10-Q 1 a13-18826_110q.htm 10-Q

Table of Contents

 

GRAPHIC

 

 

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 September 30, 2013, 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)

 

600 La Terraza Boulevard, Escondido, California  92025-3873

(Address of Principal Executive Offices)

 

Registrant’s telephone number, including area code: (760) 741-2111

 

 

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

 

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

 

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

 

Large accelerated filer x   Accelerated filer o   Non-accelerated filer o   Smaller reporting company o

 

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

 

There were 196,347,147 shares of common stock outstanding as of October 24, 2013.

 



Table of Contents

 

REALTY INCOME CORPORATION

 

Form 10-Q

September 30, 2013

 

TABLE OF CONTENTS

 

 

 

PART I.

FINANCIAL INFORMATION

 

Page

 

 

 

 

Item 1:

Financial Statements

 

 

 

 

 

 

 

Consolidated Balance Sheets

 

3

 

Consolidated Statements of Income

 

4

 

Consolidated Statements of Cash Flows

 

5

 

Notes to Consolidated Financial Statements

 

6

 

 

 

 

Item 2:

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

 

 

 

 

 

 

 

Forward-Looking Statements

 

26

 

The Company

 

27

 

Recent Developments

 

30

 

Liquidity and Capital Resources

 

35

 

Results of Operations

 

41

 

Funds from Operations Available to Common Stockholders (FFO) And Normalized Funds from Operations Available to Common Stockholders (Normalized FFO)

 

47

 

Adjusted Funds from Operations Available to Common Stockholders (AFFO)

 

49

 

Property Portfolio Information

 

50

 

Impact of Inflation

 

57

 

Impact of Recent Accounting Pronouncements

 

57

 

Other Information

 

57

 

 

 

 

Item 3:

Quantitative and Qualitative Disclosures About Market Risk

 

58

 

 

 

 

Item 4:

Controls and Procedures

 

59

 

 

 

 

PART II.

OTHER INFORMATION

 

 

 

 

 

 

Item 1:

Legal Proceedings

 

60

Item 1A:

Risk Factors

 

60

Item 2:

Unregistered Sales of Equity Securities and Use of Proceeds

 

60

Item 6:

Exhibits

 

61

SIGNATURE

 

65

 

2



Table of Contents

 

PART I.  FINANCIAL INFORMATION

Item 1.   Financial Statements

 

REALTY INCOME CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

September 30, 2013 and December 31, 2012

(dollars in thousands, except per share data)

 

 

 

2013

 

2012

 

ASSETS

 

(unaudited)

 

 

 

Real estate, at cost:

 

 

 

 

 

Land

 

$

2,753,192

 

$

1,999,820

 

Buildings and improvements

 

7,002,560

 

3,920,865

 

Total real estate, at cost

 

9,755,752

 

5,920,685

 

Less accumulated depreciation and amortization

 

(1,051,950

)

(897,767

)

Net real estate held for investment

 

8,703,802

 

5,022,918

 

Real estate held for sale, net

 

17,276

 

19,219

 

Net real estate

 

8,721,078

 

5,042,137

 

Cash and cash equivalents

 

9,960

 

5,248

 

Accounts receivable, net

 

32,169

 

21,659

 

Acquired lease intangible assets, net

 

955,893

 

242,125

 

Goodwill

 

15,739

 

16,945

 

Other assets, net

 

146,088

 

115,249

 

Total assets

 

$

9,880,927

 

$

5,443,363

 

 

 

 

 

 

 

LIABILITIES AND EQUITY

 

 

 

 

 

Distributions payable

 

$

39,359

 

$

23,745

 

Accounts payable and accrued expenses

 

69,299

 

70,426

 

Acquired lease intangible liabilities, net

 

137,693

 

26,471

 

Other liabilities

 

38,792

 

26,059

 

Lines of credit payable

 

468,400

 

158,000

 

Mortgages payable, net

 

811,058

 

175,868

 

Term loan

 

70,000

 

-

 

Notes payable

 

3,200,000

 

2,550,000

 

Total liabilities

 

4,834,601

 

3,030,569

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock and paid in capital, par value $0.01 per share,

 

 

 

 

 

69,900,000 shares authorized and 25,150,000 shares issued and

 

 

 

 

 

outstanding as of September 30, 2013 and December 31, 2012

 

609,363

 

609,363

 

Common stock and paid in capital, par value $0.01 per share,

 

 

 

 

 

370,100,000 shares authorized, 196,334,470 shares issued and

 

 

 

 

 

outstanding as of September 30, 2013 and 133,452,411 shares issued

 

 

 

 

 

and outstanding at December 31, 2012

 

5,333,761

 

2,572,092

 

Distributions in excess of net income

 

(932,876

)

(768,661

)

Total stockholders’ equity

 

5,010,248

 

2,412,794

 

Noncontrolling interests

 

36,078

 

-

 

Total equity

 

5,046,326

 

2,412,794

 

Total liabilities and equity

 

$

9,880,927

 

$

5,443,363

 

 

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

 

3



REALTY INCOME CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

 

For the three and nine months ended September 30, 2013 and 2012

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

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

REVENUE

 

 

 

 

 

 

 

 

 

Rental

 

$

195,429

 

$

116,795

 

$

543,557

 

$

339,598

 

Other

 

3,875

 

354

 

6,841

 

1,211

 

Total revenue

 

199,304

 

117,149

 

550,398

 

340,809

 

 

 

 

 

 

 

 

 

 

 

EXPENSES

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

80,869

 

37,039

 

221,603

 

105,828

 

Interest

 

49,703

 

29,720

 

130,271

 

87,477

 

General and administrative

 

16,628

 

9,335

 

40,316

 

27,775

 

Property

 

5,898

 

1,532

 

12,735

 

5,156

 

Income taxes

 

671

 

405

 

2,063

 

1,215

 

Merger-related costs

 

240

 

5,495

 

12,875

 

5,495

 

Total expenses

 

154,009

 

83,526

 

419,863

 

232,946

 

Income from continuing operations

 

45,295

 

33,623

 

130,535

 

107,863

 

Income from discontinued operations

 

6,612

 

3,835

 

51,115

 

12,266

 

Net income

 

51,907

 

37,458

 

181,650

 

120,129

 

Net income attributable to noncontrolling interests

 

(336

)

-

 

(422

)

-

 

Net income attributable to the Company

 

51,571

 

37,458

 

181,228

 

120,129

 

Preferred stock dividends

 

(10,482

)

(10,482

)

(31,447

)

(30,435

)

Excess of redemption value over carrying value of preferred shares redeemed (see note 10)

 

-

 

-

 

-

 

(3,696

)

Net income available to common stockholders

 

$

41,089

 

$

26,976

 

$

149,781

 

$

85,998

 

 

 

 

 

 

 

 

 

 

 

Amounts available to common stockholders per common share:

 

 

 

 

 

 

 

 

 

Income from continuing operations:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.18

 

$

0.17

 

$

0.53

 

$

0.56

 

Diluted

 

$

0.18

 

$

0.17

 

$

0.53

 

$

0.56

 

Net income:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.21

 

$

0.20

 

$

0.80

 

$

0.65

 

Diluted

 

$

0.21

 

$

0.20

 

$

0.80

 

$

0.65

 

Weighted average common shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

195,768,298

 

132,764,877

 

187,805,222

 

132,731,984

 

Diluted

 

196,619,866

 

132,931,813

 

188,399,848

 

132,845,970

 

 

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

 

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Table of Contents

 

REALTY INCOME CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the nine months ended September 30, 2013 and 2012

(dollars in thousands)(unaudited)

 

 

 

2013

 

2012

 

CASH FLOWS FROM OPERATING ACTIVITIES

 

 

 

 

 

Net income

 

$

181,650

 

$

120,129

 

Adjustments to net income:

 

 

 

 

 

Depreciation and amortization

 

221,603

 

105,828

 

Income from discontinued operations

 

(51,115

)

(12,266

)

Amortization of share-based compensation

 

14,235

 

7,780

 

Non-cash rental revenue adjustments

 

(3,862

)

(2,096

)

Amortization of net premiums on mortgages payable

 

(6,959

)

(278

)

Amortization of deferred financing costs

 

6,682

 

4,759

 

Other non-cash adjustments

 

 

(301

)

Cash provided by discontinued operations

 

5,257

 

9,984

 

Change in assets and liabilities:

 

 

 

 

 

Accounts receivable and other assets

 

1,481

 

3,594

 

Accounts payable, accrued expenses and other liabilities

 

(23,305

)

(28,605

)

Net cash provided by operating activities

 

345,667

 

208,528

 

CASH FLOWS FROM INVESTING ACTIVITIES

 

 

 

 

 

Acquisition of investment properties, net of cash received

 

(1,286,384

)

(650,627

)

Improvements to real estate, including leasing costs

 

(5,902

)

(4,501

)

Proceeds from sales of real estate:

 

 

 

 

 

Continuing operations

 

8

 

23

 

Discontinued operations

 

98,768

 

34,283

 

Loans receivable

 

(10,551

)

 

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

 

(7,344

)

(4,753

)

Net cash used in investing activities

 

(1,211,405

)

(625,575

)

CASH FLOWS FROM FINANCING ACTIVITIES

 

 

 

 

 

Cash distributions to common stockholders

 

(298,544

)

(175,719

)

Cash dividends to preferred stockholders

 

(31,447

)

(28,962

)

Borrowings on line of credit

 

2,096,300

 

908,000

 

Payments on line of credit

 

(1,785,900

)

(536,400

)

Proceeds from notes payable issued

 

750,000

 

 

Principal payment on notes payable

 

(100,000

)

 

Principal payments on mortgages payable

 

(16,207

)

(11,171

)

Proceeds from term loan

 

70,000

 

 

Proceeds from common stock offering, net

 

755,085

 

 

Proceeds from preferred stock offerings, net

 

 

395,377

 

Redemption of preferred stock

 

 

(127,500

)

Repayment of ARCT line of credit

 

(317,207

)

 

Repayment of ARCT term loan

 

(235,000

)

 

Distributions to noncontrolling interests

 

(751

)

 

Debt issuance costs

 

(9,150

)

(7,069

)

Proceeds from dividend reinvestment and stock purchase plan, net

 

3,827

 

2,159

 

Other items

 

(10,556

)

(3,039

)

Net cash provided by financing activities

 

870,450

 

415,676

 

Net increase (decrease) in cash and cash equivalents

 

4,712

 

(1,371

)

Cash and cash equivalents, beginning of period

 

5,248

 

4,165

 

Cash and cash equivalents, end of period

 

$

9,960

 

$

2,794

 

 

For supplemental disclosures, see note 18.

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

 

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Table of Contents

 

REALTY INCOME CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2013

(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, 2012, which are included in our 2012 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.

 

We report, in discontinued operations, the results of operations of properties that have either been sold or are classified as held for sale.  As a result, certain of the 2012 balances have been reclassified on our consolidated statements of income and statements of cash flows to conform to the 2013 presentation.  Due to the significance of recent acquisitions, we have separately reported acquired lease intangible assets and liabilities, which were previously reported in 2012 as a portion of other assets, net and other liabilities, net, respectively, on our consolidated balance sheets.

 

At September 30, 2013, we owned 3,866 properties, located in 49 states and Puerto Rico, containing over 61.2 million leasable square feet.

 

2.                  Summary of Significant Accounting Policies and Procedures

 

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 notes 4 and 12).  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, or the Code. 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 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, which are included in discontinued operations. The income taxes recorded on our consolidated statements of income represent amounts paid by Realty Income for city and state income and franchise taxes.

 

C.  We recognize an allowance for doubtful accounts relating to accounts receivable for amounts deemed uncollectible. We consider tenant specific issues, such as financial stability and ability to pay rent, when determining collectability of accounts receivable and appropriate allowances to record.  The allowance for doubtful accounts was $417,000 at September 30, 2013 and $448,000 at December 31, 2012.

 

D.  We allocate a portion of goodwill to our 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 allocating goodwill.  As we sell properties, our goodwill will likely continue to gradually decrease over time.

 

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E.  Under the amendments issued in conjunction with ASU No. 2011-08, Intangibles — Goodwill and Other (Topic 350), an entity, through an assessment of qualitative factors, is not required to calculate the estimated fair value of a reporting unit, in connection with the two-step goodwill impairment test, unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. Despite the issuance of ASU No. 2011-08, we elected to continue testing goodwill for impairment during the second quarter of each year as well as when events or circumstances occur, indicating that our goodwill might be impaired. During our tests for impairment of goodwill during the second quarters of 2013 and 2012, we determined that the estimated fair values of our reporting units exceeded their carrying values.  We did not have an impairment on our existing goodwill in 2013 and 2012.

 

3.         Supplemental Detail for Certain Components of Consolidated Balance Sheets

 

 

 

September 30,

 

December 31,

 

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

 

2013

 

2012

 

Loans receivable

 

 $

48,736

 

$

35,126

 

Deferred financing costs on notes payable, net

 

35,422

 

29,687

 

Notes receivable issued in connection with property sales

 

19,176

 

19,300

 

Prepaid expenses

 

11,323

 

9,489

 

Note receivable issued in connection with acquisition

 

8,780

 

8,780

 

Restricted escrow deposits

 

7,344

 

1,805

 

Credit facility origination costs, net

 

6,399

 

8,188

 

Impounds related to mortgages payable

 

5,325

 

-

 

Deferred financing costs on mortgages payable, net

 

1,346

 

1,541

 

Corporate assets, net

 

1,213

 

909

 

Deferred financing costs on term loan, net

 

263

 

-

 

Other items

 

761

 

424

 

 

 

 $

146,088

 

$

115,249

 

 

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

 

September 30,

 

December 31,

 

(dollars in thousands) at:

 

2013

 

2012

 

Acquired in-place leases

 

 $

832,583

 

$

235,914

 

Accumulated amortization of acquired in-place leases

 

(75,955

)

(29,601

)

Acquired above-market leases

 

215,532

 

40,389

 

Accumulated amortization of acquired above-market leases

 

(16,267

)

(4,577

)

 

 

 $

955,893

 

$

242,125

 

 

C.    Distributions payable consist of the following declared

 

September 30,

 

December 31,

 

distributions (dollars in thousands) at:

 

2013

 

2012

 

Common stock distributions

 

 $

35,704

 

$

20,251

 

Preferred stock dividends

 

3,494

 

3,494

 

Noncontrolling interests distributions

 

161

 

-

 

 

 

 $

39,359

 

$

23,745

 

 

D.    Accounts payable and accrued expenses consist of the

 

September 30,

 

December 31,

 

following (dollars in thousands) at:

 

2013

 

2012

 

Notes payable - interest payable

 

 $

27,877

 

$

40,061

 

Accrued costs on properties under development

 

11,556

 

8,595

 

Mortgages payable - accrued interest payable

 

3,007

 

648

 

Other items

 

26,859

 

21,122

 

 

 

 $

69,299

 

$

70,426

 

 

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

 

September 30,

 

December 31,

 

following (dollars in thousands) at:

 

2013

 

2012

 

Acquired below-market leases

 

 $

145,638

 

$

28,975

 

Accumulated amortization of acquired below-market leases

 

(7,945

)

(2,504

)

 

 

 $

137,693

 

$

26,471

 

 

F.     Other liabilities consist of the following

 

September 30,

 

December 31,

 

(dollars in thousands) at:

 

2013

 

2012

 

Rent received in advance

 

 $

26,007

 

$

20,929

 

Preferred units issued upon acquisition of ARCT

 

6,750

 

-

 

Security deposits

 

6,035

 

5,130

 

 

 

 $

38,792

 

$

26,059

 

 

 

4.         American Realty Capital Trust, Inc. (ARCT)

 

A.  Acquisition

On January 22, 2013, we completed our acquisition of ARCT for approximately $3.2 billion.  Each outstanding share of ARCT common stock was converted into the right to receive a combination of: (i) $0.35 in cash and (ii) 0.2874 shares of our common stock, resulting in the issuance of a total of 45,573,144 shares of our common stock to ARCT shareholders, valued at a per share amount of $44.04, which was the closing price of our common stock on January 22, 2013.  In connection with the closing of the ARCT acquisition, we repaid and terminated the amounts then outstanding of approximately $552.9 million under ARCT’s revolving credit facility and term loan.

 

The acquisition of ARCT is expected to provide immediate and long-term benefits to Realty Income, including accretion to net earnings, growth in the size of our real estate portfolio, diversification of industries and property type, increase in the percentage of investment grade tenants, and larger size and scope of our Company, which increases competitive advantages in the net-lease marketplace.

 

With this acquisition, we added 515 properties to our portfolio.  The preliminary allocation of the purchase price reflects aggregate consideration of approximately $2.1 billion, as calculated below (in thousands):

 

Consideration associated with equity issued (1)

 

 $

2,027,753

Cash consideration paid to previous owners of ARCT

 

56,216

Total purchase consideration

 

 $

2,083,969

 

(1) Includes the value associated with the issuance of the Tau Operating Partnership units discussed in 4.C. below.

 

We have accounted for the ARCT acquisition in accordance with ASC 805, Business Combinations, and are in the process of completing our allocation of the purchase price for this acquisition, which we expect to finalize later this year.  The following table summarizes our preliminary purchase price allocation, which represents our current best estimate of acquisition date fair values of the assets acquired and liabilities assumed (in thousands):

 

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Assets:

 

 

 

Real estate

 

 $

2,672,053

 

Acquired lease intangible assets

 

562,339

 

Cash and cash equivalents, accounts receivable, and other assets, net

 

42,275

 

Total Assets

 

3,276,667

 

 

 

 

 

Liabilities:

 

 

 

Lines of credit payable

 

317,207

 

Term loan

 

235,000

 

Mortgages payable

 

538,960

 

Acquired lease intangible liabilities

 

78,711

 

Accounts payable, accrued expenses, and other liabilities, net

 

22,820

 

Total Liabilities

 

1,192,698

 

 

 

 

 

Estimated fair value of net assets acquired

 

 $

2,083,969

 

 

 

The final allocation of the purchase price will be based on our assessment of the fair value of the acquired assets and liabilities using both Level 2 and 3 inputs.  The final purchase price allocation may be different from the estimates above.  Measurement period adjustments were made to the first two quarters of 2013 to adjust preliminary real estate values to reflect new information obtained about facts and circumstances that existed as of the acquisition date.  We consider these measurement period adjustments to be immaterial to our consolidated financial statements.

 

Investments in Real Estate Properties. We will estimate the fair value generally by applying an income approach methodology using both direct capitalization and discounted cash flow analysis. Key assumptions include capitalization and discount rates. Our valuations will be based, in part, on valuations prepared by an independent valuation firm.

 

Acquired Lease Intangibles. The fair value of in-place leases will be calculated based upon our estimate of the costs to obtain tenants in each of the applicable markets. An asset or liability will be recognized for acquired leases with favorable or unfavorable rents based on our estimate of current market rents in each of the applicable markets. Our valuations of the intangible assets will be based, in part, on valuations prepared by an independent valuation firm.

 

Debt. The fair value of debt will be estimated based on contractual future cash flows discounted using borrowing spreads and market interest rates that would be available to us for the issuance of debt with similar terms and remaining maturities.

 

B.  Transaction Costs

In connection with our acquisition of ARCT, we expect to incur total merger-related transaction costs of approximately $21 million, which include, but are not limited to, advisor fees, legal fees, accounting fees, printing fees and transfer taxes. During the first nine months of 2013, we incurred $12.9 million of the estimated $21 million of total merger-related transaction costs, which are included in income from continuing operations.  In 2012, we incurred $7.9 million of these total merger-related transaction costs.

 

C. Noncontrolling interests and preferred units

Consideration associated with equity issued includes the value of common and preferred partnership units issued in Tau Operating Partnership, L.P., or Tau Operating Partnership, the consolidated subsidiary which owns properties acquired through the ARCT acquisition.  Since the date of acquisition, Realty Income and its subsidiaries hold a 99.3% interest in the Tau Operating Partnership.

 

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The common units do not have voting rights, 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.  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 evaluated this guidance and determined that the common units meet the requirements to qualify for presentation as permanent equity.  See note 12 for the change in the carrying value of these common units from January 22, 2013 through September 30, 2013.

 

The Tau Operating Partnership preferred units have also been recorded at fair value as of the date of acquisition.  Since they are redeemable at a fixed price on a determinable date, we have classified them in other liabilities on our consolidated balance sheet.  Payments on these preferred units are made monthly at a rate of 2% per annum and are included in interest expense.  As of September 30, 2013, the preferred units have a carrying value of $6.75 million.

 

D.  Litigation

See note 23 for a discussion of certain legal proceedings related to our acquisition of ARCT.

 

5.     Investments in Real Estate

 

We acquire the land, buildings and improvements that are necessary for the successful operations of commercial enterprises.

 

A.                 Acquisitions during the First Nine Months of 2013 and 2012

During the first nine months of 2013, we invested $1.37 billion in 407 new properties and properties under development or expansion (excluding ARCT), with an estimated initial weighted average contractual lease rate of 7.0%. The 407 new properties and properties under development or expansion are located in 40 states, will contain over 8.0 million leasable square feet, and are 100% leased with a weighted average lease term of 14.1 years. The tenants occupying the new properties operate in 21 industries and the property types consist of 84.1% retail, 10.4% office, 3.1% industrial and distribution, and 2.4% manufacturing, based on rental revenue.

 

During the first nine months of 2013, we also completed our acquisition of ARCT for $3.2 billion, which added 515 properties to our real estate portfolio.  The 515 properties are located in 44 states and Puerto Rico, contain over 16.0 million leasable square feet, and are 100% leased with a weighted average lease term of 12.2 years.  The 69 tenants, occupying the 515 properties acquired, operate in 28 industries and the property types consist of 53.5% retail, 32.0% industrial and distribution, and 14.5% office, based on rental revenue.  We recorded ARCT merger-related transaction costs of $12.9 million in the first nine months of 2013.

 

Our combined total investment in real estate assets, including the ARCT acquisition, during the first nine months of 2013, was $4.52 billion.  None of our investments, during the first nine months of 2013, caused any one tenant to be 10% or more of our total assets at September 30, 2013.

 

Additionally, in September 2013, we purchased a property for $45.4 million in San Diego, California, which will serve as our new corporate headquarters. We plan on relocating to this facility during the second half of 2014.

 

The $4.52 billion invested during the first nine months of 2013, was allocated as follows: $769.4 million to land, $3.10 billion to buildings and improvements, $765.3 million to intangible assets related to leases, $13.5 million to other assets, net, and $143.4 million to intangible liabilities related to leases and other assumed liabilities.  We also recorded mortgage premiums of $28.4 million associated with the mortgages acquired.  There was no contingent consideration associated with these acquisitions.

 

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The properties acquired during the first nine months of 2013 generated total revenues of $148.1 million and income from continuing operations of $36.0 million.

 

The purchase price allocation for $3.43 billion of the $4.52 billion invested by us in the first nine months of 2013 is based on a preliminary measurement of fair value that is subject to change.  The allocation for these properties represents our current best estimate of fair value and we expect to finalize the valuations and complete the purchase price allocations in 2013.  In the first nine months of 2013, we finalized the purchase price allocations for $106.4 million invested in the second half of 2012 and $1.09 billion invested in the first nine months of 2013.  There were no material changes to our consolidated financial statements as a result of the finalization of these purchase price allocations.

 

During the first nine months of 2012, we invested $717.6 million in 245 new properties and properties under development or expansion, with an estimated initial weighted average contractual lease rate of 7.1%. These 245 new properties and properties under development or expansion, are located in 34 states, contain over 7.0 million leasable square feet, and are 100% leased with a weighted average lease term of 13.7 years. The tenants occupying the new properties operate in 20 industries and the property types consist of 77.0% retail, 16.4% industrial and distribution, 5.4% manufacturing, and 1.2% office, based on rental revenue.

 

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 under the lease 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 estimated initial weighted average contractual lease rate is computed as follows: estimated net operating income (which is calculated by multiplying the capitalization rate determined by the lease by our projected total investment in the property, including land, construction and capitalized interest costs) for the first full year of each lease, divided by such projected total investment in the property.  Of the $4.52 billion we invested in the first nine months of 2013, $28.8 million was invested in 19 properties under development or expansion with an estimated initial weighted average contractual lease rate of 8.5%.

 

B.                 Acquisition Transaction Costs

Acquisition transaction costs of $1.7 million and $1.4 million, respectively, were recorded to general and administrative expense on our consolidated statements of income for the nine months ended September 30, 2013, and September 30, 2012.

 

C.                 Investments in Existing Properties

During the first nine months of 2013, we capitalized $5.9 million of costs on existing properties in our portfolio, consisting of $1.1 million for re-leasing costs and $4.8 million for building and tenant improvements. In comparison, during the first nine months of 2012, we capitalized $4.5 million of costs on existing properties in our portfolio, consisting of $1.2 million for re-leasing costs and $3.3 million for building and tenant improvements.

 

D.                 Properties with Existing Leases

Of the $4.52 billion we invested in the first nine months of 2013, approximately $4.25 billion was used to acquire 756 properties with existing leases. Associated with these 756 properties, we recorded $596.4 million as the intangible value of the in-place leases, $177.8 million as the intangible value of above-market leases and $116.0 million as the intangible value of below-market leases. The value of the in-place and above-market leases is recorded to acquired lease intangible assets, net on our consolidated balance sheet, and the value of the below-market leases is recorded to acquired lease intangible liabilities, net on our consolidated balance sheet.  The values recorded to a majority of these intangible values, during the first nine months of 2013, are based on a preliminary measurement of fair value that is subject to change.

 

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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 nine months of 2013 and 2012, were $46.4 million and $10.3 million, respectively.

 

The values of the above-market and below-market leases are amortized as rental revenue on our consolidated statements of income. All of these amounts are amortized over the term of the respective leases.  The amounts amortized as a net decrease to rental revenue for capitalized above-market and below-market leases, for the first nine months of 2013 and 2012, were $6.2 million and $1.4 million, respectively.

 

If a lease were to be terminated prior to its stated expiration, all unamortized amounts relating to that lease would be recorded to revenue or expense as appropriate.

 

The following table presents the estimated impact during the next five years and thereafter related to the net decrease to rental revenue from the amortization of the acquired above-market and below-market lease intangibles and the increase to amortization expense from the amortization of the in-place lease intangibles for properties owned at September 30, 2013 (in thousands):

 

 

 

Net decrease

 

Increase to

 

 

 

to rental

 

amortization

 

 

 

revenue

 

expense

 

2013

 

$

(2,419

)

$

19,092

 

2014

 

(9,771

)

75,917

 

2015

 

(9,614

)

72,436

 

2016

 

(9,469

)

70,236

 

2017

 

(9,447

)

69,239

 

Thereafter

 

(20,852

)

449,708

 

Totals

 

$

(61,572

)

$

756,628

 

 

E.   Pro Forma Information

 

The following pro forma total revenue and income from continuing operations, for the first nine months of 2013 and 2012, assumes all of our property acquisitions, including ARCT, for the first nine months of 2013 occurred on January 1, 2012.  This pro forma supplemental information does not include: (1) the impact of any synergies or lower borrowing costs that we have or may achieve as a result of the acquisitions, or any strategies that management has or may consider in order to continue to efficiently manage our operations, and (2) ARCT’s historical operational costs, including general and administrative costs and property expenses.  Additionally, this information does not purport to be indicative of what our operating results would have been, had the acquisitions occurred on January 1, 2012, and may not be indicative of future operating results.  For purposes of calculating these pro-forma amounts, we assumed that merger-related costs of approximately $12.4 million, which represent the estimated merger-related costs incurred after consummation of our ARCT acquisition, occurred on January 1, 2012.  Other than the item specified above, no material, non-recurring pro-forma adjustments were included in the calculation of this information.

 

 

 

 

 

Income from

 

 

 

Total

 

continuing

 

Dollars in millions

 

revenue

 

operations

 

Supplemental pro forma for the nine months ended September 30, 2013

 

$

606.1

 

$

166.0

 

Supplemental pro forma for the nine months ended September 30, 2012

 

$

540.1

 

$

146.1

 

 

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6.     Credit Facility

 

We have a $1 billion unsecured acquisition credit facility, with an initial term that expires in May 2016, and includes, at our election, a one-year extension option. Under this credit facility, our current investment grade credit ratings provide for financing at the London Interbank Offered Rate, commonly referred to as LIBOR, plus 1.075% with a facility commitment fee of 0.175%, for all-in drawn pricing of 1.25% over LIBOR. The borrowing rate is not subject to an interest rate floor or ceiling. We also have other interest rate options available to us under this credit facility. Our credit facility is unsecured and, accordingly, we have not pledged any assets as collateral for this obligation.  On October 29, 2013, our credit facility was increased by $500 million to $1.5 billion and the available borrowing capacity under our acquisition credit facility was approximately $1.4 billion, after expansion of the credit facility and paying down borrowings with proceeds from our stock offering in October 2013 (see note 23).  All other material business terms of the credit facility remain unchanged.

 

At September 30, 2013, credit facility origination costs of $6.4 million are included in other assets, net, on our consolidated balance sheet.  These costs are being amortized over the remaining term of our current $1 billion credit facility.

 

At September 30, 2013, we had a borrowing capacity of $531.6 million available on our credit facility (subject to customary conditions to borrowing) and an outstanding balance of $468.4 million, as compared to an outstanding balance of $158.0 million at December 31, 2012.

 

The weighted average interest rate on outstanding borrowings under our credit facility was 1.3%, during the first nine months of 2013, and 1.6% during the first nine months of 2012. At September 30, 2013, the effective interest rate was 1.3%.  Our current and prior credit facilities are and were subject to various leverage and interest coverage ratio limitations. At September 30, 2013, we remain in compliance with these covenants.

 

7.     Mortgages Payable

 

During the first nine months of 2013, we assumed mortgages totaling $630.0 million, excluding net premiums.  The mortgages are secured by the properties on which the debt was placed. Of the $630.0 million of mortgages assumed during the first nine months of 2013, approximately $608.8 million is considered non-recourse with limited customary exceptions for items such as bankruptcy, misrepresentation, fraud, misapplication of payments, environmental liabilities, failure to pay taxes, insurance premiums, liens on the property and uninsured losses.  Approximately $6.6 million has full recourse to Realty Income, and the remaining $14.6 million of the assumed debt is not guaranteed by and is non-recourse to Realty Income.  We expect to pay off the mortgages as soon as prepayment penalties have declined to a level that will make it economically feasible to do so.  We intend to continue to primarily identify property acquisitions that are free from mortgage indebtedness.  In August 2013, we repaid one mortgage in full for $11.7 million.

 

During the first nine months of 2013, aggregate net premiums totaling $28.4 million were recorded upon assumption of the mortgages for above-market interest rates, as compared to net premiums totaling $7.1 million recorded in 2012. Amortization of these net premiums is recorded as a reduction to interest expense over the remaining term of the respective mortgages, using a method that approximates the effective-interest method.

 

These mortgages contain customary covenants, such as limiting our ability to further mortgage each applicable property or to discontinue insurance coverage, without the prior consent of the lender. At September 30, 2013, we remain in compliance with these covenants.

 

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As a result of assuming mortgages payable, we incurred deferred financing costs of $211,000 in the first nine months of 2013 and $1.1 million in all of 2012, which are classified as part of other assets, net, on our consolidated balance sheets.  The balance of these deferred financing costs was $1.3 million at September 30, 2013 and $1.5 million at December 31, 2012 which is being amortized over the remaining term of each mortgage.

 

The following is a summary of all our mortgages payable as of September 30, 2013, and December 31, 2012, respectively (dollars in thousands):

 

 

 

 

 

Weighted

 

Weighted

 

Weighted

 

 

 

 

 

 

 

 

 

 

 

Average

 

Average

 

Average

 

 

 

 

 

 

 

 

 

 

 

Stated

 

Effective

 

Remaining

 

Remaining

 

Unamortized

 

Mortgage

 

 

 

Number of

 

Interest

 

Interest

 

Years Until

 

Principal

 

Premium

 

Payable

 

As Of

 

Properties(1)

 

Rate(2)

 

Rate(3)

 

Maturity

 

Balance

 

Balance

 

Balance

 

9/30/13

 

229

 

5.4%

 

4.0%

 

4.1

 

$

779,684

 

$

31,373

 

$

811,058

 

12/31/12

 

11

 

5.8%

 

4.4%

 

4.8

 

$

165,927

 

$

9,941

 

$

175,868

 

 

(1) At September 30, 2013, there were 50 mortgages on 229 properties, while at December 31, 2012, there were 13 mortgages on 11 properties.  The mortgages require monthly payments, with principal payments due at maturity.  The mortgages are at fixed interest rates, except for: (1) a $23.6 million mortgage maturing on June 10, 2015 with a floating variable interest rate calculated as the sum of the current one month LIBOR plus 4.5%, not to exceed an all-in interest rate of 5.5%, (2) a $8.3 million mortgage maturing on September 3, 2021, with a floating interest rate calculated as the sum of the current one month LIBOR plus 2.4%, and (3) a $32.4 million mortgage maturing on April 10, 2017, which is fixed at 5.07% through December 28, 2015, but is reset to the greater of 4.0%, or the two-year swap rate plus 2.75% thereafter.  As part of the $8.3 million mortgage payable assumed in 2012, we also acquired an interest rate swap which essentially fixes the interest rate on this mortgage payable at 6.0%.  As part of the $32.4 million mortgage payable assumed in 2013, we have the opportunity to prepay the mortgage at par on December 28, 2015, prior to the variable interest rate reset.  As part of two mortgages totaling $8.8 million and maturing on December 28, 2013, we also acquired an $8.8 million note receivable, upon which we receive interest income at a stated rate of 8.1% through December 28, 2013.

(2) Stated interest rates ranged from 2.5% to 8.3% at September 30, 2013, while stated interest rates ranged from 2.6% to 8.3% at December 31, 2012.

(3) Effective interest rates ranged from 2.4% to 9.2% at September 30, 2013, while effective interest rates ranged from 2.7% to 8.3% at December 31, 2012.

 

The following table summarizes the maturity of mortgages payable, excluding net premiums of $31.4 million, as of September 30, 2013 (dollars in millions):

 

Year of

 

 

 

Maturity

 

 

 

2013

 

$

10.7

 

2014

 

64.4

 

2015

 

125.5

 

2016

 

248.4

 

2017

 

133.1

 

Thereafter

 

197.6

 

Totals

 

$

779.7

 

 

8.     Term Loan

 

In January 2013, in conjunction with our acquisition of ARCT, we entered into a $70 million senior unsecured term loan maturing January 21, 2018.  Borrowing under the term loan bears interest at the current one month LIBOR, plus 1.2%.  In conjunction with this term loan, we also acquired an interest rate swap, which essentially fixes our per annum interest rate on the term loan at 2.15%.  The interest rate swap has a nominal value at September 30, 2013. As a result of entering into our term loan, we incurred deferred financing costs of $303,000, which are being amortized over the remaining term of the term loan. The net balance of these deferred financing costs was $263,000, which are classified as part of other assets, net, on our consolidated balance sheet at September 30, 2013.

 

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9.     Notes Payable

 

A.  General

 

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

 

 

 

September 30,

 

December 31,

 

 

 

2013

 

2012

 

5.375% notes, issued in March 2003 and repaid in March 2013

 

   $

-

 

$

100

 

5.5% notes, issued in November 2003 and due in November 2015

 

150

 

150

 

5.95% notes, issued in September 2006 and due in September 2016

 

275

 

275

 

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

 

175

 

175

 

2.0% notes, issued in October 2012 and due in January 2018

 

350

 

350

 

6.75% notes, issued in September 2007 and due in August 2019

 

550

 

550

 

5.75% notes, issued in June 2010 and due in January 2021

 

250

 

250

 

3.25% notes, issued in October 2012 and due in October 2022

 

450

 

450

 

4.65% notes, issued in July 2013 and due in August 2023

 

750

 

-

 

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

 

 

 

 

 

June 2011, both due in March 2035

 

250

 

250

 

 

 

   $

3,200

 

$

2,550

 

 

As of September 30, 2013, the weighted average interest rate of our notes and bonds payable was 4.9% and the weighted average remaining years until maturity was 7.9 years.

 

B.    Note Repayment

In March 2013, we repaid the $100 million of outstanding 5.375% notes, plus accrued and unpaid interest, using proceeds from our March 2013 common stock offering and our credit facility.

 

C.     Note Issuance

In July 2013, we issued $750 million of 4.65% senior unsecured notes due August 2023, or the 2023 Notes.  The price to the investors for the 2023 Notes was 99.775% of the principal amount for an effective yield of 4.678% per annum.  The total net proceeds of approximately $741.4 million from these offerings were used to repay all outstanding borrowings under our acquisition credit facility, and the remaining proceeds were used for other general corporate purposes and working capital, including additional property acquisitions.  Interest is paid semiannually on the 2023 Notes.

 

10.     Issuance and Redemption of Preferred Stock

 

A.  In February 2012, we issued 14.95 million shares of our 6.625% Monthly Income Class F Cumulative Redeemable Preferred Stock at a price of $25.00 per share, including 1.95 million shares purchased by the underwriters upon the exercise of their overallotment option. In April 2012, we issued an additional 1.4 million shares of our Class F preferred stock at a price of $25.2863 per share.  After aggregate underwriting discounts and other offering costs of $13.8 million, we received net proceeds of $395.4 million for the February and April offerings combined, of which $127.5 million was used to redeem all of our outstanding 7.375% Monthly Income Class D Cumulative Redeemable Preferred Stock and the balance was used to repay a portion of the borrowings under our credit facility. Beginning February 15, 2017, the Class F preferred shares are redeemable, at our option, for $25 per share.  The initial dividend of $0.1702257 per share was paid on March 15, 2012 and covered 37 days. Thereafter, dividends of $0.138021 per share are paid monthly in arrears on the Class F preferred stock.

 

B.  We redeemed all of the 5.1 million shares of our 7.375% Monthly Income Class D Cumulative Redeemable Preferred Stock in March 2012 for $25.00 per share, plus accrued dividends.  We incurred a charge of $3.7 million for the first nine months of 2012, representing the Class D preferred stock original issuance costs that we paid in 2004.

 

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11.   Issuance of Common Stock

 

In March 2013, we issued 17,250,000 shares of common stock at a price of $45.90 per share, including 2,250,000 shares purchased by the underwriters upon the exercise of their overallotment option.  After underwriting discounts and other offering costs of $36.7 million, the net proceeds of $755.1 million were used to redeem our 5.375% notes in March 2013 and repay borrowings under our acquisition credit facility, which were used to fund property acquisitions, including our acquisition of ARCT.

 

In connection with our January 2013 acquisition of ARCT, as described in note 4, we issued a total of 45,573,144 shares of our common stock to ARCT shareholders and we received 208,709 shares of our common stock that were previously held by ARCT.  The closing price per share of our common stock on the date of the ARCT acquisition was $44.04.  The total value of the 45,573,144 common shares was approximately $2 billion.

 

12.   Noncontrolling Interests

 

In June 2013, we completed the acquisition of a portfolio of properties by issuing units in a newly formed entity, Realty Income, L.P.  The units issued as consideration for the acquisition represent a

2.2% ownership in Realty Income, L.P. at September 30, 2013.  Realty Income holds the remaining 97.8% interests in this entity, and consolidates the entity.

 

The Realty Income, L.P. units do not have voting rights, 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 evaluated this guidance and determined that the units meet the requirements to qualify for presentation as permanent equity.

 

The following table represents the change in the carrying value of all noncontrolling interests, including Tau Operating Partnership units which are discussed in note 4, through September 30, 2013 (dollars in thousands):

 

 

 

Tau Operating

 

Realty Income, L.P.

 

 

 

 

 

Partnership units(1)

 

units(2)

 

Total

 

Fair value of units issued

 

$

13,962

 

$

22,600

 

$

36,562

 

Distributions

 

(518

)

(388

)

(906

)

Allocation of net income

 

153

 

269

 

422

 

Carrying value at September 30, 2013

 

$

13,597

 

$

22,481

 

$

36,078

 

 

(1)

Tau Operating Partnership units issued on January 22, 2013.

(2)

Realty Income, L.P. units issued on June 27, 2013.

 

13.   Fair Value of Financial Assets and Liabilities

 

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.

 

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We believe that the carrying values reflected on our consolidated balance sheets reasonably approximate the fair values for cash and cash equivalents, accounts receivable, escrow deposits, loans receivable, lines of credit payable, term loan 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 or acquired in connection with an acquisition, mortgages payable and our senior notes and bonds payable, which are disclosed below (dollars in millions):

 

 

 

Carrying value per

 

Estimated fair

 

At September 30, 2013

 

balance sheet

 

value

 

Notes receivable issued in connection with property sales

 

$

19.2

 

$

21.1

 

Note receivable issued in connection with an acquisition

 

8.8

 

8.8

 

Mortgages payable assumed in connection with acquisitions

 

811.1

 

798.1

 

Notes payable

 

3,200.0

 

3,369.1

 

 

 

 

 

 

 

 

 

Carrying value per

 

Estimated fair

 

At December 31, 2012

 

balance sheet

 

value

 

Notes receivable issued in connection with property sales

 

$

19.3

 

$

20.5

 

Note receivable issued in connection with an acquisition

 

8.8

 

8.8

 

Mortgages payable assumed in connection with acquisitions

 

175.9

 

176.7

 

Notes payable

 

2,550.0

 

2,827.1

 

 

The estimated fair values of our notes receivable, issued in connection with property sales or acquired in connection with an acquisition, and our mortgages payable have been calculated by discounting the future cash flows using an interest rate based upon the current 5-year, 7-year or 10-year Treasury yield curve, plus an applicable credit-adjusted spread. Because this methodology includes unobservable inputs that reflect our own internal assumptions and calculations, the measurement of estimated fair values, related to our notes receivable and mortgages payable, is categorized as level three on the three-level valuation hierarchy.

 

The estimated fair value of our notes payable is 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 payable, is categorized as level two on the three-level valuation hierarchy.

 

14.   Gain on Sales of Investment Properties

 

During the third quarter of 2013, we sold 19 investment properties for $22.4 million, which resulted in a gain of $6.2 million.  During the first nine months of 2013, we sold 53 investment properties for

$106.1 million, which resulted in a gain of $50.5 million.  The results of operations for these properties have been reclassified as discontinued operations.

 

In comparison, during the third quarter of 2012, we sold 11 investment properties for $15.8 million, which resulted in a gain of $2.0 million.   During the first nine months of 2012, we sold 30 investment properties for $34.3 million, which resulted in a gain of $6.0 million.  The results of operations for these properties have been reclassified as discontinued operations.

 

15.   Discontinued Operations

 

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 estimate in this analysis include projected rental rates, estimated holding periods, 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.

 

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For the third quarter of 2013, we recorded total provisions for impairment of $76,000 on one sold property in the restaurant-casual dining industry.  For the first nine months of 2013, we recorded total provisions for impairment of $3.0 million on seven sold properties, and two properties classified as held for sale, in the following industries: one in the automotive parts industry, two in the automotive service industry, two in the child care industry, one in the grocery store industry, one in the pet supplies and services industry, and two in the restaurant-casual dining industry.  These provisions for impairment are included in income from discontinued operations on our consolidated statement of income for the three and nine months ended September 30, 2013.  For the three and nine months ended September 30, 2012, we recorded total provisions for impairment of $667,000 on two properties, one in the convenience store industry and one in the automotive tire services industry, both of which were sold during 2012.

 

Operations from 22 Realty Income investment properties and two owned by our wholly owned taxable REIT subsidiary, Crest Net Lease, Inc., or Crest, investment properties classified as held for sale at September 30, 2013, plus properties previously sold, are reported as discontinued operations. Their respective results of operations have been reclassified as income from discontinued operations on our consolidated statements of income. We do not depreciate properties that are classified as held for sale.

 

No debt was assumed by buyers of our investment properties, or repaid as a result of our investment property sales, and we do not allocate interest expense to discontinued operations related to real estate held for investment. We allocate interest expense related to borrowings specifically attributable to Crest. The interest expense amounts allocated to Crest are included in income from discontinued operations.

 

The following is a summary of income from discontinued operations on our consolidated statements of income (dollars in thousands):

 

 

 

Three months ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

Income from discontinued operations

 

2013

 

2012

 

2013

 

2012

 

Gain on sales of investment properties

 

$

6,163

 

$

2,045

 

$

50,467

 

$

6,010

 

Rental revenue

 

789

 

3,480

 

4,618

 

10,902

 

Other revenue

 

7

 

45

 

414

 

66

 

Depreciation and amortization

 

(387

)

(834

)

(1,436

)

(2,971

)

Property expenses

 

(136

)

(459

)

(665

)

(1,579

)

Provisions for impairment

 

(76

)

(667

)

(3,028

)

(667

)

Crest’s income from discontinued operations

 

252

 

225

 

745

 

505

 

Income from discontinued operations

 

$

6,612

 

$

3,835

 

$

51,115

 

$

12,266

 

Per common share, basic and diluted

 

$

0.03

 

$

0.03

 

$

0.27

 

$

0.09

 

 

16.   Distributions Paid and Payable

A.  Common Stock

We pay monthly dividends to our common stockholders. The following is a summary of the monthly dividends paid per common share for the first nine months of 2013 and 2012:

 

Month

 

2013

 

2012

 

January

 

$

0.1517500

 

$

0.1455000

 

February

 

0.1809167

 

0.1455000

 

March

 

0.1809167

 

0.1455000

 

April

 

0.1812292

 

0.1458125

 

May

 

0.1812292

 

0.1458125

 

June

 

0.1812292

 

0.1458125

 

July

 

0.1815417

 

0.1461250

 

August

 

0.1815417

 

0.1461250

 

September

 

0.1815417

 

0.1511250

 

 

 

 

 

 

 

Total

 

$

1.6018961

 

$

1.3173125

 

 

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At September 30, 2013, a distribution of $0.1818542 per common share was payable and was paid in October 2013.

 

B.  Preferred Stock

In March 2012, we redeemed all of our 5.1 million shares of 7.375% Monthly Income Class D Cumulative Redeemable Preferred Stock, which were issued in 2004. During the first three months of 2012, we paid dividends to holders of our Class D preferred stock totaling $0.3841147 per share, or $2.0 million.

 

In 2006, we issued 8.8 million shares of our 6.75% Monthly Income Class E Cumulative Redeemable Preferred Stock for $25.00 per share.  As of December 7, 2011, the Class E preferred shares were redeemable, at our option, for $25.00 per share. During each of the first nine months of 2013 and 2012, we paid nine monthly dividends to holders of our Class E preferred stock totaling $1.265625 per share, or $11.1 million, and at September 30, 2013, a monthly dividend of $0.140625 per share was payable and was paid in October 2013.

 

In February 2012, we issued 14.95 million shares of 6.625% Monthly Income Class F Cumulative Redeemable Preferred Stock at a price of $25.00 per share. In April 2012, we issued an additional 1.4 million shares of our Class F preferred stock at a price of $25.2863 per share.  Beginning February 15, 2017, shares of our Class F preferred shares are redeemable, at our option, for $25.00 per share, plus any accrued and unpaid dividends. During the first nine months of 2013, we paid nine monthly dividends to holders of our Class F preferred stock totaling $1.242189 per share, or $20.3 million, and during the first nine months of 2012, we paid seven monthly dividends to holders of our Class F preferred stock totaling $.9983517, or $15.9 million.  The initial March 2012 dividend on our Class F preferred stock covered 37 days.  At September 30, 2013, a monthly dividend of $0.138021 per share was payable and was paid in October 2013.

 

We are current in our obligations to pay dividends on our Class E and Class F preferred stock.

 

C.  Tau Operating Partnership Common Units

As part of our acquisition of ARCT, we issued 317,022 common partnership units of Tau Operating Partnership.  These common units are entitled to monthly distributions equivalent to the per common share amounts paid to the common stockholders of Realty Income.  For the first nine months of 2013, we paid eight monthly distributions to holders of these common units totaling $1.4501461 per unit, or $460,000, and at September 30, 2013, a monthly distribution of $0.1818542 per common unit was payable and was paid in October 2013.

 

D.  Realty Income, L.P. units

In June 2013, we issued 534,546 common partnership units of Realty Income, L.P. These common units are entitled to monthly distributions equivalent to the per common share amount paid to the common stockholders of Realty Income.  For the first nine months of 2013, we paid three monthly distributions to holders of these common units totaling $0.5446251 per unit, or $291,000, and at September 30, 2013, a monthly distribution of $0.1818542 per common unit was payable and was paid in October 2013.

 

17.   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 for the period by the weighted average number of common shares that would have been outstanding assuming the issuance of common shares for all potentially dilutive common shares outstanding during the reporting period.

 

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

 

 

 

Three months ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

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

 

195,768,298

 

132,764,877

 

187,805,222

 

132,731,984

 

Weighted average of Tau Operating Partnership common units convertible to common shares

 

317,022

 

-

 

292,636

 

-

 

Weighted average of Realty Income, L.P. common units convertible to common shares

 

534,546

 

-

 

187,972

 

-

 

Incremental shares from share-based compensation

 

-

 

166,936

 

114,018

 

113,986

 

Adjusted weighted average shares used for diluted net income per share computation

 

196,619,866

 

132,931,813

 

188,399,848

 

132,845,970

 

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

 

60,259

 

600

 

59,749

 

17,200

 

 

18.    Supplemental Disclosures of Cash Flow Information

 

Cash paid for interest was $142.4 million in the first nine months of 2013 and $105.7 million in the first nine months of 2012.

 

Interest capitalized to properties under development was $579,000 in the first nine months of 2013 and $388,000 in the first nine months of 2012.

 

Cash paid for income taxes was $1.5 million in the first nine months of 2013 and $961,000 in the first nine months of 2012.

 

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

 

A.   Share-based compensation expense was $14.2 million for the first nine months of 2013 and was $7.8 million for the first nine months of 2012.

 

B.  See note 15 for a discussion of impairments in discontinued operations, for the first nine months of 2013 and 2012.

 

C.  During the first nine months of 2013, the following components were acquired in connection with our acquisition of ARCT: (1) real estate investments and related intangible assets of $3.2 billion, (2) other assets of $20.0 million, (3) lines of credit payable of $317.2 million, (4) a term loan for $235.0 million, (5) mortgages payable of $539.0 million, (6) intangible liabilities of $78.7 million, (7) other liabilities of $29.6 million, and (8) noncontrolling interests of $14.0 million.

 

D.   During the first nine months of 2013, we acquired mortgages payable, (excluding the mortgages payable discussed in items C. and E.) to third-party lenders of $81.3 million and recorded $5.7 million of net premiums related to property acquisitions.  During the first nine months of 2012, we assumed $70.0 million of mortgages payable to third-party lenders and recorded $7.1 million of net premiums.

 

E.   During the first nine months of 2013, we acquired $55.9 million of real estate through the assumption of a $32.4 million mortgage payable, the issuance of 534,546 units by Realty Income, L.P. and cash of $1.0 million.

 

F.  During the first nine months of 2013, we acquired real estate for $7.4 million via exchanges of our properties.

 

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G.  During the first nine months of 2013, we recorded receivables of $1.9 million for the sale of two investment properties as a result of an eminent domain action.  These receivables are included in “other assets” on our consolidated balance sheet at September 30, 2013.

 

H.  Accrued costs on properties under development resulted in an increase in buildings and improvements and accounts payable of $3.0 million at September 30, 2013.

 

19.   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 48 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, revenue is the only component of segment profit and loss we measure.

 

The following tables set forth certain information regarding the properties owned by us, classified according to the business of the respective tenants, as of September 30, 2013 (dollars in thousands):

 

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Table of Contents

 

 

 

September 30,

 

December 31,

Assets, as of:

 

2013

 

2012

Segment net real estate:

 

 

 

 

Automotive service

 

     $

 114,319

 

     $

 96,830

Automotive tire services

 

260,783

 

184,601

Beverages

 

307,347

 

310,555

Child care

 

58,137

 

61,747

Convenience stores

 

776,483

 

672,109

Dollar stores

 

804,024

 

450,566

Drug stores

 

912,878

 

159,482

Financial services

 

254,177

 

25,166

Food processing

 

131,206

 

102,964

Grocery stores

 

284,665

 

219,216

Health and fitness

 

480,030

 

330,503

Health care

 

228,471

 

4,562

Home improvement

 

136,558

 

55,149

Restaurants-casual dining

 

483,578

 

448,569

Restaurants-quick service

 

320,932

 

250,692

Theaters

 

371,176

 

381,123

Transportation services

 

624,524

 

130,203

Wholesale club

 

458,866

 

308,202

30 other non-reportable segments

 

1,712,924

 

849,898

Total segment net real estate

 

8,721,078

 

5,042,137

 

 

 

 

 

Intangible assets:

 

 

 

 

Automotive service

 

3,346

 

-

Automotive tire services

 

16,142

 

470

Beverages

 

3,119

 

3,313

Convenience stores

 

13,938

 

-

Dollar stores

 

46,874

 

12,475

Drug stores

 

187,131

 

14,885

Financial services

 

41,394

 

4,443

Food processing

 

24,184

 

21,785

Grocery stores

 

23,424

 

5,650

Health and fitness

 

60,460

 

15,056

Health care

 

38,381

 

-

Home improvement

 

21,989

 

-

Restaurants-casual dining

 

12,163

 

-

Restaurants-quick service

 

16,447

 

3,464

Theaters

 

24,819

 

28,475

Transportation services

 

110,446

 

27,997

Wholesale club

 

33,977

 

-

Other non-reportable segments

 

277,659

 

104,112

 

 

 

 

 

Goodwill:

 

 

 

 

Automotive service

 

470

 

471

Automotive tire services

 

865

 

865

Child care

 

5,160

 

5,276

Convenience stores

 

2,049

 

2,064

Restaurants-casual dining

 

2,349

 

2,430

Restaurants-quick service

 

1,150

 

1,176

Other non-reportable segments

 

3,696

 

4,663

Other corporate assets

 

188,217

 

142,156

Total assets

 

     $

 9,880,927

 

     $

 5,443,363

 

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Table of Contents

 

 

 

Three months ended

 

Nine Months Ended

 

 

September 30,

 

September 30,

Revenue

 

2013

 

2012

 

2013

 

2012

Segment rental revenue:

 

 

 

 

 

 

 

 

Automotive service

 

     $

 3,858

 

     $

 3,576

 

     $

 11,488

 

     $

 10,823

Automotive tire services

 

6,882

 

5,641

 

20,154

 

16,962

Beverages

 

6,246

 

6,171

 

18,603

 

18,381

Child care

 

5,141

 

5,237

 

15,761

 

15,695

Convenience stores

 

21,727

 

19,128

 

62,178

 

57,198

Dollar stores

 

12,185

 

3,618

 

31,959

 

4,745

Drug stores

 

17,767

 

4,165

 

40,690

 

12,180

Financial services

 

3,890

 

702

 

10,950

 

2,084

Food processing

 

2,815

 

1,383

 

8,299

 

4,148

Grocery stores

 

5,626

 

4,436

 

16,583

 

13,308

Health and fitness

 

11,843

 

8,059

 

33,005

 

23,981

Health care

 

3,824

 

70

 

10,633

 

210

Home improvement

 

3,148

 

1,784

 

9,078

 

5,322

Restaurants-casual dining

 

9,805

 

8,299

 

28,719

 

24,975

Restaurants-quick service

 

8,096

 

6,617

 

23,848

 

19,990

Theaters

 

11,538

 

11,364

 

34,584

 

33,622

Transportation services

 

10,427

 

2,942

 

29,505

 

8,569

Wholesale club

 

8,655

 

3,359

 

20,696

 

9,410

30 other non-reportable segments

 

41,956

 

20,244

 

116,824

 

57,995

Total rental revenue

 

195,429

 

116,795

 

543,557

 

339,598

Other revenue

 

3,875

 

354

 

6,841

 

1,211

Total revenue

 

     $

 199,304

 

     $

 117,149

 

     $

 550,398

 

     $

 340,809

 

20.     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, employees and consultants considered essential to our long-term success. The 2012 Plan offers our directors, employees and consultants an opportunity to own stock in Realty Income 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 10 years from the date it was adopted by the Board of Directors.

 

The amount of share-based compensation costs recognized in general and administrative expense on our consolidated statements of income was $6.7 million during the third quarter of 2013, $2.2 million during the third quarter of 2012, $14.2 million during the first nine months of 2013, and $7.8 million during the first nine months of 2012.

 

The following table summarizes our common stock grant activity under the 2012 Plan and the previous 2003 Incentive Award Plan of Realty Income Corporation, or the 2003 Plan. Our common stock grants vest over periods ranging from immediately to five years.

 

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Table of Contents

 

 

 

For the nine months ended

 

For the year ended

 

 

September 30, 2013

 

December 31, 2012

 

 

 

 

Weighted

 

 

 

Weighted

 

 

Number of

 

average

 

Number of

 

average

 

 

shares

 

price(1)

 

shares

 

price(1)

Outstanding nonvested shares, beginning of year

 

895,550

 

$

 19.94

 

925,526

 

$

 20.21

Shares granted

 

402,296

 

41.89

 

261,811

 

35.06

Shares vested

 

(541,774

)

29.43

 

(290,877

)

27.47

Shares forfeited

 

(2,646

)

37.35

 

(910

)

31.67

Outstanding nonvested shares, end of each period

 

753,426

 

$

 27.04

 

895,550

 

$

 19.94

 

(1) Grant date fair value.

 

During the first nine months of 2013, we issued 402,296 shares of common stock under the 2012 Plan. These shares vest over the following service periods: 25,662 vested immediately, 62,989 vest over a service period of one year, 12,000 vest over a service period of three years, 77,180 shares vest over a service period of four years, and 173,011 vest over a service period of five years.  Additionally, 51,454 shares of performance-based common stock was granted, of which 12,864 shares may vest at the end of 2013, 2014, 2015 and 2016, if certain performance metrics are reached.

 

As of September 30, 2013, the remaining unamortized share-based compensation expense totaled $20.4 million, which is being amortized on a straight-line basis over the service period of each applicable award.

 

Due to a historically low turnover rate, we do not estimate a forfeiture rate for our nonvested shares. Accordingly, unexpected forfeitures will lower share-based compensation expense during the applicable period. Under the terms of our 2012 and 2003 Plans, we pay non-refundable dividends to the holders of our nonvested shares. Applicable accounting guidance requires that the dividends paid to holders of these nonvested shares be charged as compensation expense to the extent that they relate to nonvested shares that do not or are not expected to vest. However, since we do not estimate forfeitures given our historical trends, we did not record any compensation expense related to dividends paid in the first nine months of 2013 or 2012.

 

The Compensation Committee of our Board of Directors approved, effective July 1, 2013, the accelerated vesting of each restricted stock award that had originally been granted with ten-year vesting to five years.  On July 1, 2013, 212,827 restricted shares vested due to this acceleration, resulting in additional compensation expense of $3.7 million during the three and nine months ended September 30, 2013.

 

In connection with his appointment to Chief Executive Officer in September 2013, John Case was granted 77,180 shares of restricted common stock that vest over a service period of four years.  Additionally, Mr. Case was granted a performance-based restricted stock award of 51,454 shares of our restricted common stock.  A portion of this performance-based award will vest each year on December 31, 2013, 2014, 2015 and 2016, up to an aggregate of 12,864 shares of our common stock each year based on the achievement of seven annual performance metrics.

 

21.            Dividend Reinvestment and Stock Purchase Plan

 

In March 2011, we established a Dividend Reinvestment and Stock Purchase Plan, or the DSPP, to provide our common stockholders, as well as new investors, with a convenient and economical method of purchasing our common stock and reinvesting their distributions. The DSPP also allows our current stockholders to buy additional shares of common stock by reinvesting all or a portion of their distributions.

 

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Table of Contents

 

The DSPP authorizes up to 6,000,000 common shares to be issued.  During the first nine months of 2013, we issued 89,975 shares and raised approximately $3.9 million under the DSPP.  During the first nine months of 2012, we issued 55,598 shares and raised approximately $2.2 million under the DSPP.  From the inception of the DSPP through September 30, 2013, we have issued 205,178 shares and raised approximately $8.1 million.

 

In March 2013, we updated our DSPP so that we are now paying for a majority of the plan-related fees, which were previously paid by the investors.

 

22.            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 September 30, 2013, we have contingent payments of $1.9 million for tenant improvements and leasing costs. In addition, as of September 30, 2013, we had committed $8.8 million under construction contracts, which is expected to be paid in the next twelve months.

 

23.            Subsequent Events

 

In October 2013, we declared the following dividends, which will be paid in November 2013:

 

-                    $0.1818542 per share to our common stockholders;

-                    $0.140625 per share to our Class E preferred stockholders; and

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

 

In October 2013, we issued 9,775,000 shares of common stock at a price of $40.63 per share, including 1,275,000 shares purchased by the underwriters upon the exercise of their option to purchase additional shares.  After underwriting discounts and other estimated offering costs of $18.8 million, the net proceeds of approximately $378.4 million were used to repay a portion of the borrowings under our acquisition credit facility, which were used to fund property acquisitions.

 

In October 2013, we amended our credit facility by increasing the borrowing capacity by $500 million to $1.5 billion.  All other material business terms of the credit facility remain unchanged.

 

A discussion of certain legal proceedings related to our acquisition of ARCT, including the consolidated class action in the Circuit Court for Baltimore City, Maryland captioned In re American Capital Realty Trust, Inc. Shareholder Litigation, No. 24-C-12-005306 (the “Maryland State Action”), can be found under Part I, Item 3 “Legal Proceedings” in our Annual Report on Form 10-K for the year ended December 31, 2012.  By order dated July 23, 2013, the Maryland state court preliminarily approved the settlement set forth in the stipulation of the parties, preliminarily certified the class, and set a settlement hearing for October 24, 2013, at 9:30 a.m. Pursuant to the Maryland state court’s preliminary approval order, ARCT provided notice to its stockholders regarding the proposed settlement. At the settlement hearing on October 24, 2013, the Maryland state court certified the class, approved the settlement set forth in the stipulation as fair, reasonable, and adequate to ARCT’s shareholders, and entered final judgment dismissing the Maryland State Action with prejudice. In addition, the Maryland state court approved $512,751 in plaintiffs’ attorneys’ fees and expenses, to be paid pursuant to the parties’ stipulation, of which, approximately 25% would be paid by Realty Income and the remainder to be paid by ARCT’s insurer.

 

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Table of Contents

 

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:

 

·                  Our continued qualification as a real estate investment trust;

·                  General business and economic conditions;

·                  Our recent acquisition of American Realty Capital Trust, Inc., or ARCT;

·                  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, 2012.

 

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.

 

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THE COMPANY

 

Realty Income Corporation, The Monthly Dividend Company®, or Realty Income, is a publicly traded real estate company with the primary business objective of generating dependable monthly cash dividends from a consistent and predictable level of cash flow from operations. Our monthly dividends are supported by the cash flow from our portfolio of properties leased to commercial enterprises. We have in-house acquisition, leasing, legal, credit research, real estate research, portfolio management and capital markets expertise. Over the past 44 years, Realty Income and its predecessors have been acquiring and owning freestanding commercial properties that generate rental revenue under long-term lease agreements.

 

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

 

We seek to increase distributions to stockholders and funds from operations, or FFO per share, through both active portfolio management and the acquisition of additional properties.

 

Generally, our portfolio management efforts seek to achieve:

 

·                  Contractual rent increases on existing leases;

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

·                  The active management of our property portfolio, including re-leasing vacant properties, and selectively selling properties, thereby mitigating our exposure to certain tenants and markets.

 

In acquiring additional properties, our strategy is primarily to acquire properties that are:

 

·                  Freestanding, single-tenant locations;

·                  Leased to regional and national commercial enterprises; and

·                  Leased under long-term, net-lease agreements.

 

At September 30, 2013, we owned a diversified portfolio:

 

·                  Of 3,866 properties;

·                  With an occupancy rate of 98.1%, or 3,793 properties leased and only 73 properties available for lease;

·                  Leased to 200 different commercial enterprises doing business in 47 separate industries;

·                  Located in 49 states and Puerto Rico;

·                  With over 61.2 million square feet of leasable space; and

·                  With an average leasable space per property of approximately 15,800 square feet.

 

Of the 3,866 properties in the portfolio, 3,846, or 99.5%, are single-tenant properties, and the remaining 20 are multi-tenant properties. At September 30, 2013, of the 3,846 single-tenant properties, 3,774 were leased with a weighted average remaining lease term (excluding rights to extend a lease at the option of the tenant) of approximately 10.9 years.

 

Investment Philosophy

We typically acquire properties under long-term leases with regional and national retailers and other commercial enterprises. We believe that owning an actively managed, diversified portfolio of commercial properties under long-term, net leases produces consistent and predictable income. Our acquisition and investment activities generally focus on businesses providing goods and services that satisfy basic consumer and business needs.  Net leases typically require the tenant to be responsible for monthly rent and property operating expenses including property taxes, insurance and maintenance.  In general, our net-lease agreements:

 

·                  Are for initial terms of 10 to 20 years;

 

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·                  Require the tenant to pay minimum monthly rent and property operating expenses (taxes, insurance and maintenance); and

·                  Provide for future rent increases based on increases in the consumer price index (typically subject to ceilings), additional rent calculated as a percentage of the tenants’ gross sales above a specified level, or fixed increases.

 

We believe that a portfolio of properties under long-term leases, coupled with the tenant’s responsibility for property expenses, 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.

 

We estimate that approximately 40% of our annualized rental revenue comes from properties leased to investment grade companies or their subsidiaries.  At September 30, 2013, our top 15 tenants represent approximately 44% of our annualized revenue and eight of these 15 tenants have investment grade credit ratings.

 

Investment Strategy

When identifying new properties for acquisition, we generally focus on providing capital to owners and operators of commercial enterprises by acquiring the real estate they consider important to the successful operation of their business.

 

We primarily focus on acquiring properties leased to commercial enterprises based on the following guidelines:

 

·                  Tenants with reliable and sustainable cash flow;

·                  Tenants with revenue and cash flow from multiple sources;

·                  Large owners and users of real estate;

·                  Real estate that is critical to the tenant’s ability to generate revenue (i.e. they need the property in which they operate in order to conduct their business);

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

·                  Property transactions where we can achieve an attractive spread over our cost of capital.

 

Historically, our investment focus has primarily been on retail enterprises that have a service component because we believe the lease revenue from these types of businesses is more stable. Because of this investment focus, for the quarter ended September 30, 2013, approximately 59.9% of our retail rental revenue was derived from tenants with a service component in their business. We believe these service-oriented businesses would generally be difficult to duplicate over the Internet and that our properties will continue to perform well relative to competition from Internet-based businesses.

 

Credit Strategy

We typically acquire and lease properties to regional and national commercial enterprises and believe that within this market we can achieve an attractive risk-adjusted return. Since 1970, our occupancy rate at the end of each year has never been below 96%.

 

We believe the principal financial obligations of most commercial enterprises 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 obligations is less than the tenant’s unsecured general obligations. It has been our experience that since tenants must retain their profitable and critical locations in order to survive; in the event of reorganization they are less likely to reject a lease for a profitable and critical location because this would terminate their right to use the property. Thus, as the property owner, we believe 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 the real estate leases can be further mitigated by monitoring the performance of the tenants’ individual locations and considering whether to sell locations that are weaker performers.

 

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In order to qualify for inclusion in our portfolio, new property acquisitions must meet stringent investment and credit requirements. The properties must generate attractive current yields and the tenant must meet our credit profile.  We have established a four-part analysis that examines each potential investment based on:

 

·                  Industry, company, market conditions and credit profile;

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

·                  The importance of the real estate location to the operations of the company’s business; and

·                  Overall real estate characteristics, including property value, replacement costs and comparative rental rates.

 

Prior to entering into any transaction, our investment professionals, assisted by our research department, conduct 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.

 

Acquisition Strategy

We seek to invest in industries in which several, well-organized, regional and national commercial enterprises are capturing market share through service, quality control, economies of scale, strong consumer brands, advertising, and the selection of prime locations. Our acquisition strategy is to act as a source of capital to regional and national commercial enterprises by acquiring and leasing back their real estate locations.  In addition, we frequently acquire large portfolios of properties net leased to multiple tenants in a variety of industries.  We undertake thorough research and analysis to identify what we consider to be appropriate industries, tenants and property locations for investment. Our research expertise is instrumental to uncovering net-lease opportunities in markets where our real estate financing program adds value. In selecting potential investments, 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 important locations for regional and national commercial enterprises;

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

·                  Properties that are located within attractive demographic areas, relative to the business of our tenants, with high visibility and easy access to major thoroughfares; 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 rent increases.

 

Portfolio Management Strategy

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

 

Our executives regularly review and analyze:

 

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

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

 

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

 

·                  Generate higher returns;

·                  Enhance the credit quality of our real estate portfolio;

·                  Extend our average remaining lease term; or

·                  Decrease tenant or industry concentration.

 

At September 30, 2013, we classified real estate with a carrying amount of $17.3 million as held for sale on our balance sheet. During the first nine months of 2013, we sold 53 investment properties for $106.1 million.  For the remainder of 2013, we intend to continue our active disposition efforts to further enhance the credit quality of our real estate portfolio and anticipate exceeding $125 million in property sales for all of 2013. We intend to invest these proceeds into new property acquisitions, if there are attractive opportunities available. However, we cannot guarantee that we will sell properties during the next 12 months at our estimated values or be able to invest the property sale proceeds in new properties.

 

Impact of Real Estate and Credit Markets

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

 

RECENT DEVELOPMENTS

 

Increases in Monthly Dividends to Common Stockholders

We have continued our 44-year policy of paying monthly dividends.  Monthly dividends per common share increased by $0.0291667 in February 2013 to $0.1809167, increased by $0.0003125 in April 2013 to $0.1812292 per share, increased by $0.0003125 in July 2013 to $0.1815417, and increased by $0.0003125 in October 2013 to $0.1818542 per share. The increase in October 2013 was our 64th consecutive quarterly increase and the 73rd increase in the amount of our dividend since our listing on the NYSE in 1994. In the first ten months of 2013, we paid one monthly cash dividend per common share of $0.15175, two monthly cash dividends per common share in the amount of $0.1809167, three monthly cash dividends per common share in the amount of $0.1812292, three monthly cash dividends per common share in the amount of $0.1815417, and one monthly cash dividend per common share in the amount of $0.1818542, totaling $1.7837503 per common share. In October 2013, we declared dividends of $0.1818542 per share, which will be paid in November 2013.

 

The current monthly dividend of $0.1818542 per share represents a current annualized dividend of $2.1822504 per share, and an annualized dividend yield of approximately 5.5% based on the closing sale price of our common stock on the NYSE of $39.75 on September 30, 2013. 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 Third Quarter of 2013

During the third quarter of 2013, we invested $502.7 million in 219 new properties and properties under development or expansion, with an estimated initial weighted average contractual lease rate of 7.1%.  The 219 new properties and properties under development or expansion are located in 33 states, will contain over 2.8 million leasable square feet and are 100% leased, with an average lease term of 14.7 years.  The tenants occupying the new properties operate in 15 industries and the property types consist of 80.7% retail, 18.9% office, and 0.4% industrial and distribution, based on rental revenue.

 

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Additionally, in September 2013, we purchased a property for $45.4 million in San Diego, California, which will serve as our new corporate headquarters.  We plan on relocating to this facility during the second half of 2014.

 

Acquisitions during the First Nine Months of 2013

During the first nine months of 2013, we invested $1.37 billion in 407 new properties and properties under development or expansion (excluding American Realty Capital Trust, Inc., or ARCT), with an estimated initial weighted average contractual lease rate of 7.0%. The 407 new properties and properties under development or expansion are located in 40 states, will contain over 8.0 million leasable square feet, and are 100% leased with a weighted average lease term of 14.1 years. The tenants occupying the new properties operate in 21 industries and the property types consist of 84.1% retail, 10.4% office, 3.1% industrial and distribution, and 2.4% manufacturing, based on rental revenue.

 

During the first nine months of 2013, we also completed our acquisition of ARCT for approximately $3.2 billion.  Each outstanding share of ARCT common stock was converted into the right to receive a combination of: (i) $0.35 in cash and (ii) 0.2874 shares of our common stock, resulting in the issuance of a total of approximately 45.6 million shares of our common stock to ARCT shareholders, valued at a per share amount of $44.04, which was the closing sale price of our common stock on January 22, 2013.  In connection with the acquisition, at the closing we terminated and repaid the amounts then outstanding of approximately $552.9 million under ARCT’s revolving credit facility and term loan.  In connection with our acquisition of ARCT, we assumed approximately $516.3 million of mortgages payable.  We incurred merger costs of $12.9 million and $5.5 million, respectively in the first nine months of 2013 and 2012.  We anticipate that the total merger costs will be approximately $21 million.

 

The acquisition of ARCT provided immediate and long-term benefits to Realty Income, including accretion to net earnings, growth in the size of our real estate portfolio, diversification of industries and property type, increase in the percentage of investment grade tenants, and larger size and scope of our company, which increases competitive advantages in the net-lease marketplace.

 

Our acquisition of ARCT added 515 properties to our real estate portfolio.  The 515 properties are located in 44 states and Puerto Rico, contain over 16.0 million leasable square feet and are 100% leased with a weighted average lease term of 12.2 years.  The 69 tenants, occupying the 515 properties acquired, operate in 28 industries and the property types consist of 53.5% retail, 32.0% industrial and distribution, and 14.5% office, based on rental revenue.

 

Our combined total investment in real estate assets during the first nine months of 2013 was $4.52 billion.  None of our real estate investments, during the first nine months of 2013, caused any one tenant to be 10% or more of our total assets at September 30, 2013.

 

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 under the lease 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 estimated initial weighted average contractual lease rate is computed as follows: estimated net operating income (which is calculated by multiplying the capitalization rate determined by the lease by our projected total investment in the property, including land, construction and capitalized interest costs) for the first full year of each lease, divided by such projected total investment in the property.  Of the $4.52 billion we invested in the first nine months of 2013, $28.8 million was invested in 19 properties under development or expansion, with an estimated initial weighted average contractual lease rate of 8.5%.  We may continue to pursue development or expansion opportunities under similar arrangements in the future.

 

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John P. Case Appointed Chief Executive Officer (CEO)

On September 3, 2013, we announced that our Board of Directors had appointed John P. Case to the position of CEO of the Company.  Mr. Case, who had previously served as President and Chief Investment Officer, succeeds Tom A. Lewis, who retired as our CEO. Mr. Lewis, who had been our CEO since 1997, will remain with us until early next year to assist with the transition, and continues to serve as Vice Chairman of our Board of Directors. With this appointment, Mr. Case became only the third CEO in Realty Income’s 44-year history.

 

Portfolio Discussion

 

Leasing Results

At September 30, 2013, we had 73 properties available for lease out of 3,866 properties in our portfolio, which represents a 98.1% occupancy rate. Since December 31, 2012, when we reported 84 properties available for lease and a 97.2% occupancy rate, we:

 

·                  Leased 20 properties;

·                  Sold 14 properties available for lease; and

·                  Have 23 new properties available for lease.

 

During the first nine months of 2013, 98 properties with expiring leases were leased to either existing or new tenants. The annual rent on these leases was $12.4 million, as compared to the previous rent on these same properties of $12.1 million. At September 30, 2013, our average annualized rental revenue was approximately $13.27 per square foot on the 3,793 leased properties in our portfolio.  At September 30, 2013, we classified 24 properties with a carrying amount of $17.3 million as held for sale on our balance sheet.

 

Investments in Existing Properties

In the third quarter of 2013, we capitalized costs of $2.6 million on existing properties in our portfolio, consisting of $369,000 for re-leasing costs and $2.2 million for building and tenant improvements.  In the third quarter of 2012, we capitalized costs of $2.1 million on existing properties in our portfolio, consisting of $521,000 for re-leasing costs and $1.6 million for building and tenant improvements.

 

In the first nine months of 2013, we capitalized costs of $5.9 million on existing properties in our portfolio, consisting of $1.1 million for re-leasing costs and $4.8 million for building and tenant improvements.  In the first nine months of 2012, we capitalized costs of $4.5 million on existing properties in our portfolio, consisting of $1.2 million for re-leasing costs and $3.3 million for building and tenant improvements. As part of our re-leasing costs, we pay leasing commissions and sometimes provide tenant rent concessions.  Leasing commissions are paid based on the commercial real estate industry standard and any rent concessions provided are minimal.  We do not consider the collective impact of the leasing commissions or tenant rent concessions to be material to our financial position or results of operations.

 

The majority of our building and tenant improvements relate to roof repairs, HVAC improvements, and parking lot resurfacing and replacements. It is not customary for us to offer significant tenant improvements on our properties as tenant incentives. The amounts of our capital expenditures can vary significantly, depending on the rental market, credit worthiness, and the willingness of tenants to pay higher rents over the terms of the leases.

 

Amendment to Credit Facility

In October 2013, we amended our credit facility by increasing the borrowing capacity by $500 million to $1.5 billion.  On October 29, 2013, the available borrowing capacity under our acquisition credit facility was approximately $1.4 billion, after the expansion of the credit facility and paying down borrowings with proceeds from our stock offering in October 2013.  All other material business terms of the credit facility remain unchanged.

 

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Note Issuance

In July 2013, we issued $750 million of 4.65% senior unsecured notes due August 2023, or the 2023 Notes.  The price to the investors for the 2023 Notes was 99.775% of the principal amount for an effective yield of 4.678% per annum.  The total net proceeds of approximately $741.4 million from these offerings were used to repay all outstanding borrowings under our acquisition credit facility, and the remaining proceeds were used for general corporate purposes, including additional property acquisitions.  Interest is paid semiannually on the 2023 Notes.

 

Accelerated Stock Vesting

The Compensation Committee of our Board of Directors approved, effective July 1, 2013, the accelerated vesting of each restricted stock award that had originally been granted with ten-year vesting to five years.  On July 1, 2013, 212,827 restricted shares vested as a result of this acceleration, resulting in additional compensation expense of $3.7 million during the three and nine months ended September 30, 2013.

 

Issuance of Common Stock

In October 2013, we issued 9,775,000 shares of common stock at a price of $40.63 per share, including 1,275,000 shares purchased by the underwriters upon the exercise of their option to purchase additional shares.  After underwriting discounts and other estimated offering costs of $18.8 million, the net proceeds of approximately $378.4 million were used to repay a portion of the borrowings under our acquisition credit facility, which were used to fund property acquisitions.

 

In March 2013, we issued 17,250,000 shares of common stock at a price of $45.90 per share. After underwriting discounts and other offering costs of $36.7 million, the net proceeds of $755.1 million were used to redeem our 5.375% notes in March 2013 and repay borrowings under our acquisition credit facility, which were used to fund property acquisitions, including our acquisition of ARCT.

 

In connection with our January 2013 acquisition of ARCT, we issued a total of 45,573,144 shares of our common stock to ARCT shareholders and redeemed 208,709 shares of our common stock that were previously held by ARCT.

 

Note Repayment

In March 2013, we repaid the $100 million of outstanding 5.375% notes, plus accrued and unpaid interest, using proceeds from our March 2013 common stock offering and our credit facility.

 

Term Loan

In January 2013, in conjunction with our acquisition of ARCT, we entered into a $70 million senior unsecured term loan maturing January 21, 2018, to partially repay the then outstanding ARCT term loan.  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 essentially fixes our per annum interest rate on the term loan at 2.15%.

 

Noncontrolling Interests

As consideration for two separate acquisitions during the first nine months of 2013, partnership interests of Tau Operating Partnership, L.P. and Realty Income, L.P. were issued to third parties.  These units (discussed in the following paragraphs below) do not have voting rights, are entitled to monthly distributions equal to the amount paid to our common stockholders, and are redeemable in cash or our common stock, at our option and at a conversion ratio of one to one, subject to certain exceptions.  As the general partner for each of these partnerships, we have operating and financial control over these entities and consolidate them in our financial statements and recorded as noncontrolling interests the partnership units held by third parties.

 

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Issuance of Common and Preferred Units

In connection with our acquisition of ARCT in January 2013, we issued 317,022 common partnership units and 6,750 preferred partnership units.  These common units are entitled to monthly distributions equivalent to the per common share amounts paid to the common stockholders of Realty Income.  The preferred units have a par value of $1,000, and are entitled to monthly payments at a rate of 2% per annum, or $135,000 per year.

 

In June 2013, we issued 534,546 common partnership units of Realty Income, L.P.  These common units are entitled to monthly distributions equivalent to the per common share amount paid to the common stockholders of Realty Income.

 

Universal Shelf Registration

In February 2013, we filed a shelf registration statement with the SEC, which is effective for a term of three years and will expire in February 2016. This replaces our prior shelf registration statement.  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 the 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.

 

Net Income Available to Common Stockholders

Net income available to common stockholders was $41.1 million in the third quarter of 2013, compared to $27.0 million in the third quarter of 2012, an increase of $14.1 million.  On a diluted per common share basis, net income was $0.21 in the third quarter of 2013, compared to $0.20 in the third quarter of 2012.

 

Net income available to common stockholders was $149.8 million in the first nine months of 2013, compared to $86.0 million in the first nine months of 2012, an increase of $63.8 million. On a diluted per common share basis, net income available to common stockholders was $0.80 in the first nine months of 2013, as compared to $0.65 in the first nine months of 2012.  Net income available to common stockholders in the first nine months of 2013 includes $12.9 million of merger-related costs for the acquisitions of ARCT, which represents $0.07 on a diluted per common share basis, and $3.7 million for  accelerated vesting of restricted shares that occurred in July 2013 from ten-year vesting to five years, which represents $0.02 on a diluted per common share basis.  Net income available to common stockholders in the first nine months of 2012 includes $5.5 million of merger-related costs for the acquisition of ARCT, which represents $0.04 on a diluted per common share basis, and a $3.7 million charge for the excess of redemption value over carrying value of the Class D preferred shares, which represents $0.03 on a diluted per common share basis.

 

The calculation to determine net income available to common stockholders includes gains from the sale of properties. The amount of gains varies from period to period based on the timing of property sales and can significantly impact net income available to common stockholders.

 

Gains from the sale of properties during the third quarter of 2013 were $6.2 million, as compared to $2.0 million during the third quarter of 2012.  Gains from the sale of properties during the first nine months of 2013 were $50.5 million, as compared to $6.0 million during the first nine months of 2012.

 

Funds from Operations Available to Common Stockholders (FFO) and Normalized Funds from Operations Available to Common Stockholders (Normalized FFO)

In the third quarter of 2013, our FFO increased by $52.5 million, or 82.8%, to $115.9 million, compared to $63.4 million in the third quarter of 2012.  On a diluted per common share basis, FFO was $0.59 in the third quarter of 2013 and $0.48 in the third quarter of 2012, an increase of 22.9%.

 

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In the first nine months of 2013, our FFO increased by $135.2 million, or 71.4%, to $324.5 million, compared to $189.3 million in the first nine months of 2012. On a diluted per common share basis, FFO was $1.72 in the first nine months of 2013, and $1.42 in the first nine months of 2012, an increase of 21.1%.  FFO, in the first nine months of 2013, includes $12.9 million of merger-related costs, which represents $0.07 on a diluted per common share basis, and $3.7 million for  accelerated vesting of restricted shares that occurred in July 2013 from ten-year vesting to five years, which represents $0.02 on a diluted per common share basis.  FFO, in the first nine months of 2012, includes $5.5 million of merger-related costs, which represents $0.04 on a diluted per common share basis, and a $3.7 million charge for the excess of redemption value over carrying value of the shares of our Class D preferred stock, which represents $0.03 on a diluted per common share basis.

 

We define normalized FFO as FFO excluding the merger-related costs for our acquisition of ARCT. In the third quarter of 2013, our normalized FFO increased by $47.2 million, or 68.5%, to $116.1 million, compared to $68.9 million in the third quarter of 2012.  On a diluted per common share basis, normalized FFO was $0.59 in the third quarter of 2013 and $0.52 in the third quarter of 2012, an increase of 13.5%.  In the first nine months of 2013, our normalized FFO increased by $142.6 million, or 73.2%, to $337.4 million, as compared to $194.8 million in the first nine months of 2012.  On a diluted per common share basis, normalized FFO was $1.79 in the first nine months of 2013, as compared to $1.47 in the first nine months of 2012, an increase of 21.8%.

 

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

 

Adjusted Funds from Operations Available to Common Stockholders (AFFO)

In the third quarter of 2013, our AFFO increased by $49.4 million, or 72.1%, to $117.9 million, compared to $68.5 million in the third quarter of 2012.  On a diluted common share basis, AFFO was $0.60 in the third quarter of 2013, and $0.52 in the third quarter of 2012, an increase of 15.4%.

 

In the first nine months of 2013, our AFFO increased by $136.1 million, or 67.6%, to $337.4 million, compared to $201.3 million in the first nine months of 2012.  On a diluted per common share basis, AFFO was $1.79 in the first nine months of 2013, and $1.52 in the first nine months of 2012, an increase of 17.8%.

 

See our discussion of AFFO (which is not a financial measure under GAAP), later in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which includes a reconciliation of net income available to common stockholders to FFO, normalized 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 from time to time. We may issue common stock when we believe that our share price is at a level that allows for the proceeds of any offering to be accretively invested into additional properties. In addition, we may issue common stock to permanently finance properties that were financed by our credit facility or debt securities. However, we cannot assure you that we will have access to the capital markets at times and at terms that are acceptable to us.

 

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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 $1 billion 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 September 30, 2013, our total outstanding borrowings of senior unsecured notes, term loan, mortgages payable and credit facility borrowings were $4.55 billion, or approximately 35.0% of our total market capitalization of $13.02 billion.

 

We define our total market capitalization at September 30, 2013 as the sum of:

 

·                  Shares of our common stock outstanding of 196,334,470, plus total common units of 851,568,  multiplied by the closing sales price of our common stock on the NYSE of $39.75 per share on September 30, 2013, or $7.84 billion;

·                  Aggregate liquidation value (par value of $25 per share) of the Class E preferred stock of

$220 million;

·                  Aggregate liquidation value (par value of $25 per share) of the Class F preferred stock of $408.8 million;

·                  Outstanding borrowings of $468.4 million on our credit facility;

·                  Outstanding mortgages payable of $811.1 million;

·                  Outstanding borrowings of $70.0 million on our term loan; and

·                  Outstanding senior unsecured notes and bonds of $3.2 billion.

 

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 September 30, 2013, we had cash and cash equivalents totaling $10.0 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.

 

$1.5 Billion Acquisition Credit Facility

Prior to October 29, 2013, we had a $1.0 billion unsecured acquisition credit facility, with an initial term that expires in May 2016, and includes, at our election, a one-year extension option. On October 29, 2013, we amended our credit facility to increase the borrowing capacity by $500 million to $1.5 billion. All other material business terms of the credit facility remain unchanged.  Under this credit facility, our current investment grade credit ratings provide for financing at the London Interbank Offered Rate, commonly referred to as LIBOR, plus 1.075% with a facility commitment fee of 0.175%, for all-in drawn pricing of 1.25% over LIBOR. The borrowing rate is not subject to an interest rate floor or ceiling.  We also have other interest rate options available to us. Our credit facility is unsecured and, accordingly, we have not pledged any assets as collateral for this obligation.  At September 30, 2013, we had a borrowing capacity of $531.6 million available on our credit facility (subject to customary conditions to borrowing) and an outstanding balance of $468.4 million. On October 29, 2013, the available borrowing capacity under our acquisition credit facility was approximately $1.4 billion, after the expansion of the credit facility and paying down borrowings with proceeds from our stock offering in October 2013. The interest rate on borrowings outstanding under our credit facility, at September 30, 2013, was 1.3% per annum. We must comply with various financial and other covenants in our credit facility. At September 30, 2013, we remain in compliance with these covenants.

 

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We expect to use our credit facility to acquire additional properties and for other corporate purposes.  Any additional borrowings will increase our exposure to interest rate risk. We regularly review our credit facility and may seek to extend or replace our credit facility, to the extent we deem appropriate.

 

We generally use our credit facility for the short-term financing of new property acquisitions. Thereafter, when capital is available on acceptable terms, 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 upon acceptable terms.

 

Mortgage Debt

As of September 30, 2013, we had $779.7 million of mortgages payable, which were assumed in connection with our property acquisitions. Included in this amount is $515.0 million of mortgages payable assumed in connection with the ARCT acquisition.  Additionally, at September 30, 2013, we had net premiums totaling $31.4 million on these mortgages, of which $17.9 million is in connection with the ARCT acquisition.  During the first nine months of 2013, we made $16.2 million of principal payments.  As of September 30, 2013, the weighted average stated interest rate of our mortgages payable was 5.4% and the weighted average remaining years until maturity was 4.1 years.

 

We expect to pay off the mortgages payable as soon as prepayment penalties have declined to a level that will make it economically feasible to do so. We intend to continue to primarily identify property acquisitions that are free from mortgage indebtedness.  In August 2013, we repaid one mortgage in full for $11.7 million.

 

Term Loan

In January 2013, in conjunction with our acquisition of 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 essentially fixes our per annum interest rate on the term loan at 2.15%.

 

Notes Outstanding

Our senior unsecured note and bond obligations consist of the following as of September 30, 2013, sorted by maturity date (dollars in millions):

 

 

 

September 30,

 

 

2013

5.5% notes, issued in November 2003 and due in November 2015

 

  $

 150

5.95% notes, issued in September 2006 and due in September 2016

 

275

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

 

175

2.0% notes, issued in October 2012 and due in January 2018

 

350

6.75% notes, issued in September 2007 and due in August 2019

 

550

5.75% notes, issued in June 2010 and due in January 2021

 

250

3.25% notes, issued in October 2012 and due in October 2022

 

450

4.65% notes, issued in July 2013 and due in August 2023

 

750

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

 

250

 

 

  $

 3,200

 

As of September 30, 2013, the weighted average interest rate of our notes and bonds payable was 4.9% and the weighted average remaining years until maturity was 7.9 years.  In March 2013, we repaid

$100 million of our 5.375% notes, at maturity, by utilizing proceeds from our March common stock offering and our credit facility.

 

All of our outstanding notes and bonds have fixed interest rates. Interest on all of our senior note and

 

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bond obligations is paid semiannually. All of these notes and bonds contain various covenants. At September 30, 2013, we remain in compliance with these covenants.

 

The following is a summary of the key financial covenants for our senior unsecured notes, as defined and calculated per the terms of our notes. 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 notes only and are not measures of our liquidity or performance. The actual amounts as of September 30, 2013 are:

 

Note Covenants

 

Required

 

Actual

 

 

 

 

 

Limitation on incurrence of total debt

 

< 60% of adjusted assets

 

45.8%

Limitation on incurrence of secured debt

 

< 40% of adjusted assets

 

8.2%

Debt service coverage (trailing 12 months)(1)

 

> 1.5 x

 

3.5x   

Maintenance of total unencumbered assets

 

> 150% of unsecured debt

 

227.8%

 

 

 

 

 

 

(1)This covenant is calculated on a pro forma basis for the preceding four-quarter period on the assumption 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 other Debt since the first day of such four-quarter period, and (iii) any acquisition or disposition by us of any asset or group of assets since the first day of such four-quarters had in each case occurred on October 1, 2012, 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 October 1, 2012, nor does it purport to reflect our debt service coverage ratio for any future period.  In addition, as noted above, the debt service coverage ratio set forth under the caption “Actual” in the above table does not give effect to the repayment of a portion of our acquisition credit facility using the net proceeds from the issuance of our common stock in October 2013.  The following is our calculation of debt service coverage at September 30, 2013 (in thousands, for trailing twelve months):

 

Net income

 

  $

 220,252

 

Plus: interest expense

 

158,865

 

Plus: provision for taxes

 

1,884

 

Plus: depreciation and amortization

 

265,550

 

Plus: provisions for impairment

 

7,500

 

Plus: pro forma adjustments

 

118,157

 

Less: gain on sales of investment properties

 

(54,330

)

Income available for debt service, as defined

 

  $

 717,878

 

Total pro forma debt service charge

 

  $

 203,108

 

Debt service coverage ratio

 

3.5

 

 

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. 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 calculation of the fixed charge coverage ratio may be different from the calculation used by other companies and, therefore, comparability may be limited. This information should not be considered as an alternative to any GAAP liquidity measures.  Below is our calculation of fixed charges at September 30, 2013 (in thousands, for trailing twelve months):

 

Income available for debt service, as defined

 

  $

 717,878

 

Pro forma debt service charge plus preferred stock dividends

 

245,037

 

Fixed charge coverage ratio

 

2.9

 

 

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Credit Agency Ratings

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

 

Based on our current ratings, the current facility interest rate is LIBOR plus 1.075% with a facility commitment fee of 0.175%, for all-in drawn pricing of 1.25% over LIBOR. The credit facility provides that the interest rate can range between: (i) LIBOR plus 1.85% if our credit rating is lower than BBB-/Baa3 and (ii) LIBOR plus 1.00% 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) 0.45% for a rating lower than BBB-/Baa3, and (ii) 0.15% 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.

 

The following table summarizes the maturity of each of our obligations as of September 30, 2013 (dollars in millions):

 

Table of Obligations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ground

 

Ground

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Leases

 

Leases

 

 

 

 

 

 

 

 

Notes

 

 

 

 

 

 

 

Paid by

 

Paid by

 

 

 

 

Year of

 

Credit

 

and

 

Term

 

Mortgages

 

 

 

Realty

 

Our

 

 

 

 

Maturity

 

Facility(1)

 

Bonds

 

Loan

 

Payable(2)

 

Interest(3)

 

Income(4)

 

Tenants(5)

 

Other(6)

 

Totals

2013

 

   $

 -

 

  $

 -

 

$

 -

 

  $

 10.7

 

$

 51.5

 

  $

 0.2

 

  $

 3.1

 

$

 1.9

 

$

 67.4

2014

 

-

 

-

 

-

 

64.4

 

204.2

 

1.0

 

12.6

 

8.8

 

291.0

2015

 

-

 

150.0

 

-

 

125.5

 

197.9

 

1.0

 

12.6

 

-

 

487.0

2016

 

468.4

 

275.0

 

-

 

248.4

 

169.4

 

1.0

 

12.7

 

-

 

1,174.9

2017

 

-

 

175.0

 

-

 

133.1

 

145.2

 

1.0

 

12.7

 

-

 

467.0

Thereafter

 

-

 

2,600.0

 

70.0

 

197.6

 

666.1

 

10.1

 

156.5

 

-

 

3,700.3

Totals

 

   $

 468.4

 

  $

 3,200.0

 

$

 70.0

 

  $

 779.7

 

$

 1,434.3

 

  $

 14.3

 

  $

 210.2

 

$

 10.7

 

$

 6,187.6

 

(1) The initial term of the credit facility expires in May 2016 and includes, at our option, a one-year extension.

(2) Excludes non-cash net premiums recorded on the mortgages payable.  The unamortized balance of these net premiums at September 30, 2013, is $31.4 million.

(3) Interest on the term loan, notes, bonds and mortgages payable has been calculated based on outstanding balances as of September 30, 2013 through their respective maturity dates.

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

(5) 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.

(6) “Other” consists of $8.8 million of commitments under construction contracts and $1.9 million of contingent payments for tenant improvements and leasing costs.

 

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

 

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Preferred Stock and Preferred Units Outstanding

In 2006, we issued 8.8 million shares of our 6.75% Monthly Income Class E Cumulative Redeemable Preferred Stock. Beginning December 7, 2011, shares of Class E preferred stock were redeemable at our option for $25.00 per share, plus any accrued and unpaid dividends. Dividends on shares of Class E preferred stock are paid monthly in arrears.

 

In February 2012, we issued 14.95 million shares of our 6.625% Monthly Income Class F Cumulative Redeemable Preferred Stock at $25.00 per share. In April 2012, we issued an additional 1.4 million shares of Class F Cumulative Redeemable Preferred Stock at $25.2863 per share. Beginning February 15, 2017, shares of our Class F preferred stock are redeemable at our option for $25.00 per share, plus any accrued and unpaid dividends. Dividends on the shares of Class F preferred shares are paid monthly in arrears.

 

We are current in our obligations to pay dividends on our Class E and Class F preferred stock.

 

As part of our acquisition of ARCT in January 2013, we issued 6,750 partnership units.  Payments on these preferred units are made monthly in arrears at rate of 2% per annum, or $135,000 per year, and are included in interest expense.

 

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 our common, Class E preferred and Class F preferred stockholders 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.

 

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 2012, our cash distributions to preferred and common stockholders totaled $275.8 million, or approximately 130.9% of our taxable income of $210.7 million. Our taxable income reflects non-cash deductions for depreciation and amortization. Our 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 more than sufficient to support our current level of cash distributions to our stockholders. Our cash distributions to common stockholders, for the first nine months of 2013, totaled $298.5 million, representing 88.5% of our adjusted funds from operations available to common stockholders of $337.4 million. In comparison, our 2012 cash distributions to common stockholders totaled $236.3 million, representing 86.2% of our adjusted funds from operations available to common stockholders of $274.2 million.

 

The Class E preferred stockholders receive cumulative distributions at a rate of 6.75% per annum on the $25.00 per share liquidation preference (equivalent to $1.6875 per annum per share). The Class F preferred stockholders receive cumulative distributions at a rate of 6.625% per annum on the $25.00 per share liquidation preference (equivalent to $1.65625 per annum per share). Dividends on our Class E and Class F preferred stock are current.

 

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Future distributions will be at the discretion of our Board of Directors and will depend on, among other things, our results of operations, FFO, normalized 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, 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 federal income 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 24.5% of the distributions to our common stockholders, made or deemed to have been made in 2012, were classified as a return of capital for federal income tax purposes. We estimate that in 2013, 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, 2012.

 

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. If we use a shorter or longer estimated useful life, it could have a material impact on our results of operations. We believe that 25 to 35 years is an appropriate estimate of useful life.

 

When acquiring a property for investment purposes, we allocate the fair value of real estate acquired to: (1) land, (2) building and improvements, and (3) indentified 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 addition, any assumed mortgages receivable or payable and any assumed or issued noncontrolling interests are recorded at their estimated fair values.

 

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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 estimate in this analysis include projected rental rates, estimated holding periods, 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 sheet. Our strategy of primarily holding properties, long-term, directly decreases the likelihood of their carrying values not being recoverable, thus requiring the recognition of an impairment. However, if our strategy, or one or more of the above assumptions were to change in the future, an impairment may need to be recognized. If events should occur that require us to reduce the carrying value of our real estate by recording provisions for impairment, they could have a material impact on our results of operations.

 

The following is a comparison of our results of operations for the three and nine months ended September 30, 2013 to the three and nine months ended September 30, 2012.

 

Rental Revenue

Rental revenue was $195.4 million for the third quarter of 2013, as compared to $116.8 million for the third quarter of 2012, an increase of $78.6 million, or 67.3%.  The increase in rental revenue in the third quarter of 2013 compared to the third quarter of 2012 is primarily attributable to:

 

·                  The 906 properties (24.1 million square feet) acquired by Realty Income in 2013, which generated $61.6 million of rent in the third quarter of 2013;

·                  The 423 properties (10.5 million square feet) acquired by Realty Income in 2012, which generated $20.3 million of rent in the third quarter of 2013 compared to $5.9 million of rent in the third quarter of 2012, an increase of $14.4 million;

·                 Same store rents generated on 2,360 properties (17.5 million square feet) during the third quarter of 2013 and 2012, increased by $1.4 million, or 1.3%, to $109.6 million from $108.2 million;

·                  A net increase of $634,000 relating to the aggregate of (i) rental revenue from properties (177 properties comprising 1.6 million square feet) that were available for lease during part of 2013 or 2012, (ii) rental revenue for six properties under development, (iii) rental revenue for 22 properties re-leased with rent-free periods, and (iv) lease termination settlements, which, in aggregate, totaled $2.3 million in the third quarter of 2013 compared to $1.6 million in the third quarter of 2012; and

·                  A net increase in straight-line rent and other non-cash adjustments to rent of $556,000 in the third quarter of 2013 as compared to the third quarter of 2012.

 

Rental revenue was $543.6 million for the first nine months of 2013, as compared to $339.6 million for the first nine months of 2012, an increase of $204.0 million, or 60.1%.  The increase in rental revenue in the first nine months of 2013 compared to the first nine months of 2012 is primarily attributable to:

 

·                  The 906 properties (24.1 million square feet) acquired by Realty Income in 2013, which generated $144.0 million of rent in the first nine months of 2013;

·                  The 423 properties (10.5 million square feet) acquired by Realty Income in 2012, which generated $60.5 million of rent in the first nine months of 2013 compared to $7.4 million of rent in the first nine months of 2012, an increase of $53.1 million;

·                  Same store rents generated on 2,360 properties (17.5 million square feet) during the first nine months of 2013 and 2012, increased by $4.2 million, or 1.3%, to $328.4 million from $324.2 million;

·                  A net increase of $967,000 relating to the aggregate of (i) rental revenue from properties (177 properties comprising 1.6 million square feet) that were available for lease during part of 2013 or 2012, (ii) rental revenue for six properties under development, (iii) rental revenue for 22 properties re-leased with rent-free periods, and (iv) lease termination settlements, which, in aggregate, totaled $6.7 million in the first nine months of 2013 compared to $5.8 million in the first nine months of 2012; and

 

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·                  A net increase in straight-line rent and other non-cash adjustments to rent of $1.8 million in the first nine months of 2013 as compared to the first nine months of 2012.

 

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 available for lease at any time, (ii) were under development, (iii) we have made an additional investment in, (iv) were involved in eminent domain and rent was reduced, and (v) were re-leased with rent-free periods. Each of the exclusions from the same store pool is separately addressed within the applicable sentences above explaining the changes in rental revenue for the period.

 

Of the 3,866 properties in the portfolio at September 30, 2013, 3,846, or 99.5%, are single-tenant properties and the remaining 20 are multi-tenant properties. Of the 3,846 single-tenant properties, 3,774, or 98.1%, were net leased with a weighted average remaining lease term (excluding rights to extend a lease at the option of the tenant) of approximately 10.9 years at September 30, 2013. Of our 3,774 leased single-tenant properties, 3,414, or 90.5%, were under leases that provide for increases in rents through:

 

·                  Primarily 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 $339,000 in the third quarter of 2013, and $170,000 in the third quarter of 2012 (excluding percentage rent reclassified to discontinued operations of $10,000 in the third quarter of 2013 and 2012).  Percentage rent was $1.4 million in the first nine months of 2013, and $1.0 million in the first nine months of 2012 (excluding percentage rent reclassified to discontinued operations of $40,000 in the first nine months of 2013 and $16,000 in the first nine months of 2012). Percentage rent, in the third quarter and first nine months of 2013, was less than 1% of rental revenue, and we anticipate percentage rent to continue to be less than 1% of rental revenue for the remainder of 2013.

 

Our portfolio of real estate, leased primarily to regional and national commercial enterprises under net leases, continues to perform well and to provide dependable lease revenue supporting the payment of monthly dividends to our stockholders. At September 30, 2013, our portfolio of 3,866 properties was 98.1% leased with 73 properties available for lease, as compared to 84 properties available for lease at December 31, 2012 and September 30, 2012. It has been our experience that approximately 2% 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.

 

Depreciation and Amortization

Depreciation and amortization was $80.9 million for the third quarter of 2013, as compared to $37.0 million for the third quarter of 2012. Depreciation and amortization was $221.6 million for the first nine months of 2013, as compared to $105.8 million for the first nine months of 2012. The increase in depreciation and amortization was primarily due to the acquisition of properties in 2013 and 2012, including the 515 properties acquired as part of our acquisition of ARCT, which was partially offset by property sales in those same periods. As discussed in the section entitled “Funds from Operations Available to Common Stockholders and Normalized Funds from Operations Available to Common Stockholders” and “Adjusted Funds from Operations Available to Common Stockholders,” depreciation and amortization is a non-cash item that is added back to net income available to common stockholders for our calculation of FFO, normalized FFO, and AFFO.

 

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Table of Contents

 

Interest Expense

Interest expense was $49.7 million for the third quarter of 2013, as compared to $29.7 million for the third quarter of 2012. Interest expense was $130.3 million for the first nine months of 2013, as compared to $87.5 million for the first nine months of 2012. The increase in interest expense was primarily due to an increase in borrowings attributable to the issuance in October 2012 of our 2.00% senior unsecured notes due January 2018, the October 2012 issuance of our 3.25% senior unsecured notes due October 2022, the July 2013 issuance of our 4.65% senior unsecured notes due August 2023, and an increase in mortgages payable and higher credit facility borrowings, which were partially offset by lower average interest rates.

 

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

 

 

 

Three months ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Interest on our credit facility, term loan, notes and mortgages

 

$

49,606

 

$

28,307

 

$

132,212

 

$

83,780

 

Interest included in discontinued operations

 

(132

)

(132

)

(396

)

(470

)

Credit facility commitment fees

 

447

 

442

 

1,327

 

1,234

 

Amortization of credit facility origination costs and deferred financing costs

 

1,914

 

1,302

 

5,356

 

3,526

 

(Gain) loss on interest rate swap

 

596

 

22

 

(690

)

74

 

Amortization of net mortgage premiums

 

(2,518

)

(111

)

(6,959

)

(279

)

Interest capitalized

 

(210

)

(110

)

(579

)

(388

)

Interest expense

 

$

49,703

 

$

29,720

 

$

130,271

 

$

87,477

 

 

 

 

Three months ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,