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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 March 31, 2017, 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

 

Emerging growth company  o

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  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 273,059,276 shares of common stock outstanding as of April 20, 2017.

 



Table of Contents

 

 

REALTY INCOME CORPORATION

 

Index to Form 10-Q

 

 

 

March 31, 2017

 

 

 

 

 

 

 

 

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

18

 

The Company

19

 

Recent Developments

22

 

Liquidity and Capital Resources

25

 

Results of Operations

30

 

Funds from Operations Available to Common Stockholders (FFO)

36

 

Adjusted Funds from Operations Available to Common Stockholders (AFFO)

37

 

Property Portfolio Information

38

 

Impact of Inflation

45

 

Impact of Recent Accounting Pronouncements

45

 

Other Information

45

Item 3:

Quantitative and Qualitative Disclosures About Market Risk

46

Item 4:

Controls and Procedures

47

PART II.

OTHER INFORMATION

 

Item 2:

Unregistered Sales of Equity Securities and Use of Proceeds

48

Item 6:

Exhibits

48

SIGNATURE

 

51

 

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PART 1. FINANCIAL INFORMATION

Item 1.   Financial Statements

 

REALTY INCOME CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

March 31, 2017 and December 31, 2016

(dollars in thousands, except per share data)

 

 

 

2017

 

2016

 

ASSETS

 

(unaudited)

 

 

 

Real estate, at cost:

 

 

 

 

 

Land

 

$

3,832,452

 

$

3,752,204

 

Buildings and improvements

 

10,327,309

 

10,112,212

 

Total real estate, at cost

 

14,159,761

 

13,864,416

 

Less accumulated depreciation and amortization

 

(2,075,711

)

(1,987,200

)

Net real estate held for investment

 

12,084,050

 

11,877,216

 

Real estate held for sale, net

 

11,790

 

26,575

 

Net real estate

 

12,095,840

 

11,903,791

 

Cash and cash equivalents

 

27,598

 

9,420

 

Accounts receivable, net

 

103,759

 

104,584

 

Acquired lease intangible assets, net

 

1,108,096

 

1,082,320

 

Goodwill

 

15,036

 

15,067

 

Other assets, net

 

71,857

 

37,689

 

Total assets

 

$

13,422,186

 

$

13,152,871

 

 

 

 

 

 

 

LIABILITIES AND EQUITY

 

 

 

 

 

Distributions payable

 

$

57,885

 

$

55,235

 

Accounts payable and accrued expenses

 

86,638

 

121,156

 

Acquired lease intangible liabilities, net

 

268,486

 

264,206

 

Other liabilities

 

122,078

 

85,616

 

Preferred shares subject to mandatory redemption

 

408,750

 

-

 

Line of credit payable

 

-

 

1,120,000

 

Term loans, net

 

319,200

 

319,127

 

Mortgages payable, net

 

463,332

 

466,045

 

Notes payable, net

 

4,641,094

 

3,934,433

 

Total liabilities

 

6,367,463

 

6,365,818

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock and paid in capital, par value $0.01 per share, 69,900,000 shares authorized, no shares issued and outstanding as of March 31, 2017 and 16,350,000 issued and outstanding as of December 31, 2016, liquidation preference $25.00 per share

 

-

 

395,378

 

Common stock and paid in capital, par value $0.01 per share, 370,100,000 shares authorized, 273,051,486 shares issued and outstanding as of March 31, 2017 and 260,168,259 shares issued and outstanding as of December 31, 2016

 

8,987,933

 

8,228,594

 

Distributions in excess of net income

 

(1,952,990

)

(1,857,168

)

Total stockholders’ equity

 

7,034,943

 

6,766,804

 

Noncontrolling interests

 

19,780

 

20,249

 

Total equity

 

7,054,723

 

6,787,053

 

Total liabilities and equity

 

$

13,422,186

 

$

13,152,871

 

 

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

 

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REALTY INCOME CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

For the three months ended March 31, 2017 and 2016

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

 

 

 

Three months ended

 

 

 

March 31,

 

 

 

2017

 

2016

 

REVENUE

 

 

 

 

 

Rental

 

$

285,821

 

$

256,801

 

Tenant reimbursements

 

11,229

 

9,105

 

Other

 

975

 

1,210

 

Total revenue

 

298,025

 

267,116

 

 

 

 

 

 

 

EXPENSES

 

 

 

 

 

Depreciation and amortization

 

121,097

 

107,933

 

Interest

 

59,305

 

60,678

 

General and administrative

 

13,565

 

12,318

 

Property (including reimbursable)

 

19,075

 

15,105

 

Income taxes

 

1,047

 

964

 

Provisions for impairment

 

5,433

 

1,923

 

Total expenses

 

219,522

 

198,921

 

Gain on sales of real estate

 

10,532

 

2,289

 

Net income

 

89,035

 

70,484

 

Net income attributable to noncontrolling interests

 

(165

)

(241

)

Net income attributable to the Company

 

88,870

 

70,243

 

Preferred stock dividends

 

(3,911

)

(6,770

)

Excess of redemption value over carrying value of preferred shares redeemed

 

(13,373

)

-

 

Net income available to common stockholders

 

$

71,586

 

$

63,473

 

 

 

 

 

 

 

Amounts available to common stockholders per common share:

 

 

 

 

 

Net income, basic and diluted

 

$

0.27

 

$

0.25

 

 

 

 

 

 

 

Weighted average common shares outstanding:

 

 

 

 

 

Basic

 

263,340,491

 

250,173,815

 

Diluted

 

263,934,304

 

250,698,023

 

 

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

 

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REALTY INCOME CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the three months ended March 31, 2017 and 2016

(dollars in thousands) (unaudited)

 

 

 

2017

 

2016

 

CASH FLOWS FROM OPERATING ACTIVITIES

 

 

 

 

 

Net income

 

$

89,035

 

$

70,484

 

Adjustments to net income:

 

 

 

 

 

Depreciation and amortization

 

121,097

 

107,933

 

Amortization of share-based compensation

 

2,753

 

2,605

 

Non-cash revenue adjustments

 

(1,343

)

(3,099

)

Amortization of net premiums on mortgages payable

 

(630

)

(1,101

)

Amortization of deferred financing costs

 

2,390

 

2,200

 

(Gain) loss on interest rate swaps

 

(1,330

)

5,778

 

Gain on sales of real estate

 

(10,532

)

(2,289

)

Provisions for impairment on real estate

 

5,433

 

1,923

 

Change in assets and liabilities

 

 

 

 

 

Accounts receivable and other assets

 

139

 

5,081

 

Accounts payable, accrued expenses and other liabilities

 

6,119

 

(53,225

)

Net cash provided by operating activities

 

213,131

 

136,290

 

CASH FLOWS FROM INVESTING ACTIVITIES

 

 

 

 

 

Investment in real estate

 

(374,573

)

(313,169

)

Improvements to real estate, including leasing costs

 

(3,749

)

(902

)

Proceeds from sales of real estate

 

31,232

 

11,038

 

Collection of loans receivable

 

30

 

12,428

 

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

 

(18,252

)

(4,088

)

Net cash used in investing activities

 

(365,312

)

(294,693

)

CASH FLOWS FROM FINANCING ACTIVITIES

 

 

 

 

 

Cash distributions to common stockholders

 

(162,506

)

(147,345

)

Cash dividends to preferred stockholders

 

(6,168

)

(6,770

)

Borrowings on line of credit

 

79,000

 

1,209,000

 

Payments on line of credit

 

(1,199,000

)

(794,000

)

Proceeds from notes and bonds payable issued

 

711,812

 

-

 

Principal payments on mortgages payable

 

(2,120

)

(164,339

)

Proceeds from common stock offerings, net

 

705,012

 

-

 

Proceeds from dividend reinvestment and stock purchase plan

 

56,991

 

3,512

 

Proceeds from At-the-Market (ATM) program

 

-

 

30,547

 

Distributions to noncontrolling interests

 

(631

)

(382

)

Debt issuance costs

 

(6,614

)

-

 

Other items, including shares withheld upon vesting

 

(5,417

)

(3,419

)

Net cash provided by financing activities

 

170,359

 

126,804

 

Net increase (decrease) in cash and cash equivalents

 

18,178

 

(31,599

)

Cash and cash equivalents, beginning of period

 

9,420

 

40,294

 

Cash and cash equivalents, end of period

 

$

27,598

 

$

8,695

 

 

For supplemental disclosures, see note 17.

 

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

 

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REALTY INCOME CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2017

(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, 2016, which are included in our 2016 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 March 31, 2017, we owned 4,980 properties, located in 49 states and Puerto Rico, containing over 84.0 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 11).  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 and its subsidiaries 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 $2.1 million at March 31, 2017 and $74,000 at December 31, 2016.

 

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.

 

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. The standard permits the use of either the retrospective or cumulative effect transition method. We plan to use the cumulative effect transition method upon adoption of the standard on January 1, 2018, and do not expect this topic to have a material impact on our consolidated financial statements or the related notes.

 

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

 

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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 may have on our consolidated financial statements.

 

In January 2017, FASB issued ASU 2017-01, which amends Topic 805, Business Combinations. FASB issued this ASU to clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The ASU is effective for interim and annual periods beginning after December 15, 2017. We have not yet adopted this topic and are currently evaluating the impact this amendment may have 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

 

March 31,

 

December 31,

 

(dollars in thousands) at:

 

2017

 

2016

 

Acquired in-place leases

 

$

1,210,506

 

$

1,164,075

 

Accumulated amortization of acquired in-place leases

 

(382,307

)

(358,040

)

Acquired above-market leases

 

375,724

 

365,005

 

Accumulated amortization of acquired above-market leases

 

(95,827

)

(88,720

)

 

 

$

1,108,096

 

$

1,082,320

 

 

 

 

 

March 31,

 

December 31,

 

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

 

2017

 

2016

 

Restricted escrow deposits

 

25,327

 

4,246

 

Prepaid expenses

 

16,910

 

14,406

 

Insurance proceeds receivable

 

10,641

 

300

 

Credit facility origination costs, net

 

6,563

 

7,303

 

Notes receivable issued in connection with property sales

 

5,360

 

5,390

 

Corporate assets, net

 

4,864

 

3,585

 

Impounds related to mortgages payable

 

2,074

 

2,015

 

Other items

 

118

 

444

 

 

 

$

71,857

 

$

37,689

 

 

 

 

 

 

 

C.   Distributions payable consist of the following declared

 

March 31,

 

December 31,

 

distributions (dollars in thousands) at:

 

2017

 

2016

 

Common stock distributions

 

$

57,799

 

$

52,896

 

Preferred stock dividends

 

-

 

2,257

 

Noncontrolling interests distributions

 

86

 

82

 

 

 

$

57,885

 

$

55,235

 

 

D.   Accounts payable and accrued expenses consist of the

 

March 31,

 

December 31,

 

following (dollars in thousands) at:

 

2017

 

2016

 

Notes payable - interest payable

 

$

42,223

 

$

60,668

 

Property taxes payable

 

13,352

 

16,949

 

Accrued costs on properties under development

 

5,163

 

9,049

 

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

 

3,182

 

5,432

 

Shares subject to mandatory redemption - interest payable

 

1,655

 

-

 

Other items

 

21,063

 

29,058

 

 

 

$

86,638

 

$

121,156

 

 

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

 

March 31,

 

December 31,

 

following (dollars in thousands) at:

 

2017

 

2016

 

Acquired below-market leases

 

$

327,697

 

$

318,926

 

Accumulated amortization of acquired below-market leases

 

(59,211

)

(54,720

)

 

 

$

268,486

 

$

264,206

 

 

 

 

 

 

 

 

 

 

 

 

 

F.   Other liabilities consist of the following

 

March 31,

 

December 31,

 

(dollars in thousands) at:

 

2017

 

2016

 

Rent received in advance and other deferred revenue (1)

 

$

110,468

 

$

74,098

 

Security deposits

 

6,516

 

6,502

 

Capital lease obligations

 

5,094

 

5,016

 

 

 

$

122,078

 

$

85,616

 

 

 

(1) In connection with Diageo’s sale of its wine business to Treasury Wine Estates, we agreed to release Diageo from its guarantee of our leases in exchange for Diageo’s payment of $75 million of additional rent to us.  The additional rent was paid in two equal installments, one of which was received in August 2016 for $37.5 million and was recorded as prepaid rent.  The final payment of $37.5 million was received in January 2017, at which time Treasury Wine Estates became the guarantor of our leases on those properties.  We have accounted for this transaction as a lease modification and the additional rent will be recognized on a straight-line basis over the remaining lease terms of approximately 15 years.

 

4.                           Investments in Real Estate

 

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

 

A.           Acquisitions During the First Three Months of 2017 and 2016

During the first three months of 2017, we invested $370.7 million in 60 new properties and properties under development or expansion with an initial weighted average contractual lease rate of 6.1%. The 60 new properties and properties under development or expansion are located in 18 states, will contain approximately 1.5 million leasable square feet, and are 100% leased with a weighted average lease term of 16.4 years. The tenants occupying the new properties operate in 13 industries and the property types consist of 98.7% retail and 1.3% industrial, based on rental revenue.  None of our investments during 2017 caused any one tenant to be 10% or more of our total assets at March 31, 2017.

 

The $370.7 million invested during the first three months of 2017 was allocated as follows: $108.7 million to land, $209.5 million to buildings and improvements, $53.9 million to intangible assets related to leases, and  $1.4 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 three months of 2017 generated total revenues of $688,000 and net income of $217,000.

 

Of the $370.7 million we invested during the first three months of 2017, $365.7 million of the purchase price allocation is based on a preliminary measurement of fair value and is subject to change. Additionally, $351.6 million invested in the fourth quarter of 2016 is based on a preliminary measurement of fair value and 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 2017. During the first three months of 2017, we finalized the purchase price allocations for $417.9 million invested in the fourth quarter of 2016. 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 three months of 2016, we invested $352.6 million in 103 new properties and properties under development or expansion with an initial weighted average contractual lease rate of 6.6%. The 103 new properties and properties under development or expansion are located in 31 states, contain approximately 1.7 million leasable square feet, and are 100% leased with a weighted average lease term of 15.8 years. The tenants occupying the new properties operate in 18 industries and the property types consisted of 85.7% retail and 14.3% industrial, based on rental revenue.

 

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The $352.6 million invested during the first three months of 2016 was allocated as follows: $102.2 million to land, $243.1 million to buildings and improvements, $10.0 million to intangible assets related to leases, and  $2.0 million to intangible liabilities related to leases and other assumed liabilities. We also recorded mortgage premiums of $692,000. There was no contingent consideration associated with these acquisitions.

 

The properties acquired during the first three months of 2016 generated total revenues of $1.1 million and net income of $408,000 for the three months ended March 31, 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 $370.7 million we invested during the first three months of 2017, $5.0 million was invested in nine properties under development or expansion with an estimated initial weighted average contractual lease rate of 7.7%. Of the $352.6 million we invested during the first three months of 2016, $52.1 million was invested in 23 properties under development or expansion with an estimated initial weighted average contractual lease rate of 6.8%.

 

B.           Acquisition Transaction Costs

Acquisition transaction costs of $131,000 and $24,000 were recorded to general and administrative expense on our consolidated statements of income during the first three months of 2017 and 2016, respectively.

 

C.           Investments in Existing Properties

During the first three months of 2017, we capitalized costs of $3.4 million on existing properties in our portfolio, consisting of $410,000 for re-leasing costs, $341,000 for recurring capital expenditures and $2.6 million for non-recurring building improvements. In comparison, during the first three months of 2016, we capitalized costs of $1.3 million on existing properties in our portfolio, consisting of $191,000 for re-leasing costs, $72,000 for recurring capital expenditures and $1.0 million for non-recurring building improvements.

 

D.          Properties with Existing Leases

Of the $370.7 million we invested during the first three months of 2017, approximately $321.7 million was used to acquire 35 properties with existing leases.  In comparison, of the $352.6 million we invested during the first three months of 2016, approximately $26.8 million was used to acquire four 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 three months of 2017 and 2016 were $24.8 million and $22.6 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 three months of 2017 and 2016 were $2.4 million and $2.1 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 at March 31, 2017 (in thousands):

 

 

 

Net increase

 

Increase to

 

 

 

(decrease) to

 

amortization

 

 

 

rental revenue

 

expense

 

2017

 

$

(7,724

)

$

75,038

 

2018

 

(10,063

)

97,739

 

2019

 

(9,084

)

87,481

 

2020

 

(8,315

)

81,997

 

2021

 

(7,038

)

73,768

 

Thereafter

 

30,813

 

412,176

 

Totals

 

$

(11,411

)

$

828,199

 

 

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 March 31, 2017 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 and may change if our investment grade credit ratings change. 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 March 31, 2017, credit facility origination costs of $6.6 million are included in other assets, net on our consolidated balance sheet. These costs are being amortized over the remaining term of our credit facility.

 

At March 31, 2017, we had a borrowing capacity of $2.0 billion available on our credit facility (subject to customary conditions to borrowing) and no outstanding balance, as compared to an outstanding balance of $1.12 billion at December 31, 2016.

 

The weighted average interest rate on outstanding borrowings under our credit facility was 1.7% during the first three months of 2017 and 1.5% during the first three months of 2016. Our credit facility is subject to various leverage and interest coverage ratio limitations, and at March 31, 2017, we were 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 2018.  Borrowing under this term loan bears interest at the current one-month LIBOR, plus 1.20%.  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 $800,000 at March 31, 2017, and $873,000 at December 31, 2016, is included within term loans, net on our consolidated balance sheets.

 

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7.     Mortgages Payable

 

During the first three months of 2017, we made $2.1 million in principal payments. No mortgages were assumed during the first three months of 2017.

 

During the first three months of 2016, we made $164.3 million in principal payments, including the repayment of seven mortgages in full for $146.7 million. Additionally, we assumed mortgages totaling $32.5 million, excluding net premiums. During the first three 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.

 

Our 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 March 31, 2017, we remain in compliance with these covenants.

 

The balance of our deferred financing costs, which are classified as part of mortgages payable, net, on our consolidated balance sheets, was $286,000 at March 31, 2017 and $324,000 at December 31, 2016. These costs are being amortized over the remaining term of each mortgage.

 

The following is a summary of all our mortgages payable as of March 31, 2017 and December 31, 2016, 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

 

3/31/17

 

127

 

4.9%

 

4.3%

 

3.7

 

$

457,888

 

$

5,444

 

$

463,332

 

12/31/16

 

127

 

4.9%

 

4.3%

 

4.0

 

$

460,008

 

$

6,037

 

$

466,045

 

 

(1) At March 31, 2017 and December 31, 2016, there were 36 mortgages on 127 properties. The mortgages require monthly payments with principal payments due at maturity. The mortgages are at fixed interest rates, except for six mortgages on 15 properties totaling $74.0 million at March 31, 2017 and December 31, 2016, including net unamortized discounts. After factoring in arrangements which limit our exposure to interest rate risk and effectively fix our per annum interest rates, our mortgage debt subject to variable rates totals $38.2 million at March 31, 2017 and December 31, 2016.

(2) Stated interest rates ranged from 2.6% to 6.9% at March 31, 2017, while stated interest rates ranged from 2.4% to 6.9% at December 31, 2016.

(3) Effective interest rates ranged from 2.8% to 8.7% at March 31, 2017, while effective interest rates ranged from 2.5% to 8.8% at December 31, 2016.

 

The following table summarizes the maturity of mortgages payable, excluding net premiums of $5.7 million and deferred finance costs of $286,000, as of March 31, 2017 (dollars in millions):

 

Year of Maturity

 

Principal

 

2017

 

$

101.1

 

2018

 

21.9

 

2019

 

42.3

 

2020

 

82.4

 

2021

 

66.9

 

Thereafter

 

143.3

 

Totals

 

$

457.9

 

 

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8.                           Notes Payable

 

A. General

 

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

 

 

 

March 31,

 

December 31,

 

 

 

2017

 

2016

 

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, $250 issued in September 2014 and $400 issued in March 2017, all of which are due in October 2026

 

650

 

250

 

3.000% notes, issued in October 2016 and due in January 2027

 

600

 

600

 

5.875% bonds, $100 issued in March 2005 and $150 issued in June 2011, all of which are due in March 2035

 

250

 

250

 

4.650% notes, issued in March 2017 and due in March 2047

 

300

 

-

 

Total principal amount

 

4,675

 

3,975

 

Unamortized original issuance discounts and deferred financing costs

 

(34

)

(41

)

 

 

$

4,641

 

$

3,934

 

 

The following table summarizes the maturity of our notes and bonds payable as of March 31, 2017, excluding unamortized original issuance discounts and deferred financing costs (dollars in millions):

 

Year of Maturity

 

Principal

 

2017

 

$

175

 

2018

 

350

 

2019

 

550

 

2020

 

-

 

2021

 

250

 

Thereafter

 

3,350

 

Totals

 

$

4,675

 

 

As of March 31, 2017, the weighted average interest rate on our notes and bonds payable was 4.4% and the weighted average remaining years until maturity was 8.1 years.

 

B. Note Issuances

In March 2017, we issued $300 million of 4.650% senior unsecured notes due 2047, or the 2047 Notes, and $400 million of 4.125% senior unsecured notes due 2026, or the 2026 Notes. The public offering price for the 2047 Notes was 99.97% of the principal amount for an effective yield to maturity of 4.65%. The public offering price for the 2026 Notes was 102.98% of the principal amount for an effective yield to maturity of 3.75%. The 2026 Notes constituted a further issuance of, and formed a single series with, the $250 million aggregate principal amount of senior notes due 2026, issued in September 2014. The net proceeds of approximately $705.2 million from the offerings were used to repay borrowings outstanding under our credit facility to fund investment opportunities, and for other general corporate purposes.

 

9.     Redemption of Preferred Stock

 

In March 2017, we issued an irrevocable notice of redemption for all 16,350,000 shares of our 6.625% Monthly Income Class F Preferred Stock for $25 per share, plus accrued dividends. The redemption occurred in        April 2017. The issuance of the redemption notice prior to the end of the quarter required us to reclassify  $408.8 million of preferred stock from stockholders’ equity to liabilities on our consolidated balance sheet at March 31, 2017. These shares subject to mandatory redemption are presented at fair value. We incurred a charge of $13.4 million, representing the Class F preferred stock original issuance costs that we paid in 2012.

 

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10.     Equity

 

A.   Issuance of Common Stock

In March 2017, we issued 11,850,000 shares of common stock.  After underwriting discounts and other offering costs of $29.7 million, the net proceeds of $705.0 million were used to repay borrowings under our credit facility.

 

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. Our 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 three months of 2017, we issued 966,557 shares and raised approximately $57.0 million under the DRSPP.  During the first three months of 2016, we issued 61,458 shares and raised approximately $3.5 million under the DRSPP.  From the inception of the DRSPP through March 31, 2017, we have issued 13,836,446 shares and raised approximately $650.2 million.

 

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 three months of 2017, we issued 927,695 shares and raised $54.7 million under the waiver approval process. We did not issue shares under the waiver approval process during the first three months of 2016.

 

C.           At-the-Market (ATM) Program

Through our “at-the-market” equity distribution program, or our ATM program, 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. We did not issue any shares under the ATM program during the first three months of 2017.  During the first three months of 2016, we issued 500,000 shares and raised approximately $30.5 million under the ATM program. From the inception of our ATM program through March 31, 2017, we have issued 3,493,441 shares and raised $203.1 million.

 

11.     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 March 31, 2017, the remaining units from this issuance represent a 0.4% ownership in Realty Income, L.P.  We hold the remaining 99.6% interests in this entity and consolidate the entity.

 

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.

 

In 2016, we completed the acquisition of two properties by acquiring a controlling interest in two separate joint ventures. We are the managing member of each of these joint ventures, and possess the ability to control the business and manage the affairs of these entities. At March 31, 2017, we and our subsidiaries held 92.4% and 74% interests, respectively, and fully consolidated these entities in our consolidated financial statements.

 

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The following table represents the change in the carrying value of all noncontrolling interests through March 31, 2017 (dollars in thousands):

 

 

 

Tau Operating

 

Realty Income, L.P.

 

Other Noncontrolling

 

 

 

 

 

Partnership units(1)

 

units(2)

 

Interests

 

Total

 

Carrying value at December 31, 2016

 

  $

13,405

 

$

2,216

 

$

4,628

 

$

20,249

 

Distributions

 

(200

)

(56

)

(378

)

(634

)

Allocation of net income

 

65

 

64

 

36

 

165

 

Carrying value at March 31, 2017

 

  $

13,270

 

$

2,224

 

4,286

 

$

19,780

 

 

(1)     317,022 Tau Operating Partnership units were issued on January 22, 2013 and remained outstanding as of March 31, 2017 and December 31, 2016.

(2)     534,546 Realty Income, L.P. units were issued on June 27, 2013, and 88,182 remain outstanding as of March 31, 2017 and December 31, 2016.

 

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.  These conclusions did not result in changes to our historical accounting for these partnerships.  Below is a summary of selected financial data of consolidated VIEs, including the joint ventures acquired during 2016, for which we are the primary beneficiary included in the consolidated balance sheets at March 31, 2017 and December 31, 2016 (in thousands):

 

 

 

March 31, 2017

 

December 31, 2016

 

Net real estate

 

$

2,996,473

 

$

3,040,903

 

Total assets

 

3,464,114

 

3,499,481

 

Total debt

 

250,002

 

251,047

 

Total liabilities

 

355,600

 

364,797

 

 

12.                    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 March 31, 2017

 

balance sheet

 

value

 

Notes receivable issued in connection with property sales

 

$

5.4

 

$

5.5

 

Mortgages payable assumed in connection with acquisitions, net

 

463.3

 

465.9

 

Notes and bonds payable, net

 

4,641.1

 

4,845.8

 

 

 

 

 

 

 

 

 

Carrying value per

 

Estimated fair

 

At December 31, 2016

 

balance sheet

 

value

 

Notes receivable issued in connection with property sales

 

$

5.4

 

$

5.5

 

Mortgages payable assumed in connection with acquisitions, net

 

466.0

 

468.7

 

Notes and bonds payable, net

 

3,934.4

 

4,143.3

 

 

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.

 

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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 March 31, 2017, interest rate swaps in a liability position valued at $1.0 million were included in accounts payable and accrued expenses and interest rate swaps in an asset position valued at $210,000 were included in other assets, net 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.

 

13.                    Gain on Sales of Real Estate

 

During the first three months of 2017, we sold 14 properties for $31.2 million, which resulted in a gain of $10.5 million. During the first three months of 2016, we sold 11 properties for $11.0 million, which resulted in a gain of $2.3 million.

 

14.                    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.

 

For the first three months of 2017, we recorded total provisions for impairment of $5.4 million on five properties classified as held for sale, three properties classified as held for investment, and one sold property in a total of five industries. For the first three months of 2016, we recorded total provisions for impairment of $1.9 million on eight sold properties in a total of seven industries.

 

15.                    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 three months of 2017 and 2016:

 

Month

 

2017

 

2016

 

January

 

$

0.2025

 

$

0.1910

 

February

 

0.2105

 

0.1985

 

March

 

0.2105

 

0.1985

 

 

 

 

 

 

 

Total

 

$

0.6235

 

$

0.5880

 

 

At March 31, 2017, a distribution of $0.211 per common share was payable and was paid in April 2017.

 

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B.                         Class F Preferred Stock

Prior to the notice of redemption of the Class F preferred stock in March 2017, dividends of $0.101215 per share were paid monthly in arrears on the Class F preferred stock.  During each of the first three months of 2017 and 2016, we paid three monthly dividends to holders of our Class F preferred stock totaling $0.414063 per share, or    $3.9 million, and $6.8 million, respectively, and at March 31, 2017, a final monthly dividend of $0.101215 per share was payable and was paid in April 2017. As discussed in note 9, during April 2017 we redeemed all 16,350,000 shares for $25 per share, plus accrued dividends. Dividends that accrued subsequent to the March 2017 notice of redemption date for the Class F preferred stock were recorded to interest expense.

 

16.            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.

 

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

 

 

March 31,

 

 

2017

 

2016

 

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

 

263,340,491

 

250,173,815

 

Incremental shares from share-based compensation

 

276,791

 

207,186

 

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

 

317,022

 

317,022

 

Weighted average shares used for diluted net income per share computation

 

263,934,304

 

250,698,023

 

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

 

58,887

 

400

 

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

 

88,182

 

330,045

 

 

17.                    Supplemental Disclosures of Cash Flow Information

 

Cash paid for interest was $75.6 million in the first three months of 2017 and $84.1 million in the first three months of 2016.

 

Interest capitalized to properties under development was $190,000 in the first three months of 2017 and $126,000 the first three months of 2016.

 

Cash paid for income taxes was $2.5 million in the first three months of 2017 and $1.6 million the first three months of 2016.

 

The following non-cash activities are included in the accompanying consolidated financial statements:

 

A.                         During the first three months of 2017, we removed the net book value of two damaged buildings from our consolidated balance sheet, and recorded net receivables of  $10.6 million in anticipation of receiving insurance proceeds for these properties.

 

B.                         During the first three months of 2016, we assumed mortgages payable to third-party lenders of $32.5 million, and recorded $692,000 of net premiums.

 

18.                    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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Table of Contents

 

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):

 

 

 

March 31,

 

December 31,

 

Assets, as of:

 

2017

 

2016

 

Segment net real estate:

 

 

 

 

 

Apparel

 

$    173,999

 

$          175,418

 

Automotive service

 

205,607

 

152,220

 

Automotive tire services

 

251,650

 

238,151

 

Beverages

 

292,377

 

293,447

 

Child care

 

48,604

 

49,584

 

Convenience stores

 

1,041,436

 

1,050,285

 

Dollar stores

 

1,111,511

 

1,120,896

 

Drug stores

 

1,529,785

 

1,541,846

 

Financial services

 

403,931

 

408,228

 

General merchandise

 

247,193

 

248,040

 

Grocery stores

 

679,524

 

464,359

 

Health and fitness

 

807,317

 

823,697

 

Home improvement

 

309,905

 

311,459

 

Motor vehicle dealerships

 

209,588

 

197,713

 

Restaurants-casual dining

 

499,380

 

511,863

 

Restaurants-quick service

 

571,215

 

574,532

 

Theaters

 

365,757

 

370,732

 

Transportation services

 

791,483

 

796,717

 

Wholesale club

 

436,306

 

439,557

 

28 other non-reportable segments

 

2,119,272

 

2,135,047

 

Total segment net real estate

 

12,095,840

 

11,903,791

 

 

 

 

 

 

 

Intangible assets:

 

 

 

 

 

Apparel

 

42,704

 

43,786

 

Automotive service

 

36,905

 

33,160

 

Automotive tire services

 

11,115

 

11,533

 

Beverages

 

2,216

 

2,280

 

Convenience stores

 

14,004

 

14,372

 

Dollar stores

 

49,853

 

51,249

 

Drug stores

 

179,784

 

182,981

 

Financial services

 

28,551

 

29,749

 

General merchandise

 

43,975

 

43,248

 

Grocery stores

 

102,491

 

65,412

 

Health and fitness

 

62,202

 

63,574

 

Home improvement

 

47,434

 

49,932

 

Motor vehicle dealerships

 

34,412

 

25,032

 

Restaurants-casual dining

 

21,563

 

22,058

 

Restaurants-quick service

 

42,606

 

43,356

 

Theaters

 

12,860

 

13,822

 

Transportation services

 

98,001

 

101,664

 

Wholesale club

 

31,941

 

32,723

 

Other non-reportable segments

 

245,479

 

252,389

 

 

 

 

 

 

 

Goodwill:

 

 

 

 

 

Automotive service

 

439

 

440

 

Automotive tire services

 

862

 

862

 

Child care

 

4,945

 

4,945

 

Convenience stores

 

2,004

 

2,008

 

Restaurants-casual dining

 

2,094

 

2,107

 

Restaurants-quick service

 

1,068

 

1,068

 

Other non-reportable segments

 

3,624

 

3,637

 

Other corporate assets

 

203,214

 

151,693

 

Total assets

 

$13,422,186

 

$     13,152,871

 

 

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Revenue for the three months ended March 31,

 

2017

 

2016

 

Segment rental revenue:

 

 

 

 

 

Apparel

 

$       4,966

 

$       4,875

 

Automotive service

 

5,543

 

4,677

 

Automotive tire services

 

7,159

 

7,264

 

Beverages

 

7,758

 

6,404

 

Child care

 

5,487

 

5,092

 

Convenience stores

 

28,303

 

22,864

 

Dollar stores

 

22,752

 

22,595

 

Drug stores

 

31,631

 

28,421

 

Financial services

 

7,159

 

4,313

 

General merchandise

 

5,361

 

4,259

 

Grocery stores

 

10,162

 

7,645

 

Health and fitness

 

21,605

 

21,304

 

Home improvement

 

6,919

 

6,054

 

Motor vehicle dealerships

 

6,736

 

4,214

 

Restaurants-casual dining

 

10,890

 

9,835

 

Restaurants-quick service

 

14,336

 

12,794

 

Theaters

 

13,344

 

13,449

 

Transportation services

 

15,388

 

13,091

 

Wholesale club

 

9,413

 

9,370

 

28 other non-reportable segments

 

50,909

 

48,281

 

Total rental revenue

 

285,821

 

256,801

 

Tenant reimbursements

 

11,229

 

9,105

 

Other revenue

 

975

 

1,210

 

Total revenue

 

$   298,025

 

$   267,116

 

 

19.                    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 $2.8 million during the first three months of 2017 and $2.6 million during the first three months of 2016.

 

A.   Restricted Stock

 

During the first three months of 2017, we granted 114,118 shares of common stock under the 2012 Plan. 72,626 of these shares vest over a four-year service period, and the remaining 41,492 shares vest over a five-year service period.

 

As of March 31, 2017, the remaining unamortized share-based compensation expense related to restricted stock totaled $23.8 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 three months of 2017, we granted 111,637 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 and peer groups 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 three months of 2017, we also granted 10,191 restricted stock units of which 6,161 vest over a four-year service period, and the remaining 4,030 vest over a five-year service period. These restricted stock units have the same economic rights as shares of restricted stock.

 

As of March 31, 2017, the remaining share-based compensation expense related to the performance shares and restricted stock units totaled $12.5 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.

 

20.                    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 March 31, 2017, we had commitments of $5.0 million for re-leasing costs, recurring capital expenditures, and non-recurring building improvements. In addition, as of March 31, 2017, we had committed $67.1 million under construction contracts, which is expected to be paid in the next twelve months.

 

21.                    Subsequent Events

 

In April 2017, we declared a dividend of $0.211 per share to our common stockholders, which will be paid in May 2017.

 

 

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.

 

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:

 

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·                  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, 2016.

 

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 company dedicated to providing stockholders with dependable monthly dividends that increase over time.  The company is structured as a real estate investment trust, or REIT, requiring it annually to distribute at least 90% of its taxable income (excluding net capital gains) in the form of dividends to its stockholders.  The monthly dividends are supported by the cash flow generated from real estate owned under long-term, net lease agreements with regional and national commercial tenants.  The company has in-house acquisition, portfolio management, asset management, real estate research, credit research, legal, finance and accounting, information technology, and capital markets capabilities.

 

Realty Income was founded in 1969, and listed on the New York Stock Exchange (NYSE: O) in 1994.  Over the past 48 years, Realty Income has been acquiring and managing freestanding commercial properties that generate rental revenue under long-term net lease agreements.  The company is a member of the S&P High Yield Dividend Aristocrats® index for having increased its dividend every year for more than 20 consecutive years.

 

At March 31, 2017, we owned a diversified portfolio:

 

·                  Of 4,980 properties;

·                  With an occupancy rate of 98.3%, or 4,897 properties leased and 83 properties available for lease;

·                  Leased to 250 different commercial tenants doing business in 47 separate industries;

·                  Located in 49 states and Puerto Rico;

·                  With over 84.0 million square feet of leasable space; and

·                  With an average leasable space per property of approximately 16,880 square feet; approximately 11,610 square feet per retail property and 221,920 square feet per industrial property.

 

Of the 4,980 properties in the portfolio, 4,956, or 99.5%, are single-tenant properties, and the remaining are multi-tenant properties. At March 31, 2017, of the 4,956 single-tenant properties, 4,873 were leased with a weighted average remaining lease term (excluding rights to extend a lease at the option of the tenant) of approximately 9.7 years.

 

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Investment Philosophy

We believe that owning an actively managed, diversified portfolio of commercial properties under long-term, net lease agreements 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 lease agreements 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 also 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 consistent and predictable income for our stockholders by reducing vulnerability that can come with any single concentration.  Our investment activities have led to a diversified property portfolio that, as of March 31, 2017, consisted of 4,980 properties located in 49 states and Puerto Rico, leased to 250 different commercial tenants doing business in 47 industries. Each of the 47 industries represented in our property portfolio individually accounted for no more than 11.1% of our rental revenue for the quarter ended March 31, 2017.

 

Investment Strategy

Our investment strategy is to acquire real estate leased to regional and national tenants. When identifying new properties for investment, we generally focus on acquiring high-quality real estate that 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, generally fungible, 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 the selection of prime real estate locations supported by superior service, quality control, economies of scale, consumer branding, 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.

 

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 internet retailers.  As a result of the execution of this strategy, over 90% of our annualized retail rental revenue at March 31, 2017 is derived from tenants with a service, non-discretionary, and/or low price point component to their business.  From a non-

 

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retail perspective, we target industrial properties leased to Fortune 1000, primarily investment grade rated companies.  We believe these characteristics enhance the stability of the rental revenue generated from these properties.

 

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

In order to be considered for acquisition, properties must meet stringent underwriting requirements. We have established a four-part analysis that examines each potential investment based on:

 

·                  The aforementioned overall real estate characteristics, including demographics, replacement cost and comparative rental rates;

·                  Industry, tenant (including credit profile), and market conditions;

·                  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.

 

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 meet our criteria for disposition.

 

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 45% of our annualized rental revenue comes from properties leased to investment grade rated companies or their subsidiaries.  At March 31, 2017, our top 20 tenants represent approximately 53% of our annualized revenue and nine of these tenants have investment grade credit ratings or are subsidiaries of investment grade companies.

 

Portfolio and Asset Management Strategy

In addition to pursuing new properties for investment, we seek to increase earnings and distributions to stockholders through active portfolio and asset management.

 

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

 

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

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

·                  Maximum asset-level returns on properties that are re-leased or sold;

·                  Additional value creation from 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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We continually monitor our portfolio for any changes that could affect the performance of our tenants, our tenants’ industries, and the real estate 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.  Our active portfolio and asset management strategy pursues asset sales 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; and/or

·                  Decrease tenant, industry, or geographic concentration.

 

At March 31, 2017, we classified 13 properties with a carrying amount of $11.8 million as held for sale on our balance sheet. For 2017, we intend to continue our active disposition efforts to further enhance our real estate portfolio and anticipate $75 to $100 million in property sales.  We plan to invest these proceeds into new property acquisitions, if there are attractive opportunities available. However, we cannot guarantee that we will sell properties during the remainder of 2017 at our estimated values or be able to invest the property sale proceeds in new properties.

 

The active management of the portfolio is an essential component of our long-term strategy of maintaining high occupancy. 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%.

 

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 48-year policy of paying monthly dividends. In addition, we increased the dividend three times during 2017.  As of April 2017, we have paid 78 consecutive quarterly dividend increases and increased the dividend 91 times since our listing on the NYSE in 1994.

 

 

 

Month

 

Month

 

Dividend

 

Increase

 

2017 Dividend increases

 

Declared

 

Paid

 

per share

 

per share

 

1st increase

 

Dec 2016

 

Jan 2017

 

$

0.2025

 

$

0.0005

 

2nd increase

 

Jan 2017

 

Feb 2017

 

$

0.2105

 

$

0.0080

 

3rd increase

 

Mar 2017

 

Apr 2017

 

$

0.2110

 

$

0.0005

 

 

The dividends paid per share during the first three months of 2017 totaled approximately $0.624, as compared to approximately $0.588 during the first three months of 2016, an increase of $0.036, or 6.1%.

 

The monthly dividend of $0.211 per share represents a current annualized dividend of $2.532 per share, and an annualized dividend yield of approximately 4.3% based on the last reported sale price of our common stock on the NYSE of $59.53 on March 31, 2017. 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.

 

Acquisitions During the First Three Months of 2017

During the first three months of 2017, we invested $370.7 million in 60 new properties and properties under development or expansion, with an initial weighted average contractual lease rate of 6.1%. The 60 new properties and properties under development or expansion are located in 18 states, will contain approximately 1.5 million leasable square feet, and are 100% leased with a weighted average lease term of 16.4 years. The tenants occupying the new properties operate in 13 industries and the property types are 98.7% retail and 1.3% industrial, based on rental revenue.  During the first three months of 2017, none of our real estate investments caused any one tenant to be 10% or more of our total assets at March 31, 2017.

 

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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 $370.7 million we invested during the first three months of 2017, $5.0 million was invested in nine properties under development or expansion with an estimated initial weighted average contractual lease rate of 7.7%.  We may continue to pursue development or expansion opportunities under similar arrangements in the future.

 

Portfolio Discussion

Leasing Results

At March 31, 2017, we had 83 properties available for lease out of 4,980 properties in our portfolio, which represents a 98.3% occupancy rate based on the number of properties in our portfolio. Since December 31, 2016, when we reported 84 properties available for lease out of 4,944 and a 98.3% occupancy rate, we:

 

·                  Had 60 lease expirations (including leases rejected in bankruptcy);

·                  Re-leased 49 properties; and

·                  Sold 12 vacant properties.

 

Of the 49 properties re-leased during the first three months of 2017, 46 properties were re-leased to existing tenants, and three were re-leased to new tenants after a period of vacancy.  The annual rent on these 49 leases was $8,007,000, as compared to the previous rent on these same properties of $7,731,000, which represents a rent recapture rate of 103.6% on the properties re-leased during the first three months of 2017.

 

As part of our re-leasing costs, we pay leasing commissions to unrelated, third party real estate brokers consistent with the commercial real estate industry standard, and sometimes provide tenant rent concessions. 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.

 

At March 31, 2017, our average annualized rental revenue was approximately $13.73 per square foot on the 4,897 leased properties in our portfolio.  At March 31, 2017, we classified 13 properties with a carrying amount of $11.8 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 and, accordingly, they are not reported as discontinued operations. The expected sale of these properties is consistent with our active disposition efforts to further enhance our real estate portfolio and maximize portfolio returns.

 

Investments in Existing Properties

In the first three months of 2017, we capitalized costs of $3.4 million on existing properties in our portfolio, consisting of $410,000 for re-leasing costs, $341,000 for recurring capital expenditures, and $2.6 million for non-recurring building improvements. In the first three months of 2016, we capitalized costs of $1.3 million on existing properties in our portfolio, consisting of $191,000 for re-leasing costs, $72,000 for recurring capital expenditures and $1.0 million for non-recurring building improvements. We define recurring capital expenditures as mandatory and recurring landlord capital obligations that have a limited useful life. We define non-recurring capital expenditures as property improvements where we invest additional capital that extends the useful life of the property.

 

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.

 

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Note Issuance

In March 2017, we issued $300 million of 4.650% senior unsecured notes due 2047, or the 2047 Notes, and $400 million of 4.125% senior unsecured notes due 2026, or the 2026 Notes. The public offering price for the 2047 Notes was 99.97% of the principal amount for an effective yield to maturity of 4.65%. The public offering price for the 2026 Notes was 102.98% of the principal amount for an effective yield to maturity of 3.75%. The 2026 Notes constituted a further issuance of, and formed a single series with, the $250 million aggregate principal amount of senior notes due 2026, issued in September 2014. The net proceeds of approximately $705.2 million from the offerings were used to repay borrowings outstanding under our credit facility to fund investment opportunities and for other general corporate purposes.

 

Issuance of Common Stock

In March 2017, we issued 11,850,000 shares of common stock.  After underwriting discounts and other offering costs of $29.7 million, the net proceeds of $705.0 million were used to repay borrowings under our credit facility.

 

Redemption of Preferred Stock

In March 2017, we issued an irrevocable notice of redemption for all 16,350,000 shares of our 6.625% Monthly Income Class F Preferred Stock for $25 per share, plus accrued dividends.  The redemption occurred in April 2017. The issuance of the redemption notice prior to the end of the quarter required us to reclassify $408.8 million of preferred stock from stockholders’ equity to liabilities on our consolidated balance sheet at March 31, 2017. These shares subject to mandatory redemption are presented at fair value.  We incurred a non-cash charge of $13.4 million. This charge is for the excess of redemption value over the carrying value and represents the Class F preferred stock original issuance costs that were paid in 2012.

 

Net Income Available to Common Stockholders

Net income available to common stockholders was $71.6 million in the first three months of 2017, as compared to $63.5 million in the first three months of 2016, an increase of $8.1 million. On a diluted per common share basis, net income was $0.27 in the first three months of 2017, as compared to $0.25 in the first three months of 2016, an increase of $0.02, or 8.0%.

 

Net income and funds from operations available to common stockholders per share for the quarter ended  March 31, 2017 were impacted by a $13.4 million non-cash redemption charge on the Class F preferred shares that were redeemed in April 2017, which represents $0.05 per share. This charge is for the excess in redemption value over the carrying value of the Class F preferred stock and represents the original issuance cost that was paid in 2012.

 

Net income and funds from operations available to common stockholders for the first three months of 2017 was impacted by a non-cash gain of $1.3 million, or $0.005 net income per share, resulting from fair value adjustments on our interest rate swaps. Net income available to common stockholders for the first three months of 2016 was impacted by a non-cash loss of $5.8 million, or $0.02 net income 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.

 

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 the interest rate environment, and can significantly impact net income available to common stockholders.

 

Gains from the sale of properties during the first three months of 2017 were $10.5 million, as compared to gains from the sale of properties of $2.3 million during the first three months of 2016.

 

Funds from Operations Available to Common Stockholders (FFO)

In the first three months of 2017, our FFO increased by $16.6 million, or 9.7%, to $187.2 million, as compared to $170.6 million in the first three months of 2016.  On a diluted per common share basis, FFO was $0.71 in the first three months of 2017, compared to $0.68 in the first three months of 2016, an increase of $0.03, or 4.4%.

 

Adjusted Funds from Operations Available to Common Stockholders (AFFO)

In the first three months of 2017, our AFFO increased by $25.4 million, or 14.4%, to $201.3 million versus $175.9 million in the first three months of 2016. On a diluted per common share basis, our AFFO was $0.76 in the first three months of 2017, compared to $0.70 in the first three months of 2016, an increase of $0.06, or 8.6%.

 

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See our discussion of FFO and AFFO (which are not financial measures under generally accepted accounting principles, or GAAP), later in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in this quarterly report, 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 initially financed by our credit facility or debt securities. However, we cannot assure you that we will have access to the capital markets at all 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 March 31, 2017, our total outstanding borrowings of senior unsecured notes and bonds, term loans, mortgages payable and credit facility borrowings, as well as our mandatorily redeemable preferred shares of $408.8 million, were $5.86 billion, or approximately 26.5% of our total market capitalization of $22.14 billion.

 

We define our total market capitalization at March 31, 2017 as the sum of:

 

·                  Shares of our common stock outstanding of 273,051,486, plus total common units outstanding of 405,204, multiplied by the last reported sales price of our common stock on the NYSE of $59.53 per share on March 31, 2017, or $16.28 billion;

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

·                  Outstanding mortgages payable of $457.9 million, excluding net mortgage premiums of $5.7 million and deferred financing costs of $286,000;

·                  Outstanding borrowings of $320.0 million on our term loans, excluding deferred financing costs of $800,000; and

·                  Outstanding senior unsecured notes and bonds of $4.68 billion, excluding unamortized original issuance discounts of $7.5 million and deferred financing costs of $26.4 million.

 

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.

 

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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.  We did not issue any shares under the ATM program during the first three months of 2017.

 

Issuance of Common Stock

In March 2017, we issued 11,850,000 shares of common stock.  After underwriting discounts and other offering costs of $29.7 million, the net proceeds of $705.0 million were used to repay borrowings under our credit facility.

 

Dividend Reinvestment and Stock Purchase Plan

Our Dividend Reinvestment and Stock Purchase Plan, or our 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.  Our DRSPP also allows our current stockholders to buy additional shares of common stock by reinvesting all or a portion of their distributions.  Our DRSPP authorizes up to 26,000,000 common shares to be issued.  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 three months of 2017, we issued 966,557 shares and raised approximately $57.0 million under our DRSPP, of which we issued 927,695 shares and raised $54.7 million under the waiver approval process.

 

$2.0 Billion Revolving Credit Facility

In June 2015, we entered into a $2.0 billion unsecured revolving credit facility, or our credit facility, that 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 March 31, 2017 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 and may change if our investment grade credit ratings were to change. 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 March 31, 2017, we had a borrowing capacity of $2.0 billion available on our credit facility and no outstanding balance. The weighted average interest rate on borrowings during the first three months of 2017 was 1.7% per annum. We must comply with various financial and other covenants in our credit facility.  At March 31, 2017, we were 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.

 

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.

 

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 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%.

 

Mortgage Debt

As of March 31, 2017, we had $457.9 million of mortgages payable, all of which were assumed in connection with our property acquisitions.  Additionally, at March 31, 2017, we had net premiums totaling $5.7 million on these mortgages and deferred financing costs of $286,000.  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 three months of 2017, we made $2.1 million in principal payments.

 

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Notes Outstanding

Our senior unsecured note and bond obligations consist of the following as of March 31, 2017, sorted by maturity date (dollars in millions):

 

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, $250 issued in September 2014 and $400 issued in March 2017, all of which are due in October 2026

 

650

 

3.000% notes, issued in October 2016 and due in January 2027

 

600

 

5.875% bonds, $100 issued in March 2005 and $150 issued in June 2011, all of which are due in March 2035

 

250

 

4.650% notes, issued in March 2017 and due in March 2047

 

300

 

Total principal amount

 

$

4,675

 

Unamortized original issuance discounts and deferred financing costs

 

(34)

 

 

 

4,641

 

 

In March 2017, we issued $300 million of the 2047 Notes, and $400 million of the 2026 Notes. The public offering price for the 2047 Notes was 99.97% of the principal amount for an effective yield to maturity of 4.65%. The public offering price for the 2026 Notes was 102.98% of the principal amount for an effective yield to maturity of 3.75%. The 2026 Notes constitutes a further issuance of, and formed a single series with, the $250 million aggregate principal amount of senior notes due 2026, issued in September 2014. The net proceeds of approximately $705.2 million from this offering were used to repay borrowings outstanding under our credit facility to fund potential investment opportunities and for other general corporate purposes.

 

All of our outstanding notes and bonds have fixed interest rates and contain various covenants, with which we remained in compliance as of March 31, 2017. 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 March 31, 2017 are:

 

Note Covenants

 

Required

 

Actual

 

 

 

 

 

 

 

Limitation on incurrence of total debt

 

< 60% of adjusted assets

 

40.9%

 

Limitation on incurrence of secured debt

 

< 40% of adjusted assets

 

3.3%

 

Debt service coverage (trailing 12 months)(1)

 

> 1.5 x

 

4.1x

 

Maintenance of total unencumbered assets

 

> 150% of unsecured debt

 

250.0%

 

 

(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 April 1, 2016, 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 April 1, 2016, 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 March 31, 2017 (in thousands, for trailing twelve months):

 

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Net income attributable to the Company

$

334,198

Plus: interest expense

209,816

Plus: provision for taxes

3,345

Plus: depreciation and amortization

463,107

Plus: provisions for impairment

24,174

Plus: pro forma adjustments

66,666

Less: gain on sales of real estate

(30,222

)

Income available for debt service, as defined

$

1,071,084

 

Total pro forma debt service charge

$

260,457

 

Debt service coverage ratio (1)

4.1

Pro forma debt service coverage ratio (1)

 

4.5

 

 

(1) The debt service coverage ratio calculation includes annualized interest expense for the mandatorily redeemable Class F preferred stock in accordance with the requirements of our note covenants. The pro forma debt service coverage ratio assumes that the redemption of the Class F preferred stock occurred on March 31, 2017 using available cash and borrowings on our line of credit. The pro forma debt service coverage ratio assumes annualized interest expense on our line of credit at the rate available to us on March 31, 2017.

 

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 March 31, 2017 (in thousands, for the trailing twelve months):

 

Income available for debt service, as defined

$

1,071,084

Pro forma debt service charge plus preferred stock dividends

$

260,457

Fixed charge coverage ratio (1)

4.1

Pro forma fixed charge coverage ratio (1)

 

4.5

 

(1) The fixed charge coverage ratio calculation includes annualized interest expense for the mandatorily redeemable Class F preferred stock in accordance with the requirements of our note covenants. The pro forma fixed charge coverage ratio assumes that the redemption of the Class F preferred stock occurred on March 31, 2017 using available cash and borrowings on our line of credit. The pro forma fixed charge coverage ratio assumes annualized interest expense on our line of credit at the rate available to us on March 31, 2017.

 

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 March 31, 2017, we had cash and cash equivalents totaling $27.6 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 March 31, 2017, we were 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.

 

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Based on our ratings as of March 31, 2017, the facility interest rate as of March 31, 2017 was LIBOR plus 0.90% 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) 0.30% for a rating lower than BBB-/Baa3 or unrated, and (ii) 0.125% for a credit rating of A-/A3 or higher.

 

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 March 31, 2017 (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

2017

$

  -

$

175.0

$

  -

$

101.1

$

172.7

$

1.2

$

10.1

$

72.1

$

532.2

2018

  -

350.0

70.0

21.9

209.5

1.6

13.4

  -

666.4

2019

  -

550.0

  -

42.3

194.3

1.5

13.3

  -

801.4

2020

  -

  -

250.0

82.4

167.4

1.4

13.1

  -

514.3

2021

  -

250.0

  -

66.9

145.7

1.2

12.8

  -

476.6

Thereafter

  -

3,350.0

  -

143.3

876.4

22.1

106.6

  -

4,498.4

Totals

 

$

  -

 

$

4,675.0

 

$

320.0

 

$

457.9

 

$

1,766.0

 

$

29.0

 

$

169.3

 

$

72.1

 

$

7,489.3

 

(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 notes payable. The unamortized balance of the original issuance discounts at March 31, 2017 is $7.5 million. Also excludes deferred financing costs of $26.4 million.

(3) Excludes deferred financing costs of $800,000.

(4) Excludes non-cash net premiums recorded on the mortgages payable.  The unamortized balance of these net premiums at March 31, 2017, is $5.7 million. Also excludes deferred financing costs of $286,000.

(5) Interest on the term loans, notes, bonds, mortgages payable, and credit facility has been calculated based on outstanding balances as of March 31, 2017 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 $67.1 million of commitments under construction contracts and $5.0 million of commitments for tenant improvements and leasing costs.

 

In March 2017, we issued an irrevocable notice of redemption for all 16,350,000 shares of our 6.625% Monthly Income Class F Preferred Stock for $25 per share, plus accrued dividends. The redemption occurred in        April 2017. The issuance of the redemption notice prior to the end of the quarter required us to reclassify preferred stock from stockholders’ equity to liabilities on our consolidated balance sheet at March 31, 2017.

 

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

 

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. Prior to the redemption of our Class F preferred stock in April 2017, distributions were paid monthly to holders of shares of our Class F preferred stock, in each case, 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 2016, our cash distributions to preferred and common stockholders totaled $637.6 million, or approximately 129.2% of our estimated taxable income of $493.4 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 three months of 2017 totaled $162.5 million, representing 80.7% of our adjusted funds from operations available to common stockholders of $201.3 million. In comparison, our 2016 cash distributions to common stockholders totaled $610.5 million, representing 82.9% of our adjusted funds from operations available to common stockholders of $736.4 million.

 

Prior to the redemption of our Class F preferred stock in April 2017, the Class F preferred stockholders received cumulative distributions at a rate of 6.625% per annum on the $25 per share liquidation preference (equivalent to $1.65625 per annum per share).

 

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 21.5% of the distributions to our common stockholders, made or deemed to have been made in 2016, were classified as a return of capital for federal income tax purposes. We estimate that in 2017, between 15% and 25% 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, 2016.

 

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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 months ended March 31, 2017, to the three months ended March 31, 2016.

 

Rental Revenue

Rental revenue was $285.8 million for the first three months of 2017, as compared to $256.8 million for the first three months of 2016, an increase of $29.0 million, or 11.3%. The increase in rental revenue in the first three months of 2017 compared to the first three months of 2016 is primarily attributable to:

 

·                  The 50 properties (1.1 million square feet) we acquired in the first three months of 2017, which generated $686,000 of rent in the first three months of 2017;

·                  The 475 properties (7.6 million square feet) we acquired in 2016, which generated $28.5 million of rent in the first three months of 2017, compared to $878,000 in the first three months of 2016, an increase of $27.6 million; and

·                  Same store rents generated on 4,322 properties (73.8 million square feet) during the first three months of 2017 and 2016, increased by $4.05 million, or 1.6%, to $250.24 million from $246.19 million; partially offset by

·                  A net decrease in straight-line rent and other non-cash adjustments to rent of $358,000 in the first three months of 2017 as compared to the first three months of 2016;

·                  A net decrease of $2.3 million relating to properties sold in the first three months of 2017 and during 2016; and

 

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·                  A net decrease of $719,000 relating to the aggregate of (i) rental revenue from properties (124 properties comprising 1.7 million square feet) that were available for lease during part of 2017 or 2016, (ii) rental revenue for seven properties under development, and (iii) lease termination settlements.  In aggregate, the revenues for these items totaled $3.0 million in the first three months of 2017, compared to $3.7 million in the first three months of 2016.

 

For purposes of determining the same store rent property pool, 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 4,980 properties in the portfolio at March 31, 2017, 4,956, or 99.5%, are single-tenant properties and the remaining are multi-tenant properties. Of the 4,956 single-tenant properties, 4,873, or 98.3%, were net leased with a weighted average remaining lease term (excluding rights to extend a lease at the option of the tenant) of approximately 9.7 years at March 31, 2017. Of our 4,873 leased single-tenant properties, 4,343 or 89.1% 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 $3.4 million in the first three months of 2017 and $1.7 million in the first three months of 2016.  We anticipate percentage rent to be less than 1% of rental revenue in 2017.

 

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 March 31, 2017, our portfolio of 4,980 properties was 98.3% leased with 83 properties available for lease, as compared to 98.3% leased, with 84 properties available for lease at December 31, 2016, and 97.8% leased with 101 properties available for lease at March 31, 2016. 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.

 

Tenant Reimbursements

Contractually obligated reimbursements from tenants for recoverable real estate taxes and operating expenses were $11.2 million in the first three months of 2017, compared to $9.1 million in the first three months of 2016.  The increase in tenant reimbursements is primarily due to our increase in acquisitions.

 

Other Revenue

Other revenue, which comprises property-related revenue not included in rental revenue or tenant reimbursements, was $975,000 in the first three months of 2017, compared to $1.2 million in the first three months of 2016.

 

Depreciation and Amortization

Depreciation and amortization was $121.1 million for the first three months of 2017, compared to $107.9 million for the first three months of 2016. The increase in depreciation and amortization in the first three months of 2017 was primarily due to the acquisition of properties in 2016 and the first three months of 2017, 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.

 

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Interest Expense

 

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

 

 

 

Three months ended

 

 

March 31,

 

 

2017

 

2016

 

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

 

$

56,058

 

$

53,169

 

Credit facility commitment fees

 

750

 

758

 

Amortization of credit facility origination costs and deferred financing costs

 

2,313

 

2,123

 

(Gain) loss on interest rate swaps

 

(1,330

)

5,778

 

Dividend on preferred shares subject to redemption

 

2,257

 

-

 

Amortization of net mortgage premiums

 

(630

)

(1,101

)

Capital lease obligation

 

77

 

77

 

Interest capitalized

 

(190

)

(126

)

Interest expense

 

$

59,305

 

$

60,678

 

 

 

 

 

 

 

Credit facility, term loans, mortgages and notes

 

 

 

 

 

Average outstanding balances (dollars in thousands)

 

$

5,711,310

 

$

4,858,114

 

Average interest rates

 

3.87%

 

4.29

%

 

We classified $2.3 million on the outstanding Class F preferred stock as interest expense at March 31, 2017. Additionally, 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 directly to interest expense.  We recorded a gain on interest rate swaps of $1.3 million during the first three months of 2017 and a loss on interest rate swaps of $5.8 million during the first three months of 2016.

 

At March 31, 2017, the weighted average interest rate on our:

·                  Term loans outstanding of $320.0 million (excluding deferred financing costs of $800,000) was 1.9%;

·                  Mortgages payable of $457.9 million (excluding net premiums totaling $5.7 million and deferred financing costs of $286,000 on these mortgages) was 4.9%;

·                  Notes and bonds payable of $4.68 billion (excluding unamortized original issue discounts of $7.5 million and deferred financing costs of $26.4 million) was 4.4%; and

·                  Combined outstanding notes, bonds, mortgages, term loan and credit facility borrowings of $5.45 billion was 4.3% (excludes $408.8 million of mandatorily redeemable preferred shares, which were redeemed in April 2017).

 

General and Administrative Expenses

General and administrative expenses increased by $1.3 million to $13.6 million for the first three months of 2017, compared to $12.3 million in the first three months of 2016. This increase was primarily due to more employees and higher compensation costs. Included in general and administrative expenses are acquisition transaction costs of $131,000 for the first three months of 2017 and $24,000 for the first three months of 2016. In April 2017, we had 149 employees, as compared to 133 employees in April 2016.

 

 

 

Three months ended

 

 

March 31,

Dollars in thousands

 

2017

 

2016

 

General and administrative expenses

 

$

13,565

 

$

12,318

 

Total revenue(1)

 

286,796

 

258,011

 

General and administrative expenses as a percentage of total revenue

 

4.7

%

4.8

%

 

(1) Excludes tenant reimbursements revenue, and gain on sales of properties.

 

Property Expenses (including tenant reimbursable expenses)

Property expenses consist of costs associated with unleased properties, non-net-leased properties and general portfolio expenses, as well as contractually obligated reimbursable costs from tenants for recoverable real estate taxes and operating expenses. Expenses related to unleased properties and non-net-leased properties include, but are not limited to, property taxes, maintenance, insurance, utilities, property inspections, bad debt expense and legal fees. General portfolio costs include, but are not limited to, insurance, legal, property inspections, and title search fees. At March 31, 2017, 83 properties were available for lease, as compared to 84 at December 31, 2016 and 101 at March 31, 2016.

 

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Property expenses were $19.1 million (including $11.2 million in reimbursable expenses) in the first three months of 2017 and $15.1 million (including $9.1 million in reimbursable expenses) in the first three months of 2016. The increase in gross property expenses in the first three months of 2017 is primarily attributable to the increased portfolio size, which contributed to higher contractually obligated reimbursements primarily due to our acquisitions during 2016 and the first three months of 2017. We also incurred higher gross property expenses as a result of maintenance and utilities, property taxes, ground rent expenses, legal costs, and bad debt expense on vacant properties.

 

 

 

Three months ended

 

 

March 31,

Dollars in thousands

 

2017

 

2016

 

Property expenses net of tenant reimbursements

 

$

7,846

 

$

6,000

 

Total revenue(1)

 

286,796

 

258,011

 

Property expenses net of tenant reimbursements as a percentage of total revenue

 

2.7

%

2.3

%

 

(1) Excludes tenant reimbursements revenue, and gain on sales of properties.

 

Income Taxes

 

Income taxes were $1.0 million in the first three months of 2017 and 2016. These amounts are for city and state income and franchise taxes paid by us and our subsidiaries.

 

Provisions for Impairment

 

For the first three months of 2017, we recorded total provisions for impairment of $5.4 million on five properties classified as held for sale, three properties classified as held for investment, and one sold property. For the first three months of 2016, we recorded total provisions for impairment of $1.9 million on eight sold properties.

 

Gain on Sales of Real Estate

 

During the first three months of 2017, we sold 14 properties for $31.2 million, which resulted in a gain of $10.5 million. During the first three months of 2016, we sold 11 properties for $11.0 million, which resulted in a gain of $2.3 million.

 

Preferred Stock Dividends

 

Preferred stock dividends totaled $3.9 million in the first three months of 2017 and $6.8 million in the first three months of 2016.

 

Excess of Redemption Value over Carrying Value of Preferred Shares Redeemed

 

When we issued the irrevocable notice of redemption on our Class F preferred stock in March 2017, we incurred a non-cash charge of $13.4 million for the excess of redemption value over the carrying value. The non-cash charge represents the Class F preferred stock original issuance cost that was paid in 2012.

 

Net Income Available to Common Stockholders

 

Net income available to common stockholders was $71.6 million in the first three months of 2017, compared to $63.5 million in the first three months of 2016, an increase of $8.1 million. On a diluted per common share basis, net income was $0.27 in the first three months of 2017, as compared to $0.25 in the first three months of 2016, an increase of $0.02, or 8.0%.

 

Net income available to common stockholders per share for the quarter ended March 31, 2017 were impacted by a $13.4 million non-cash redemption charge on the Class F preferred shares that were redeemed in April 2017, which represents $0.05 net income per share. This charge is for the excess in redemption value over the carrying value of the Class F preferred stock and represents the original issuance cost that was paid in 2012.

 

Net income available to common stockholders for the first three months of 2017 was impacted by a non-cash gain of $1.3 million, or $0.005 net income per share, resulting from fair value adjustments on our interest rate swaps. Net income available to common stockholders for the first three months of 2016 was impacted by a non-cash loss of $5.8 million, or $0.02 net income per share. 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.

 

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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 the interest rate environment, and can significantly impact net income available to common stockholders.

 

Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA)

 

EBITDA, a non-GAAP financial measure, means, for the most recent quarter, earnings (net income) before (i) interest expense, including non-cash loss (gain) on swaps, (ii) income and franchise taxes, (iii) real estate depreciation and amortization, (iv) impairment losses, and (v) gain on sales of real estate. Our EBITDA may not be comparable to EBITDA reported by other companies that interpret the definitions of EBITDA differently than we do. Management believes EBITDA to be a meaningful measure of a REIT’s performance because it is widely followed by industry analysts, lenders and investors. The ratio of our total debt to EBITDA is also used to determine vesting of performance share awards granted to our executive officers. EBITDA should be considered along with, but not as an alternative to net income as a measure of our operating performance. Our ratio of debt to EBITDA, which is used by management as a measure of leverage, is calculated by annualizing quarterly EBITDA and then dividing by our total debt per the consolidated balance sheet.

 

 

 

Three months ended

 

 

 

 

 

March 31,

 

 

 

 

 

 

Dollars in thousands

 

2017

 

2016

 

Net income

 

$

89,035

 

$

70,484

 

Interest

 

59,305

 

60,678

 

Income taxes

 

1,047

 

964

 

Depreciation and amortization

 

121,097

 

107,933

 

Impairment loss

 

5,433

 

1,923

 

Gain on sales of real estate

 

(10,532

)

(2,289

)

Quarterly EBITDA

 

$

265,385

 

$

239,693

 

 

 

 

 

 

 

Annualized EBITDA (1)

 

$

1,061,540

 

$

958,772

 

Total Debt (2)

 

$

5,832,376

 

$

5,105,098

 

Debt/EBITDA

 

5.5

 

5.3

 

 

(1) We calculate Annualized EBITDA by multiplying the Quarterly EBITDA by four.

 

(2) Total debt is consistent with its definition under market capitalization as described in “Liquidity and Capital Resources – Conservative Capital Structure” earlier in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” As part of our declared redemption of preferred stock in March 2017, we classified $408.8 million of preferred stock to liabilities as of March 31, 2017, and included this amount as part of total debt in our calculation of debt-to-EBITDA.

 

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FUNDS FROM OPERATIONS AVAILABLE TO COMMON STOCKHOLDERS (FFO)

 

In the first three months of 2017, our FFO increased by $16.6 million, or 9.7%, to $187.2 million, compared to $170.6 million in the first three months of 2016.  On a diluted per common share basis, FFO was $0.71 in the first three months of 2017, compared to $0.68 in the first three months of 2016, an increase of $0.03, or 4.4%. FFO in the first three months of 2017 includes a non-cash redemption charge of $13.4 million on the Class F preferred shares that were redeemed in April 2017, which represents $0.05 on a diluted per common share basis. This charge is for the excess of redemption value over the carrying value and represents the Class F preferred stock original issuance cost that was paid in 2012.

 

The following is a reconciliation of net income available to common stockholders (which we believe is the most comparable GAAP measure) to FFO. Also presented is information regarding distributions paid to common stockholders and the weighted average number of common shares used for the basic and diluted computation per share (dollars in thousands, except per share amounts):

 

 

 

Three months ended

 

 

March 31,

 

 

2017

 

2016

 

Net income available to common stockholders

 

$

71,586

 

$

63,473

 

Depreciation and amortization

 

121,097

 

107,933

 

Depreciation of furniture, fixtures and equipment

 

(157

)

(193

)

Provisions for impairment on investment properties

 

5,433

 

1,923

 

Gain on sales of investment properties

 

(10,532

)

(2,289

)

FFO adjustments allocable to noncontrolling interests

 

(214

)

(218

)

FFO available to common stockholders

 

$

187,213

 

$

170,629

 

FFO allocable to dilutive noncontrolling interests

 

220

 

-

 

Diluted FFO (1)

 

$

187,433

 

$

170,629

 

 

 

 

 

 

 

FFO per common share, basic and diluted (2)

 

$

0.71

 

$

0.68

 

 

 

 

 

 

 

Distributions paid to common stockholders

 

$

162,506

 

$

147,345

 

 

 

 

 

 

 

FFO available to common stockholders in excess of distributions paid to common stockholders

 

$

24,707

 

$

23,284

 

 

 

 

 

 

 

Weighted average number of common shares used for computation per share:

 

 

 

 

 

Basic

 

263,340,491

 

250,173,815

 

Diluted (2)

 

263,934,304

 

250,381,001

 

 

(1)            FFO available to common stockholders and dilutive noncontrolling interests for the first quarter of 2017 is $187,433 after the inclusion of $220 of FFO allocable to dilutive noncontrolling interests. Noncontrolling interests were antidilutive for all other periods presented.

(2)            The computation of diluted FFO does not assume conversion of securities that are exchangeable for common shares if the conversion of those securities would increase diluted FFO per share in a given period.

 

We define FFO, a non-GAAP measure, consistent with the National Association of Real Estate Investment Trusts’ definition, as net income available to common stockholders, plus depreciation and amortization of real estate assets, plus impairments of depreciable real estate assets, and reduced by gains on property sales.

 

We consider FFO to be an appropriate supplemental measure of a REIT’s operating performance as it is based on a net income analysis of property portfolio performance that adds back items such as depreciation and impairments for FFO. The historical accounting convention used for real estate assets requires straight-line depreciation of buildings and improvements, which implies that the value of real estate assets diminishes predictably over time. Since real estate values historically rise and fall with market conditions, presentations of operating results for a REIT, using historical accounting for depreciation, could be less informative. The use of FFO is recommended by the REIT industry as a supplemental performance measure. In addition, FFO is used as a measure of our compliance with the financial covenants of our credit facility.

 

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ADJUSTED FUNDS FROM OPERATIONS AVAILABLE TO COMMON STOCKHOLDERS (AFFO)

 

In the first three months of 2017, our AFFO increased by $25.4 million, or 14.4%, to $201.3 million, compared to $175.9 million in 2016. On a diluted per common share basis, AFFO was $0.76 in the first three months of 2017, compared to $0.70 in the first three months of 2016, an increase of $0.06, or 8.6%. We consider AFFO to be an appropriate supplemental measure of our performance. Most companies in our industry use a similar measurement, but they may use the term “CAD” (for Cash Available for Distribution), “FAD” (for Funds Available for Distribution) or other terms.

 

The following is a reconciliation of net income available to common stockholders (which we believe is the most comparable GAAP measure) to FFO and AFFO. Also presented is information regarding distributions paid to common stockholders and the weighted average number of common shares used for the basic and diluted computation per share (dollars in thousands, except per share amounts):

 

 

 

Three months ended

 

 

March 31,

 

 

2017

 

2016

 

Net income available to common stockholders

 

$

71,586

 

$

63,473

 

Cumulative adjustments to calculate FFO (1)

 

115,627

 

107,156

 

FFO available to common stockholders

 

187,213

 

170,629

 

Amortization of share-based compensation

 

2,753

 

2,605

 

Amortization of deferred financing costs (2)

 

1,487

 

1,299

 

Amortization of net mortgage premiums

 

(630

)

(1,101

)

(Gain) loss on interest rate swaps

 

(1,330

)

5,778

 

Leasing costs and commissions

 

(410

)

(191

)

Recurring capital expenditures

 

(341

)

(72

)

Straight-line rent

 

(3,283

)

(5,151

)

Amortization of above and below-market leases

 

2,432

 

2,052

 

Excess of redemption value over carrying value of Class F preferred share redemption

 

13,373

 

-

 

Other adjustments (3)

 

72

 

70

 

Total AFFO available to common stockholders

 

$

201,336

 

$

175,918

 

AFFO allocable to dilutive noncontrolling interests

 

294

 

-

 

Diluted AFFO (4)

 

$

201,630

 

$

175,918

 

 

 

 

 

 

 

AFFO per common share, basic and diluted (5)

 

$

0.76

 

$

0.70

 

 

 

 

 

 

 

Distributions paid to common stockholders

 

$

162,506

 

$

147,345

 

 

 

 

 

 

 

AFFO available to common stockholders in excess of distributions paid to common stockholders

 

$

38,830

 

$

28,573

 

 

 

 

 

 

 

Weighted average number of common shares used for computation per share:

 

 

 

 

 

Basic

 

263,340,491

 

250,173,815

 

Diluted (5)

 

264,022,486

 

250,381,001

 

 

(1)           See reconciling items for FFO presented under “Funds from Operations Available to Common Stockholders (FFO).”

 

(2)           Includes the amortization of costs incurred and capitalized upon issuance of our notes payable, assumption of our mortgages payable and upon issuance of our term loans.  The deferred financing costs are being amortized over the lives of the respective mortgages and term loans.  No costs associated with our credit facility agreements or annual fees paid to credit rating agencies have been included.

 

(3)           Includes adjustments allocable to both non-controlling interests and capital lease obligations.

 

(4)           AFFO available to common stockholders and dilutive noncontrolling interests for the first quarter of 2017 is $201,630 after the inclusion of $294 of AFFO allocable to dilutive noncontrolling interests.