Realty Income Corp

NYSE:O

Earnings Call Transcript 2023-Q2

[Operator]

Good afternoon, and welcome to the Realty Income Second Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Steve Bakke, Vice President of Capital Markets and Investor Relations. Please go ahead.

[Steve Bakke, VP, Capital Markets and IR]

Thank you all for joining us today for Realty Income’s second quarter operating results conference call.

Discussing our results will be Sumit Roy, President and Chief Executive Officer; Christie Kelly, Executive Vice President, Chief Financial Officer and Treasurer; and Jonathan Pong, Senior Vice President, Head of Corporate Finance.

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

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

[Sumit Roy, President and CEO]

Thank you, Steve. Welcome, everyone.

We successfully executed on our strategy in the second quarter and continue to see momentum across the business. I would like to sincerely thank our One Team whose focus and commitment to continue to propel our business forward, serving all our clients and stakeholders. We believe the strength of our platform and quality of our real estate portfolio were evident in the quarter’s results.

Despite a challenging interest rate environment, AFFO per share grew 3.1% from last year to $1 per share. Combined with our dividend, we are pleased to have delivered a total operational return of over 8% on a trailing 12-month basis. Delivering stable and consistent growth is foundational to our mission at Realty Income. Underlying this growth, our team continues to source and invest in high-quality properties at accretive spreads to our cost of capital while partnering with our clients who are leaders in nondiscretionary, low-price point and service-oriented industries. Partnering with industry leaders across over 13,000 properties in a diversified real estate portfolio offers us durability of cash flows that results in the predictable nature of our revenues, earnings and dividend payments.

Our investment activities remain robust as we continue to demonstrate that size and scale are unique advantages in the sale-leaseback and portfolio transaction markets. In the second quarter, we closed on approximately $3.1 billion of high-quality real estate investments, which brings our year-to-date investment activity to over $4.7 billion. Cap rates in our acquisitions appear to have stabilized after a meaningful adjustment period to a higher interest rate environment. Though in select situations, we continue to find unique opportunities to source and close on larger transactions where our relationships, platform and access to capital allow us to take advantage of more favorable terms.

Our second quarter initial cash lease yield of 6.9% represents a 120 basis-point increase compared to the second quarter of 2022 and resulted in a realized investment spread of approximately 133 basis points when calculating our WACC on a leverage-neutral basis using the cost of equity and debt raised in the quarter.

In addition to closing our $1.5 billion U.S. convenience store acquisition from the EG Group, we remained active internationally during the second quarter, closing on $416 million of investments at an initial cash lease yield of 7.1%. This international activity includes the addition of a new geographic vertical in Ireland where we acquired two properties for $54 million at healthy cash yields.

Given the transaction velocity we have achieved in the first half of the year, we are increasing our outlook for investments to over $7 billion for 2023. Year-to-date, we have acquired 15% of source investment volume compared to an average of 7% over the last five years. In today’s more constrained environment for capital, we have found the size and scale of our platform have become increasingly meaningful differentiators as we seek accretive growth opportunities.

Shifting to operations, our portfolio continues to perform, and we ended the quarter with occupancy of 99%, the third consecutive quarter at that level. This matches our highest occupancy at the end of a reporting period in over 20 years. Additionally, our rent recapture rates increased from last quarter to 103.4% across 201 new and renewed leases, bringing the year-to-date recapture rate to 102.7% across 377 new or renewed leases executed in the period.

As further testament to the stability of our portfolio and the leading clients with whom we partner, our client watch list declined from last quarter and now represent less than 4% of our annualized rental revenue. This is the lowest level in the last five years.

Finally, our same-store rental revenue increased 2.0% in the quarter, a tangible result of our purposeful decision to seek investment opportunities with higher internal growth characteristics as well as the benefit of uncapped CPI-based rent escalators, present in nearly 30% of the leases in our growing international portfolio.

Our efforts to increasingly pursue leases with meaningful contractual rent escalators has helped contribute to a portfolio with contractual rent growth at approximately 1.5% per annum as of the second quarter, or 2% annual growth on a levered basis.

Before turning it over to Christie, I would like to recognize the tremendous value she has brought to Realty Income, first as a Board member, and then as Chief Financial Officer. Her leadership and counsel through a very active period for our company has left a lasting positive mark. As well, I would also like to congratulate Jonathan on his upcoming promotion to CFO. Christie?

[Christie Kelly, EVP, CFO and Treasurer]

Thank you, Sumit.

It’s an honor to serve our colleagues, Board and stakeholders during this exciting time at Realty Income. As we previously announced at the end of this year, I will be retiring as CFO and passing our CFO baton to Jonathan Pong, who is our current Senior Vice President, Head of Corporate Finance. Jonathan has been with the Company for the last nine years and brings significant experience to the role, having overseen our capital markets, investor relations, FP&A and derivatives functions during his time here. Over the last 2.5 years, since joining the management team, we have worked closely together as part of a planned succession, and Jonathan is well positioned to carry the torch moving forward.

With that, I would like to hand the call over to Jonathan to go over the financial results from our quarter.

[Jonathan Pong, SVP and Head, Corporate Finance]

Thank you, Christie. I would be remiss without acknowledging your many contributions to the Company and its stakeholders during your tenure. I’m grateful for your guidance, support and leadership, all of which have laid the foundation for excellence as our business continues to evolve.

Over my 9-year, 10-year at Realty Income, we have experienced significant growth in new industry verticals, geographies and property types. However, we’ve continued to view a reliable growing dividend and a well-capitalized balance sheet as critical components of our business. To that end, we finished the second quarter with healthy leverage as measured by net debt to annualized pro forma adjusted EBITDA of 5.3 times and our fixed charge coverage ratio remains solid at 4.6 times. We are once again active issuers of equity capital via the ATM, raising approximately $2.2 billion in the aggregate in the second quarter, $651 million of unsettled forward equity remains outstanding as of today.

As our platform has advanced and grown over time, our investment spread business has been supported by access to a wide range of products in the capital markets. Last month, we added another capital source to our inventory, raising €1.1 billion through our debut public offering of euro-denominated unsecured bonds. This dual tranche offering resulted in a weighted average tenure of 9 years and a weighted average annual yield to maturity of 5.08%.

Establishing a presence in the euro unsecured bond market allowed us to diversify our fixed income investor base, and generate a natural hedge for yield denominated earnings and access of source of debt capital that was priced approximately 60 basis points inside of indicative U.S. dollar bond pricing at the time of execution. Proceeds from the offering effectively repaid short-term borrowings on a multicurrency revolver and commercial paper programs, which had a combined balance of $990 million at quarter end. Combined with $254 million of cash on hand at quarter end and the $650 million of forward equity previously mentioned, we believe we are well capitalized with significant liquidity heading into the third quarter.

Finally, from an earnings outlook perspective, the midpoint of our 2023 AFFO per share guidance is unchanged, though we are narrowing the guidance range of $3.96 to $4.01, representing approximately 1.8% growth at the midpoint.

With that, I would like to turn the call back over to Sumit.

[Sumit Roy, President and CEO]

Thank you, Jonathan.

As our second quarter results illustrate, our company is well positioned to provide consistent results in a variety of economic environments and to grow through a variety of different acquisition channels. The optionality we have to toggle between different sources of capital is also a competitive advantage as it broadens our reach of investors and oftentimes provides a lower cost of capital alternative to the public U.S. dollar market.

Looking at the S&P 500 constituents within our addressable market, we count approximately 300 firms with $1.6 trillion of owned real estate. To quantify the near-term opportunity, which is available to us as sale-leaseback capital providers, this group has approximately $1.2 trillion of debt representing 34% of the group’s outstanding debt capital maturing between 2024 and 2027. Meanwhile, corporate bond deals have risen anywhere between 240 and 400 basis points from the 2021 average to today. This compares to a 140 basis-point increase in initial cash lease yields for Realty Income’s investments over the same time frame, making our capital solutions even more competitively priced on a relative basis than in the past.

Because of this cost of capital convergence and because of the many benefits sale-leaseback financing provides, including the elimination of maturity risk, we believe there is a more compelling case to be made than ever for corporates to look to sale-leaseback financing to replace maturing debt. As the attractiveness of sale-leaseback financing accelerates for corporates with looming debt maturities and elevated debt costs, we believe our growth opportunities will continue to expand on a sustainable basis.

At this time, we can open it up for questions. Operator?

[Operator]

We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Nate Crossett of BNP Paribas. Please go ahead.

[Nate Crossett, BNP Paribas]

Maybe just a question on guidance. Maybe you could just unpack, you guys increased acquisition and volume guidance but the midpoint on AFFO remained the same. Maybe you can just kind of go over the puts and takes there. And then also, what are you guys assuming for kind of cap rates in your guidance, I think were down 10 basis points in the quarter. What’s kind of the outlook of the pipeline right now?

[Sumit Roy, President and CEO]

So Nate, I’ll take your second question first, and then I’ll hand it off to Jonathan to talk about puts and takes with regards to the earnings guidance. With regards to the cap rate, we are assuming the cap rate to be within the ZIP code that we’ve announced in the second quarter and in the first quarter. That’s where we believe where the cap rates have settled down. Opportunistically, there are situations that we could enter into where we could drive those cap rates higher. But for modeling purposes, I would request that you keep it within these ZIP codes that we’ve announced in the first and second quarter. Jonathan?

[Jonathan Pong, SVP and Head, Corporate Finance]

Hey Nate, on the guidance question, I would, first of all say, the midpoint of our guide is the same as the as it was at the start of the year. And so, when you think about how we put guidance together, there’s a lot of puts and takes that we look at, at the beginning of the year, revisit at every quarter. We know that on a probability-weighted basis, not all of the takes are going to happen and all the puts are going to happen. And so when you think about acquisition guidance increasing two quarters now, that was a scenario that we had expected at the start of the year, but there was always going to be puts and takes that could offset that a bit. I think the biggest one for us has been short-term interest rates.

When you look at what was implied back in January and February on the SOFR forward curve, you compare that to what it is implying today, about a 40 basis-point increase. And so that alone is $0.01 per share for our business in the back half of the year.

So I would say that, and there’s also some other things that we always get that maybe we’re taking a slightly more conservative view on over the second half of the year appropriately, but we feel very good about being more or less accurate from what we came out at the start of the year.

[Nate Crossett, BNP Paribas]

Okay. That’s helpful. Maybe just one on the debt rates are much lower in Europe. You did that recent bond deal. Can you just like talk about how much you could kind of theoretically raise over there to kind of take advantage of the better cost of capital? Are there any like hindrances like in terms of size?

[Jonathan Pong, SVP and Head, Corporate Finance]

Yes, Nate. We’re not going to go crazy and have significantly more liabilities denominated in one currency relative to the assets we have denominated in that same currency, especially when it’s foreign denominated. And so for us, when we’re going out and issuing in various currencies, we’re thinking about the income statement, FX risk that we might have, and we’re using the natural interest expense in that currency to serve as a hedge. If we don’t have that, there’s not a lot of reason for us to go out and do that type of issuance. We also know that we have a very active acquisition pipeline across all currencies. We know that we’re going to need the capital at some point really denominated in dollars, sterling or euro.

So, that’s how we think about it. It was a 60 basis-point pickup relative to comparable U.S. dollar, but for us, it’s really about diversification. And so, you can expect us to utilize everything in our toolkit going forward. But I think we are all set on the euro side, at least for the near term.

[Operator]

The next question comes from Greg McGinniss of Scotiabank.

[Greg McGinniss, Scotiabank]

So, as always, I’m interested in any larger portfolio deals. And we appreciate your opening remarks regarding the size of the potentially addressable S&P 500 market. But have you noticed any material uptick in sale-leaseback interest from those companies at this point, or is that still a developing potential?

[Sumit Roy, President and CEO]

I guess, we have to post one of these large transactions per quarter. And I think we’ve done that. If you look at what we’ve done in the fourth quarter of last year, that’s when we closed on the gaming asset, which was $1.7 billion. You look at the large portfolio deal we did in the first quarter, it was a CIM transaction. That was circa $900 million. And in the second quarter, we’ve announced the $1.5 billion and closed the $1.5 billion EG Group transaction.

And look, the reason why we are sharing all of this data is to help support what we are seeing develop in our pipeline and the conversations that we are having currently. Now, how much of that gets translated to close transactions, time will tell. But clearly, we are very optimistic. And that is one of the main drivers of why we have increased our guidance by another $1 billion in terms of acquisitions. So, we just feel like -- I wish our cost of capital was slightly better. But in terms of actual transactions, we feel like the pipeline is robust and it’s largely a function of what is happening in the debt capital market.

[Greg McGinniss, Scotiabank]

Okay. What are your thoughts on increasing maybe the level of tenant debt investments to push earnings growth higher and offset some of that cost of capital? It’s not exactly where you want it.

[Sumit Roy, President and CEO]

Well, we think of ourselves as an investment company. And Greg, so where we invest on the capital stack is always available for debate within the four walls of Realty Income. And wherever we feel like we can quantify the risk and underwrite the benefits of doing a sale-leaseback versus doing a direct loan to one of our clients, we are going to go down the path of whichever yields the best risk-adjusted return. So, yes, we haven’t done one of those, but it is certainly up for discussion, and it’s one that we have been discussing with my colleagues here at Realty Income.

[Operator]

The next question comes from Brad Heffern of RBC Capital Markets. Please go ahead.

[Brad Heffern, RBC Capital Markets]

Sumit, can you give your updated thoughts on how you feel about the theater business broadly right now? Obviously, AMC recently reported its best week, but then you have the strikes, which will theoretically start affecting things at some point and the release schedule isn’t back to normal. So, are you feeling worse at this point or better given the recent strength?

[Sumit Roy, President and CEO]

Yes. So Brad, I’ve always stated this about the theater business that it is largely a function of content. And as long as the content continues to develop and it goes back to levels that it was pre-pandemic, which was circa 70, 75 big tent type releases, we’re going to get back to levels pretty close to the revenue levels that we had in 2019. And anytime you have situations like the one that you’ve just described where you have a strike, it does obviously put a little bit of a breaker in terms of the ability of studios to continue to release those big tent movies.

The good news in today’s environment versus the last time there was a strike, which lasted, if I remember correctly from -- for about four months. The good news today is we’ve got a lot more studios beyond the big four that are releasing big budget movies, and I’d put Amazon and Netflix in the mix there. But yes, all else being equal, a strike is not a good thing. Do I see this having a near-term impact, I don’t think so because a lot of these movies have already been completed, and it’s just a question of staging the release. But longer term, it could have a disruption on how many of these movies get released. And so, we are watching this closely. I believe there’s a meeting on Friday, where the studios are getting together with the writers and the actors and all of that. And my hope is that there’s a resolution soon. And -- but yes, it is a situation that we are monitoring closely. But my expectation, if it is anything like what it was last time, this should resolve itself in the next couple of months.

[Brad Heffern, RBC Capital Markets]

Okay. I appreciate that. And then can you give your expectations for the Cineworld sites that were rejected and maybe talk through some of the opportunities with those, whether it’s just typical releasing or if there’s a development opportunity for any of them?

[Sumit Roy, President and CEO]

Yes. So Brad, I’m not going to give -- go into the details of the Cineworld situation, just because we haven’t quite penned the contract yet. What I will say is that any of the potential economic outcomes have been completely reflected in our updated earnings guidance. So, that’s how I’m going to leave it with the Cineworld situation. And I’ll just add something to stuff that I’ve already talked about in the past, there will be a few assets that we expect to get back. And we have already started to look at what are the alternatives at those particular sites.

And the gamut runs from a complete redevelopment of the site to an alternative use, i.e., industrial to situations where we have a retailer coming in and talking about potentially just taking the asset as is, even though they’re not movie theater operators, to potentially re-entitling the asset for an alternative use and selling it, i.e., creating more value for ourselves. And the last bucket will be just selling the asset as is. So, all of those various permutations are being considered on a handful of assets that we expect will get rejected through this process. But, I’m not going to go into any more detail than that.

[Operator]

The next question comes from Haendel St. Juste of Mizuho. Please go ahead.

[Haendel St. Juste, Mizuho]

Sumit, I’d like to go back to a conversation we’ve had in the past on i-grade. You continue to source deals here with a lower share of i-grade than historically. And I know in the past, you’ve talked about that your experience in acquiring higher-yielding assets and you’re focused on generating the best risk-adjusted returns. But this quarter, particularly, we had a big drop, but it continues the trend of having below average i-grade. So I guess, is this a dynamic that we should just expect to continue going forward? Is this a new norm? How should we think about the share of i-grade going forward? Thank you.

[Sumit Roy, President and CEO]

Sure. Thank you for that question, Haendel. So just to continue to reiterate the point, we are not targeting investment-grade. What we are targeting are opportunities that yield the best risk-adjusted return. If it so happens that it is an investment-grade client and so be it. But ultimately, it’s the economic profile of that investment that’s going to dictate as to whether or not we are going to invest.

Today, truth be told, we are looking at some of these investment-grade opportunities and cannot pencil the risk-adjusted returns. We are finding far more value in areas where we’re looking at subinvestment-grade tenants who are willing to give us a return profile that is commensurate with the inherent risk in that particular opportunity. And that’s what’s driving the approximately 26% year-to-date investment-grade closings that we’ve done and is close to 18%, I think, for the second quarter. But that’s how we think about the world.

And the other thing I’d just point out is just to make it equivalent because I have seen some of these cap rates being reported and there’s a bit of a mixed match. When we’re talking about a 6.9% cash lease yield, if you layer in the straight line, we’re talking about an additional 100 basis points. And I’ve seen certain reports that are sort of conflating these two numbers. So just to make it apples-to-apples, our straight line yields are closer to 7.9% on $3.1 billion worth of acquisitions. That’s where we are seeing the value, with, I would argue, much better growth profile. And clearly, that’s represented in the 100 basis points of increase when compared to cash yields.

So that’s how you should think about us Haendel. And if it just so happens that this dynamic were to shift and suddenly investment-grade was to go back to our 40%, 45% that we have in our portfolio, then that will be it. But it’s not something that we target, and you shouldn’t expect us to be targeting that number going forward.

[Haendel St. Juste, Mizuho]

That’s really helpful. I appreciate the color there. And one more. I guess, I wanted to get your updated thoughts on investing in gaming assets today. I know in the past, you’ve talked about having an interest. I’m curious if you’re seeing anything out there today that would interest you, what type of returns or incremental spreads you require there? And specifically, your potential -- or your level of interest in a potential Bellagio trade. Thank you.

[Sumit Roy, President and CEO]

Sure. So again, I’m not going to talk about specifics, but I’ll repeat what I’ve said in the past about our desire to grow our gaming vertical. We are obviously looking at many opportunities. And thankfully, it’s a fairly robust environment today for gaming. And yes, in terms of how we’re going to view these opportunities, it’s along the lines of how I answered the previous question. So that’s what you should expect from us for this particular vertical.

[Operator]

The next question comes from Joshua Dennerlein of Bank of America. Please go ahead.

[Joshua Dennerlein, Bank of America]

I just -- I saw your cap rates on -- it looks like domestic acquisitions is about 6.8% and then, for developments, it was like a 6.9%. Some basis point spread seems kind of small. So just -- is that a function of kind of when deals were struck or just the risk profile of the tenants or just something that you’re seeing broadly in the market?

[Sumit Roy, President and CEO]

Yes. Very good question, Joshua. As you know, when you enter into transactions that have a long duration associated with it, which is what development by its very definition, is going to have. It does become a function of when were those transactions entered into and what’s the duration of that build-out period. And so, what you might have noticed is if you’re tracking our development yields over the last few quarters, you’ve noticed a marked increase in those cash yields on developments. It’s largely a function of when did we strike those.

So things that you’re starting to see filter through in the second quarter, which has a similar yield to what you saw on the domestic side, it’s largely a function of us having entered into those transactions over the last two to three quarters, when we were anticipating a much higher interest rate environment and therefore, being able to work with our clients to get that yield reflected in the development cycle. And you should continue to see that. Trends slightly higher looking into the next few quarters as some of the older generation development opportunities start to sort of get fully developed and are -- become cash paying opportunities. So I think just keep a close eye on that and that’s the trend you should see manifest itself over the next few quarters.

[Joshua Dennerlein, Bank of America]

Okay. All right. That makes sense. And then I think Jonathan might have answered this, but I just wanted to clarify, the top end of guidance, it looks like you took down $0.02. Was it just the interest rate environment that’s pushing down -- put downward pressure on that top range or anything else in there? Just curious, given acquisition guidance a bit, so.

[Jonathan Pong, SVP and Head, Corporate Finance]

Hey Josh. To address that, Sumit brought it up earlier, the impact of what we felt was the greatest uncertainty out there, the Cineworld resolution, tat impact is now that is known to us. And going into the quarter, it was something where there was a range of possibilities that we built into the high end and the low end. And so with a greater sense of confidence now where that’s trending, we felt that it was appropriate to take the high end down by $0.02 in addition to bringing the low end up by $0.02.

[Operator]

The next question comes from Michael Goldsmith of UBS. Please go ahead.

[Michael Goldsmith, UBS]

Jonathan, you’ve been with Realty Income for a while, and I think you’re developing a reputation for a creative solution from a financing perspective. But as you move into the CFO seat, is there anything different that -- is there anything different that you would think about doing in their new position or different approaches to what Realty is doing overall? Thanks.

[Jonathan Pong, SVP and Head, Corporate Finance]

Thanks, Michael. I appreciate the question. I would say, look, what’s made Realty Income so successful over the years, regardless of what we’ve done, what verticals we’ve established, it’s commitment to a fortress balance sheet. And that’s the one thing that is going to be sacrosanct to us for as long as we’re in existence in these seats. And so, we’re not going to sacrifice things like the A3 minus credit rating that we worked very hard to get. We’re not going to sacrifice the trust of the fixed income community that now spans across three different currencies. And so, you’re going to see us continue to focus on low leverage, plenty of liquidity and we’re going to be very predictable from that standpoint.

I think going forward, given the added complexity of the business, the volume, the transaction volume that we see, the different countries that we’re in, and we’ll continue to be in, I think it’s really more of a focus on more of the internal operations now. The external side of things, I think we’re pretty well established. We’re going to continue to be creative. But I think it’s about building and continuing this momentum on the internal platform that we’ve created, which we think is a differentiator in the net lease industry and frankly, in the real estate industry.

[Michael Goldsmith, UBS]

And Sumit, you mentioned your size and scale as a competitive advantage, at least twice, if not 3 times on the call. Do you feel like -- do you feel like your competitive advantage is growing? Are you seeing fewer bidders on some of the larger deals out there? Is that gap and the strength of the size and scale, is that improving and widening versus peers? Thanks.

[Sumit Roy, President and CEO]

Thanks for the question, Michael. I might have actually said it four times. I’m not sure. I just believe in it so much. And it’s really not something that we believe. It’s what we are hearing. When we are engaging in these conversations with clients who are big clients who have big questions that they’re trying to answer, it’s the fact that who gets invited to the table. And when we see that we are the only REIT in the net lease space at the table competing against private sources of capital, that in itself gives us continued confidence that we are playing a game that is very different from some of our smaller peers. And we want to be that. We want to be the real estate partners of choice for the S&P 500 names. We want to be the first name that is considered when we -- when folks think about -- they have the ability to write big checks. They have the ability to stand by what it is they say. Their reputation speaks for itself and their ability to close is bar none. And when we hear those comments from clients who work with us and more recently with some of our new clients who’ve been added to our registry, it gives us continued confidence to say that our scale and size is being appreciated within this space.

[Operator]

The next question comes from Eric Wolfe of Citi. Please go ahead.

[Eric Wolfe, Citi]

Just wanted to follow up on Greg’s question. When you look at your S&P peers, just curious what percentage would you say are receptive to the sale-leaseback conversation? And how has that changed versus a couple of years ago? Just trying to understand how your addressable market has changed. And for those that perhaps aren’t as receptive what’s the typical pushback?

[Sumit Roy, President and CEO]

I can’t give you percentages, Eric. But what I can point to is just look at some of the larger transactions we’ve done and who have we done it with. And they’re all first time sale-leaseback candidates, right? Think about Wind. [ph] They were -- they’ve never done a sale-leaseback before, and they chose to do it with us. Think about EG Group they’ve never done a sale-leaseback before. Their best chance of doing a sale-leaseback was when they actually ended up being the winners in the Cumberland Farms portfolio. This was three, four years ago. And they chose not to do it at that time.

And so part of the reason why I believe that sale-leaseback as a product is maturing, is certainly driven by the capital markets environment that we find ourselves in and suddenly finding that sale-leaseback as an alternative to raise capital is quite beneficial vis-à-vis as we were traditionally being compared to the debt capital markets, especially for names that are lower investment-grade or sub-investment-grade candidates. And so I believe that that will continue. And there will be other transactions that we hope to get over the finish line that we can speak to. That will again be first-time candidates. And yes, we feel like that that will continue to grow.

[Eric Wolfe, Citi]

That’s helpful. And then you look at the 10-year or whatever interest rate you want to look at and it’s up pretty meaningfully over the last couple of weeks. When you see moves like this and how quickly will you adjust your pricing on future acquisitions or potentially even re-trade some deals, just trying to understand how sort of real-time capital market volatility changes and return all those?

[Sumit Roy, President and CEO]

Yes. So Eric, I’m going to have Jonathan talk a little bit about things that we try to do to anticipate what I’ll call unanticipated movements in 10 years, okay? We talk about a hedging strategy that we have in place. But I just want to make one point very clear. Our cost of capital gets mark-to-market pretty much by the second. That’s not how cap rates move. There is absolutely a lag time, how sticky these movements, these upward movements and the cost of capital -- people have a different opinion about how sticky that is. And that drives their view around what cap rates should be. And it does take time for people to adjust to a higher cost of capital environment. And if there’s a lot of volatility that makes that adjustment period that much more difficult.

So yes, we’ve seen movements on the 10-year from 3.86 to 4.17, 4.18 today within a matter of days, you’re not going to see a 30 basis-point movement in cap rates to reflect this movement in 10-years, unless we see that this 4.7 -- I mean, 4.17, God forbid, 4.7. 4.17, 4.2 become a more sustainable rate. But then what do we do balance sheet perspective to sort of anticipate those situations? I’ll have Jonathan speak to that.

[Jonathan Pong, SVP and Head, Corporate Finance]

Thanks, Sumit. We’ve been very active on the hedging front, both for FX, which I alluded to earlier, but also on the interest rate front. If you look at the 10-Q from the first quarter, you’ll see that we actually purchased swaptions, which really go out until January of next year that protects us against rising rates on the tender. The reason why we chose 1 billion, the reason why we went out to January is because we do have some debt maturities coming up of around $1 billion, $1.1 billion in the first quarter of next year. We put those hedges in place in late March, early April and as far as you might imagine, it’s pretty healthily in the money right now. So from that standpoint, we’ve taken out the primary balance sheet risk -- or refi risk that we have coming up over the 6 to 9 months, but we’re always going to look for opportunities where we see a risk, we want to be proactive. We can’t time to market, but what we can do is mitigate the exposure that we have on potential risk.

And so -- that’s something that we’ve done now twice, and the first time we did it was the middle of pandemic, and we were able to monetize that what swapped at a $72 million gain. We’re not always going to be so fortunate, but that’s how we’re thinking about managing risk.

[Operator]

The next question comes from Wes Golladay of Baird.

[Wes Golladay, Baird]

Can you talk about what’s going on in the UK? It looks like volume was low. I’m just curious if this is a function of just low deal volume, or is it just pricing, just lagging still over there?

[Sumit Roy, President and CEO]

Yes. Neil needs to work a little bit harder, I think. It really is a timing issue as we had some great momentum towards the end of last year driven by pressures that funds were experiencing on the redemption side and it created some amazing opportunities for us. That momentum continued into the first quarter. Second quarter was still very healthy. We did about $420 million which is a big number, but it’s just -- it got dominated by what we did on the U.S. side, largely driven by the $1.5 billion.

If you take that $1.5 billion away, and you look at what we’ve done, we were at $1.6 billion, of which the European -- the international business represented, I would say, trying to do a quick math right around 30%. So -- and that’s generally been where the international business has contributed. But look, I’m very excited about that business, and there’s more to come.

[Wes Golladay, Baird]

Okay. It sounds good. And yes, good job, Neil. That’s actually good volume once adjusted. I guess next question is more bigger picture. I’m kind of curious what your opinion would be, what is the bigger risk to net lease? Would it be inflation and potentially having this price escalators, would it be tenant credit at this point of the cycle?

[Sumit Roy, President and CEO]

I would think it’s tenant credit. You’ll have to look at all of the various different net lease businesses and take a view on where do you see the credit risk largely driven by these inflationary pressures, the persistence of those inflationary pressures which then obviously is resulting in this higher interest rate environment. I think that’s going to sort of filter through and it will impact net lease businesses, net lease companies differently, depending on the makeup of where their exposure lies.

For me, one of the advantages that we have is, do we -- can we perfectly match inflation with -- of the inherent growth rates that we have, we can’t. So there’s always going to be a bit of a mismatch. But have we, and now I’m talking about Realty Income, done a much better job of growing the inherent growth profile of our leases? The answer is a categorical yes. Today -- and I think it was part of my prepared remarks, our overall portfolio, if you were to do nothing, will grow by 1.5% and on a levered basis closer to 2%. Some of it is actually benefited from non-capped CPIs that we’ve been able to get on one-third of the assets that have CPI growth rates built into them in the international markets. And those have contributed greatly to increasing our inherent growth rate.

So, it’s never going to be perfectly matched, but the risk of not having a perfectly matched growth rate inherent in your leases is somewhat muted versus credit risks that could translate into much bigger impact on your overall business.

[Operator]

The next question comes from Ronald Kamdem of Morgan Stanley. Please go ahead.

[Ronald Kamdem, Morgan Stanley]

Just two quick ones. Staying on the tenant credit risk. So, I see occupancy 99%; median EBITDA, it looks like it ticked up 2.8% versus 2.7% last quarter. And I know that’s reported with a lag, but still pretty interesting. And I think in your opening comments, you mentioned that basically the watch list was the lowest sort of ever. So things are certainly feeling pretty good. But as you sort of look forward, when you hear stuff like student loans starting again for property insurance in Florida. Just sort of curious, how does your team sort of stress test that or think about that, what the potential impact did it have on the tenant side? Thanks.

[Sumit Roy, President and CEO]

Yes. Good question, Ronald. And just to clarify, it wasn’t the last five years that I said that our credit watch list is in the 3s. It’s the lowest it’s been in the last five years. Those are very good questions. what is it when student loans get instituted back again and discretionary income falls? What are the first things to go? It’s going to be discretionary spend, right? And if you look at the portfolio that we’ve created that largely consist of nondiscretionary, low-price point, service-oriented businesses, these are things that will be the last to go. Could they be impacted? Of course, they can. But when you have discretionary income that is getting compressed, those are not going to be the types of businesses that will get impacted first. And that’s how we’ve constituted our portfolio of assets is being very much focused on what are the industries that are going to be a lot more resilient under economic conditions like the one that we are facing today. So, it is not by luck that we find ourselves with a credit watch list that is circa 3.7%. It is by design. And that’s how we run our business, Ronald.

[Ronald Kamdem, Morgan Stanley]

Great. And then my second one was just -- so going back to guidance a little bit and taking a step back thinking about this year, just can you -- what are the big two or three sort of comp issues that the guidance was facing this year? I think you hit on one, which is the interest cost sort of headwind, right, for this year. But presumably, that’s not going to be an issue for ‘24 because the comp just is not as tough. But was there anything else sort of onetimey or unique to this year, it could be property tax, it could be whatever that we should be mindful of, for ‘23 that maybe does not sort of happen again in ‘24?

[Jonathan Pong, SVP and Head, Corporate Finance]

Hey Ron, it’s Jonathan. I’ll say -- I’ll expand on what I said earlier regarding short-term rates. We talked about the impact to the back half of this year. But when you really zoom out and you look at year-over-year versus all of 2022 versus 2023, it’s even a greater impact. It’s closer to $0.07 or $0.08, which based off the midpoint of our guide is about 2%. And so, you take that out and on a normalized basis, the volume that we’re doing, everything that we’re doing from a portfolio and asset management standpoint, we’re trending closer to a 5% number year-over-year if you were at 3.1% this quarter.

The first quarter did have a little bit of a tougher comp, if you recall the first quarter of 2022. We did have a significant reserve reversal in the other industry. So that’s why the first quarter was a little bit flat. Second quarter outside of rates is getting back more towards a normalized level. So, back half of the year, I think you’ll continue to see some difficult comps on the SOFR front. And given that we do have even an 8%, 10% exposure to variable rates, just given the magnitude of the move, that’s going to be the biggest difference.

[Operator]

The next question comes from Linda Tsai of Jefferies. Please go ahead.

[Linda Tsai, Jefferies]

Just going back to your comment regarding the stickiness of cap rates, the investment spread of 133 basis points. How does that vary between international and domestic investments? And where would you see investment spreads in those two categories trending?

[Sumit Roy, President and CEO]

Yes. If you actually follow the headline cap rates that we are registering, I think the international business was 20 basis points higher. So, that should answer your question, Linda. But, again, this is going to be very much a product-by-product opportunity-by-opportunity discussion in terms of what is the actual spread that we are going to realize, and is there an advantage between the domestic markets and the international markets. I think the advantages are very different. Here in the U.S. market, there’s clearly more competition, there are more players. In the international markets, we don’t experience that. The U.S. market, however, is a much more mature sale-leaseback market. And so there are more opportunities that one can participate in, whereas I would say the international market is still in the nascent stages of sale-leaseback as a viable product. It is maturing, but it is behind the curve.

And for us, what we want to try to do is position ourselves in both these markets and work from our points of strength that allows us to then win transactions. Our average has been 150 basis points of spread from the time we’ve been tracking spreads. And first quarter, it was 200 basis points, based on realized capital that we raised to actually help finance our business. This quarter, based on, again, the same method, it’s 133 basis points. So, if you average out year-to-date, it’s still north of what our 150 basis points historical average has been. But it’s very difficult, Linda to tell you, going forward, you’re going to have one geography that is going to dominate the spread versus another. It’s very much opportunity-driven.

[Linda Tsai, Jefferies]

Got it. And then I think you said 30% of your international leases have uncapped CPI. What is the nature of those tenants that are open to that versus the other 70% of leases that don’t have uncapped?

[Sumit Roy, President and CEO]

Yes. Linda, let me be a bit more precise. Of the international leases that have CPI as the driver of internal growth, one third or 30% of them are uncapped. So not all of our leases in the international markets have CPI drivers of internal growth. So, I just want to make that clarification. And again, it is very much a function of the market. A market that is used to seeing CPI growth as the metric for -- in their leases, they’re far more receptive to continuing to see that. Now there has been some pushback given just the sheer magnitude of inflation that’s being experienced in some of these markets, and we are trying to be commercial about that. But, it’s very difficult suddenly to go to a client here who happens to be an investment-grade client and say, "Sorry, we want CPI growth", you’re not going to get that. So yes, we see -- we tend to see more uncapped CPI growth in the international markets than we do here. And yes, but that too is evolving.

[Operator]

The next question comes from Harsh Hemnani of Green Street.

[Harsh Hemnani, Green Street]

Sumit, you mentioned that in the past, sourcing, what you close is roughly 7% of what you’ve sourced. And this quarter, it was closer to 15%. Do you worry at all of the net lease transaction market sort of continues to remain illiquid and at Realty Income, you’re closing $5 billion to $7 billion annually, that you might not have the luxury to be as selective as you were in the past and maybe you have to execute on your second or third best idea. How are you thinking about that looking over the next 12 months?

[Sumit Roy, President and CEO]

Well, the good news, Harsh, is that we haven’t gone to executing on our second or third best ideas yet. We’re very fortunate. Let me shed some light on this 15% closing rather than what we’ve traditionally done, which is the 7% to 10%. What is skewing this is clearly the $1.5 billion transaction that we closed on in the second quarter, but it’s not reflected in the denominator in the sourcing volume of $15 billion. We had sourced that asset, I would say, probably in the fourth quarter of last year. So, that’s where the mismatch occurs. In some ways the sourcing volume is much more real time, what did we see. And there is generally a lag between when we engage in a conversation, i.e., when it is sourced versus when does that particular transaction get over the finish line or closes. And I think that lag sometimes does create this mismatch.

So, if we were to sort of take away the $1.5 billion and then look at the $1.6 billion that we ended up closing in a year that -- in a quarter where we source $15 billion, $16 billion, that’s still 10%. So, I think that’s probably the way to think about this mismatch that we saw in the second quarter.

[Harsh Hemnani, Green Street]

Okay. That’s helpful. And then the $1.6 trillion that you provided that there’s $1.6 trillion of commercial real estate on S&P 500 company balance sheet. How much of that is real estate that you would actually want to have in your portfolio? So, I imagine you’re not actively acquiring office assets. Could you share how much of that is maybe retail gaming, et cetera, that you might go after?

[Sumit Roy, President and CEO]

Yes. That’s a great question, Harsh, and we did that when we talk about $4 trillion here in the U.S. and $8 trillion in Europe. And just to be also super clear about this particular statistics that we shared in the prepared remarks. It does not include other real estate companies. It does not include certain sectors like finance companies, banks, energy companies, et cetera, et cetera. These are operating businesses that have assets.

And an easy way to think about it is, let’s assume that half of it is office. Let’s assume that another 20% of it is something that we wouldn’t want. Even if it is 20% or 30% of this $1.6 trillion, that is a massive number. And the point is that these are companies that are going to have to refinance their debt, this $1.2 trillion of debt over the next three years. It’s maturing over the next 3 years. And sale-leaseback should be a conversation that is appealing to them, especially given the cost of doing a sale-leaseback today in this environment versus the cost of refinancing that a lot of these companies are going to experience. That’s really the point.

[Operator]

This concludes our question-and-answer session. I would like to turn the conference back over to Sumit Roy for any closing remarks.

[Sumit Roy, President and CEO]

Thank you all for joining us today. We’re looking forward to seeing many of you at the various conferences this fall. Have a good rest of your summer. Bye, bye.

[Operator]

The conference has now concluded. Thank you for attending today’s presentation, and you may now disconnect.