Realty Income Corp

NYSE:O

Earnings Call Analysis

Realty Income: Strong Results and Merger Promise Growth

Realty Income showcased a robust quarter with a notable signing of a merger agreement with Spirit Realty, promising to increase AFFO per share upon completion. Investments totaled $2 billion across 132 transactions, demonstrating a strong approach to sale-leaseback deals and larger investments. These activities support raising AFFO per share guidance to $3.98 to $4.01 and pushing 2023 investment guidance to approximately $9 billion, excluding the Spirit deal. AFFO per share grew to $1.02, marking a 4.1% increase while delivering a 9% operational return. Despite a slight dip in occupancy to 98.8%, the company recorded a rent recapture rate of 106.9% and lifted full-year same-store rent growth forecast to around 1.5%.

Executive Overview of Q3 Performance and Outlook

Realty Income demonstrated robust execution of its growth strategy during the third quarter of 2023. The merger agreement with Spirit Realty, announced last week, marked a significant milestone. The quarter saw $2 billion in high-quality acquisitions and over $2 billion in long-term capital raised. Leasing activities reaped a 106.9% recapture rate, which fueled an upward adjustment in the 2023 AFFO per share guidance to $3.98-$4.01. AFFO per share climbed by 4.1% from the previous year to reach $1.02, translating to a total operational return of around 9%. Looking ahead, management has good visibility on a compelling earnings growth potential for the next year without external capital needs for the Spirit merger.

Capital Markets and Investment Strategy Amid Uncertainty

Despite the current capital market volatility, further emphasized by a narrow investment spread outlook, Realty Income remains committed to capital discipline. An impressive year-to-date investment of $6.8 billion has led to the decision to raise investment guidance to approximately $9 billion for 2023, not including the upcoming Spirit transaction. Though occupancy slightly dipped to 98.8%, largely predictable client move-outs, the portfolio maintains a strong health signal. Executives emphasized the need for prudent investments while focusing on delivering attractive risk-adjusted returns to shareholders.

Enhanced Portfolio Performance and Recapture Rates

With a historical average of 102.3%, the rent recapture rate of 106.9% across 284 new and renewed leases showcases Realty Income's asset management prowess. Notable was the ability to recover 60% of prior base rent on renegotiated leases without capital contributions. Encouragingly, management expects to recapture roughly 85% of prior rent after certain asset sales, supported by strong same-store rent growth of 2.2% for the quarter. These positive indicators have allowed for a raise in full-year rent growth guidance to an estimated 1.5%.

Maintaining Liquidity and Hedging Interest Rate Exposure

The company concluded the quarter with strong liquidity of $4.5 billion, encompassing multiple sources like unsettled forward equity and availability on credit facilities. Proactively hedging against a rise in the 10-year yield, the company invested in a swaption corridor, capping future rate exposure on note issuance, subsequently gaining about $25 million in net value from these transactions.

Strategic Debt Management and Post-Merger Projections

Management discussed a well-laddered debt maturity schedule that will result from the Spirit merger, highlighting refinancing risk management and numerous opportunities for opportunistic liability management in the years to come. The company projects to maintain a max of 12% of its total fixed rate debt maturing in any given year post-merger. The Spirit debt stack integration is seen as strategic with beneficial financial flexibility expected from 2025 through 2032.

Acquisition Strategy and Asset Quality Considerations

The leadership stressed a lack of focus on investment-grade ratings when selecting investments. The goal remains to achieve superior risk-adjusted returns where investment grade classification is a secondary concern. This approach was demonstrated in the past quarter with significant investments in the UK, including top operators like Asda and Morrisons, focusing on asset quality over credit ratings.

Selective Investment Approach and Revenue Maximization Focus

Heading into 2024, Realty Income plans to be 'hyper selective,' emphasizing the importance of adjusting cap rates to ensure sufficient investment spreads over the cost of capital. A proactive and disciplined investment approach seeks to not just maintain but maximize revenue while striking a balance with occupancy levels.

Earnings Call Transcript 2023-Q3

[Operator]

Good day, and welcome to the Realty Income Third Quarter 2023 Earnings Conference Call.

[Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Tyler Grant, Investor Relations. Please go ahead.

[Tyler Grant, executive]

Thank you all for joining us today for Realty Income's Third Quarter Operating Results Conference Call. Discussing our results will be Sumit Roy, President and Chief Executive Officer; and Jonathan Pong, Senior Vice President, Head of Corporate Finance.

During this conference call, we will make statements that may be considered forward-looking statements under federal securities law. The company's actual future results may differ significantly from the matters discussed in any forward-looking statements. We will disclose in greater detail the factors that may cause such differences in the company's Form 10-Q.

We will be observing a 2-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, executive]

Thank you, Tyler. Welcome, everyone. We are proud of the solid execution we've delivered on our strategy in the third quarter and maintain a favorable outlook for our business.

Our One Team at Realty Income continues to work diligently toward delivering strong results to our clients and stakeholders. The resilience, tenacity and range of our One Team has been impressive, culminating in the signing of the merger agreement with Spirit Realty, which we announced last week. This followed a quarter in which we invested $2 billion in high-quality acquisitions, raised over $2 billion in long-term and permanent capital, re-leased 284 properties at a 106.9% recapture rate, supporting an increase to our 2023 AFFO per share guidance range, which now stands at $3.98 to $4.01. I would like to thank our One Team for their leadership, efforts and dedication on behalf of all of whom we serve.

Our third quarter results demonstrate the consistency of our earnings profile through varying economic environments and the attractive internal growth of our high-quality real estate portfolio while highlighting the capabilities of our One Team and platform. Notwithstanding the challenging capital markets backdrop, AFFO per share grew 4.1% from last year to $1.02 per share. Combined with our dividend, we are pleased to have delivered an annualized total operational return up approximately 9%.

As announced last week, we entered into a definitive merger agreement with Spirit Realty in an all-stock transaction valued at $9.3 billion. The deal is expected to be immediately accretive to AFFO per share on a leverage-neutral basis with -- without requiring any external capital to fund the merger. The accretion from the transaction, once completed, creates the foundation for AFFO per share growth in the coming year and puts us in a unique situation where we've had good visibility to an attractive forward earnings growth rate potential 2 months prior to the start of the new year.

Given that, that, of course, remains a fair amount of uncertainty in the capital markets environment, the accretion from the Spirit transaction is made more compelling given the lack of capital markets risk we are absorbing to effectuate this outcome.

In fact, we believe our conservative underwriting of the portfolio provides for meaningful upside potential to our headline accretion expectations. We believe Spirit's portfolio is complementary to ours and we help to further diversify our industry, client and property concentrations. We expect our increased size, diversification, trading liquidity and overall presence in the market will enable us to access the capital markets even more efficiently, while also improving our ability to digest larger deals without creating concentration issues within our portfolio.

We are excited about the attractive cost basis, earnings accretion and enhanced ability to buy in bulk that will be effectuated through this transaction. I would like to express great appreciation for the Spirit and Realty Income teams given their hard work and collaboration, which enabled us to successfully progress the transaction.

In the third quarter, we invested approximately $2 billion in high-quality real estate investments leased to a diversified group of clients at a 6.9% initial cash yield. $1.4 billion of this total was derived from the international business at a 6.9% yield. Investments in the quarter were made across 132 discrete transactions.

I would highlight that our volume include 34 sale-leaseback transactions for $1.3 billion of volume and 6 deals that were greater than $50 million in size. This demonstrates that both the corporate sale leaseback and larger transaction initiatives remained advantageous for us during the quarter. A testament to our ability to source, negotiate and close on transactions that are less trafficked amongst other net lease companies, both public and private.

Our investment activity year-to-date is $6.8 billion, with investments in international markets representing approximately 1/3 of this total. Investment spreads realized during the quarter were over 100 basis points when calculating our WACC on a leverage-neutral basis and using the cost of equity and debt actually executed during the quarter. This is a decline of 30 basis points from last quarter, which is a result of the significant increase in the cost of capital felt across the capital markets in a short amount of time.

To put it into context, the average 10-year yield increased by approximately 55 basis points from Q2 to Q3. Following the sharp changes in the public debt and equity markets during the quarter, the private market cap rates have not adequately adjusted. Accordingly, we believe that it is particularly important to be disciplined and patient allocators of capital and ensuring that we are appropriately compensated for the capital we provide. We are confident in our ability to source and allocate capital in scale and with efficiency, and we are deeply focused on delivering attractive risk-adjusted returns to our shareholders.

Given the level of transactions completed in the first three quarters of the year, combined with an outlook for narrowed investment spreads, we are modestly increasing our investment guidance to approximately $9 billion for 2023, which excludes the Spirit transaction that is anticipated to close in 2024. This increased target reflects deals that we already had in the closing pipeline prior to the recent surge in our cost of capital.

With the sharp recent changes in cost of capital, we remain highly selective in pursuing new investment opportunities and will assertively hold the line on entering into any new transactions unless we can be assured of generating ample spreads to our cost of capital.

From an operating perspective, our portfolio continues to be healthy and performed well. At the end of the quarter, occupancy was 98.8%. This is down slightly from last quarter's historically high occupancy level of 99%, and it is a result of expected client move-outs. Rent recapture rates across 284 new and renewed leases was 106.9%. This outcome is better than our historical average of 102.3% and results in year-to-date rent recapture of 104.3% on 661 new and renewed leases.

I would highlight that since 1996, we have managed over 5,300 lease expirations. And the improving recapture rates in recent years is a testament to our asset management expertise and the unparalleled historical data we have at our disposal. This competitive advantage enhances the quality of our asset management decisions through unique insights gleaned from our proprietary data analytics platform.

Our credit watch list represents 2.5% of our annualized base rent as of the end of the quarter. This is a decline of 120 basis points from the second quarter and is primarily the result of removing Cineworld from the watch list following our amendment, which became effective on October 1.

We recovered 60% of prior base rent on our 41 locations without any capital contributions. Importantly, we also negotiated the ability to recover rent through percentage rent agreements, which could give us the ability to recapture a total of 70% of prior rent based on our internal estimates of performance.

Finally, with the reinvestment of certain asset sales, we expect to recapture a total of approximately 85% of prior rent. Same-store rent grew at an elevated rate of 2.2%. We continue to generate increasing higher average rent escalators within the portfolio due to our commitment to investing in leases with stronger rent escalators particularly in international markets where we have a relatively outsized number of leases with uncapped inflation escalators. The better-than-expected same-store rent growth in the quarter has enabled us to raise our full year guidance to approximately 1.5%.

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

[Jonathan Pong, executive]

Thank you, Sumit. Discipline and a commitment to our A3/A- credit ratings continue to be our priorities from a balance sheet management perspective.

During the third quarter, our net debt to annualized pro forma adjusted EBITDA and fixed charge coverage ratios, each fell by 1/10 of a turn to 5.2x and 4.5x, respectively. In the third quarter, we issued $886 million of equity primarily through our ATM program, while ending the quarter with $749 million of unsettled forward equity outstanding. Combined with cash on hand with $344 million and net availability on our credit facility of $3.4 billion, we ended the quarter with $4.5 billion of liquidity.

As we look forward to future capital raising needs, we continue to have rate protection on $1 billion of notional value to hedge against a rising 10-year yield. We purchased this protection in the form of a derivative instrument called a swaption corridor, which effectively limits our rate exposure on a future note issuance at an option premium below the cost of a regular way vanilla option. We purchased this option in late March when a 10-year yield was in the 3.5% area. And as of quarter end, the net value of the swaptions had a mark-to-market value of approximately $25 million.

As Sumit mentioned previously, the Spirit transaction provides us with the opportunity for meaningful earnings accretion in the coming years. From a balance sheet perspective, the Spirit team has done a great job in curating a well-laddered debt maturity schedule, which limits our future refinancing risk in any given year.

As we have experienced throughout the company's history, the global rate environment provides both headwinds and tailwinds in any given year, which is why the assumption of balance fixed rate debt stack that is spread fairly ratably from 2025 through 2032, provides us with extended financial benefits with manageable refinancing risk.

When giving effect to the combined debt maturity stack, we estimate that there will not be a year when more than 12% of our total fixed rate debt comes due. Similar to the Complementary real estate portfolio, Spirits debt stack is also a good fit with our existing maturity schedule, and we expect the continued debt stack or the combined debt stack to remain well laddered, giving us numerous opportunities to engage in opportunistic liability management exercises when prudent and economically advantageous to do so.

When I -- finally, I would like to thank all of our team members who have worked so incredibly hard in helping to support this transaction, and we will continue to be integral as we move towards close an integration.

With that, I would like to turn it back to Sumit.

[Sumit Roy, executive]

Thank you, Jonathan. In conclusion, as further demonstrated in the quarter, Realty Income has a well-established growth-focused business model that provides stable and predictable cash flows to fund the payout of our monthly dividend. We believe the platform we have created, evolved and refined is not easily replicable.

We have a long history of prudently allocating capital that is complemented by our industry-leading capital leasing abilities that we used to invest across properties that fall within our well-defined investment criteria. The results of our efforts have produced our net lease portfolio that consists of more than 13,200 properties diversified across property types, industries, geographies and clients.

We're excited for the future of our business. Our anticipated acquisition of Spirit provides a solid building block for growth as we head into 2024 and our existing portfolio continues to perform well. As such, we find ourselves in a favorable position to produce high single or low double-digit operational returns while offering the same stability that has defined this platform for decades.

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

[Operator]

[Operator Instructions] The first question today comes from Joshua Dennerlein with Bank of America.

[Joshua Dennerlein, analyst]

Maybe just going back to some of the opening remarks on the re-leasing the spreads. Just curious what drove that historically better than -- or the releasing spread is better than the historical run rate? And then just how should we think about that going forward?

[Sumit Roy, executive]

Yes. Great question, Josh. A lot of this was driven by our non-retail re-leasings. And you can see the breakout, I think we provide that in the supplemental, it was closer to 140% in terms of re-leasing spreads. It was also largely driven by this one very large industrial distribution center that we released to a new client. If you looked at just the retail side of the equation, that was closer to 104%, which is still slightly better than average. And I think a lot of this is really what I said in my opening remarks, the more assets we control, the kind of conversations that we can enter into with our clients is a different one.

One of the largest renewals was Circle K and where we looked at 100 of their assets, and we're able to enter into long-term lease discussions at very favorable rates. And that is what makes this platform so unique. The fact that we do control so many assets for some of these clients, the discussion we can have where if there is an asset that's not performing well, we are more than willing to give them a rent haircut but make that more than up across the portfolio and come up with a win-win situation for both parties.

And again, it's all about size and scale but I'd be remiss if I don't compliment the asset management team, the predictive analytics team that continues to refine the models and give scores on each asset, which gives the asset management team the confidence to then go in and negotiate knowing that these are assets that are performing well and therefore, warrant an increase. So I think it's a combination of all of those factors, Joshua, that we were able to realize 106.9% re-leasing spreads.

[Joshua Dennerlein, analyst]

Appreciate that color. Maybe just stepping back, how do you think about -- like your strategy? Is it something you want to lean into or you can try to get assets that get better internal growth going forward? Just curious.

[Sumit Roy, executive]

Yes. Obviously, what this is implying, Josh, is that if there are assets that we believe based on some of the things that I just shared with you, that we can do better than the current in-place rent. We are going to take a bit of a different stance and try to take control of those assets, especially if the existing client is looking for a rent haircut, et cetera. Which obviously, we may have a bit of a negative drag on occupancy levels because we want to take control and despite our best efforts, sometimes when you take control, there's a bit of a lag time between getting this new client into this building at that elevated rents.

But for us, the bottom line is going to be about creating better economics on rent recapture and at a small expense on the occupancy side, if that's what's going to be needed to do that. So going forward, you will see us continue to push this strategy and continue to show to the market that we do have a differentiated asset management platform.

[Operator]

The next question comes from Nate Crossett with BNP.

[Nathan Daniel Crossett, analyst]

Maybe you could just talk about the current pipeline. What do the yields look like right now? And then also, how big is the Spirit pipeline? What are those yields look like?

[Tyler Grant, executive]

Yes. I'm not going to speak to Spirit because it's not a transaction that we've closed on yet. So I'll speak very much to the pipeline that we have, Nate. And as you can tell, we obviously have a very healthy pipeline. We just increased the acquisitions to approximately $9 billion, which is an increase from where we were at the end of the third quarter.

And again, these are very similar to what we showed you in the third quarter. If you look at some of the largest transactions we did, they were -- with grocery operators in the U.K., it was Asda and Morrisons, both names that we like and we're able to get these very large transactions, Asda I believe was close to a $900 million transaction. Morrisons slightly smaller, closer to $170 million sale-leaseback. Both of these were sale-leasebacks and done purely on a negotiated basis. That type of transaction is what you're going to see when we get those over the finish line in the fourth quarter. Those are the types of transactions that we have in our pipeline today.

Some of the comments I've made around cap rates moving but not moving commensurate with our cost of capital movement remains true. The other piece that I will overlay is the fact that some of these transactions that we have in our pipeline were created 6 to 9 months ago. And so people may have questions, "Oh, how come you were only able to get a 6.9% cash cap rate?" which, by the way, if you look at it on a straight-line basis, it's almost 8.1% and just given the inherent growth in these leases and to make it equivalent to some of the other data that is shown by some of our peers.

Has the growth profile that we are targeting, but potentially is not reflective, which was obviously shown in the spreads that we were able to recapture 105 basis points, which is about 30 basis points inside of what we did in the second quarter. And that goes to the point I'm making is that cap rates, though adjusting, are adjusting much, much more slowly than our cost of capital.

And so this is a time where going forward, we are going to be hyper selective. But the makeup of the fourth quarter will be very similar. You should see a movement in cap rates in the right direction, i.e. higher cap rates and more reflective of when these transactions were essentially came on to the pipeline, which started to reflect the more rapid movement in our cost of capital. So that's what you should see. It's obviously fairly healthy. But thankfully, we've raised a fair amount of capital through the ATM, et cetera, already.

[Nathan Daniel Crossett, analyst]

Just one on the Bellagio, I just wanted to ask like what is your appetite to do investments where you don't own the asset 100%, whether it's a JV or a loan? And is there anything in the pipeline that is a JV?

[Sumit Roy, executive]

Off the top of my head, outside of the Bellagio transaction, I don't believe we have a JV structure in the pipeline. Similar to the way we structured the Bellagio transaction. We do tend to have JVs with developers where they hold on to a small stake in the development while developing the assets, et cetera, but we generally tend to be the takeout on the back end. But I don't think, Nate, and correct me if I'm wrong, that you meant those types of JVs. You were talking about more permanent JV structures like the one that we've entered into with Bellagio. I don't believe we have one like that.

There is one -- there are products out there, by the way, that do lend themselves to this JV structure. There are asset classes that require a tremendous amount of capital where we will be more than forthcoming about entering into a JV, just given the sheer amount of capital required. But those are going to be very specific to a very specific asset type, and I would put casinos in that bucket and perhaps some other asset types that lends itself to this. But as of right now, we don't have other JVs that we've entered into.

[Nathan Daniel Crossett, analyst]

Okay. So like what are the other asset types like? Would data centers be on that list? I'm just curious.

[Sumit Roy, executive]

Yes. Data centers is certainly an asset type that will require, based on this influx of AI, et cetera. It's an asset type that will have a massive requirement in terms of capital. I could see if we choose to go into that area, that's an area that JV-ing with an operator would make perfect sense.

[Operator]

The next question comes from Haendel St. Juste with Mizuho.

[Haendel St. Juste, analyst]

So Sumit, I guess first question for you is on the composition of the transaction in the third quarter. The share of Europe was historically high. The high-grade share and cap rates seemed low. Understanding there is a little bit of a lag at least on the cap rate. But I guess I'm curious if you can help us square some of that and maybe perhaps offer any commentary or facts and figures that would help ease any concern regarding the quality of the assets you're buying? And if we should expect Europe to continue playing a greater role near term?

[Sumit Roy, executive]

Sure. So you tell me, if buying Asda and Morrisons is diluting the quality of the asset pool at realty income handle. I think we've tried to answer this question before that we do not target investment grade. What we are looking for are assets that we believe are priced and have a profile of generating a return that is on a risk-adjusted basis, the right return profile. That is how we think about the world.

And the fact that we are able to enter into these negotiated transactions with some of the best operators in the -- in U.K., I think is something we are very comfortable doing. And the fact that they don't have an investment-grade rating is not an issue for us given how we were able to price it, the fact that these are top quartile assets that we were able to get and have inherent growth profiles that will continue to pay dividend in years to come.

So for us, it's looking at the entire investment in totality. To determine how much risk are we really taking on? What is the operator? Where are they in terms of positioning? How are they positioned within that particular sector? What is the actual real estate that we are getting? What is the performance of the 4 wall? I think those are the things that we focus on. And the fact that they turn out to be investment grade or not, is almost a byproduct of that analysis rather than something that we target.

And I think I've said this before but thank you for asking the question. I'll keep repeating this. I believe we had about 20% of our investments this quarter that was investment grade. But again, that could be in some quarters 40%, in some quarters it could even be less than that. And we will, of course, continue to share that information with you, but a portfolio that on a straight-line basis, generates 8 -- north of 8% yield. I think is something that we are very proud of, Haendel.

[Haendel St. Juste, analyst]

Okay. I certainly appreciate that, Sumit. And maybe one follow-up perhaps for Jon, a question on the reserves. I think there's been about $11 million of reserve reversal year-to-date. Can you clarify what's assumed in the 4Q guide, which includes the Cineworld restructuring and if we should expect any reversals in 2024?

[Jonathan Pong, executive]

Haendel, no -- nothing that you should expect for the fourth quarter, pretty much all of the reserve reversals that were significant have been taken as of the third quarter. You may have seen in our same-store rent growth slide in the supplement that we saw a bit of a bump in health and fitness and that was really related to one more regional client that we reserved -- or reverse to reserve off of.

As we look forward into 2024, nothing lumpy from that standpoint that would be on the radar. As we think about just bad debt expense in general, modeling out the following year, we always have some semblance of an unidentified reserve that we put in there just given our history. And we're obviously very conservative on that front. And I think we've said this before, but we've historically realized about a 25-basis point credit loss in the portfolio at any given year.

[Operator]

The next question comes from Michael Goldsmith with UBS.

[Michael Goldsmith, analyst]

Sumit, you used the term hyper selective in your opportunity -- you used the terms hyper selective in term how you're going to approach the next year, can you kind of define what hyper selective means? And does that mean that you would only look at for opportunities greater than the 100-basis point of investment trends that you saw this quarter?

[Sumit Roy, executive]

That's a great question, Michael. Look, I think, if you look at where we are today and you look a year ahead in 2024, we believe that without having to rely on the equity capital markets, we'll be able to deliver approximately 4% to 5% AFFO per share growth. And that is a pretty powerful statement to make, and that obviously assumes that the Spirit transaction closes either in the first month, either in January or in February. And with just the free cash flow that we are going to generate pro forma, which is going to be right around $800 million, some of the headwinds that we are going to experience in the refinancing, absorbing all of that to be able to sit here today and say that we could deliver that growth without having to raise $1 of equity, I think it's a very good place to be.

And so when I said about being hyper selective, what has happened more recently is that the cost of capital has moved so dramatically, so quickly that the cap rates haven't had a chance to sort of adjust. And so we find ourselves in this -- like I said, in the second quarter, we had about 135 basis points of spread. And then in this quarter, we have 105 basis points of spread. It's a tough environment to be in when we are entering into transactions 6 months, 7 months in advance of closing a transaction and the cap rate environment -- I mean, the cost of capital environment changes and when you are permanently financing it, it sort of eats into what you had originally underwritten. That is what I meant when I said we want to be hyper selective because we want to help drive the cap rates out to help accommodate for these unforeseen movements in the cost of capital.

And so clearly, the cap rates haven't adjusted as much and that's what I said -- that's what I mean when I say we want to be hyper selective. We want to wait for the cap rates to adjust to make sure that we can get the spreads that we have historically achieved. That was really the color behind that comment.

[Michael Goldsmith, analyst]

That's really helpful. And then as I follow up, occupancy took a slight step back but still well above your guidance range. So can you just talk about what you're seeing in the market in terms of pushing rents versus occupancy? And how that -- how's that drive -- or how you use that to drive maximize revenue overall?

[Sumit Roy, executive]

Sure. That's a great follow-on question, Michael. So for us, we are looking at a particular real estate through the lens of maximizing revenue. And the revenue maximization strategy by its very definition, will mean that we are more than comfortable holding on to certain assets that are vacant for longer.

If we have concluded that there is a use for that particular location, and that it's not the very first client that comes in and gives us a rent proposal, but the kind of client that we are targeting and the client -- and a profile of rent that we are targeting, that takes time. And so we are more than comfortable taking a little bit of a hit on the occupancy side to make sure that we get the best revenue optimization for that given location.

And that's what you're going to see. That's the reason why even though we've been running the portfolio at 99% for the last 3 quarters, we have always maintained that our occupancy is going to be up slightly above 98%. Because that, we believe, is a natural state of occupancy for the business model that we are trying to run here.

And look, where it makes sense, we will continue to sell assets vacant if we believe that, that is the most economically desirable outcome, that holding on to those assets does have a cost, and that just continues to drag into the return profile. So selling assets vacant is also a strategy that we will continue to implement. So I just don't want you to start thinking now in terms of, hey, there will be no more vacant asset sales. All of those options are available to us, and we will pursue the one that generates the best revenue outcome.

[Operator]

The next question comes from Brad Heffern with RBC Capital Markets.

[Brad Heffern, analyst]

Sumit, European deal volume was a record this quarter after a period of time where it seemed like the region was maybe a bit slower to reflect the new reality. I'm wondering if Europe is back to competing for capital on sort of a heads-up basis with the U.S. or if this was just a one-off where you happen to have 2 large deals get over the finish line at the same time?

[Sumit Roy, executive]

It's -- we've been talking about this -- these 2 transactions for a while now, Brad. So some of it's just taken a little bit longer to get this over the finish line. And some of it has been that cap rates do take a little bit longer to adjust in the international markets than they do here just because of the depth of the market here.

You should continue to see a fair amount of product coming in from the international markets and that's reflected in our pipeline. But I always go back to when somebody asks at the beginning of the year, where do you think you're going to end up? We always say that it's right around that 30% to 40% will be the international investments. And 60% to 70% will be the U.S. And I think that is probably where we'll end up at the end of the year as well.

[Brad Heffern, analyst]

Okay. Got it. And then can you talk broadly about the attractiveness of the different capital sources. The $750 million in unsettled equity isn't quite as much as I would have thought, given you have the $3-plus billion to close by the end of the year. But I'm wondering if you're shifting to maybe a greater debt balance given where the relative costs of capital are.

[Jonathan Pong, executive]

Brad, it's Jonathan. So all options are available to us. Obviously, each one of them on a nominal or absolute basis isn't where we would want it to be. But I think the one thing to consider is we're always going to prioritize that 5.5x leverage, first and foremost. And so when you look at our equity costs, you compare it to our indicative cost of 10-year unsecured debt across all three currencies that we can operate in. There is a difference that isn't necessarily wider than usual but there is a bit of a gap, but we aren't going to sacrifice the balance sheet, we are going to lever up just to eke out a couple of extra tenth of a basis point of growth for next year.

So you could expect us to be very predictable from that standpoint and by predictable, it's carrying a reasonable balance on the line in our CP program having 10% or so of variable rate debt outstanding at any point in time and being very prudent with laddering out our maturities on a go-forward basis.

[Operator]

The next question comes from Eric Wolfe with Citi.

[Eric Wolfe, analyst]

With regard to the Cineworld agreement, can you talk about whether that helped your guidance relative to what you were forecasting before and remind us how much income you booked on Cineworld prior to October 1, just so we can understand the incremental impact for next year?

[Sumit Roy, executive]

Yes. Everything that we've shared with you on Cineworld is obviously in the form of an agreement. So any impact that it's going to have is reflected in the comments that we've made about next year and the fourth quarter of this year.

Eric, I don't know if you're looking for anything more that we are not expecting to give you a surprise that because of the Cineworld transaction there's going to be a drag on anything that we've shared with you. That's already been absorbed and shared. It's reflected in the updated guidance that we have for 2023 and in the comments that I've made about what we expect to see happen in 2024.

[Eric Wolfe, analyst]

And then in the second quarter, so I guess not the third quarter but the second quarter, you saw around $0.5 billion increase in financing receivables within other assets. Is that more a reflection of the type of deals that were done in that quarter or rents were on those deals relative to the market? Just wondering whether we should expect a similar jump in the third quarter and sort of the quarters going forward?

[Jonathan Pong, executive]

Eric, that's really driven by the accounting guidance where when you have sale-leaseback transactions and you look at the rent relative to market, the classification of that revenue goes into a different bucket, it goes into other revenues and also the corresponding balance sheet impact also will show up there. So it's no different than any other regular way transaction we do, it's just given the nature of it being a sale-leaseback deal with the purchase price accounting that's dictating some of the valuation associated with the real estate versus the cash flow, and that's why you see that bump.

[Eric Wolfe, analyst]

Okay. Right. So any type of sale leaseback would create sort of more outsized impact on financing receivables versus another type of deal. I'm just understanding that correctly?

[Jonathan Pong, executive]

Yes.

[Operator]

The next question comes from Wes Golladay with Baird.

[Wesley Golladay, analyst]

I'm just curious what are the clients saying right now? I assume you're still the cheapest form of capital for them. Are they just looking to pause and to see where rates settle?

[Sumit Roy, executive]

Yes, this is an ongoing debate. The clients tend to think about the world 12 months ago and we are trying to get them to understand the world has changed dramatically. It is that stickiness that causes the cap rate movements to drag, and that's no different today, Wes. What we are seeing, however, is that when there is pressure on the client, i.e., there's a maturity that they have to deal with on the debt side, or they have a pipeline that is helping drive their growth, and they have to build out assets or operate assets. That's where we see a willingness to transact and accommodate the new cost of capital environment.

But it depends on the client, it depends on the sophistication of the client, it depends on the need, and the urgency that the client is experiencing at that point in time where these conversations are either fairly straightforward and easy or there's a bit of a delta between what they're expecting and hoping versus what we can deliver.

[Operator]

The next question comes from Ron Kamdem with Morgan Stanley.

[Ronald Kamdem, analyst]

The first couple of quick ones. Just back on tenant health, I'm looking at the supplement in this, I see rent coverage is [ 2.8% ]. Just wondering, does the Cineworld transaction sort of -- is that going to hit that number next quarter? Number one. And then if you could just broadly talk about just what are you seeing in terms of tenant health? Any sort of sectors or areas where you're starting to see some softness or any areas that are outperforming?

[Sumit Roy, executive]

Ron, so the Cineworld will not have an impact on the 4-wall coverage because we don't get store-specific on a quarter-by-quarter basis. That number that we share with you, our own assets where we do have a fair amount of visibility with regards to 4-wall coverage. So when we have assets that have a point in time disclosure, we generally don't try to include that. So no, it won't have an impact.

With regards to what we are seeing, that [ 2.8% ] to [ 2.9% ] has been a fairly consistent number over the last, call it, 3 quarters. And it was a bit surprising all of last year because the cost of capital has started moving, and we were expecting there to be a little bit more noise and what we ended up learning through the processes, even the reserves that we had created, we had to sort of unwind to reflect that the clients were doing better than what we had expected. And that theme has sort of played out.

There are certainly some bankruptcies in the casual dining side on franchisee side but they are such a small portion of our overall portfolio. I am talking single-digit basis points that they don't have much of an impact on the overall portfolio where, by and large, given the essential retail that we've targeted, those clients are doing well.

Sorry?

[Ronald Kamdem, analyst]

Sorry about that. Go ahead.

[Sumit Roy, executive]

No, that was it, Ron.

[Ronald Kamdem, analyst]

Okay. Great. So just -- I guess, moving on to my second question. Just want to go back to one of the comments you made about sitting here and potentially getting 4% to 5% AFFO growth per share. Just to be clear, does that include the $1.8 billion of debt coming due next year, I think, at a 4 [indiscernible] change rate being refinanced? Or how are you thinking about the interest cost headwind in that number?

[Sumit Roy, executive]

Yes, it does. And I think when -- it does. So that's definitely going to be a headwind and the way we are thinking about it is forecasting out what the forward curve looks like today, what we think we'll be able to refinance that $1.8 billion of debt and what's the negative impact running through the income statement and therefore, to the AFFO per share.

All of that's been taken into account. And the big caveat here is making sure that the Spirit transaction does close in January, February, and that our portfolio as we've shown to you in the third quarter continues to perform the way we expected to. And just those two pieces, I do think will allow us to get to that 4% to 5% without having to really raise $1 of equity, I keep going back to that because that is a very important component of 2024.

[Operator]

The next question comes from Linda Tsai with Jefferies.

[Linda Yu Tsai, analyst]

What are your plans around assuming Spirit's term loan? And how has lender reception been?

[Jonathan Pong, executive]

Linda, we fully expect to assume Spirit's term loan, they've got $1.1 billion outstanding with a delayed draw to get to $1.3 billion. And so it's obviously all swapped at a very attractive fixed rates for us. We have had some preliminary discussions with the lender group. The good news is that there's quite a bit of overlap with our lenders and their lenders, and we've been very flattered by the reception so far from our banking orders. And so everything is going according to plan there. We'll be able to utilize those swaps that carry quite a bit of value and it fits nicely again into our maturity schedule. So everything is going fine there.

[Linda Yu Tsai, analyst]

And then in terms of the Spirit acquisition, what's the impact on Realty's credit ratings and how do fixed income investors or [ rating agencies ] view transaction?

[Jonathan Pong, executive]

Yes. So Linda, it was a very favorable reaction and constructive feedback from the rating agencies, both Moody's and S&P, they came out and reaffirmed the A3/A- ratings, stable outlooks. And so again, we talk about how this is a very complementary portfolio and balance sheet. I would say, if you look at the before and after for some of the key credit metrics and our bond covenants, it's essentially unmoved. And so from that standpoint, it was at a very lease credit neutral and some could argue giving credit positive, given the additional scale that it provides us. And so all good on the fixed income and rating agency side.

[Linda Yu Tsai, analyst]

Just one last one. How do you think about portfolio discounts broadly, like the EG group deal? Do you think they'll persist in 2024 and beyond?

[Sumit Roy, executive]

I do, Linda. And in fact, the larger the transaction, the better discount you're going to get. We genuinely -- at least here at Realty Income, we believe that to be one of the core differentiators of Realty Income and anybody else in this space, the ability to do these $1 billion transaction, $2 billion transactions and not have to worry about diversification.

Obviously, you know of Jonathan and his team's ability to access capital. I mean that's a big advantage for us. And even pre-Spirit, we are probably the name that trades the most on an average daily basis and that too helps on the equity side of the equation. So I think setting aside the capital and people are more and more talking about our ability to access differentiated capital, they are approaching us with solutions that they're looking for that has multiple millions of dollars associated with it and even potentially billions of dollars associated with it.

And so that's how we want to be viewed. And as soon as you start to have those discussions on a one-on-one basis, you have the ability to move cap rates a little bit more. You have the ability to construct leases that are a lot more favorable. And we've seen that. We saw that on the transactions we just announced in the third quarter with Asda and Morrison. We saw that on EG Group in the second quarter. We saw that on the gaming asset that we did in the fourth quarter of last year. These are all these $1 billion plus or close to $1 billion transactions. And that's where I think we will continue to shine.

[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, executive]

Thank you all for joining us today. We look forward to seeing many of you at the Nareit Conference in Los Angeles next week. Have a great afternoon. Bye-bye.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.