rate swaps. Each quarter we adjust the carrying value of our interest rate swaps to fair value. The changes in the fair value of our interest rate swaps are recorded to interest expense.

 

In the first six months of 2016, our FFO increased by $34.9 million, or 11.2%, to $347.3 million versus $312.4 million in the first six months of 2015.  On a diluted per common share basis, FFO was $1.38 in the first six months of 2016, compared to $1.36 in the first six months of 2015, an increase of $0.02, or 1.5%. FFO for the six months ended June 30, 2016 was impacted by a non-cash loss of $7.9 million, or $0.03 per share, resulting from fair value adjustments on our interest rate swaps, as described above.

 

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Adjusted Funds from Operations Available to Common Stockholders (AFFO)

In the second quarter of 2016, our AFFO increased by $21.8 million, or 13.7%, to $180.9 million, compared to $159.1 million in the second quarter of 2015.  On a diluted common share basis, AFFO was $0.71 in the second quarter of 2016 and $0.68 in the second quarter of 2015, an increase of $0.03, or 4.4%.

 

In the first six months of 2016, our AFFO increased by $45.6 million, or 14.7%, to $356.8 million versus $311.2 million in the first six months of 2015. On a diluted per common share basis, AFFO was $1.42 in the first six months of 2016, compared to $1.36 in the first six months of 2015, an increase of $0.06, or 4.4%.

 

See our discussion of FFO and AFFO (which are not financial measures under generally accepted accounting principles, or GAAP), later in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which includes a reconciliation of net income available to common stockholders to FFO and AFFO.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Capital Philosophy

Historically, we have met our long term capital needs by issuing common stock, preferred stock and long-term unsecured notes and bonds. Over the long-term, we believe that common stock should be the majority of our capital structure; however, we may issue additional preferred stock or debt securities. We may issue common stock when we believe that our share price is at a level that allows for the proceeds of any offering to be accretively invested into additional properties. In addition, we may issue common stock to permanently finance properties that were financed by our credit facility or debt securities. However, we cannot assure you that we will have access to the capital markets at times and at terms that are acceptable to us.

 

Our primary cash obligations, for the current year and subsequent years, are included in the “Table of Obligations,” which is presented later in this section. We expect to fund our operating expenses and other short-term liquidity requirements, including property acquisitions and development costs, payment of principal and interest on our outstanding indebtedness, property improvements, re-leasing costs and cash distributions to common and preferred stockholders, primarily through cash provided by operating activities, borrowing on our credit facility and periodically through public securities offerings.

 

Conservative Capital Structure

We believe that our stockholders are best served by a conservative capital structure. Therefore, we seek to maintain a conservative debt level on our balance sheet and solid interest and fixed charge coverage ratios. At June 30, 2016, our total outstanding borrowings of senior unsecured notes and bonds, term loans, mortgages payable and credit facility borrowings were $4.97 billion, or approximately 21.3% of our total market capitalization of $23.31 billion.

 

We define our total market capitalization at June 30, 2016 as the sum of:

 

·     Shares of our common stock outstanding of 257,954,902, plus total common units outstanding of 545,204, multiplied by the last reported sales price of our common stock on the NYSE of $69.36 per share on June 30, 2016, or $17.93 billion;

·     Aggregate liquidation value (par value of $25.00 per share) of the Class F preferred stock of $408.8 million;

·     Outstanding borrowings of $512.0 million on our credit facility;

·     Outstanding mortgages payable of $488.9 million, excluding net mortgage premiums of $7.9 million and deferred financing costs of $442,000;

·     Outstanding borrowings of $320.0 million on our term loans, excluding deferred financing costs of $1.0 million; and

·     Outstanding senior unsecured notes and bonds of $3.65 billion, excluding unamortized original issuance discounts of $12.6 million and deferred financing costs of $17.1 million.

 

At-the-Market (ATM) Program

In September 2015, we established an “at-the-market” equity distribution program, or our ATM program, pursuant to which we can offer and sell up to 12,000,000 shares of common stock to, or through, a consortium of banks acting as our sales agents by means of ordinary brokers’ transactions on the NYSE at prevailing market prices or at negotiated prices.  During the first six months of 2016, we issued 710,000 shares and raised approximately $44.6 million under the ATM program.

 

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Dividend Reinvestment and Stock Purchase Plan

Our Dividend Reinvestment and Stock Purchase Plan, or the DRSPP, provides our common stockholders, as well as new investors, with a convenient and economical method of purchasing our common stock and reinvesting their distributions.  The DRSPP also allows our current stockholders to buy additional shares of common stock by reinvesting all or a portion of their distributions.  The DRSPP authorizes up to 26,000,000 common shares to be issued.  In 2013, we revised our DRSPP so that we would pay for a majority of the plan-related fees, which were previously paid by investors, and to institute a waiver approval process, allowing larger investors or institutions, per a formal approval process, to purchase shares at a small discount, if approved by us. During the first six months of 2016, we issued 98,585 shares and raised approximately $5.8 million under the DRSPP. During the first six months of 2016, we did not issue shares under the waiver approval process.

 

Universal Shelf Registration

In December 2015, we filed a shelf registration statement with the SEC, which is effective for a term of three years and will expire in December 2018. In accordance with SEC rules, the amount of securities to be issued pursuant to this shelf registration statement was not specified when it was filed and there is no specific dollar limit. The securities covered by this registration statement include (1) common stock, (2) preferred stock, (3) debt securities, (4) depositary shares representing fractional interests in shares of preferred stock, (5) warrants to purchase debt securities, common stock, preferred stock, or depositary shares, and (6) any combination of these securities. We may periodically offer one or more of these securities in amounts, prices and on terms to be announced when and if these securities are offered. The specifics of any future offerings, along with the use of proceeds of any securities offered, will be described in detail in a prospectus supplement, or other offering materials, at the time of any offering.

 

Mortgage Debt

As of June 30, 2016, we had $488.9 million of mortgages payable, all of which were assumed in connection with our property acquisitions.  Additionally, at June 30, 2016, we had net premiums totaling $7.9 million on these mortgages and deferred financing costs of $442,000.  We expect to pay off the mortgages payable as soon as prepayment penalties have declined to a level that would make it economically feasible to do so.  During the first six months of 2016, we made $181.3 million of principal payments, including the repayment of eight mortgages in full for $161.5 million.

 

Term Loans

In June 2015, in conjunction with entering into our credit facility, we entered into a $250 million senior unsecured term loan maturing June 30, 2020.  Borrowing under this term loan bears interest at the London Interbank Offered Rate, commonly referred to as LIBOR, plus 0.95%.  In conjunction with this term loan, we also entered into an interest rate swap which effectively fixes our per annum interest rate on this term loan at 2.67%.

 

In January 2013, in conjunction with our acquisition of American Realty Capital Trust, or ARCT, we entered into a $70 million senior unsecured term loan maturing in January 2018.  Borrowing under the term loan bears interest at LIBOR, plus 1.20%.  In conjunction with this term loan, we also acquired an interest rate swap which effectively fixes our per annum interest rate on this term loan at 2.15%.

 

$2.0 Billion Revolving Credit Facility

In June 2015, we entered into a $2.0 billion unsecured revolving credit facility, which replaced our $1.5 billion credit facility that was scheduled to expire in May 2016. The initial term of our credit facility expires in June 2019 and includes, at our option, two six-month extensions. Our credit facility has a $1.0 billion accordion expansion option.  Under our credit facility, our investment grade credit ratings as of June 30, 2016 provide for financing at LIBOR, plus 0.9%, with a facility commitment fee of 0.15%, for all-in drawn pricing of 1.05% over LIBOR. The borrowing rate is subject to an interest rate floor. We also have other interest rate options available to us under our credit facility. Our credit facility is unsecured and, accordingly, we have not pledged any assets as collateral for this obligation.

 

At June 30, 2016, we had a borrowing capacity of $1.49 billion available on our credit facility and an outstanding balance of $512.0 million.  The interest rate on borrowings outstanding under our credit facility, at June 30, 2016, was 1.5% per annum.  We must comply with various financial and other covenants in our credit facility.  At June 30, 2016, we remain in compliance with these covenants. We expect to use our credit facility to acquire additional properties and for other general corporate purposes. Any additional borrowings will increase our exposure to interest rate risk.

 

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We generally use our credit facility for the short-term financing of new property acquisitions. Thereafter, we generally seek to refinance those borrowings with the net proceeds of long-term or permanent financing, which may include the issuance of common stock, preferred stock or debt securities. We cannot assure you, however, that we will be able to obtain any such refinancing, or that market conditions prevailing at the time of the refinancing will enable us to issue equity or debt securities at acceptable terms.

 

Notes Outstanding

Our senior unsecured note and bond obligations consist of the following as of June 30, 2016, sorted by maturity date (dollars in millions):

 

5.950% notes, issued in September 2006 and due in September 2016

 

$

275

 

5.375% notes, issued in September 2005 and due in September 2017

 

175

 

2.000% notes, issued in October 2012 and due in January 2018

 

350

 

6.750% notes, issued in September 2007 and due in August 2019

 

550

 

5.750% notes, issued in June 2010 and due in January 2021

 

250

 

3.250% notes, issued in October 2012 and due in October 2022

 

450

 

4.650% notes, issued in July 2013 and due in August 2023

 

750

 

3.875% notes, issued in June 2014 and due in July 2024

 

350

 

4.125% notes, issued in September 2014 and due in October 2026

 

250

 

5.875% bonds, $100 issued in March 2005 and $150 issued in

 

 

 

June 2011, both due in March 2035

 

250

 

Total principal amount

 

$

3,650

 

Unamortized original issuance discounts and deferred financing costs

 

(30

)

 

 

$

3,620

 

 

In September 2016, we expect to repay our $275 million 5.95% notes.  All of our outstanding notes and bonds have fixed interest rates and contain various covenants, with which we remain in compliance as of June 30, 2016. Additionally, interest on all of our senior note and bond obligations is paid semiannually.

 

The following is a summary of the key financial covenants for our senior unsecured notes, as defined and calculated per the terms of our senior notes and bonds. These calculations, which are not based on U.S. GAAP measurements, are presented to investors to show our ability to incur additional debt under the terms of our senior notes and bonds as well as to disclose our current compliance with such covenants, and are not measures of our liquidity or performance.  The actual amounts as of June 30, 2016 are:

 

Note Covenants

 

Required

 

Actual    

 

 

 

 

 

Limitation on incurrence of total debt

 

< 60% of adjusted assets

 

38.3%   

Limitation on incurrence of secured debt

 

< 40% of adjusted assets

 

3.9%   

Debt service coverage (trailing 12 months)(1)

 

> 1.5 x

 

4.7x   

Maintenance of total unencumbered assets

 

> 150% of unsecured debt

 

270.1%   

 

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(1) This covenant is calculated on a pro forma basis for the preceding four-quarter period on the assumptions that: (i) the incurrence of any Debt (as defined in the covenants) incurred by us since the first day of such four-quarter period and the application of the proceeds therefrom (including to refinance other Debt since the first day of such four-quarter period), (ii) the repayment or retirement of any of our Debt since the first day of such four-quarter period, and (iii) any acquisition or disposition by us of any asset or group since the first day of such four quarters had in each case occurred on July 1, 2015, and subject to certain additional adjustments.  Such pro forma ratio has been prepared on the basis required by that debt service covenant, reflects various estimates and assumptions and is subject to other uncertainties, and therefore does not purport to reflect what our actual debt service coverage ratio would have been had transactions referred to in clauses (i), (ii) and (iii) of the preceding sentence occurred as of July 1, 2015, nor does it purport to reflect our debt service coverage ratio for any future period.  The following is our calculation of debt service coverage at June 30, 2016 (in thousands, for trailing twelve months):

 

Net income attributable to the Company

 

$

296,474

 

Plus: interest expense

 

225,450

 

Plus: provision for taxes

 

3,384

 

Plus: depreciation and amortization

 

428,352

 

Plus: provisions for impairment

 

13,434

 

Plus: pro forma adjustments

 

41,110

 

Less: gain on sales of real estate

 

(22,297

)

 

 

 

 

 

Income available for debt service, as defined

 

$

985,907

 

 

 

 

 

 

Total pro forma debt service charge

 

$

208,642

 

Debt service coverage ratio

 

4.7

 

 

Fixed Charge Coverage Ratio

Fixed charge coverage ratio is calculated in exactly the same manner as the debt service coverage ratio, except that preferred stock dividends are also added to the denominator.  Similar to debt service coverage ratio, we consider fixed charge coverage ratio to be an appropriate supplemental measure of a company’s ability to make its interest and preferred stock dividend payments.  Our calculations of both debt service and fixed charge coverage ratios may be different from the calculations used by other companies and, therefore, comparability may be limited.  The presentation of debt service and fixed charge coverage ratios should not be considered as alternatives to any U.S. GAAP operating performance measures.  Below is our calculation of fixed charges at June 30, 2016 (in thousands, for the trailing twelve months):

 

Income available for debt service, as defined

 

$

985,907

 

Pro forma debt service charge plus preferred stock dividends

 

$

235,722

 

Fixed charge coverage ratio

 

4.2

 

 

Cash Reserves

We are organized to operate as an equity REIT that acquires and leases properties and distributes to stockholders, in the form of monthly cash distributions, a substantial portion of our net cash flow generated from leases on our properties.  We intend to retain an appropriate amount of cash as working capital.  At June 30, 2016, we had cash and cash equivalents totaling $20.4 million.

 

We believe that our cash and cash equivalents on hand, cash provided from operating activities, and borrowing capacity is sufficient to meet our liquidity needs for the next twelve months.  We intend, however, to use permanent or long-term capital to fund property acquisitions and to repay future borrowings under our credit facility.

 

Credit Agency Ratings

The borrowing interest rates under our credit facility are based upon our ratings assigned by credit rating agencies. As of June 30, 2016, we are assigned the following investment grade corporate credit ratings on our senior unsecured notes and bonds:  Moody’s Investors Service has assigned a rating of Baa1 with a “positive” outlook, Standard & Poor’s Ratings Group has assigned a rating of BBB+ with a “positive” outlook, and Fitch Ratings has assigned a rating of BBB+ with a “stable” outlook.

 

Based on our current ratings, the facility interest rate as of June 30, 2016 is LIBOR plus 0.9% with a facility commitment fee of 0.15%, for all-in drawn pricing of 1.05% over LIBOR.  Our credit facility provides that the interest rate can range between: (i) LIBOR plus 1.55% if our credit rating is lower than BBB-/Baa3 or unrated and (ii) LIBOR plus 0.85% if our credit rating is A-/A3 or higher.  In addition, our credit facility provides for a facility commitment fee based on our credit ratings, which range from: (i) 0.3% for a rating lower than BBB-/Baa3 or unrated, and (ii) 0.125% for a credit rating of A-/A3 or higher.

 

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We also issue senior debt securities from time to time and our credit ratings can impact the interest rates charged in those transactions.  If our credit ratings or ratings outlook change, our cost to obtain debt financing could increase or decrease. The credit ratings assigned to us could change based upon, among other things, our results of operations and financial condition. These ratings are subject to ongoing evaluation by credit rating agencies and we cannot assure you that our ratings will not be changed or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. Moreover, a rating is not a recommendation to buy, sell or hold our debt securities, preferred stock or common stock.

 

Table of Obligations

The following table summarizes the maturity of each of our obligations as of June 30, 2016 (dollars in millions):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ground

 

Ground

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Leases

 

Leases

 

 

 

 

 

 

 

 

Notes

 

 

 

 

 

 

 

Paid by

 

Paid by

 

 

 

 

Year of

 

Credit

 

and

 

Term

 

Mortgages

 

 

 

Realty

 

Our

 

 

 

 

Maturity

 

Facility

(1)

Bonds

(2)

Loan

(3)

Payable

(4)

Interest

(5)

Income

(6)

Tenants

(7)

Other

(8)

Totals

2016

 

$

-

 

$

275.0

 

$

-

 

$

4.8

 

$

104.3

 

$

0.7

 

$

6.6

 

$

16.8

 

$

408.2

2017

 

-

 

175.0

 

-

 

149.7

 

185.1

 

1.5

 

13.4

 

16.8

 

541.5

2018

 

-

 

350.0

 

70.0

 

15.5

 

166.5

 

1.6

 

13.3

 

-

 

616.9

2019

 

512.0

 

550.0

 

-

 

26.3

 

147.9

 

1.4

 

13.2

 

-

 

1,250.8

2020

 

-

 

-

 

250.0

 

82.4

 

118.3

 

1.4

 

13.0

 

-

 

465.1

Thereafter

 

-

 

2,300.0

 

-

 

210.2

 

452.2

 

23.2

 

119.2

 

-

 

3,104.8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Totals

 

$

512.0

 

$

3,650.0

 

$

320.0

 

$

488.9

 

$

1,174.3

 

$

29.8

 

$

178.7

 

$

33.6

 

$

6,387.3

 

(1)  The initial term of the credit facility expires in June 2019 and includes, at our option, two six-month extensions.

(2)  Excludes non-cash original issuance discounts recorded on the notes payable.  The unamortized balance of the original issuance discounts at June 30, 2016, is $12.6 million. Also excludes deferred financing costs of $17.1 million.

(3)  Excludes deferred financing costs of $1.0 million.

(4)  Excludes non-cash net premiums recorded on the mortgages payable.  The unamortized balance of these net premiums at

June 30, 2016, is $7.9 million. Also excludes deferred financing costs of $442,000.

(5)  Interest on the term loans, notes, bonds, mortgages payable, and credit facility has been calculated based on outstanding balances as of June 30, 2016 through their respective maturity dates.

(6)  Realty Income currently pays the ground lessors directly for the rent under the ground leases.

(7)     Our tenants, who are generally sub-tenants under ground leases, are responsible for paying the rent under these ground leases. In the event a tenant fails to pay the ground lease rent, we are primarily responsible.

(8)  “Other” consists of $32.2 million of commitments under construction contracts and $1.4 million of commitments for tenant improvements and leasing costs.

 

Our credit facility, term loans, and notes payable obligations are unsecured. Accordingly, we have not pledged any assets as collateral for these obligations.

 

Preferred Stock

In February 2012, we issued 14,950,000 shares of our Class F preferred stock at $25.00 per share. In April 2012, we issued an additional 1,400,000 shares of Class F preferred stock at $25.2863 per share. Beginning February 15, 2017, shares of our Class F preferred stock are redeemable at our option for $25.00 per share, plus any accrued and unpaid dividends. Dividends on the shares of our Class F preferred stock are paid monthly in arrears. We are current on our obligations to pay dividends on our Class F preferred stock.

 

No Unconsolidated Investments

We have no unconsolidated investments, nor do we engage in trading activities involving energy or commodity contracts.

 

Dividend Policy

Distributions are paid monthly to holders of shares of our common stock and Class F preferred stock if, and when, declared by our Board of Directors.

 

Distributions are paid monthly to the limited partners holding common units of Tau Operating Partnership, L.P. and Realty Income, L.P., each on a per unit basis that is generally equal to the amount paid per share to our common stockholders.

 

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In order to maintain our status as a REIT for federal income tax purposes, we generally are required to distribute dividends to our stockholders aggregating annually at least 90% of our taxable income (excluding net capital gains), and we are subject to income tax to the extent we distribute less than 100% of our taxable income (including net capital gains). In 2015, our cash distributions to preferred and common stockholders totaled $560.3 million, or approximately 136.9% of our estimated taxable income of $409.4 million. Our estimated taxable income reflects non-cash deductions for depreciation and amortization. Our estimated taxable income is presented to show our compliance with REIT dividend requirements and is not a measure of our liquidity or operating performance.  We intend to continue to make distributions to our stockholders that are sufficient to meet this dividend requirement and that will reduce or eliminate our exposure to income taxes. Furthermore, we believe our funds from operations are sufficient to support our current level of cash distributions to our stockholders. Our cash distributions to common stockholders in the first six months of 2016 totaled $298.6 million, representing 83.7% of our adjusted funds from operations available to common stockholders of $356.8 million. In comparison, our cash distributions to common stockholders in 2015 totaled $533.2 million, representing 82.4% of our adjusted funds from operations available to common stockholders of $647.0 million.

 

The Class F preferred stockholders receive cumulative distributions at a rate of 6.625% per annum on the $25.00 per share liquidation preference (equivalent to $1.65625 per annum per share). Dividends on our Class F preferred stock are current.

 

Future distributions will be at the discretion of our Board of Directors and will depend on, among other things, our results of operations, FFO, AFFO, cash flow from operations, financial condition, capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code of 1986, as amended, or the Code, our debt service requirements, and any other factors the Board of Directors may deem relevant. In addition, our credit facility contains financial covenants that could limit the amount of distributions payable by us in the event of a default, and which prohibit the payment of distributions on the common or preferred stock in the event that we fail to pay when due (subject to any applicable grace period) any principal or interest on borrowings under our credit facility.

 

Distributions of our current and accumulated earnings and profits for federal income tax purposes generally will be taxable to stockholders as ordinary income, except to the extent that we recognize capital gains and declare a capital gains dividend, or that such amounts constitute “qualified dividend income” subject to a reduced rate of tax. The maximum tax rate of non-corporate taxpayers for “qualified dividend income” is generally 20%. In general, dividends payable by REITs are not eligible for the reduced tax rate on qualified dividend income, except to the extent that certain holding requirements have been met with respect to the REIT’s stock and the REIT’s dividends are attributable to dividends received from certain taxable corporations (such as our taxable REIT subsidiaries) or to income that was subject to tax at the corporate or REIT level (for example, if we distribute taxable income that we retained and paid tax on in the prior taxable year).

 

Distributions in excess of earnings and profits generally will first be treated as a non-taxable reduction in the stockholders’ basis in their stock, but not below zero. Distributions in excess of that basis generally will be taxable as a capital gain to stockholders who hold their shares as a capital asset. Approximately 23.8% of the distributions to our common stockholders, made or deemed to have been made in 2015, were classified as a return of capital for federal income tax purposes. We estimate that in 2016, between 15% and 30% of the distributions may be classified as a return of capital.

 

RESULTS OF OPERATIONS

 

Critical Accounting Policies

Our consolidated financial statements have been prepared in accordance with GAAP, and are the basis for our discussion and analysis of financial condition and results of operations. Preparing our consolidated financial statements requires us to make a number of estimates and assumptions that affect the reported amounts and disclosures in the consolidated financial statements. We believe that we have made these estimates and assumptions in an appropriate manner and in a way that accurately reflects our financial condition. We continually test and evaluate these estimates and assumptions using our historical knowledge of the business, as well as other factors, to ensure that they are reasonable for reporting purposes. However, actual results may differ from these estimates and assumptions. This summary should be read in conjunction with the more complete discussion of our accounting policies and procedures included in note 2 to our consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2015.

 

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In order to prepare our consolidated financial statements according to the rules and guidelines set forth by GAAP, many subjective judgments must be made with regard to critical accounting policies. One of these judgments is our estimate for useful lives in determining depreciation expense for our properties. Depreciation on a majority of our buildings and improvements is computed using the straight-line method over an estimated useful life of 25 to 35 years for buildings and 4 to 20 years for improvements, which we believe are appropriate estimates of useful life. If we use a shorter or longer estimated useful life, it could have a material impact on our results of operations.

 

Management must make significant assumptions in determining the fair value of assets acquired and liabilities assumed.  When acquiring a property for investment purposes, we typically allocate the fair value of real estate acquired to: (1) land, (2) building and improvements, and (3) identified intangible assets and liabilities, based in each case on their estimated fair values. Intangible assets and liabilities consist of above-market or below-market lease value of in-place leases, the value of in-place leases, and tenant relationships, as applicable.  In an acquisition of multiple properties, we must also allocate the purchase price among the properties.  The allocation of the purchase price is based on our assessment of estimated fair value and is often based upon the expected future cash flows of the property and various characteristics of the market where the property is located.  In addition, any assumed mortgages receivable or payable and any assumed or issued noncontrolling interests are recorded at their estimated fair values. The estimated fair values of our mortgages payable have been calculated by discounting the future cash flows using applicable interest rates that have been adjusted for factors, such as industry type, tenant investment grade, maturity date, and comparable borrowings for similar assets.  The initial allocation of the purchase price is based on management’s preliminary assessment, which may differ when final information becomes available.  Subsequent adjustments made to the initial purchase price allocation are made within the allocation period, which does not exceed one year.  The use of different assumptions in the allocation of the purchase price of the acquired properties and liabilities assumed could affect the timing of recognition of the related revenue and expenses.

 

Another significant judgment must be made as to if, and when, impairment losses should be taken on our properties when events or a change in circumstances indicate that the carrying amount of the asset may not be recoverable. A provision is made for impairment if estimated future operating cash flows (undiscounted and without interest charges) plus estimated disposition proceeds (undiscounted) are less than the current book value of the property. Key inputs that we utilize in this analysis include projected rental rates, estimated holding periods, historical sales and releases, capital expenditures, and property sales capitalization rates. If a property is held for sale, it is carried at the lower of carrying cost or estimated fair value, less estimated cost to sell. The carrying value of our real estate is the largest component of our consolidated balance sheets. Our strategy of primarily holding properties, long-term, directly decreases the likelihood of their carrying values not being recoverable, thus requiring the recognition of an impairment. However, if our strategy, or one or more of the above assumptions were to change in the future, an impairment may need to be recognized. If events should occur that require us to reduce the carrying value of our real estate by recording provisions for impairment, they could have a material impact on our results of operations.

 

The following is a comparison of our results of operations for the three and six months ended June 30, 2016, to the three and six months ended June 30, 2015.

 

Rental Revenue

 

Rental revenue was $260.1 million for the second quarter of 2016, as compared to $241.4 million for the second quarter of 2015, an increase of $18.7 million, or 7.7%. The increase in rental revenue in the second quarter of 2016 compared to the second quarter of 2015 is primarily attributable to:

 

·

The 128 properties (3.2 million square feet) we acquired in 2016, which generated $6.2 million of rent in the second quarter of 2016;

·

The 254 properties (5.6 million square feet) we acquired in 2015, which generated $20.0 million of rent in the second quarter of 2016, compared to $7.8 million in the second quarter of 2015, an increase of $12.2 million;

·

Same store rents generated on 4,093 properties (67.1 million square feet) during the second quarter of 2016 and 2015, increased by $3.0 million, or 1.4% to $224.4 million from $221.4 million;

·

A net decrease in straight-line rent and other non-cash adjustments to rent of $367,000 in the second quarter of 2016 as compared to the second quarter of 2015;

 

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·

A net decrease of $1.6 million relating to properties sold in the first six months of 2016 and during 2015; and

·

A net decrease of $772,000 relating to the aggregate of (i) rental revenue from properties (133 properties comprising 1.3 million square feet) that were available for lease during part of 2016 or 2015, (ii) rental revenue for 22 properties under development, and (iii) lease termination settlements. In aggregate, the revenues for these items totaled $6.46 million in the second quarter of 2016, compared to $7.23 million in the second quarter of 2015.

 

Rental revenue was $516.9 million for the first six months of 2016, as compared to $476.6 million for the first six months of 2015, an increase of $40.3 million, or 8.5%. The increase in rental revenue in the first six months of 2016 compared to the first six months of 2015 is primarily attributable to:

 

·

The 128 properties (3.2 million square feet) we acquired in the first six months of 2016, which generated $7.3 million of rent in the first six months of 2016;

·

The 254 properties (5.6 million square feet) we acquired in 2015, which generated $40.0 million of rent in the first six months of 2016, compared to $9.4 million in the first six months of 2015, an increase of $30.6 million;

·

Same store rents generated on 4,093 properties (67.1 million square feet) during the first six months of 2016 and 2015, increased by $5.8 million or 1.3%, to $448.5 million from $442.7 million;

·

A net decrease in straight-line rent and other non-cash adjustments to rent of $149,000 in the first six months of 2016 as compared to the first six months of 2015;

·

A net decrease of $3.1 million relating to properties sold in the first six months of 2016 and during 2015 that were reported in continuing operations; and

·

A net decrease of $153,000 relating to the aggregate of (i) rental revenue from properties (133 properties comprising 1.3 million square feet) that were available for lease during part of 2016 or 2015, (ii) rental revenue for 22 properties under development, and (iii) lease termination settlements. In aggregate, the revenues for these items totaled $14.16 million in the first six months of 2016 compared to $14.31 million in the first six months of 2015.

 

For purposes of determining the same store rent property pool disclosed above, we include all properties that were owned for the entire year-to-date period, for both the current and prior year, except for properties during the current or prior year that; (i) were vacant at any time, (ii) were under development or redevelopment, and (iii) were involved in eminent domain and rent was reduced. Each of the exclusions from the same store pool are separately addressed within the applicable sentences above, explaining the changes in rental revenue for the period.

 

Of the 4,646 properties in the portfolio at June 30, 2016, 4,624, or 99.5%, are single-tenant properties and the remaining are multi-tenant properties. Of the 4,624 single-tenant properties, 4,530, or 98.0%, were net leased with a weighted average remaining lease term (excluding rights to extend a lease at the option of the tenant) of 9.8 years at June 30, 2016. Of our 4,530 leased single-tenant properties, 3,996 or 88.2% were under leases that provide for increases in rents through:

 

·                  Base rent increases tied to a consumer price index (typically subject to ceilings);

·                  Percentage rent based on a percentage of the tenants’ gross sales;

·                  Fixed increases; or

·                  A combination of two or more of the above rent provisions.

 

Percentage rent, which is included in rental revenue, was $1.6 million in the second quarter of 2016, and $859,000 in the second quarter of 2015. Percentage rent was $3.2 million in the first six months of 2016, and $2.3 million in the first six months of 2015.  Percentage rent in the first six months of 2016 was less than 1% of rental revenue and we anticipate percentage rent to be less than 1% of rental revenue for the remainder of 2016.

 

Our portfolio of real estate, leased primarily to regional and national tenants under net leases, continues to perform well and provides dependable lease revenue supporting the payment of monthly dividends to our stockholders.  At June 30, 2016, our portfolio of 4,646 properties was 98.0% leased with 95 properties available for lease, as compared to 98.4% leased, with 71 properties available for lease at December 31, 2015, and 98.2% leased with 81 properties available for lease at June 30, 2015. It has been our experience that approximately 1% to 4% of our property portfolio will be unleased at any given time; however, it is possible that the number of properties available for lease could exceed these levels in the future.

 

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Tenant Reimbursements

Contractually obligated reimbursements from tenants for recoverable real estate taxes and operating expenses were $11.1 million in the second quarter of 2016, compared to $11.6 million in the second quarter of 2015, and $20.2 million in the first six months of 2016, compared to $21.6 million in the first six months of 2015.

 

Other Revenue

Other revenue, which comprises property-related revenue not included in rental revenue or tenant reimbursements, was $(129,000) in the second quarter of 2016, compared to $822,000 in the second quarter of 2015, and $1.1 million in the six months ended June 30, 2016, compared to $2.6 million in the same period of 2015. The decrease in the second quarter of 2016 is related to the reclassification of an approximately $1.0 million payment that was received from a tenant in March 2016, initially recorded to other revenue, and subsequently reclassified to rental revenue on our consolidated statement of income during April 2016 based on additional information received regarding the nature of the payment.

 

Depreciation and Amortization

Depreciation and amortization was $110.3 million for the second quarter of 2016, compared to $101.1 million for the second quarter of 2015. Depreciation and amortization was $218.3 million for the first six months of 2016, compared to $199.1 million for the first six months of 2015. The increase in depreciation and amortization in the first six months of 2016 was primarily due to the acquisition of properties in 2015 and the first six months of 2016, which was partially offset by property sales in those same periods.  As discussed in the sections entitled “Funds from Operations Available to Common Stockholders (FFO)” and “Adjusted Funds from Operations Available to Common Stockholders (AFFO),” depreciation and amortization is a non-cash item that is added back to net income available to common stockholders for our calculation of FFO and AFFO.

 

Interest Expense

The following is a summary of the components of our interest expense (dollars in thousands):

 

 

 

Three months ended

 

Six months ended

 

 

 

June 30,

 

June 30,

 

 

 

2016

 

2015

 

2016

 

2015

 

Interest on our credit facility, term loans, notes, mortgages and interest rate swaps

 

$

53,198

 

$

56,828

 

$

106,368

 

$

113,402

 

Credit facility commitment fees

 

758

 

665

 

1,517

 

1,321

 

Amortization of credit facility origination costs and deferred financing costs

 

2,107

 

2,246

 

4,229

 

4,401

 

Loss on interest rate swaps

 

2,109

 

899

 

7,886

 

1,958

 

Amortization of net mortgage premiums

 

(754

)

(1,862

)

(1,855

)

(3,823

)

Capital lease obligation

 

77

 

77

 

155

 

155

 

Interest capitalized

 

(86

)

(173

)

(212

)

(266

)

 

 

 

 

 

 

 

 

 

 

Interest expense

 

$

57,409

 

$

58,680

 

$

118,088

 

$

117,148

 

 

 

 

 

 

 

 

 

 

 

Credit facility, term loans, mortgages and notes

 

 

 

 

 

 

 

 

 

Average outstanding balances (dollars in thousands)

 

$

4,963,248

 

$

5,092,271

 

$

4,909,826

 

$

5,037,516

 

Average interest rates

 

4.20

%

4.43

%

4.24

%

4.47

%

 

The increase in interest expense from the first six months of 2015 to the first six months of 2016 was primarily due to an increase in non-cash losses resulting from fair value adjustments on our interest rate swaps, partially offset by a lower average outstanding debt balance, resulting from the payment of $150.0 million of notes during November 2015, and the payoff of mortgages during 2015 and first six months of 2016. Each quarter we adjust the carrying value of our interest rate swaps to fair value.  Changes in the fair value of our interest rate swaps are recorded to interest expense. We recorded a loss on interest rate swaps of $7.9 million during the first six months of 2016, compared to a loss of $2.0 million during the first six months of 2015.

 

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At June 30, 2016, the weighted average interest rate on our:

 

·

Notes and bonds payable of $3.65 billion (excluding unamortized original issuance discounts of $12.6 million and deferred financing costs of $17.1 million) was 4.7%;

·

Mortgages payable of $488.9 million (excluding net premiums totaling $7.9 million and deferred financing costs of $442,000 on these mortgages) was 5.0%;

·

Credit facility outstanding borrowings of $512.0 million was 1.5%;

·

Term loans outstanding borrowings of $320.0 million (excluding deferred financing costs of $1.0 million) was 1.5%; and

·

Combined outstanding notes, bonds, mortgages, term loan and credit facility borrowings of $4.97 billion was 4.2%.

 

General and Administrative Expenses

General and administrative expenses increased by $1.4 million to $14.0 million in the second quarter of 2016, compared to $12.6 million in the second quarter of 2015. Included in general and administrative expenses are acquisition transaction costs of $61,000 in the second quarter of 2016 and $205,000 in the second quarter of 2015. General and administrative expenses increased by $833,000 to $26.3 million for the first six months of 2016, compared to $25.5 million in the first six months of 2015.  Included in general and administrative expenses are acquisition transaction costs of $85,000 for the first six months of 2016 and $298,000 for the first six months of 2015. General and administrative costs increased during the first six months of 2016 primarily due to higher stock compensation costs. In July 2016, we had 133 employees, as compared to 127 employees in July 2015.

 

 

 

Three months ended

 

Six months ended

 

 

 

June 30,

 

June 30,

 

Dollars in thousands