Realty Income Corp

NYSE:O

Earnings Call Analysis

Realty Income's Q3 2024 Results Highlight Growth and Investment Strategy

Realty Income's third-quarter results reveal steady growth, with AFFO per share rising 2.9% to $1.05. The company raised its 2024 investment volume guidance to $3.5 billion, showcasing strong market momentum and a robust $1.3 billion planned for Q4. Notably, the firm achieved a 105% rent recapture rate on lease renewals, affirming its resilient portfolio. Despite external challenges, Realty Income maintains a focus on diversifying investments across retail, industrial, data centers, and gaming. The establishment of a private capital fund aims to expand its investment reach, potentially enhancing long-term growth and stability while alleviating reliance on public equity.

Strong Performance in Q3 2024

Realty Income reported robust results in the third quarter of 2024, showcasing a continued momentum in their operations. With an Adjusted Funds From Operations (AFFO) per share of $1.05, the company saw a growth of 2.9% compared to the previous year. The CEO noted this growth reflects the resilience of their diversified real estate portfolio, which comprises over 15,400 properties leased to high-quality tenants. The stability within this diverse client base has been pivotal in overcoming various economic challenges.

Increased Investment Volume Guidance

In a positive adjustment to their outlook, Realty Income raised its 2024 investment volume guidance to approximately $3.5 billion, bolstered by strong investment activity observed year-to-date and an encouraging pipeline for the fourth quarter. This new figure indicates an eagerness to leverage improving market conditions, particularly following a recent U.S. rate cut, which has created a more favorable transaction climate.

High-Quality Investments Yielding Strong Returns

In Q3, Realty Income invested $740 million into high-quality opportunities, achieving a blended initial cash yield of 7.4%. This yield reflects a healthy spread above their historical average. The investments comprised $378 million in the U.S. with a 7.4% cash yield, and $362 million in Europe at a 7.3% yield. Notably, the quarterly acquisition activity more than doubled from Q2, with strong indications of continued momentum heading into the fourth quarter, where an implied investment of around $1.3 billion is expected.

Portfolio and Occupancy Stability

Realty Income's portfolio maintained a high occupancy rate of 98.7%, albeit reflecting a slight decrease from the previous quarter. Rent recapture efforts proved effective, with a remarkable 105% on 170 renewed leases, collectively generating approximately $38 million in new annualized cash rent. Such performance emphasizes the company's strategy of active asset management and its ability to fortify cash flows.

Strategic Shift to Private Capital Fund

A significant highlight during the call was the announcement of a strategic shift towards establishing a private capital fund, aimed at accessing a broader investable universe, particularly in the U.S. private real estate market, which is substantially larger than public equity markets. This fund is expected to allow Realty Income to pursue lower initial yield opportunities with higher long-term growth potential. While specifics on the fund size remain tentative, the company emphasizes a strong commitment to co-investment, aligning interests with all stakeholders involved.

Focus on Capital Management and Debt Strategy

Realty Income reported a healthy balance sheet with a net debt to annualized pro forma adjusted EBITDA ratio of 5.4x, remaining within their target range. The company has also expanded its access to capital through recent bond offerings, totaling $1.2 billion, enhancing their financial flexibility. The commitment to disciplined capital management is pivotal for supporting ongoing growth initiatives and investment strategies, ensuring resilience against market fluctuations.

Looking Ahead: Market Opportunities

Going forward, Realty Income is focused on leveraging multiple growth verticals, including retail, industrial, and emerging sectors like data centers and gaming. The diverse portfolio not only secures stable cash flows but also positions the company to capitalize on evolving market trends. As the fourth quarter approaches, the leadership remains optimistic about continued investment opportunities, with confident projections of maintaining healthy returns on new acquisitions.

Earnings Call Transcript 2024-Q3

[Operator]

Good day, and welcome to the Realty Income Third Quarter 2024 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Kelsy Muller, Vice President, Investor Relations. Please go ahead.

[Unknown 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, Chief Financial Officer and Treasurer.

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 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, Kelsy. Welcome, everyone. Realty Income's third quarter results highlight our continued momentum, disciplined execution and the benefits of our global investment and operating platform. Our value proposition to investors is simple, a real estate partner to the world's leading companies. We've created a defensive and diversified real estate portfolio consisting of top-tier clients to drive stable and predictable cash flow. As a result, we've delivered positive total operational returns each year since becoming a public company 30 years ago, successfully navigating a variety of economic environments.

Importantly, as we move through an improving external backdrop helped by a recent rate cut in the U.S., we've started to see a more attractive transaction landscape. Given this, we are pleased to increase our 2024 investment volume guidance to approximately $3.5 billion, underpinned by strong investment activity year-to-date as well as a robust pipeline for the fourth quarter.

Concurrently, we are raising the low end of our AFFO per share guidance for the year to a range of $4.17 to $4.21. Despite some recent volatility driven by exogenous factors, we remain confident in our strategic vision and the opportunity ahead. Our investment strategy offers significant opportunities for growth across multiple verticals, including our core of retail and industrial and newer verticals such as data centers and gaming. At the same time, we are making progress towards the establishment of a private capital fund, which I'll touch on later in this call.

Turning to the details of the third quarter. We delivered AFFO per share of $1.05, representing a 2.9% growth compared to last year. We invested $740 million into high-quality opportunities at a blended 7.4% initial cash yield or a 7.8% straight-line yield assuming CPI growth of 2%. Of this, $378 million of volume was invested in the U.S. at a 7.4% initial cash yield with a balance of $362 million invested in Europe at a 7.3% initial cash yield.

We've seen meaningful improvements in both the U.S. and Europe. Our international markets continue to contribute a greater share of volume relative to prior years with healthy investment activity year-to-date, exemplifying the benefits we achieved by cultivating multiple avenues for growth. In total, we completed 70 discrete transactions, including 4 transactions over $50 million, which represented nearly 60% of our investment volume, highlighting the breadth of our platform. As I noted, the momentum we are seeing in the transaction market supports increase to this year's investment volume guidance to $3.5 billion.

In the third quarter, our organic acquisition activity, which excludes credit investments as well as development spending largely negotiated in prior quarters totaled $594 million or more than double the second quarter's volume. We expect further momentum through the balance of the year, with an implied fourth quarter outlook of approximately $1.3 billion in investments, which is fully funded as we are vigilantly focused on deploying capital into high-quality opportunities that meet our risk-adjusted return requirements.

Capital deployed in the third quarter yielded an investment spread of 243 basis points, above our historical average spread of 150 basis points. This spread was supported by $165 million of adjusted free cash flow available after dividend payments to fund investments. These spreads are based on our short-term nominal cost of capital that measures the year 1 dilution from utilizing external capital and excess free cash flow on a leverage-neutral basis to fund our investment volume. As a reminder, our ultimate investment decisions are based on our long-term weighted average cost of capital, which burdens every dollar of equity with the same cost of equity.

Underpinning our increased investment activity of external capital improved by approximately 65 basis points in the third quarter. This compares to the decline in our weighted average initial cash yield of approximately 50 basis points during the quarter.

Turning to portfolio operations. We've created a diversified portfolio of more than 15,400 properties with high-quality clients that have proven resilient through various economic cycles and continue to deliver stable returns. In addition, our vast data availability, proprietary predictive analytic tools and insights of our asset management and research teams enhance our ability to anticipate future trends. We finished the quarter with 98.7% occupancy, a 10 basis point decrease from the prior quarter. Our rent recapture rate on the 170 leases we renewed was 105% and totaling approximately $38 million in new annualized cash rent, thanks to the diligent efforts of our team.

Separately, we are continuing to lean into dispositions as an additional source of capital. In the third quarter, we sold 92 properties for total net proceeds of $249 million, of which $87 million was related to vacant properties. This brings our year-to-date total to $451 million. For the year, we now expect proceeds of $550 million to $600 million in asset sales.

With that, I'd like to turn it over to Jonathan to discuss our third quarter financial results in more detail.

[Jonathan Pong, executive]

Thank you, Sumit. We are pleased to [ level ] over another strong quarter while increasing our investment in AFFO guidance for the year, reflecting continued momentum. Consistent with our investment strategy, we remain disciplined in our balance sheet management. Our strong balance sheet underscored by A3 A- credit ratings and deep access to capital globally continue to represent significant competitive advantages, fueling the opportunity to grow earnings through multiple channels. Our leverage, as measured by net debt to annualized pro forma adjusted EBITDA was a healthy 5.4x, well within our target ratio or 5.2x including $969 million of unsettled forward equity outstanding as of today.

Our fixed charge coverage ratio of 4.6x remains in line with the 4.5 to 4.7x range. We have delivered consistently over the last 7 quarters. A focus on derisking our future funding needs was a catalyst behind our 2 bond offerings during the third quarter, which consisted of a $500 million 30-year U.S. dollar bond offering and an effective semiannual yield to maturity of 5.49% and a dual tranche sterling bond offering that raised GBP 700 million at a weighted average tenor of 11.1 years and a weighted average annual yield maturity of 5.4%. These offerings illustrate the diversity of debt products available to us and the intentionality of our capital diversification philosophy.

Our 30-year offering was our first 30-year issuance since 2017, and our public sterling offering was our fifth non-U.S. public bond offering in approximately 3 years, bringing our foreign denominated outstanding unsecured debt to over $8 billion. We are grateful for the loyal support we have received from the fixed income community as we continue to expand our credit presence globally.

At quarter end, we held $5.2 billion of liquidity, including unsettled forward equity, in addition to retaining almost full capacity net of cash available on our $4.25 billion revolving credit facility, only 3.4% of our outstanding debt at the end of the quarter was variable rate in nature, illustrating the financing flexibility we have heading into the end of the year. Access to capital is paramount to the success of our company and our portfolio size, scale, diversification and our trading liquidity in the public markets, have consistently afforded us well all priced capital to grow with large-scale, high-quality investment opportunities.

With that said, we strive to demonstrate a proactive forward-looking mindset as we plan, position and evolve our financing strategy for future growth. Over the last few years, we have evaluated additional sources of equity capital beyond the public markets and have recently begun in earnest to build a private capital infrastructure that we believe, over time, will leverage our strengths and expand the breadth of our capital allocation opportunities globally.

I would like to hand it back to Sumit to provide additional color. Sumit?

[Sumit Roy, executive]

Thank you, Jonathan. As we mentioned last year, a natural step in our evolution is to diversify and enlarge our access to equity capital through private markets. We see multiple strategic benefits of entering the private capital business. First, the amount of equity available from private sources far exceeds that, which is available through the public markets we have traditionally accessed. The size of the U.S. private real estate market is approximately $18.8 trillion, 10x larger than the $1.9 trillion of assets owned by public REITs. Thus, private capital controls more than 90% of the U.S. commercial real estate market based on research from the National Association of Real Estate Investment Trusts.

Creation of a private capital investment platform is expected to provide us with access to a deep pool of institutional capital from investors who may otherwise lack the mandate or ability to invest in real estate securities.

Second, access to the alternative source of equity with generally less pricing volatility will give us the opportunity to accelerate the monetization of the scalable and proven investment in operating platform we have built, in turn, supporting our ability to continue delivering value to shareholders.

Third, a powerful element of the fund management strategy is the incremental capital-light fee earnings it's anticipated to offer. Base management income earned by managing third-party capital represents a source of recurring and potentially high-growth revenue, which we observed as receiving a premium multiple from the investment community. The vast majority of fees earned would be recurring in nature and generated through open-end perpetual life funds rather than performance-based or transaction-oriented fees.

Fourth, the capability of our differentiated business model will allow us to advance this initiative with limited incremental investment while leveraging the collective talent and experience of our top-tier team and platform. We have a long history of underwriting, operating and maximizing the value of our real estate holdings, dating back to our founding in 1969. Leveraging that history, we have harnessed an impressive quantum of property level data to develop our proprietary predictive analytics model to support decision-making.

With additional size and scale, these data-driven insights will become increasingly robust and accurate. Together with the expertise of our team, we believe we provide a compelling co-investing platform for investors.

Finally, we believe private capital will enable us to source, acquire and manage a large percentage of available market opportunities that we currently acquire for the public vehicle. Overall, our intent is to create and operate an evergreen open-end fund that will manage private capital on behalf of institutional investors, such as pension funds, sovereign wealth funds, endowments, foundations and large insurance companies.

To be clear, this structure will be distinct from a typical private equity style closed-end fund that may have a fixed duration or a narrower opportunity set. Importantly, this fund will be designated to target institutional investors. It will not be structured as a non-traded REIT, and we do not intend to market to high net worth or retail investors. Our fund business is expected to follow the same balance sheet and prudent leverage philosophy that Realty Income describes today.

We do not anticipate an adverse impact on our balance sheet strength or credit ratings Rather, it will enhance our financial flexibility. Realty Income intends to be a meaningful co-investor in the fund while receiving management and potentially incentive fees generated by operation of the fund. These additional earnings would bolster Realty Income's return on investment while ensuring incentives between public and private investors are aligned. This approach also reinforces our commitment to transparency and shared objectives.

In summary, we believe this private capital platform will be complementary and additive to our existing business. We intend to take a thoughtful approach to allocating investment opportunities between realty income and the fund to maximize the returns for our public shareholders, benefiting both our shareholders and private investors. We expect this initiative to enhance our ability to grow our earnings and dividend, expand our addressable market for investments and reduce our reliance on public equity across market cycles when strategically advantageous. We look forward to sharing more information as we progress on launching the fund.

In closing, our year-to-date performance has exceeded our expectations, propelled by momentum on the investment front and supported by the stability of our portfolio, consisting of leading clients across the globe. Looking forward, I'm optimistic about the multiple verticals for growth we have cultivated for capital deployment. Importantly, pairing these growth verticals with alternative sources of capital will further accelerate the maturation of our platform.

I would now like to open it up for questions. Operator?

[Operator]

[Operator Instructions]. Today's first question comes from [ John Kielczewski ] with Wells Fargo.

[Unknown Analyst]

Maybe if we could jump to the 3Q acquisition guide -- or excuse me, just the acquisition numbers you put up and then talk about the acquisition guide for 4Q. There was a good bit of cap rate compression. Just curious what's going on in the acquisition market. And then maybe part 2 of that would be you have a big step-up in terms of acquisition volumes. I'm curious if you can speak to the potential for maybe a transaction on the large 7-Eleven deal. And then if so, given where we've talked about cap rates being for that deal, is that accretive to your long-term weighted average cost of capital?

[Sumit Roy, executive]

There's a lot of questions you've asked, John. So let me just take it one at a time. The $740 million that we did in the third quarter at a 4% cap rate, you're absolutely right. It is 50 basis points inside of what we did in the second quarter, which was a [ 7.9% ] cap, but it is also a function of the cost of capital. If you notice, our cost of capital improved during the third quarter vis-a-vis what we -- where we were at the beginning of the year. And that improvement was about 65 basis points. So despite the 50 basis points of cash yield compression, the fact that our cost of capital has improved by 65 basis points, it was more accretive to do the transactions that we did in the third quarter with the lower cost of capital that we were able to experience versus what we had done in the first half.

So to look at anything in isolation, just based on cap rate or just based on cost of capital, I think may lead you to the wrong conclusion. So I would request that you take those 2 pieces in conjunction to figure out what is the true spread that we are being able to cultivate through these investments.

The second question that you had was around the $1.3 billion approximately that we are anticipating closing in the fourth quarter. It is true that we have a very healthy pipeline and it is largely a function of what we were experiencing for most of the -- all of the third quarter, say for what's happened over the last week, 1.5 weeks where there's been a lot more volatility on the cost of capital side, but that has allowed us to basically build our pipeline and we have essentially forward funded all of the $1.3 billion that we are planning on investing in the fourth quarter. So we have zero reliance at this point in the public markets to help finance what we are planning on achieving with regards to our fourth quarter numbers.

The volatility in the cost of capital is something that we always take into account when we are looking at potential opportunities and making sure that we have enough margin of safety in any particular transaction that we pursue is critical to how we think about making investments. And long term, making sure that our hurdle rates on the long-term cost of capital is superseded by, again, a healthy margin is inherently important to what we do. I'm not going to go into specifics around what transactions make up the fourth quarter. But we've heard certain comments around there being a difference in when you're buying a large portfolio versus the one-off market. I can assure you that we are in the one-off market every day. And just because you mentioned 7-Eleven, there are 35 transactions that have taken place in 2024 year-to-date and with the same approximate lease term, et cetera, if you look at where they traded, they traded at a 5 to 9 cap rate. Anytime we are pursuing a portfolio deal and there were large -- 4 large portfolio deals that we were able to accomplish in the third quarter, we make sure that it is at a discount to what we would be able to find in the one-off market.

And that has played out. If you look at what our the actual rent is compared to market rent that we bought, the $740 million. The rent that is inherent in that $740 million of investments is 6% below market and 26% below replacement costs. That is why we feel very confident that on a risk-adjusted basis, the transactions that we are pursuing are ones that will create long-term value for our investors.

[Operator]

Our next question today comes from Greg McGinniss of Scotiabank.

[Greg McGinniss, analyst]

Sumit, although you mentioned an improving acquisition environment benefiting full year investments based on this foray into private capital market equity raising, it seems like kind of inherently saying the limiting factor on acquisition volume this year has been capital raising and not lack of sourcing investments at widened up spreads. Do you expect the cost of equity in the fund business is going to be lower?

And how well investment philosophies between the fund and core business differ to avoid any potential conflicts of interest when determining where an investment should be placed?

[Sumit Roy, executive]

That's a very good question, Greg. The biggest difference between the private markets and the public markets that I can point to is this focus on first year spread versus a focus on long-term IRR. When we are looking at a particular transaction that is inside of our historical spreads, which has been 150 basis points, we hesitate to pursue that transaction because it is not in line with what we can generate in the first year.

And as you know, better than most, that we are valued off of that initial spread that we are able to capture, which then translates into AFFO per share growth. But that does not allow us to pursue transactions that have a similar, potentially even a higher total return profile given the inherent growth, et cetera, that they might have despite having a much lower initial cash cap rate. That is where we feel like being able to access private capital that has similar expectations on the long-term horizon, the return horizon that we have -- we focus on even as a standalone public entity, but not with that short-term focus, as acutely as the public entity does, will allow us to expand our sandbox and make investments alongside this private capital business, to take advantage of much higher growth rate opportunities, but potentially at a lower initial yield. So we think of this as truly complementary to our business. Go ahead. Were you going to ask something else?

[Greg McGinniss, analyst]

Yes. I just was hoping you might be able to give us maybe some examples as to types of investments or tenants that you guys have had to pass up on because of current structure versus what this this new type of equity capital will allow you to pursue?

[Sumit Roy, executive]

Sure. Industrial is a perfect example. We've looked at opportunities in the 5.5 ZIP code. We cannot go there today. as -- based on where our cost of capital is, with 3% growth, 20-year leases. You do the math and you're going to have a return profile, that is very much in line with what we're looking for long term, but we can't pursue that particular transaction because of what the -- maybe not the dilution, but the non-spread day 1, that's a perfect example. There are other asset types.

Data centers being a perfect example of another asset type that is going to fall squarely in this bucket, which we may not be able to pursue currently given our cost of capital. And that is a particular area of the business that we believe can help drive earnings growth for the public entity in years to come.

[Operator]

Our next question comes from Brad Heffern of RBC Capital Markets.

[Brad Heffern, analyst]

Yes. So it sounds like really the target for the fund would be just a lower cap rate opportunity set. I'm curious, do you expect that there would be any overlap in the investment profiles between the 2 vehicles?

[Sumit Roy, executive]

Of course, we are going to continue to be a very large equity holder in the fund. So our interests are going to be perfectly aligned. So there will be a lot of opportunities that we are going to be looking at, which actually works for both entities long term, but potentially in the short term does not work for the stand-alone public entity. But this is also going to be a function of the capital raising.

We are not going to be buying things into the farm that we would never have touched even taking the long-term return profile into account as a public entity. So this is truly to enhance the box and to pursuit transactions, assuming our capital raising is successful, and participate together through the fund structure. That is how we would like to deploy capital.

[Brad Heffern, analyst]

Okay. And then do you have any sort of target in mind for a size where it makes sense, given just the added complication?

[Sumit Roy, executive]

I hope it's going to be very simple. What causes added complication. Well, it's a different pocket of capital, but unlike pockets of capital that have finite life, this is a perpetual vehicle. And we are going to be very large co-investors in this perpetual vehicle. And for all intents and purposes, it will be fully consolidated with our financial statements. So you will have perfect visibility.

The fact that we have scale and the fact that we have a platform that we are very proud of, unfortunately, does not get valued at points in time by the public markets. And this is a way for us to monetize this platform and, therefore, incur very little incremental cost to stand up this vehicle. That, too, is a value that our current platform is going to bring. And I might go so far as to say that given our size and scale, which we have talked about being such a massive advantage, this is one of the ways that we can show that to the market.

[Operator]

And our next question today comes from Smedes Rose with Citigroup.

[Bennett Rose, analyst]

I wanted to ask a little bit about the $63 million charge in the quarter related to convenience store client. Is that related to the same client where you took some smaller charges in the first half of the year? And could you maybe just talk a little bit more about kind of what the outcome be there? I guess you can't name the client, but maybe just a little more color around what's going on there?

[Jonathan Pong, executive]

First of all, I'd say we absolutely expect a fair welcome. We've talked historically about situations where we've had credit issues in the portfolio, we've recouped north of 80% of rent that's been impacted. As it relates to the accounting that drove the $64 million charge, it's noncash first and foremost, it really has to do with the fact that upon the allocation of the original purchase price. You've got land, you've got building and then you've got the intangible, which is meant to account for the future cash flows inherent in the lease.

And so the reserve that you see, which rolls into impairment, but is classified because these were originally sale leasebacks as a financing receivables. And that's really just a difference in nomenclature and that's why it's excluded from from AFFO is noncash. And we've already expensively accounted for all of the lost rent for the entire of 2024 that's built into our guidance.

[Sumit Roy, executive]

And I'll just add it to that just because we're talking about credit, let me just share a bit more. I mean these are assets that we really want to one control over. And we are doing everything in our power to get control of this asset. It is essentially a client who's decided not to pay rent while operating these assets. And we -- given the work that the asset management team has done, we already have a tremendous amount of interest in these assets, which are primarily located in Texas. And so we feel very confident about being able to replace the rent, which is not significant in this case. The actual cash rent that is very quickly once we gain control. So that's this convenience store operator. But while we are on the topic of credit, I want to walk you through some of what has dominated the conversations over the last few quarters.

Red Lobster has emerged from bankruptcy and just hired a CEO. They've hired a Chief Marketing Officer. They've got a new CFO. Let me close the storyline on that. We had 216 assets, prebankruptcy. 9 assets were rejected through bankruptcy. We had a 91% recapture rate on that particular name.

Rite Aid. We have 29 locations today. We had an 88% recapture rate on Rite Aid, which is now emerged from bankruptcy and is an ongoing concern.

Regal, where we have 35 assets today and an 85% recapture rate and it has emerged from bankruptcy. So those are the story lines that have dominated multiple quarters of conversations, and this is the end result of all of those conversations.

Let's talk about Walgreens. Everybody is concerned about what used to be a 2,000 store closings, which has now been reduced to 1,500. Year-to-date, we've had 13 Walgreens come up for renewal. They had lease maturity. All 13 were renewed by Walgreens. In our history of 55 renewals with Walgreens, we've had a recapture rate of over 100%.

Let's throw CVS in that mix. We've had 40 leases renew with CVS in our history at over 102% renewal. Let's talk about Family Dollar, Dollar Tree. We've had 135 lease renewals with Family Dollar Dollar Tree in our history at over 108% renewal rate. Dollar General is a similar story. So I just asked that what we see in the headlines don't necessarily translate to what is happening on the ground for our portfolio. And that's the emphasis I want to make is that we are very selective and the data proves that out to be the case. Go ahead, Smedes. Sorry, I cut you off.

[Bennett Rose, analyst]

No. No. I mean I appreciate the detail is understood. But of course, as we see these headlines, we have to ask about them, right? I mean that's the nature of the business. I wanted to ask you on the -- just going back to the fund for a moment. You -- I think it was asked previously, but I don't think I heard the answer. Just do you have a sense of kind of what the scope of the fund would be? And are we talking maybe $1 billion to start? Or would you see it in several billions? Or kind of how do you think about the size of the fund, I guess, initially and maybe how it might grow over time?

[Sumit Roy, executive]

Yes. It's too early to tell. We obviously believe in our pieces. We believe in what we are doing. We believe it's -- the benefits of what we are doing is going to accrue to our public shareholders, but it is too early Smedes me to opine on how big this could potentially become.

[Operator]

And our next question today comes from [ Jay Kornreich ] with SMBC.

[Unknown Analyst]

I was wondering if you can comment on kind of the opportunities that you're currently seeing in Europe. And as you see things today, are you looking into exploring into new territories and do you expect that acquisition opportunity in Europe to continue to outpace the U.S.

[Sumit Roy, executive]

That's a great question, Jay, given what we've done in the quarters, it is a legitimate question. Yes, 56% of what we've done year-to-date has been in Europe, but we view that as an advantage that's precisely the reason why we created all of these growth verticals to be able to take advantage of wherever the best opportunities reside. And Europe is where we found that to be the case for the first 3 quarters. I believe the momentum in Europe will continue. We are seeing very good opportunities in Europe.

And yes, our ability to go beyond our current geography, by geography, I mean, countries in Europe is also something that we are constantly looking. And so for the right opportunity, there are several countries that we don't happen to be in that we would consider going into with the right client and with the right opportunity.

Jay had asked about the future as well. And so the $1.3 billion that's expected in the fourth quarter, I want to close a loop on that. The momentum that I had referenced was the momentum that we are seeing here in the U.S. In Europe, the momentum has continued. It's been there at the beginning of the year. That momentum has continued, but it's in the fourth quarter that you will see it reverting back to more historical norms in terms of U.S. versus international.

[Operator]

And our next question today comes from Haendel St. Juste from Mizuho.

[Haendel St. Juste, analyst]

Sumit, I wanted to go back to the fund one more time. There appears to be a long list of benefits that you mentioned already, but I'm also thinking that there could be a long-term benefit of allowing you at some point to potentially generate mid-single-digit AFFO growth, your long-term kind of core growth target without the need for sizable annual equity raises when you think about your existing rent bumps and the reinvestment of your free cash flow. So I guess, first, is that fair? And then maybe some color on if you'd look to fund it with existing assets within your portfolio and what that mix could look like?

[Sumit Roy, executive]

That's a very good question, Haendel. Thank you. And you're right. I mean, the idea here is we get into this business to expand the investable universe for ourselves and for the fund while making sure that we adhere to the return expectations of all parties concerned.

Look, it's a mathematical fact that it's not an issue today, but 10 years from now, at the rate we are growing, if we continue to rely on just the public markets to finance our growth, we're going to run up into capacity issues. I don't believe that the public markets are, especially the fund business in the public markets are growing at the same level that we have expectations of growing as a public entity. And so it is not a dearth of opportunities that is driving this desire to get into the fund business. it is making sure that this complementary source of equity capital will help us monetize our platform and create a business that will then allow us to continue the momentum that we have shown over the last 55 years, 30 of which has been as a public entity. That is the goal of what we are trying to do.

And outside of the initial call it, seating of this fund, which, by the way, that portfolio will look and feel very similar to what Realty income looks like. And at the appropriate time, all of that will get disclosed, is a way to attract capital and start our business. But subsequently, it will be new transactions that they participate in, either alongside us or it will be on balance sheet for the public entity. That's how the business is going to function.

[Haendel St. Juste, analyst]

No, that's incremental. I appreciate that. And one more, and I'm not sure if you answered it, but I didn't quite catch if the pipeline for the fourth quarter, if you expect the cap rates to be comparable or lower? And then just thinking about the uptick in volume into the fourth quarter, if that's an appropriate run rate to think about into next year?

[Sumit Roy, executive]

Yes. Haendel, I'm not going to opine on cap rates, et cetera, because things can move around quite a bit. But what I will tell you is that the spread that we are going to make will be -- will continue to be healthy and will continue to be north of our historical spreads. That you can take a fair amount of confidence. And the other piece I'll leave you with Haendel is we have already prefunded our need for the fourth quarter. So there is no reliance on the public markets to help fund this $1.3 billion that we are planning on doing in the fourth quarter. Hopefully, that helps.

[Operator]

And our next question today comes from Spencer Allaway with Green Street Advisors.

[Spenser Allaway, analyst]

One more on the private fund. Can you maybe just talk about how time will be spent just in terms of underwriting deals and opportunities for the team in general, but also for you, Sumit. And then I know you commented on economies of scale around our data and data analytics. But just curious if you foresee any changes to headcount or to the investment process just in the early stages of that launch?

[Sumit Roy, executive]

That's a great question, Spencer, because it really goes to the heart of when I say we're going to scale -- use our scale as a company that we are today to mitigate what would be an insurmountable cost for a start-up to stop this business. We have 465 people in the business. We already have a fully staffed investment arm, both here in the U.S. as well as in the U.K. and in Amsterdam, taking care of our international business. So we don't see any need or any incremental personnel on the investment side. That's scale benefit, number 1.

Scale benefit #2. We are going to be agnostic as to whether these assets are held in a fund, which, by the way, the public entity will have a fairly large interest in or whether it is on balance sheet. And thus, our asset management team that has done a superb job on the public side, both here in the U.S. as well as in the international markets in London, they will continue to manage these assets. That's benefit #2.

Any dispositions, any elements of that, we already have the team here. We have a very large legal team that we are going to leverage that obviously is a massive source of pride for us given that we do a majority of the work in-house. We will continue to lean on them to help with transaction negotiations, lease negotiations, et cetera. That scale benefits, #3.

We already have the setup in place -- and so we are not going to be needing new people to help do the block and tackle work that is required of an investment arm where we will have incremental cost will be around a fund manager and the reporting as well as an IR function that will be dealing with a very specific type of investor base on the private side. But outside of that, from accounting finance, which, by the way, is again something we are very proud of, will all be leveraged with the existing platform that we have. That's my comment around the incremental cost in standing this business up will be fairly muted.

[Spenser Allaway, analyst]

Very helpful. And then just last one, can you talk about how the competitive landscape is changing? Or if there's been any changes in the U.S. and Europe right now as it relates to the transaction market?

[Sumit Roy, executive]

Yes, Spencer, it's the -- it's very fluid in terms of who we are starting to compete against. There is no doubt that private arms are becoming much bigger players in transactions that we are pursuing. And of course, we've had a few more companies in the net lease space that have become public. We don't run into most of them given the types of transactions that we pursue, but it is a crowded field in terms of competition here in the U.S.

In the international market, it continues to be one of the biggest advantages that we have, where we are running into more competition today than we did, let's call it, a year or 2 years ago, but we -- but it's still not quite as intense as what we experienced here in the U.S. And most of that competition comes from private capital in the international market. So that's the flavor of who we compete against in the U.S. and in the international markets.

[Operator]

And our next question today comes from Upal Rana with KeyBanc Capital Markets.

[Upal Rana, analyst]

Sumit, you talked about the momentum in the transaction market, an but I wanted to kind of get a sense on on have buyers and sellers really reacted to that 50 basis points rate cut and with another 25 basis points cut likely this week and then with the 10-year really driving higher about 65 basis points since the last Fed rate cuts. So I want to get good sense on that.

[Sumit Roy, executive]

Yes. I think, Upal, so much of the volatility across the curve at this point is around what will happen today. And it's the largest exogenous factor that's going to determine where the curve settles down. We are not as exposed to the short end of the curve. We are -- but it's not to the same extent as we are to the long end of the curve. And so what's happening on the long end of the curve definitely has an impact on our cost of capital because that becomes a permanent source of financing and our ability to pursue transactions.

And that is a function of inflation expectations that people have about the future. And if policies are going to get put into place, where the inflation expectation is going to suddenly be much higher than what it had been traditionally, that is going to have an impact on where the tenure is going to settle and that will certainly have an impact either on the positive side or on the negative side for the permanent cost of capital for a net lease business. And those are largely policy driven. We've had parties coming up with proposals that have a diverse set of impacts on this particular inflation expectations. So too early to tell where all of this is going to settle. It is creating a fair amount of volatility, and we are hopeful that regardless of who wins, once we have more clarity in terms of what the curve is going to look like, we'll be able to execute on business as usual.

[Upal Rana, analyst]

Great. That was helpful. And then last 1 for me. Going back to the private capital fund. I know you've already listed a bunch of benefits there. But I wanted to get your sense on why now and why this makes sense in today's economic environment. And I know you mentioned capacity could be an issue in the future, but is there anything else that you may have been dealing with that was creating some friction on your end?

[Sumit Roy, executive]

Really, Upal, there is nothing that we are seeing either on the credit side. I think I went through a pretty detailed list to share with you that on the credit side, we feel very good. Our credit watch list actually came down by 10 basis points to 4.2%. And from the previous quarter. So we feel very good on the credit side. We feel very good on the health of the market to precipitate transactions setting aside what's happened over the last couple of weeks, but that too shall pass is our expectation.

Really, the timing is around to do this right, which obviously is our collective desire. We want to do this very slowly and we want to do it very thoughtfully and it's going to take a long time, a long time for this to become a mature business. I mean look at one of our peers who has probably one of the most successful open-ended fund businesses, and that's Prologis. And they've been in that business for 20-plus years.

And today, it has become -- we can step back and say it is a super successful business that some very smart people went into 20 years ago. And so in anticipation of what could happen 10 years from now, et cetera, when we start to run up against this, our desire to put out capital and perhaps the limits of just accessing the capital sources that we have today, that could become more acute. And so we have to start today to build this history and to build this fun business to a point where it really starts to bear fruit for our public shareholders et cetera. And that's it. That's why we are doing it today. There is no -- there is -- it doesn't matter at which point in the cycle we would have done this, that question would and should be asked, but it's really about starting now when we don't have a need for additional capital and building this business to get ahead of what could be a limiting factor multiple years down the road.

[Operator]

And our next question today comes from Linda Tsai with Jefferies.

[Linda Yu Tsai, analyst]

Just a few quick ones. Can you give us an update on where 2024 bad debt year-to-date has trended? And what's your outlook for '25?

[Jonathan Pong, executive]

Yes. So Linda, if you look at the earnings release, First 9 months of this year, we've incurred about $6 million in bad debt expense. That's around 40 basis points of our rental revenue. When you take out this one C-store operator that we referenced earlier. You're really looking at sub-20 basis points on 18 basis points. We've talked historically about how when you exclude the pandemic, we've been right there around 25 basis points of credit loss in a given year as a percentage of revenue. So to be at 18 outside of this onetime unusual events, we think is pretty indicative of a very constructive and healthy portfolio.

And I think we -- as Sumit alluded to earlier, the credit loss was at 4.2%. There's really not a lot out there that we're really monitoring that meaningful. There's no 1-plus percent exposure tenants on there. We feel as though those that are on the watch list, we've been monitoring for quite some time. And in some cases, we have very good visibility into the cash flow coverage on these assets. And so we'll get into all of the assumptions that we're baking in for 2025 come February when we release our guidance.

[Linda Yu Tsai, analyst]

And then in terms of the C-store write-down in the quarter, what's the potential AFFO impact on earnings? And then what do you think is the recapture rate?

[Jonathan Pong, executive]

So in terms of this 1 C-store operator, it's really, I call it $1 million a month or so. And all of that is built in. All of that is built into our guidance. And we'll see where we trend out to in terms of recovery. But as we referenced earlier, we do feel like there could be quite a bit of interest in these assets. So I think the default response that we have to offer up is you look at our historical precedents and being able to get 84%, 85% or recapture of any rent that's been impacted by from bank or credit event.

[Operator]

And our next question today comes from Ronald Kamdem with Morgan Stanley.

[Ronald Kamdem, analyst]

Just 2 quick ones back to the fund. I think you talked about some of the investments that the fund would be interesting in the fund where the public equity couldn't do it. I guess my other question is just, is there any other differences in terms of dividend policy in terms of geography, like in the fund go anywhere. And in your mind, is that investor that's going into the fund, is that a completely different investor base that would contemplate the stock? Or is there some overlap?

[Sumit Roy, executive]

Yes. Ron, we haven't really done any work on the investor profile, but the comments I made about how much bigger this investable universe is of potential investors to look to invest in real estate through a fund structure is what's so compelling. Is it possible that you have some of these funds that have ambit to invest in public securities and they have a mandate to invest in private direct investments.

I'm sure that may be the case. But even those investors will tell you that what they have to invest through a fund structure directly into real estate is multiples of what they have on the security side. So I can't give you a more precise answer than that, but the vast majority, I believe, are going to be investors who don't have the ability to invest in public securities but would like to utilize our platform, work with us and invest in the product that we invest in.

And outside of that, the strategy is one that I've already touched on. There's not going to be anything new that the fund business is going to be doing that we won't do on balance sheet. Keep in mind that the goal is we will be a a massive co-investor in this fund. And so our interests are going to be perfectly aligned in terms of what it is that we pursue.

[Ronald Kamdem, analyst]

Great. And then my second quick 1 is just an update on sort of the data center sort of initiatives. Obviously, there's been a lot of data points about demand ramping? Just how are you guys sort of seeing the pipeline in that vertical evolving?

[Sumit Roy, executive]

Yes. So I won't talk about pipelines, Ronald, but what you've referenced in terms of the demand, we're seeing that in space. And we've been very lucky to be speaking with multiple operators in this space. We see it in terms of what they're showing us regarding the pipeline that they've created we are trying to craft a value proposition that is compelling to these operators.

And we are very optimistic about where this particular business could go for realty income going forward. We feel like we can be a solution that helps meet some of the demand and the capital needs to execute on what is a once in a cycle type situation. And at the end of the day, we have capital allocators. And if we can allocate capital exposed to S&P 10, S&P 20 clients for 20 years, that's our core business. And so we are excited, but it's too early to tell in terms of how this is all going to play out.

[Operator]

And our next question today comes from R.J. Milligan at Raymond James.

[R.J. Milligan, analyst]

So I wanted to ask a couple more questions on the funds, given those examples of some of the transactions that might be more appropriate there, has been helpful. And I just just wanted to be clear, do you expect the fund to invest in properties that might not necessarily have triple net leases and therefore, have better internal growth or more structured investments, development loans. So I'm just trying to get an idea of what the mix is or if it's going to be pure triple net.

[Sumit Roy, executive]

R.J., what I'll share with you is you should think of these investments in terms of flow-through, rental income flowing through to NOI to be very similar to what we've done on balance sheet right? The idea is not to go and start executing on businesses that have a 40% NOI margin. That's not what we do. And so when we talk about data centers, we are not going to be going out there and buying colocation sites where the flow-through is very different versus hyperscale single-tenant 20-year leases that may not be precisely triple net, but the flow-through is still incredibly high, i.e., mimicking what a triple net asset should be generated. That's really the -- what we are going to be doing.

[R.J. Milligan, analyst]

Okay. And then 2 quick follow-ups, and I may have missed the answers. But number one, do you expect the cost of equity to be higher or lower than Realty's.

[Sumit Roy, executive]

So the cost of equity as defined by long-term return hurdles should be very similar, but their focus is on the long-term hurdle rate, not on day one accretion. And that's the big difference, R.J. That's why I gave the examples that I did that the return profile long term is very similar for both of these businesses. But we, as a public entity, 100% public entity, today cannot meet our dual mandate of generating that year 1 spread and the long-term hurdle rate.

Both those have to be met in order for us to pursue transactions in the public markets today. That's how we are valued, and we are very grateful for that. We understand that that's how -- that's the game we have to play. But there are assets that we are passing up on very high-quality assets that can meet the long-term hurdle, but will potentially have a much lower starting point. And that, I think, is what we'll be able to do through this fund structure and enhance our co-investment through the recurring asset management fee stream, which is essentially the monetization of the platform that we have. to the benefit of our public shareholders. That's how this will work.

[R.J. Milligan, analyst]

Okay. And one last follow-up is, will Realty Income be contributing properties to the fund?

[Sumit Roy, executive]

There will be a seat portfolio that will allow us to have conversations with potential investors. But thereafter, it will be new investments that we pursue. That's how we're thinking about it today. So outside of that initial seed portfolio, everything else will be new transactions that that we'll be pursuing.

[Operator]

And our next question comes from Greg McGinniss of Scotiabank.

[Greg McGinniss, analyst]

Sumit, I just want to follow up on that last question. So you mentioned Prologis, right? And I think that's where the contribution question comes from. But -- could you instead maybe envision increasing investment into developments, which may be otherwise you wouldn't have underwritten that would then be contributed to the platform? Or would you instead pursue those developments within the platform itself?

[Sumit Roy, executive]

Greg, that's a very good question because when we pursue development, we do have certain accounting elements that we have to adhere to. And there are times where we are unable to recognize the full cash impact, the positive cash yield that we are able to generate on dollars that we are investing in a development scenario, just given the lease accounting that we have, that's certainly not going to be a prohibitive factor doing it through the fund structure.

And so could we do more of those? Yes. In the fund -- the answer is yes. But again, it needs to meet and exceed the overall return hurdles that we would we would need to address. So there are a lot of things that this alternative source of financing could allow us to do, which we have done as a public entity, but only in a limited way because of some of the inherent limitations that we have either in terms of how we can report stuff, et cetera. So I do think that this will give us the flexibility and thus, the comment I made about expanding the sandbox of the types of transactions that we would be able to pursue by having this alternative source of capital available to us.

[Greg McGinniss, analyst]

And do you already have kind of first investors in mind or conversations that you've had on this front?

[Sumit Roy, executive]

We have none of that in mind. We have and I think I've talked about this, what is -- the profile of this investor would look like. We certainly have that, and we are working with our advisers who have shared with us what the details are around that, but we haven't had any conversations today.

[Greg McGinniss, analyst]

Okay. And just final follow-up for Jonathan. Is there anything specific to point to in the slight increase in the midpoint to the expense leakage guidance?

[Jonathan Pong, executive]

Yes. It's a combination of a few things. Greg, First of all, there's been some deferred expenses we brought forward, some that were carried forward from last year. We're just trying to get ahead of spend and trying to catch up in some cases. So there is a little bit of heavier load this quarter. I would also say for this year, I would also say that there are some carry costs that we are incurring with a few vacant assets that do comprise a bit of an increase on a year-over-year basis from a margin perspective.

And then also, I think when you're just comparing to the 1.1% leakage that we experienced last year, keep in mind we did bring in a $9 billion portfolio in January with the Spirit portfolio. And that did have slightly more leakage as well just on a run rate basis. So I would really attribute it to those factors as what's driving the slight increase going from 1.1%and now to a midpoint of 1.35%.

[Operator]

And our next question comes from Wes Golladay with Baird.

[Wesley Golladay, analyst]

I just want to have a question on the development pipeline. When do you expect the nonretail to lease up? Are you holding back leasing on that right now?

[Sumit Roy, executive]

Yes, that's a great question, Wes. Look, it's a very small portion of the overall development. I think it's like 15% plus/minus in that ZIP code. And even though the quantum that we have identified for this particular type of development, we really don't spend until we get clarity on the leases coming through. And so we feel very confident.

We are partnering with one of the best developers in [ Panattoni ] and we feel very confident that some of these are going to get leased up in the near term. And keep in mind, we won't make the big capital investment without having line of sight on potential clients being able to step in and take over those leases.

[Wesley Golladay, analyst]

Maybe just a quick follow-up on that, since it's more spec in nature. Are you going to get a little bit more incremental yield?

[Sumit Roy, executive]

Yes, absolutely. And in fact, in situations where -- we've had 2 buildings, one was leased and the other one wasn't. We have expectations and what we think the lease rates are going to be and -- so far, more often than not, those lease rates -- our expected lease rates have been superseded by what actually ends up happening. So this continues to build a fair amount of confidence in not only our partners, but also our team's ability to underwrite these types of transactions.

[Operator]

Thank you. And this concludes our question-and-answer session. I'd 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 speaking soon and seeing you at a conference in the coming weeks. Thank you, guys.

[Operator]

Thank you. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.