Item 1: Business
THE COMPANY
Realty Income Corporation, The Monthly Dividend Company®, is a Maryland corporation organized to operate as an equity real estate investment trust, or REIT. Our primary business objective is to generate dependable monthly cash distributions from a consistent and predictable level of funds from operations, or FFO per share. The monthly distributions are supported by the cash flow from our portfolio of retail properties leased to regional and national retail chains. We have in-house acquisition, leasing, legal, retail and real estate research, portfolio management and capital markets expertise. Over the past 37 years, Realty Income and its predecessors have been acquiring and owning freestanding retail properties that generate rental revenue under long-term lease agreements (primarily 15- to 20-years).
In addition, we seek to increase distributions to stockholders and FFO per share through both active portfolio management and the acquisition of additional properties. Our portfolio management focus includes:
• Contractual rent increases on existing leases;
• Rent increases at the termination of existing leases when market conditions permit; and
• The active management of our property portfolio, including re-leasing of vacant properties and selective sales of properties.
Our acquisition of additional properties adheres to a focused strategy of primarily acquiring properties that are:
• Freestanding, single-tenant, retail locations;
• Leased to regional and national retail chains; and
• Leased under long-term, net-lease agreements.
At December 31, 2005, we owned a diversified portfolio:
• Of 1,646 retail properties;
• With an occupancy rate of 98.5%, or 1,621 properties occupied of the 1,646 properties in the portfolio;
• Leased to 101 different retail chains doing business in 29 separate retail industries;
• Located in 48 states;
• With over 13.4 million square feet of leasable space; and
• With an average leasable retail space of 8,200 square feet.
Of the 1,646 properties in the portfolio, 1,641, or 99.7% are single-tenant, retail properties and the remaining five are multi-tenant, distribution and office properties. At December 31, 2005, 1,617, or 98.5%, of the 1,641 single-tenant were leased with a weighted average remaining lease term (excluding extension options) of approximately 12.4 years.
In addition, our wholly-owned taxable REIT subsidiary, Crest Net Lease, Inc., owned 17 properties with a total investment of $45.7 million at December 31, 2005, which are classified as held for sale. Crest Net was created to buy, own and sell properties, primarily to individual investors, many of whom are involved in tax-deferred exchanges under Section 1031 of the Internal Revenue Code of 1986, as amended, the “Code.”
We typically acquire retail store properties under long-term leases with retail chain store operators. These transactions generally provide capital to owners of retail real estate and retail chains for expansion or other corporate purposes. Our acquisition and investment activities are concentrated in well-defined target markets and generally focus on retailers providing goods and services that satisfy basic consumer needs.
Our net-lease agreements generally:
• Are for initial terms of 15 to 20 years;
• Require the tenant to pay minimum monthly rents and property operating expenses (taxes, insurance and maintenance); and
• Provide for future rent increases (typically subject to ceilings) based on increases in the consumer price index, fixed increases, or to a lesser degree, additional rent calculated as a percentage of the tenants’ gross sales above a specified level.
Realty Income commenced operations as a REIT on August 15, 1994 through the merger of 25 public and private real estate limited partnerships with and into the Company. Each of the partnerships was formed between 1970 and 1989 for the purpose of acquiring and managing long-term, net-leased properties.
The six senior officers of Realty Income owned 1.3% of our outstanding common stock with a market value of $25.1 million at February 10, 2006. The directors and six senior officers of Realty Income, as a group, owned 2.7% of our outstanding common stock with a market value of $51.6 million at February 10, 2006.
Realty Income’s common stock is listed on The New York Stock Exchange (“NYSE”) under the ticker symbol “O.” Our central index key number is 726728 and cusip number is 756109-104.
Realty Income’s Class D cumulative redeemable preferred stock is listed on the NYSE under the ticker symbol “OprD” and its cusip number is 756109-609.
Realty Income’s 8.25% Monthly Income Senior Notes, due 2008 are listed on the NYSE under the ticker symbol “OUI.” The cusip number of these notes is 756109-203.
At February 10, 2006, we had 69 permanent employees and four temporary employees as compared to February 15, 2005 when we had 64 permanent employees and six temporary employees. The temporary employees have been working on a record retention project that is expected to conclude during 2006.
We maintain an Internet website at www.realtyincome.com. On our website we make available, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8 K, and amendments to those reports, as soon as reasonably practicable after we electronically file these reports with the SEC. None of the information on our website is deemed to be part of this report.
RECENT DEVELOPMENTS
Credit Facility
In June 2005, Realty Income entered into a new $300 million acquisition credit facility to replace our existing $250 million acquisition credit facility that expired in October 2005. Under the terms of the new credit facility, which commenced in October 2005, the borrowing rate was reduced to LIBOR (London Interbank Offered Rate) plus 65 basis points with a facility fee of 15 basis points, for all-in drawn pricing of 80 basis points over LIBOR, based on our current credit ratings. The new credit facility offers us other interest rate options as well. The term of the new facility expires in October 2008, unless extended as provided in the agreement.
Common Stock Issuance
In September 2005, we issued 4.1 million shares of common stock. The net proceeds of $92.7 million were used to fund new property acquisitions and for other general corporate purposes.
Credit Ratings Upgrade
In September 2005, our credit ratings were upgraded by Fitch Ratings. Our senior unsecured debt rating was raised to BBB+ from BBB and our preferred stock rating was raised to BBB from BBB- with a stable outlook.
In February 2006, Moody’s Investors Service, Inc. affirmed its ratings on our senior unsecured debt rating of Baa2 and our preferred stock rating of Baa3 and raised the outlook to “positive” from “stable.”
Issuance of 12-Year Senior Unsecured Notes
In September 2005, Realty Income issued $175 million in aggregate principal amount of 12-year, 5-3/8% senior unsecured notes due 2017. The price to the public for the notes was 99.974% of the principal
amount for an effective yield of 5.378%. The net proceeds from the offering were used to repay borrowings under the Company’s unsecured acquisition credit facility, for property acquisitions and for other general corporate purposes. Our outstanding notes and bonds are rated BBB+ by Fitch Ratings, Baa2 by Moody’s Investors Service and BBB by Standard & Poor’s Ratings Group.
Issuance of 30-Year Senior Unsecured Bonds
In March 2005, Realty Income issued $100 million in aggregate principal amount of 30-year, 5-7/8% senior unsecured bonds due 2035. The price to the investor for the bonds was 98.296% of the principal amount for an effective yield of 5.998%. The net proceeds from the offering were used to repay borrowings under our unsecured acquisition credit facility and for other general corporate purposes.
Acquisitions During 2005
During 2005, Realty Income and Crest Net invested in aggregate $486.6 million in 156 new properties and properties under development. These 156 properties are located in 30 states and are 100% leased with an initial average lease term of 15.8 years. As described below, Realty Income acquired 135 properties and Crest Net acquired 21 properties.
Included in the $486.6 million is $430.7 million invested by Realty Income in 135 new properties and properties under development with an initial weighted average contractual lease rate of 8.4%. These 135 properties are located in 28 states, are 100% leased with an initial average lease term of 15.6 years and will contain over 1.7 million leasable square feet. The 135 new properties acquired by Realty Income are net-leased to 13 different retail chains in the convenience store, drug store, financial services, health and fitness, motor vehicle dealership, restaurant and theater industries.
Included in the $486.4 million is $55.9 million invested by Crest Net in 21 new retail properties and properties under development.
Of the $430.7 million Realty Income invested in real estate during 2005, $43.9 million was invested in 10 properties that were leased and under contract for development by the tenant at December 31, 2005 (with development costs funded by Realty Income). Rent on these properties is scheduled to begin at various times during 2006. At December 31, 2005, we also had committed to pay estimated unfunded development costs totaling $42.2 million.
The initial weighted average contractual lease rate is computed as estimated contractual net operating income (in a net-leased property this is equal to the base rent or, in the case of properties under development, the estimated base rent under the lease) for the first year of each lease, divided by the estimated total costs. Since it is possible that a tenant could default on the payment of contractual rent, we cannot assure you that the actual return on the funds invested will remain at the percentages listed above.
Investments in Existing Properties
In 2005, we capitalized costs of $1.6 million on existing properties in our portfolio, consisting of $570,000 for re-leasing costs and $1.0 million for building improvements.
Net Income Available to Common Stockholders
Net income available to common stockholders was $89.7 million in 2005 versus $90.2 million in 2004, a decrease of $452,000. On a diluted per common share basis, net income was $1.12 per share in 2005 as compared to $1.15 per share in 2004.
The calculation to determine net income available to common stockholders includes gains from the sale of investment properties. The amount of gains varies from period to period based on the timing of property sales and can significantly impact net income available to common stockholders.
The gain recognized from the sales of investment properties during 2005 was $6.6 million as compared to $12.7 million during 2004.
Funds from Operations (FFO)
In 2005, our FFO increased by $11.4 million, or 9.6%, to $129.6 million versus $118.2 million in 2004. On a diluted per common share basis, FFO was $1.62 in 2005 compared to $1.50 for 2004, an increase of $0.12, or 8.0%.
See our discussion of FFO in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this annual report, which includes a reconciliation of net income available to common stockholders to FFO.
Crest Net Property Sales
During 2005, Crest Net sold 12 properties from its inventory for $23.5 million, which resulted in a gain of $3.3 million.
Crest Net’s Property Inventory
Crest Net’s property inventory at December 31, 2005 and December 31, 2004 totaled $45.7 million and $10.1 million, respectively, and is included in “real estate held for sale, net”, on our consolidated balance sheets.
Increases in Monthly Cash Distributions to Common Stockholders
We continue our 36-year policy of paying distributions monthly. Monthly distributions per share were increased in April 2005 by $0.000625 to $0.110625, in July 2005 by $0.000625 to $0.11125, in September 2005 by $0.00375 to $0.115, in October 2005 by $0.000625 to $0.115625 and in January 2006 by .000625 to $0.11625. The increase in January 2006 was our 33rd consecutive quarterly increase and the 37th increase in the amount of our dividend since our listing on the NYSE in 1994. In 2005, we paid the following monthly cash distributions per share: three in the amount of $0.11, three in the amount of $0.110625, two in the amount of $0.11125, one in the amount of $0.115, and three in the amount of $0.115625 totaling $1.34625. In December 2005, January 2006 and February 2006, we declared distributions of $0.11625 per share, which were paid on January 17, 2006, February 15, 2006 and will be paid on March 15, 2006, respectively.
The monthly distribution of $0.11625 per share represents a current annualized distribution of $1.395 per share, and an annualized distribution yield of approximately 6.1% based on the last reported sale price of our common stock on the NYSE of $22.78 on February 10, 2006. Although we expect to continue our policy of paying monthly distributions, we cannot guarantee that we will maintain the current level of distributions that we will continue our pattern of increasing distributions per share, or what the actual distribution yield will be in any future period.
DISTRIBUTION POLICY
Distributions are paid monthly to our common stockholders and Class D preferred stockholders if, and when declared by our Board of Directors. The Class D preferred stockholders receive cumulative distributions at a rate of 7.375% per annum on the $25 per share liquidation preference (equivalent to $1.84375 per annum per share).
In order to maintain our tax status as a REIT for federal income tax purposes, we generally are required to distribute dividends to our stockholders aggregating annually at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction and by excluding net capital gains) and we are subject to income tax to the extent we distribute less than 100% of our REIT taxable income (including net capital gains). In 2005, our cash distributions totaled $118.0 million, or approximately 113.2% of our estimated REIT taxable income of $104.2 million. Our estimated REIT taxable income reflects non-cash deductions for depreciation and amortization. We intend to continue to make distributions to our stockholders that are sufficient to meet this distribution requirement and that will reduce our exposure to income taxes. Our 2005 cash distributions to common stockholders totaled $108.6 million, representing 83.8% of our funds from operations available to common stockholders of $129.6 million.
Future distributions will be at the discretion of our Board of Directors and will depend on, among other things, our results of operations, FFO, cash flow from operations, financial condition and capital requirements, the annual distribution requirements under the REIT provisions of the Code, our debt service requirements and any other factors the Board of Directors may deem relevant. In addition, our credit facility contains financial covenants that
could limit the amount of distributions payable by us in the event of a deterioration in our results of operations or financial condition, and which prohibit the payment of distributions on the common or preferred stock in the event that we fail to pay when due (subject to any applicable grace period) any principal or interest on borrowings under our credit facility.
Distributions of our current and accumulated earnings and profits for federal income tax purposes, generally will be taxable to stockholders as ordinary income, except to the extent that we recognize capital gains and declare a capital gains dividend or that such amounts constitute “qualified dividend income” subject to a reduced rate of tax. The maximum tax rate of non-corporate taxpayers for “qualified dividend income” has generally been reduced to 15% (for taxable years beginning after December 31, 2002). In general, dividends payable by REITs are not eligible for the reduced tax rate on corporate dividends, except to the extent the REIT’s dividends are attributable to dividends received from taxable corporations (such as our taxable REIT subsidiary, Crest Net), to income that was subject to tax at the corporate or REIT level (for example, if we distribute taxable income that we retained and paid tax on in the prior taxable year) or, as discussed above, dividends properly designated by us as “capital gain dividends.” Distributions in excess of earnings and profits generally will be treated as a non-taxable reduction in the stockholders’ basis in the stock. Distributions above that basis, generally, will be taxable as a capital gain. Approximately 10.1% of the distributions, made or deemed to have been made in 2005, to our common stockholders were classified as a return of capital for federal income tax purposes. We are unable to predict the portion of future distributions that may be classified as a return of capital.
BUSINESS PHILOSOPHY AND STRATEGY
Investment Philosophy
We believe that owning an actively managed, diversified portfolio of retail properties under long-term, net leases produces consistent and predictable income. Under a net-lease agreement, the tenant agrees to pay monthly rent and property operating expenses (taxes, maintenance and insurance) plus, typically, future rent increases (generally subject to ceilings) based on increases in the consumer price index, fixed increases, or to a lesser degree, additional rent calculated as a percentage of the tenants’ gross sales above a specified level. We believe that a portfolio of properties under long-term leases, coupled with the tenant’s responsibility for property expenses, generally produces a more predictable income stream than many other types of real estate portfolios, while continuing to offer the potential for growth in rental income.
Investment Strategy
In identifying new properties for acquisition, our focus is generally on providing capital to retail chain owners and operators by acquiring, then leasing back, retail store locations. We categorize retail tenants as: 1) venture market, 2) middle market, and 3) upper market. Venture companies typically offer a new retail concept in one geographic region of the country and operate between five and 50 retail locations. Middle market retail chains typically have 50 to 500 retail locations, operations in more than one geographic region, have been successful through one or more economic cycles, and have a proven, replicable concept. The upper market retail chains typically consist of companies with 500 or more locations, operating nationally, in a proven, mature retail concept. Upper market retail chains generally have strong operating histories and access to several sources of capital.
Realty Income primarily focuses on acquiring properties leased to middle market retail chains that we believe are attractive for investment because:
• They generally have overcome many of the operational and managerial obstacles that can adversely affect venture retailers;
• They typically require capital to fund expansion but have more limited financing options;
• They generally have provided us with attractive risk-adjusted returns over time since their financial strength has, in many cases, tended to improve as their businesses have matured;
• Their relatively large size allows them to spread corporate expenses across a greater number of stores; and
• Middle market retailers typically have the critical mass to survive if a number of locations are closed due to underperformance.
We also focus on and have selectively made investments in properties of upper market retail chains. We believe upper market retail chains can be attractive for investment because:
• They typically are of a higher credit quality;
• They usually are larger public and private retailers with more commonly recognized brand names;
• They utilize a larger building ranging in size from 10,000 to 50,000 square feet; and
• They are able to grow because access to capital facilitates larger transaction sizes.
While our investment strategy focuses primarily on acquiring properties leased to middle and upper market retail chains, we also selectively seek investment opportunities with venture market retail chains. Periodically, venture market opportunities arise where we feel that the real estate used by the tenant is high quality and can be purchased at favorable prices. To meet our stringent investment standards, however, venture retail companies must have a well-defined retailing concept and strong financial prospects. These opportunities are examined on a case by case basis and we are highly selective in making investments in this area.
Historically, our investment focus has been on retail industries that have a service component because we believe the lease revenue from these types of businesses is more stable. Because of this investment focus, for the quarter ended December 31, 2005, approximately 81.2% of our rental revenue was derived from retailers with a service component in their business. Furthermore, we believe these service-oriented businesses would be difficult to duplicate over the Internet and that our properties continue to perform well relative to competition from Internet businesses.
Credit Strategy
We generally provide sale-leaseback financing to less than investment grade retail chains. We typically acquire and lease back properties to regional and national retail chains and believe that within this market we can achieve an attractive risk-adjusted return on the financing we provide to retailers. Since 1970, our overall weighted average occupancy rate at the end of each year has been 98.5%, and the occupancy rate at the end of each year has never been below 97.5%.
We believe the principal financial obligations of most retailers typically include their bank and other debt, payment obligations to suppliers and real estate lease obligations. Because we typically own the land and building in which a tenant conducts its retail business, we believe the risk of default on a retailers’ lease obligations is less than the retailers’ unsecured general obligations. It has been our experience that since retailers must retain their profitable retail locations in order to survive, in the event of reorganization they are less likely to reject a lease for a profitable location because this would terminate their right to use the property. Thus, as the property owner, we believe we will fare better than unsecured creditors of the same retailer in the event of reorganization. If a property is rejected by the tenant during reorganization, we own the property and can either lease it to a new tenant or sell the property. In addition, we believe that the risk of default on the real estate leases can be further mitigated by monitoring the performance of the retailers’ individual unit locations and considering whether to sell locations that are weaker performers.
In order to qualify for inclusion in our portfolio, new property acquisitions must meet stringent investment and credit requirements. The properties must generate attractive current yields and the tenant must meet our credit profile. We have established a three-part analysis that examines each potential investment based on:
• Industry, company, market conditions and credit profile;
• Location profitability, if profitability data is available; and
• Overall real estate characteristics, including value and comparative rental rates.
The typical profile of companies whose properties have been approved for acquisition are those with 50 or more retail locations. Generally the properties:
• Are located in highly visible areas,
• Have easy access to major thoroughfares; and
• Have attractive demographics.
Acquisition Strategy
We seek to invest in industries in which several, well-organized, regional and national chains are capturing market share through service, quality control, economies of scale, advertising and the selection of prime retail locations. We execute our acquisition strategy by acting as a source of capital to regional and national retail chain store owners and operators, doing business in a variety of industries, by acquiring and leasing back retail store locations. We undertake thorough research and analysis to identify appropriate industries, tenants and property locations for investment. Our research expertise is instrumental to uncovering net-lease opportunities in markets where our real estate financing program adds value. In selecting real estate for potential investment, we generally seek to acquire properties that have the following characteristics:
• Freestanding, commercially-zoned property with a single tenant;
• Properties that are important retail locations for regional and national retail chains;
• Properties that are located within attractive demographic areas relative to the business of their tenants, with high visibility and easy access to major thoroughfares; and
• Properties that can be purchased with the simultaneous execution or assumption of long-term, net-lease agreements, offering both current income and the potential for rent increases.
Portfolio Management Strategy
The active management of the property portfolio is an essential component of our long-term strategy. We continually monitor our portfolio for changes that could affect the performance of the industries, tenants and locations in which we have invested. The portfolio is regularly analyzed with a view toward optimizing its returns and enhancing its credit quality. Our executives review industry research, tenant research, property due diligence and significant portfolio management activities. This monitoring typically includes regular review and analysis of:
• The performance of various retail industries; and
• The operation, management, business planning and financial condition of the tenants.
We have an active portfolio management program that incorporates the sale of assets when we believe the reinvestment of the sales proceeds will generate higher returns, enhance the credit quality of our real estate portfolio, or extend our average remaining lease term. At December 31, 2005, we classified real estate with a carrying amount of $47.1 million as held for sale, which includes $45.5 million in properties owned by Crest Net. In addition, $219,000 invested by Crest Net in real estate is included in other assets and was classified as intangible assets in accordance with Financial Accounting Standards Board Statement No. 141, Business Combinations. Additionally, we anticipate selling investment properties from our portfolio that have not yet been specifically identified from which we anticipate receiving between $15 million and $35 million in proceeds during the next 12 months. We intend to invest these proceeds into new property acquisitions. However, we cannot guarantee that we will sell properties during the next 12 months.
Conservative Capital Structure
We believe that our stockholders are best served by a conservative capital structure. Therefore, we seek to maintain a conservative debt level on our balance sheet and solid interest and fixed charge coverage ratios. At February 10, 2006, our total outstanding credit facility borrowings and outstanding notes were $886.6 million or approximately 30.3% of our total market capitalization of $2.92 billion. We calculate our total market capitalization at February 10, 2006 as the sum of:
• Shares of our common stock outstanding of 83,880,873 multiplied by the last reported sales price of our common stock on the NYSE of $22.78 per share, or $1.91 billion;
• Aggregate liquidation value of the Class D preferred stock of $127.5 million;
• Outstanding borrowings of $131.6 million on our credit facility; and
• Outstanding notes of $755.0 million.
Historically, we have met our long-term capital needs through the issuance of common stock, preferred stock and long-term unsecured notes and bonds. Over the long term, we believe that the majority of our future securities issuances should be in the form of common stock, however, we may issue additional preferred stock or debt securities from time to time. We may issue common stock when we believe that our share price is at a level that allows for the proceeds of any offering to be invested into additional properties on an accretive basis. In addition, we may issue common stock to permanently finance properties that were financed by our credit facility
or debt securities. However, we cannot assure you that we will have access to the capital markets at terms that are acceptable to us.
We have a $300 million revolving, unsecured credit facility that expires in October 2008. At February 10, 2006, the outstanding balance on the acquisition credit facility was $131.6 million, with an effective interest rate of approximately 5.2%. A commitment fee of 0.15% per annum accrues on the total $300 million credit commitment of the credit facility. The credit facility has been, and is expected to be, used to acquire additional retail properties leased to regional and national retail chains under long-term, net-lease agreements. The credit facility has also been used to provide capital to subsidiaries for the purpose of funding the acquisition of properties. We regularly evaluate our credit facility and may seek to extend, renew or replace our credit facility, to the extent we deem appropriate.
We use our credit facility for the short-term financing of new property acquisitions. When outstanding borrowings under the credit facility reach a certain level (generally in the range of $100 million to $200 million) and capital is available on acceptable terms, we generally seek to refinance those borrowings with the net proceeds of long-term or permanent financing, which may include the issuance of common stock, preferred stock, convertible preferred stock, debt securities or convertible debt securities. We cannot assure you, however, that we will be able to obtain any such refinancing or that market conditions prevailing at the time of refinancing will enable us to issue equity or debt securities upon acceptable terms.
We are currently assigned investment grade corporate credit ratings, on our senior unsecured notes, from Fitch Ratings, Moody’s Investors Service, Inc. and Standard & Poor’s Ratings Group. Currently, Fitch Ratings has assigned a rating of BBB+, Moody’s has assigned a rating of Baa2 and Standard & Poor’s has assigned a rating of BBB to our senior notes. Moody’s rating has a “positive” outlook and the other ratings have a “stable” outlook.
We have also been assigned investment grade credit ratings from the same rating agencies on our preferred stock. Fitch Ratings has assigned a rating of BBB, Moody’s has assigned a rating of Baa3 and Standard & Poor’s has assigned a rating of BBB- to our preferred stock. Moody’s rating has a “positive” outlook and the other ratings have a “stable” outlook.
The credit ratings assigned to us could change based upon, among other things, our results of operations and financial condition.
We have no mortgage debt on any of our properties.
No Off-Balance Sheet Arrangements or Unconsolidated Investments
Realty Income and its subsidiaries have no unconsolidated or off-balance sheet investments in “variable interest entities” or off-balance sheet financing, nor do we engage in trading activities involving energy or commodity contracts or other derivative instruments.
As we have no joint ventures, off-balance sheet entities, or mandatory redeemable preferred stock, our financial position and results of operations are currently not affected by Financial Accounting Standards Board Interpretation No. 46R, Consolidation of Variable Interest Entities and Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.
Competitive Strategy
We believe that to successfully pursue our investment philosophy and strategy, we must seek to maintain the following competitive advantages:
• Size and Type of Investment Properties: We believe smaller ($500,000 to $10,000,000) net-leased retail properties represent an attractive investment opportunity in today’s real estate environment. Due to the complexities of acquiring and managing a large portfolio of relatively small assets, we believe these types of properties have not experienced significant institutional ownership interest or the corresponding yield reduction experienced by larger income-producing properties. We believe the less intensive day-to-day
property management required by net-lease agreements, coupled with the active management of a large portfolio of smaller properties, is an effective investment strategy. The tenants of our freestanding retail properties generally provide goods and services that satisfy basic consumer needs. In order to grow and expand, they generally need capital. Since the acquisition of real estate is typically the single largest capital expenditure of many of these retailers, our method of purchasing the property and then leasing it back, under a net-lease arrangement, allows the retail chain to free up capital.
• Investment in New Retail Industries: Though we specialize in single-tenant properties, we will seek to further diversify our portfolio among a variety of retail industries. We believe diversification will allow us to invest in retail industries that currently are growing and have characteristics we find attractive. These characteristics include, but are not limited to, retail industries that are dominated by local store operators where regional and national chain store operators can increase market share and dominance by consolidating local operators and streamlining their operations, as well as capitalizing on major demographic shifts in a population base.
• Diversification: Diversification of the portfolio by retail industry type, tenant, and geographic location is key to our objective of providing predictable investment results for our stockholders, therefore further diversification of our portfolio is a continuing objective. At December 31, 2005, our retail property portfolio consisted of 1,646 properties located in 48 states, leased to 101 retail chains doing business in 29 industry segments. Each of the 29 industry segments, represented in our property portfolio, individually accounted for no more than 17.8% of our rental revenue for the quarter ended December 31, 2005.
• Management Specialization: We believe that our management’s specialization in single-tenant retail properties, operated under net-lease agreements, is important to meeting our objectives. We plan to maintain this specialization and will seek to employ and train high-quality professionals in this specialized area of real estate ownership, finance and management.
• Technology: We intend to stay at the forefront of technology in our efforts to efficiently and economically carry out our operations. We maintain sophisticated information systems that allow us to analyze our portfolio’s performance and actively manage our investments. We believe that technology and information-based systems will play an increasingly important role in our competitiveness as an investment manager and source of capital to a variety of industries and tenants.
PROPERTIES
At December 31, 2005, we owned a diversified portfolio:
• Of 1,646 retail properties;
• With an occupancy rate of 98.5%, or 1,621 properties occupied of the 1,646 properties in the portfolio;
• Leased to 101 different retail chains doing business in 29 separate retail industries;
• Located in 48 states;
• With over 13.4 million square feet of leasable space; and
• With an average leasable retail space of 8,200 square feet.
In addition to our real estate portfolio at December 31, 2005, our subsidiary, Crest Net had invested $45.7 million in a portfolio of 17 properties located in nine states. These properties are classified as held for sale.
At December 31, 2005, 1,617, or 98.2%, of our 1,646 retail properties were owned under net-lease agreements. Net leases typically require the tenant to be responsible for minimum monthly rent and property operating expenses including property taxes, insurance and maintenance. In addition, tenants are typically responsible for future rent increases (generally subject to ceilings) based on increases in the consumer price index, fixed increases or , to a lesser degree, additional rent calculated as a percentage of the tenants’ gross sales above a specified level.
Our net-leased retail properties primarily are leased to regional and national retail chain store operators. Most buildings are single-story structures with adequate parking on site to accommodate peak retail traffic periods. The properties tend to be on major thoroughfares with relatively high traffic counts and adequate access and proximity to a sufficient population base constituting a suitable market or trade area for the retailer’s business.
The following table sets forth certain information regarding Realty Income’s property portfolio (excluding properties owned by Crest Net) classified according to the business of the respective tenants, expressed as a percentage of our total rental revenue:
(1) Includes rental revenue for all properties owned by Realty Income at the end of each period presented, including revenue from properties reclassified to discontinued operations.
The following table sets forth certain information regarding the properties owned by Realty Income (excluding properties owned by Crest Net) at December 31, 2005, classified according to the retail business types and the level of services they provide (dollars in thousands):
(1) Includes rental revenue for all properties owned by Realty Income at December 31, 2005, including revenue from properties reclassified to discontinued operations of $59.
The following table sets forth certain information regarding Realty Income’s property portfolio (excluding properties owned by Crest Net) regarding the timing of the initial lease term expirations (excluding extension options) on our 1,617 net leased, single-tenant and certain other retail properties as of December 31, 2005 (dollars in thousands):
* Less than 0.1%
(1) Excludes four multi-tenant properties and 25 vacant unleased properties, one of which is a multi-tenant property. The lease expirations for properties under construction are based on the estimated date of completion of those properties.
(2) Includes rental revenue of $59 from properties reclassified to discontinued operations and excludes revenue of $1,852 from four multi-tenant properties and from 25 vacant and unleased properties at December 31, 2005.
(3) Represents leases to the initial tenant of the property that are expiring for the first time.
(4) Represents lease expirations on properties in the portfolio, which have previously been renewed, extended or re-tenanted.
The following table sets forth certain state-by-state information regarding Realty Income’s property portfolio (excluding properties owned by Crest Net) as of December 31, 2005 (dollars in thousands):
* Less than 0.1%
(1) Includes rental revenue for all properties owned by Realty Income at December 31, 2005, including revenue from properties reclassified to discontinued operations of $59.
Description of Leasing Structure
At December 31, 2005, 1,617 single tenant and certain other retail properties or 98.2% of our 1,646 properties were net leased. In most cases, the leases:
• Are for initial terms of 15 to 20 years;
• Require the tenants to pay minimum monthly rents and property operating expenses (taxes, insurance and maintenance); and
• Provide for future rent increases (typically subject to ceilings) based on increases in the consumer price index, fixed increases, or to a lesser degree, additional rent based upon the tenants’ gross sales above a specified level. Where leases provide for rent increases based on increases in the consumer price index, generally these increases become part of the new permanent base rent. Where leases provide for percentage rent, this additional rent is typically payable only if the tenants’ gross sales, for a given period (usually one year), exceed a specified level and is then typically calculated as a percentage of only the amount of gross sales in excess of that level.
Matters Pertaining to Certain Properties and Tenants
Of the 25 properties available for lease or sale at December 31, 2005; all but one are single-tenant properties. At December 31, 2005, 17 of our properties under lease were unoccupied and available for sublease by the tenants, all of which were current with their rent and other obligations. During 2005, each of our tenants accounted for less than 10% of our rental revenue.
Certain Properties Under Development
Of the 135 properties Realty Income acquired in 2005, all were occupied at December 31, 2005, except for 10 properties that were leased and being developed. In the case of development properties, we either enter into an agreement with a retail chain where the retailer retains a contractor to construct the improvements and we fund the costs of that development, or we fund a developer who constructs the improvements. In either case, there is an executed lease with a retail tenant at the time of the land purchase (with a fixed rent commencement date) and there is a requirement to complete the construction in a timely basis and within a specific budget, typically within eight months after we purchase the land. The tenant or developer generally is required to pay construction cost overruns to the extent that they exceed the construction budget by more than a predetermined amount. We also enter into a lease with the tenant at the time we purchase the land, which generally requires the tenant to begin paying base rent when the store opens for business. The base rent is calculated by multiplying a predetermined capitalization rate by our total investment in the property including the land cost for the property, construction costs and capitalized interest. In 2005, Realty Income acquired 21 development properties. Crest Net did not acquire any development property in 2005. Both Realty Income and Crest Net will continue to pursue development opportunities under similar arrangements in the future.
Item 1A:
Item 1A: Risk Factors
As used under this caption “Risk Factors,” references to our capital stock include our common stock and any class or series of our preferred stock and references to our stockholders include holders of our common stock or any class or series of our preferred stock, in each case unless otherwise expressly stated or the context otherwise requires.
In order to grow we need to continue to acquire investment properties which may be subject to competitive pressures.
We face competition in the acquisition, operation and sale of property. We expect competition from:
• businesses;
• individuals;
• fiduciary accounts and plans; and
• other entities engaged in real estate investment and financing.
Some of these competitors are larger than we are and have greater financial resources. This competition may result in a higher cost for properties we wish to purchase.
Our tenants’ creditworthiness and ability to pay rent may be affected by competition within their industries from other operators.
The tenants leasing our properties can face significant competition from other operators. This competition may adversely impact:
• that portion, if any, of the rental stream to be paid to us based on a tenant’s revenues; and
• the tenants’ results of operations or financial condition.
As a property owner, we may be subject to unknown environmental liabilities.
Investments in real property can create a potential for environmental liability. An owner of property can face liability for environmental contamination created by the presence or discharge of hazardous substances on the property. We can face such liability regardless of:
• our knowledge of the contamination;
• the timing of the contamination;
• the cause of the contamination; or
• the party responsible for the contamination of the property.
There may be environmental problems of which we are unaware associated with our properties. In that regard, a number of our properties are leased to operators of convenience stores that sell petroleum-based fuels, as well as to operators of oil change and tune-up facilities. These facilities, and some other of our properties, use, or may have used in the past, underground lifts or underground tanks for the storage of petroleum-based or waste products, which could create a potential for release of hazardous substances.
The presence of hazardous substances on a property may adversely affect our ability to sell that property and we may incur substantial remediation costs. Although our leases generally require our tenants to operate in compliance with all applicable federal, state and local environmental laws, ordinances and regulations and to indemnify us against any environmental liabilities arising from the tenants’ activities on the property, we could nevertheless be subject to strict liability by virtue of our ownership interest. There also can be no assurance that our tenants could or would satisfy their indemnification obligations under their leases. The discovery of environmental liabilities attached to our properties could have an adverse effect on our results of operations, our financial condition or our ability to make distributions to stockholders and to pay the principal of and interest on our debt securities and other indebtedness.
In addition, several of our properties were built during the period when asbestos was commonly used in building construction and other facilities with asbestos may be acquired by the Company in the future. Environmental laws govern the presence, maintenance and removal of asbestos-containing materials, or ACMs, and require that owners or operators of buildings containing asbestos properly manage and maintain the asbestos, that they adequately inform or train those who may come into contact with asbestos and that they undertake special precautions, including removal or other abatement in the event that asbestos is disturbed during renovation or demolition of a building. These laws may impose fines and penalties on building owners or operators for failure to comply with these requirements and may allow third parties to seek recovery from owners or operators for personal injury associated with exposure to asbestos fibers.
Compliance. We have not been notified by any governmental authority, and are not otherwise aware, of any material noncompliance, liability or claim relating to hazardous substances, toxic substances, or petroleum products in connection with any of our present properties. Nevertheless, if environmental contamination should exist, we could be subject to strict liability by virtue of our ownership interest. In addition, we believe we are in compliance in all material respects with all present federal, state and local laws relating to ACMs.
Insurance and Indemnity. In June 2005, we entered into a new seven-year environmental insurance policy on our property portfolio which replaced the previous five-year environmental insurance policy. The limits on our new policy are $10 million per occurrence, and $50 million in the aggregate, subject to a $40,000 self insurance retention, per occurrence, for properties with underground storage tanks and a $100,000 self insurance retention, per occurrence, for all other properties. It is possible that our insurance could be insufficient to address any particular environmental situation and that, in the future, we could be unable to obtain insurance for environmental matters at a reasonable cost, or at all.
Our tenants are generally responsible for and indemnify us against liabilities for environmental matters that occur on our properties. For properties that have underground storage tanks, in addition to providing an indemnity in our favor, the tenants generally obtain environmental insurance or rely upon the state funds in the states where these properties are located.
If we fail to qualify as a real estate investment trust, the amount of dividends we are able to pay would decrease, which could adversely affect the market price of our capital stock and could adversely affect the value of our debt securities.
Commencing with our taxable year ended December 31, 1994, we believe that we have been organized and have operated, and we intend to continue to operate, so as to qualify as a “REIT” under Sections 856 through 860 of the Code. However, we cannot assure you that we have been organized or have operated in a manner that has satisfied the requirements for qualification as a REIT, or that we will continue to be organized or operate in a manner that will allow us to continue to qualify as a REIT.
Qualification as a REIT involves the satisfaction of numerous requirements under highly technical and complex Code provisions, for which there are only limited judicial and administrative interpretations, and the determination of various factual matters and circumstances not entirely within our control.
For example, in order to qualify as a REIT, at least 95% of our gross income in each year must be derived from qualifying sources, and we must pay distributions to stockholders aggregating annually at least 90% of our REIT taxable income (as defined in the Code and determined without regard to the dividends paid deduction and by excluding net capital gains).
In the future, it is possible that legislation, new regulations, administrative interpretations or court decisions will change the tax laws with respect to qualification as a REIT, or the federal income tax consequences of such qualification.
If we fail to satisfy all of the requirements for qualifications as a REIT, we may be subject to certain penalty taxes or, in some circumstances, we may fail to qualify as a REIT. If we were to fail to qualify as a REIT in any taxable year:
• we would be required to pay federal income tax (including any applicable alternative minimum tax) on our taxable income at regular corporate rates;
• we would not be allowed a deduction in computing our taxable income for amounts distributed to our stockholders;
• we could be disqualified from treatment as a REIT for the four taxable years following the year during which qualification is lost;
• we would no longer be required to make distributions to stockholders; and
• this treatment would substantially reduce amounts available for investment or distribution to stockholders because of the additional tax liability for the years involved, which could have a material adverse effect on the market price of our capital stock and the value of our debt securities.
Even if we qualify for and maintain our REIT status, we may be subject to certain federal, state and local taxes on our income and property. For example, if we have net income from a prohibited transaction, that income will be subject to a 100% tax. Our subsidiary Crest Net is subject to federal and state taxes at the applicable tax rates on its income and property.
Distributions requirements imposed by law limit our flexibility.
To maintain our status as a REIT for federal income tax purposes, we generally are required to distribute to our stockholders at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and by excluding net capital gains each year. We also are subject to tax at regular corporate rates to the extent that we distribute less than 100% of our REIT taxable income (including net capital gains) each year.
In addition, we are subject to a 4% nondeductible excise tax to the extent that we fail to distribute during any calendar year at least the sum of 85% of our ordinary income for that calendar year, 95% of our capital gain net
income for the calendar year, and any amount of that income that was not distributed in prior years.
We intend to continue to make distributions to our stockholders to comply with the distribution requirements of the Code as well as to reduce our exposure to federal income taxes and the nondeductible excise tax. Differences in timing between the receipt of income and the payment of expenses to arrive at taxable income, along with the effect of required debt amortization payments, could require us to borrow funds on a short-term basis to meet the distribution requirements that are necessary to achieve the tax benefits associated with qualifying as a REIT.
Future issuances of equity securities could dilute the interest of holders of our common stock.
Our future growth will depend, in large part, upon our ability to raise additional capital. If we were to raise additional capital through the issuance of equity securities, we could dilute the interests of holders of our common stock. The interests of our common stockholders could also be diluted by the issuance of shares of common stock upon the exercise of outstanding options or pursuant to stock incentive plans. Likewise, our Board of Directors is authorized to cause us to issue preferred stock of any class or series (with dividend, voting and other rights as determined by the Board of Directors). Accordingly, the Board of Directors may authorize the issuance of preferred stock with voting, dividend and other similar rights that could dilute, or otherwise adversely affect, the interests of holders of our common stock.
We are subject to risks associated with debt financing.
We intend to incur additional indebtedness in the future, including borrowings under our $300 million acquisition credit facility. At February 10, 2006, we had borrowings outstanding under our $300 million acquisition credit facility of $131.6 million and we had a total of $755 million outstanding in unsecured notes and bonds. To the extent that new indebtedness is added to our current debt levels, the related risks that we now face would increase. As a result, we are and will be subject to risks associated with debt financing, including the risk that our cash flow could be insufficient to meet required payments on our debt. We also face variable interest rate risk as the interest rate on our $300 million credit facility is variable and could therefore increase over time. We also face the risk that we may be unable to refinance or repay our debt as it comes due. In addition, our $300 million credit facility contains financial covenants that could limit the amount of distributions payable by us on our common stock and preferred stock in the event of deterioration in our results of operations or financial condition. Our $300 million credit facility also provides that in the event of a failure to pay principal or interest on borrowings there under when due (subject to any applicable grace period), we and our subsidiaries may not pay any dividends on our capital stock, including our outstanding common and preferred stock. If this were to occur, it would likely have an adverse effect on the market price of our outstanding common and preferred stock and on the value of our debt securities.
Our indebtedness could also have other important consequences to holders of the common stock, such as:
• increase our vulnerability to general adverse economic and industry conditions;
• limit our ability to obtain additional financing to fund future working capital, capital expenditures and other general corporate requirements;
• require the use of a substantial portion of our cash flow from operations to pay principal and interest on, our indebtedness thereby reducing our ability to use our cash flow to fund working capital, capital expenditures and general corporate requirements;
• limit our flexibility in planning for, or reacting to, changes in our business and our industry; and
• place us at a disadvantage compared to our competitors with less indebtedness.
Our business operations may not generate the cash needed to make distributions on our capital stock or to service our indebtedness.
Our ability to make distributions on our common stock and preferred stock and payments on our indebtedness and to fund planned capital expenditures will depend on our ability to generate cash in the future. There can be no assurance that our business will generate sufficient cash flow from operations or that future borrowings will be available to us in an amount sufficient to enable us to make distributions on our common stock and preferred stock, to pay our indebtedness or to fund our other liquidity needs.
The market value of our capital stock and debt securities could be substantially affected by various factors.
The market value of our capital stock and debt securities will depend on many factors, which may change from time to time, including, but not limited to:
• interest rate increases that may have an adverse effect on the market value of our capital stock and our debt securities;
• the market for other similar securities issued by other REITs;
• general economic and financial market conditions;
• the financial condition, performance and prospects of us and our competitors;
• changes in financial estimates or recommendations by securities analysts with respect to us, our competitors or our industry;
• changes in our credit ratings; and
• actual or anticipated variations in quarterly operating results.
As a result of these and other factors, investors who purchase our capital stock and debt securities may experience a decrease, which could be substantial, in the market value of our capital stock and debt securities, including decreases unrelated to our operating performance or prospects.
Real Estate ownership is subject to particular economic conditions that may have a negative impact on our revenue.
We are subject to all of the general risks associated with the ownership of real estate. In particular, we face the risk that rental revenue from our properties may be insufficient to cover all corporate operating expenses, debt service payments on indebtedness we incur and distributions on our stock. Additional real estate ownership risks include:
• adverse changes in general or local economic conditions;
• changes in supply of, or demand for, similar or competing properties;
• changes in interest rates and operating expenses;
• competition for tenants;
• changes in market rental rates;
• inability to lease properties upon termination of existing leases;
• renewal of leases at lower rental rates;
• inability to collect rents from tenants due to financial hardship, including bankruptcy;
• changes in tax, real estate, zoning and environmental laws that may have an adverse impact upon the value of real estate;
• uninsured property liability;
• property damage or casualty losses;
• unexpected expenditures for capital improvements or to bring properties into compliance with applicable federal, state and local laws;
• acts of terrorism and war; and
• acts of God and other factors beyond the control of our management.
An uninsured loss or a loss that exceeds the policy limits on our properties could subject us to lost capital or revenue on those properties.
Under the terms and conditions of the leases currently in force on our properties, tenants generally are required to indemnify and hold us harmless from liabilities resulting from injury to persons, air, water, land or property, due to activities conducted on the properties, except for claims arising from the negligence or intentional misconduct of us or our agents. Additionally, tenants are generally required, at the tenant’s expense, to obtain and keep in full force during the term of the lease, liability and property damage insurance policies. The insurance policies our tenants are required to maintain for property damage are generally in amounts not less than the full replacement cost of the improvements less slab, foundations, supports and other customarily excluded improvements. Our tenants are generally required to maintain general liability coverage varying between $1,000,000 and $10,000,000 depending on the tenant and the industry in which it operates.
In addition to the indemnities and required insurance policies identified above, many of our properties are also covered by flood and earthquake insurance policies (subject to substantial deductibles) obtained and paid for by
the tenants as part of their risk management programs. Additionally, we have obtained blanket liability, flood and earthquake (subject to substantial deductibles) and property damage insurance policies to protect us and our properties against loss should the indemnities and insurance policies provided by the tenants fail to restore the properties to their condition prior to a loss. However, should a loss occur that is uninsured or in an amount exceeding the combined aggregate limits for the policies noted above, or in the event of a loss that is subject to a substantial deductible under an insurance policy, we could lose all or part of our capital invested in, and anticipated revenue from, one or more of the properties, which could have a material adverse effect on our results of operations or financial condition and on our ability to pay the principal of and interest on our debt securities and other indebtedness and to make distributions to our stockholders.
Compliance with the Americans With Disabilities Act of 1990 and fire, safety, and other regulations may require us to make unintended expenditures that could adversely impact our results of operation.
Our properties are generally required to comply with the Americans with Disabilities Act of 1990, or the ADA. The ADA has separate compliance requirements for “public accommodations” and “commercial facilities,” but generally requires that buildings be made accessible to people with disabilities. Compliance with the ADA requirements could require removal of access barriers and non-compliance could result in imposition of fines by the U.S. government or an award of damages to private litigants. The retailers to whom we lease properties are obligated by law to comply with the ADA provisions, and we believe that these retailers may be obligated to cover costs associated with compliance. If required changes involve greater expenditures than anticipated, or if the changes must be made on a more accelerated basis than anticipated, the ability of these retailers to cover costs could be adversely affected and we could be required to expend our own funds to comply with the provisions of the ADA, which could materially adversely affect our results of operations or financial condition and our ability to pay the principal of and interest on our debt securities and other indebtedness and to make distributions to our stockholders. In addition, we are required to operate our properties in compliance with fire and safety regulations, building codes and other land use regulations, as they may be adopted by governmental agencies and bodies and become applicable to our properties. We may be required to make substantial capital expenditures to comply with those requirements and these expenditures could materially adversely affect our results of operations or financial condition and our ability to pay the principal of and interest on our debt securities and other indebtedness and to make distributions to our stockholders.
Property taxes may increase without notice.
The real property taxes on our properties and any other properties that we develop or acquire in the future may increase as property tax rates change and as those properties are assessed or reassessed by tax authorities.
A downturn in our tenants’ industries could adversely impact our business.
For 2005, our tenants in the convenience store and child care industries accounted for approximately 18.7% and 12.7%, respectively, of our rental revenue. Individually, each of the other industries in our property portfolio accounted for less than 10% of our rental revenue for the year 2005. A downturn in any of these industries, whether nationwide or limited to specific sectors of the United States, could adversely affect tenants in these industries, which in turn could have a material adverse affect on our financial position, results of operations and our ability to pay the principal of and interest on our debt securities and other indebtedness and to make distributions on our common stock and preferred stock.
In addition, a substantial number of our properties are leased to middle-market retail chains that generally have more limited financial and other resources than certain upper-market retail chains, and therefore they are more likely to be adversely affected by a downturn in their respective business or in the regional or national economy.
We depend on key personnel.
We depend on the efforts of our executive officers and key employees. The loss of the services of our executive officers and key employees could have a material adverse effect on our results of operations or financial condition and on our ability to pay the principal of and interest on our debt securities and other indebtedness and to make distributions to our stockholders. It is possible that we will not be able to recruit additional personnel with equivalent experience in the retail, net-leasing industry.
Terrorist attacks and other acts of violence or war may affect the value of our debt and equity securities, the markets in which we operate and our results of operations.
Terrorist attacks may negatively affect our operations and your investment. There can be no assurance that there will not be further terrorist attacks against the United States or United States businesses. These attacks or armed conflicts may directly impact our physical facilities or the businesses of our tenants.
Such events could cause consumer confidence and spending to decrease or result in increased volatility in the U.S. and worldwide financial markets and economy. They also could result in or prolong an economic recession in the U.S. or abroad. Any of these occurrences could have a significant adverse impact on our operating results and revenues and on the market price of our capital stock and on the value of our debt securities. It could also have an adverse effect on our ability to pay principal and interest on our debt securities or other indebtedness and to make distributions to our stockholders.
Item 1B:
Item 1B: Unresolved Staff comments
This item is not applicable.
Item 2:
Item 2: Properties
Information pertaining to our properties can be found under Item 1.
Item 3:
Item 3: Legal Proceedings
We are subject to certain claims and lawsuits in the ordinary course of business, the outcome of which cannot be determined at this time. In the opinion of management, any liability we might incur upon the resolution of these claims and lawsuits will not, in the aggregate, have a material adverse effect on our consolidated financial statements taken as a whole.
Item 4:
Item 4: Submission of Matters to a Vote of Security Holders
No matters were submitted to stockholders during the fourth quarter of the fiscal year.
PART II
Item 5:
Item 5: Market For Registrant’s Common Equity And Related Stockholder Matters
A. Our common stock is traded on the NYSE under the ticker symbol “O.” The following table shows the high and low sales prices per share for our common stock as reported by the NYSE, and distributions declared per share of common stock for the periods indicated.
Common stock cash distributions currently are declared monthly by us based on financial results for the prior months. At December 31, 2005 a distribution of $0.11625 per common share had been declared and was paid in January 2006
A 2-for-1 stock split was declared in November 2004 and became effective after the market close on December 31, 2004. Common stockholders received a dividend of an additional share of common stock for each share they owned. The increase in the number of common shares outstanding after the stock split is reflected for all periods presented and all per share data has been adjusted for the stock split.
B. There were 10,179 registered holders of record of our common stock as of January 31, 2006. We estimate that our total number of shareholders is approximately 65,000 when we include both registered and beneficial holders of our common stock.
Item 6:
Item 6: Selected Financial Data
(not covered by Report of Independent Registered Public Accounting Firm)
(1) Ratio of Earnings to Fixed Charges is calculated by dividing earnings by fixed charges. For this purpose, earnings consist of net income before interest expense. Fixed charges are comprised of interest costs (including capitalized interest) and the amortization of debt issuance costs. In computing the ratio of earnings to combined fixed charges and preferred stock cash dividends, preferred stock cash dividends consist of dividends on our Class B preferred stock, Class C preferred stock and our outstanding Class D preferred stock. We redeemed our Class B preferred stock in June 2004 and our Class C preferred stock in July 2004, we issued 4,000,000 shares of our 7-3/8% Class D preferred stock in May 2004 and we issued 1,100,000 shares of our 7-3/8% Class D preferred stock in October 2004.
Item 7:
Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
GENERAL
Realty Income Corporation, The Monthly Dividend Company®, is a Maryland corporation organized to operate as an equity real estate investment trust, or REIT. Our primary business objective is to generate dependable monthly cash distributions from a consistent and predictable level of funds from operations, or FFO per share. The monthly distributions are supported by the cash flow from our portfolio of retail properties leased to regional and national retail chains. We have in-house acquisition, leasing, legal, retail and real estate research, portfolio management and capital markets expertise. Over the past 37 years, Realty Income and its predecessors have been acquiring and owning freestanding retail properties that generate rental revenue under long-term lease agreements (primarily 15- to 20-years).
In addition, we seek to increase distributions to stockholders and FFO per share through both active portfolio management and the acquisition of additional properties. At December 31, 2005, we owned a diversified portfolio:
• Of 1,646 retail properties;
• With an occupancy rate of 98.5%, or 1,621 properties occupied of the 1,646 properties in the portfolio;
• Leased to 101 different retail chains doing business in 29 separate retail industries;
• Located in 48 states;
• With over 13.4 million square feet of leasable space; and
• With an average leasable retail space per property of 8,200 square feet.
Of the 1,646 properties in the portfolio, 1,641, or 99.7%, are single-tenant, retail properties and the remaining five are multi-tenant, distribution and office properties. At December 31, 2005, 1,617, or 98.5%, of the 1,641 single-tenant properties were leased with a weighted average remaining lease term (excluding extension options) of approximately 12.4 years.
In addition, our wholly-owned taxable REIT subsidiary, Crest Net Lease, Inc., owned 17 properties with a total investment of $45.7 million at December 31, 2005, which are classified as held for sale. Crest Net was created to buy, own and sell properties, primarily to individual investors, many of whom are involved in tax-deferred exchanges under Section 1031 of the Internal Revenue Code of 1986, as amended.
LIQUIDITY AND CAPITAL RESOURCES
Cash Reserves
Realty Income is organized to operate as an equity REIT that acquires and leases properties and distributes to stockholders, in the form of monthly cash distributions, a substantial portion of its net cash flow generated from leases on its retail properties. We intend to retain an appropriate amount of cash as working capital. At December 31, 2005, we had cash and cash equivalents totaling $65.7 million.
We believe that our cash and cash equivalents on hand, cash provided from operating activities and borrowing capacity is sufficient to meet our liquidity needs for the foreseeable future. We intend, however, to use additional sources of capital to fund property acquisitions and to repay our credit facility.
$300 Million Credit Facility
We have a $300 million revolving, unsecured credit facility that expires in October 2008. Realty Income’s current investment grade credit ratings provide for financing under the credit facility at the London Interbank Offered Rate, commonly referred to as LIBOR, plus 65 basis points with a facility fee of 15 basis points, for all-in drawn pricing of 80 basis points over LIBOR. At February 10, 2006, we had a borrowing capacity of $168.4 million available on our credit facility and an outstanding balance of $131.6 million at an effective interest rate of 5.2%.
The credit facility is expected to be used to acquire additional retail properties and for other corporate purposes. Any additional borrowings will increase our exposure to interest rate risk.
Mortgage Debt
We have no mortgage debt on any of our properties.
Universal Shelf Registration of $800 Million
In February 2004, we filed a universal shelf registration statement with the SEC registering the issuance, from time to time, of up to $800 million in aggregate value of common stock, preferred stock and debt securities. At February 10, 2006, $227.9 million remained available for issuance under our universal shelf registration statement.
Issuance of Common Stock in 2005
In September 2005, Realty Income issued 4.1 million shares of common stock. The net proceeds of approximately $92.7 from this offering were used to fund new property acquisitions and for other general corporate purposes.
Issuance of 12-Year Senior Unsecured Notes
In September 2005, Realty Income issued $175 million in aggregate principal amount of 12-year, 5-3/8% senior unsecured notes due 2017. The price to the public for the notes was 99.974% of the principal amount for an effective yield of 5.378%. The net proceeds from the offering were used to repay borrowings under the Company’s unsecured acquisition credit facility, for property acquisitions and for other general corporate purposes.
Issuance of 30-Year Senior Unsecured Bonds
In March 2005, Realty Income issued $100 million in aggregate principal amount of 30-year, 5-7/8% senior unsecured bonds due 2035. The price to the investor for the bonds was 98.296% of the principal amount for an effective yield of 5.998%. The net proceeds from the offering were used to repay borrowings under our unsecured acquisition credit facility and for other general corporate purposes.
Conservative Capital Structure
We believe that our stockholders are best served by a conservative capital structure. Therefore, we seek to maintain a conservative debt level on our balance sheet and solid interest and fixed charge coverage ratios. At February 10, 2006, our total outstanding credit facility borrowings and outstanding notes were $886.6 million or approximately 30.3% of our total market capitalization of $2.92 billion. We calculate our total market capitalization at February 10, 2006 as the sum of:
• Shares of our common stock outstanding of 83,880,873 multiplied by the last reported sales price of our common stock on the NYSE of $22.78 per share, or $1.91 billion;
• Aggregate liquidation value of the Class D preferred stock of $127.5 million;
• Outstanding borrowings of $131.6 million on our credit facility; and
• Outstanding notes of $755.0 million.
Historically, we have met our long-term capital needs through the issuance of common stock, preferred stock and long-term unsecured notes and bonds. Over the long term, we believe that the majority of our future securities issuances should be in the form of common stock, however, we may issue additional preferred stock or debt securities from time to time. We may issue common stock when we believe that our share price is at a level that allows for the proceeds of any offering to be accretively invested into additional properties. In addition, we may issue common stock to permanently finance properties that were financed by our credit facility or debt securities. However, we cannot assure you that we will have access to the capital markets at terms that are acceptable to us.
Credit Agency Ratings
We are currently assigned investment grade corporate credit ratings, on our senior unsecured notes, from Fitch Ratings, Moody’s Investors Service, Inc. and Standard & Poor’s Ratings Group. Currently, Fitch Ratings has
assigned a rating of BBB+, Moody’s has assigned a rating of Baa2 and Standard & Poor’s has assigned a rating of BBB to our senior notes. Moody’s rating has a “positive” outlook and the other ratings have a “stable” outlook.
We have also been assigned investment grade credit ratings from the same rating agencies on our preferred stock. Fitch Ratings has assigned a rating of BBB, Moody’s has assigned a rating of Baa3 and Standard & Poor’s has assigned a rating of BBB- to our preferred stock. Moody’s rating has a “positive” outlook and the other ratings have a “stable” outlook.
The credit ratings assigned to us could change based upon, among other things, our results of operations and financial condition.
Notes Outstanding
In September 2005, we issued $175 million of 5-3/8%, 12-year, senior unsecured notes due 2017. Interest on these notes is paid semiannually.
In March 2005, we issued $100 million of 5-7/8%, 30-year, senior unsecured bonds due 2035. Interest on these bonds is paid semiannually.
In November 2003, we issued $150 million of 5-1/2%, 12-year, senior unsecured notes due 2015 (the “2015 Notes”). Interest on the 2015 Notes is paid semiannually.
In March 2003, we issued $100 million of 5-3/8%, 10-year, senior unsecured notes due 2013 (the “2013 Notes”). Interest on the 2013 Notes is paid semiannually.
In January 1999, we issued $20 million of 8% senior unsecured notes due 2009 (the “2009 Notes”). Interest on the 2009 Notes is payable semiannually.
In October 1998, we issued $100 million of 8-1/4% Monthly Income Senior Notes due 2008 (the “2008 Notes”). Interest on the 2008 Notes is payable monthly. The 2008 Notes are unsecured.
In May 1997, we issued $110 million of 7-3/4% senior unsecured notes due 2007 (the “2007 Notes”). Interest on the 2007 Notes is payable semiannually.
All of these notes contain various covenants, including: (i) a limitation on incurrence of any debt which would cause our debt to total adjusted assets ratio to exceed 60%; (ii) a limitation on incurrence of any secured debt which would cause our secured debt to total adjusted assets ratio to exceed 40%; (iii) a limitation on incurrence of any debt which would cause our debt service coverage ratio to be less than 1.5 times; and (iv) the maintenance at all times of total unencumbered assets not less than 150% of our outstanding unsecured debt. We have been in compliance with these covenants since each of the notes were issued.
The following is a summary of the key financial covenants to our senior unsecured notes. The actual amounts are as of December 31, 2005.
All of our outstanding notes have fixed interest rates. Our credit facility interest rate is variable.
The following table summarizes the maturity of each of our obligations as of December 31, 2005 (dollars in millions):
Table of Obligations
(1) The credit facility balance was $131.6 million as of February 10, 2006.
(2) Interest on credit facility and notes has been calculated based on outstanding balances as of December 31, 2005 through their respective maturity dates.
(3) Other consists of $42.2 million of estimated unfunded costs on properties under development and $456,000 of contingent payments for tenant improvements and leasing costs.
Our credit facility and note obligations are unsecured. Accordingly, we have not pledged any assets as collateral for these obligations.
Preferred Stock Outstanding
In May and October 2004, we issued an aggregate of 5.1 million shares of 7.375% Class D cumulative redeemable preferred stock. Beginning May 27, 2009, shares of Class D preferred stock are redeemable at our option for $25.00 per share, plus any accrued and unpaid dividends. Dividends on shares of Class D preferred are paid monthly in arrears.
No Off-Balance Sheet Arrangements or Unconsolidated Investment
Realty Income and its subsidiaries have no unconsolidated or off-balance sheet investments in “variable interest entities” or off-balance sheet financing, nor do we engage in trading activities involving energy or commodity contracts or other derivative instruments.
As we have no joint ventures, off-balance sheet entities, or mandatory redeemable preferred stock, our financial position or results of operations are currently not affected by Financial Accounting Standard Board Interpretation No. 46R, Consolidation of Variable Interest Entities and Statement of Financial Accounting Standard No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.
Acquisitions During 2005
During 2005, Realty Income and Crest Net invested in aggregate $486.6 million in 156 new properties and properties under development. These 156 properties are located in 30 states and are 100% leased with an initial average lease term of 15.8 years. As described below, Realty Income acquired 135 properties and Crest Net acquired 21 properties.
Included in the $486.6 million is $430.7 million invested by Realty Income in 135 new properties and properties under development with an initial weighted average contractual lease rate of 8.4%. These 135 properties are located in 28 states, are 100% leased with an initial average lease term of 15.6 years and will contain over 1.7 million leasable square feet. The 135 new properties acquired by Realty Income are net-leased to 13 different retail chains in the convenience store, drug store, financial services, health and fitness, motor vehicle dealership, restaurant and theater industries. At December 31, 2005, 10 new properties acquired during 2005 were leased and under contract for development by the tenant (with development costs funded by Realty Income) with rent scheduled to begin at various times during the next 12 months.
Included in the $486.6 million is $55.9 million invested by Crest Net in 21 new retail properties and properties under development.
Of the $430.7 million Realty Income invested in real estate during 2005, $43.9 million was invested in properties under development with rent scheduled to begin at various times during 2006. At December 31, 2005, we also had committed to pay estimated unfunded development costs totaling $42.2 million.
The initial weighted average contractual lease rate is computed as estimated contractual net operating income (in a net-leased property this is equal to the base rent or, in the case of properties under development, the estimated base rent under the lease) for the first year of each lease, divided by the estimated total costs. Since it is possible that a tenant could default on the payment of contractual rent, we cannot assure you that the actual return on the funds invested will remain at the percentages listed above.
Investments in Existing Properties
In 2005, we capitalized costs of $1.6 million on existing properties in our portfolio, consisting of $570,000 for re-leasing costs and $1.0 million for building improvements.
Sales of Investment Properties
During 2005, we sold 23 properties and sold a portion of land from two properties for an aggregate of $23.4 million, which resulted in a gain on sales of $6.6 million. This gain is included in discontinued operations, except for $18,000 that is included in other revenue. The 23 properties sold consisted of one automotive service store, two automotive tire service locations, seven child care facilities, two consumer electronics stores, one convenience store, one motor vehicle dealership, one private education facility, seven restaurants, and one property classified as “other.” The net proceeds from the sale of these properties were used to repay outstanding indebtedness on our credit facility and to invest in new properties.
Crest Net Property Sales
During 2005, Crest Net, our wholly-owned subsidiary, sold 12 properties from its inventory for $23.5 million, which resulted in a gain of $3.3 million.
Crest Net’s Property Inventory
Crest Net’s property inventory totaled $45.7 million at December 31, 2005 as compared to $10.1 million at December 31, 2004. Crest Net’s properties are included in “real estate held for sale, net”, on our consolidated balance sheets.
The financial statements of Crest Net are consolidated into Realty Income’s financial statements. All material intercompany transactions have been eliminated in consolidation.
Increases in Monthly Cash Distributions to Common Stockholders
We continue our 36-year policy of paying distributions monthly. Monthly distributions per share were increased in April 2005 by $0.000625 to $0.110625, in July 2005 by $0.000625 to $0.11125, in September 2005 by $0.00375 to $0.115, in October 2005 by $0.000625 to $0.115625 and in January 2006 by .000625 to $0.11625. The increase in January 2006 was our 33rd consecutive quarterly increase and the 37th increase in the amount of our dividend since our listing on the NYSE in 1994. In 2005, we paid the following monthly cash distributions per share: three in the amount of $0.11, three in the amount of $0.110625, two in the amount of $0.11125, one in the amount of $0.115, and three in the amount of $0.115625 totaling $1.34625. In December 2005, January 2006 and February 2006, we declared distributions of $0.11625 per share, which were paid on January 17, 2006 and February 15, 2006 and will be paid on March 15, 2006, respectively.
The monthly distribution of $0.11625 per share represents a current annualized distribution of $1.395 per share, and an annualized distribution yield of approximately 6.1% based on the last reported sale price of our common stock on the NYSE of $22.78 on February 10, 2006. Although we expect to continue our policy of paying monthly distributions, we cannot guarantee that we will maintain the current level of distributions that we will continue our pattern of increasing distributions per share, or what the actual distribution yield will be in any future period.
RESULTS OF OPERATIONS
Critical Accounting Policies
Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). Our consolidated financial statements are the basis for our discussion and analysis of financial condition and results of operations. Preparing our consolidated financial statements requires us to make a number of estimates and assumptions that affect the reported amounts and disclosures in the consolidated financial statements. We believe that we have made these estimates and assumptions in an appropriate manner in a way that accurately reflects our financial condition. We continually test and evaluate these estimates and assumptions using our historical knowledge of the business, as well as other factors, to ensure that they are reasonable for reporting purposes. However, actual results may differ from these estimates and assumptions.
In order to prepare our consolidated financial statements according to the rules and guidelines set forth by GAAP, many subjective judgments must be made with regard to critical accounting polices. One of these judgments is our estimate for useful lives in determining depreciation expense for our properties. Depreciation of buildings and improvements is computed using the straight-line method over an estimated useful life of 25 years. If we use a shorter or longer estimated useful life it could have a material impact on our results of operations. We believe that 25 years is an appropriate estimate of useful life. No depreciation has been recorded on Crest Net’s properties because they are held for sale.
Another significant judgment that must be made is, if and when the impairment losses should be taken on our properties when events or change in circumstances indicate that the carrying amount of the asset may not be recoverable. Generally, a provision is made for impairment loss if estimated future operating cash flows (undiscounted and without interest charges) plus estimated disposition proceeds (undiscounted) are less than the current book value. Impairment losses are measured as the amount by which the current book value of the asset exceeds the fair value of the asset. If a property is held for sale, it is carried at the lower of carrying cost or estimated fair value, less costs to sell. The carrying value of our real estate is the largest component of our consolidated balance sheet. If events should occur that require us to reduce the carrying value of our real estate by recording provisions for impairment losses, it could have a material impact on our results of operations.
The following is a comparison of our results of operations for the years ended December 31, 2005, 2004 and 2003.
Rental Revenue
Rental revenue was $196.3 million for 2005 versus $172.7 million for 2004, an increase of $23.6 million, or 13.7%. Rental revenue was $142.9 million in 2003. The increase in rental revenue in 2005 compared to 2004 is primarily attributable to:
• The 135 retail properties acquired by Realty Income in 2005, which generated $12.1 million in 2005;
• The 172 retail properties acquired by Realty Income in 2004, which generated $17.1 million in 2005 compared to $9.4 million in 2004, an increase of $7.7 million;
• Same store rents generated on 1,269 properties during 2005 and 2004 increased by $1.3 million, or 0.8%, to $158.1 million from $156.8 million. These properties were leased during all of both 2005 and 2004;
• An increase in straight-line rent and other non-cash adjustments to rent of $1.5 million in 2005 as compared to 2004; and
• An increase of $807,000 relating to the aggregate of (i) development properties acquired before 2004 that started paying rent in 2004, (ii) properties that were vacant during part of 2005 or 2004 and (iii) lease termination settlements. These items in aggregate totaled $5.2 million in 2005 and $4.4 million in 2004.
Realty Income acquired 135 retail properties in 2005, excluding Crest Net acquisitions, and as a result, our 2005 operating results included less than a full year of rental revenue from these properties. Accordingly, we anticipate that the contribution to rental revenue from these 135 properties will increase in 2006, because there
will be a full year of rent from these properties.
Our portfolio of retail real estate, leased primarily to regional and national chains under net leases, continues to perform well and provides dependable lease revenue supporting the payment of monthly dividends to our stockholders. At December 31, 2005, our portfolio of 1,646 retail properties was 98.5% leased with 25 properties available for lease, one of which is a multi-tenant property.
Of the 1,646 properties in the portfolio at December 31, 2005, 1,641, or 99.7%, are single-tenant properties and the remaining properties are multi-tenant, distribution and office properties. Of the 1,641 single-tenant properties, 1,617, or 98.5 %, were net leased with a weighted average remaining lease term (excluding rights to extend a lease at the option of the tenant) of approximately 12.4 years at December 31, 2005. Of our 1,617 leased single-tenant and certain other properties, 1,488, or 92.0%, were under leases that provide for increases in rents through:
• Base rent increases tied to a consumer price index with adjustment ceilings;
• Fixed increases;
• To a lesser degree, overage rent based on a percentage of the tenants’ gross sales; or
• A combination of two or more of the above rent provisions.
Percentage rent, which is included in rental revenue, was $1.2 million in 2005, $1.3 million in 2004 and $1.1 million in 2003. Percentage rent in 2005 was less than 1% of rental revenue and we anticipate percentage rent to be less than 1% of rental revenue in 2006.
As of February 10, 2006, transactions to lease or sell 6 of the 25 properties available for lease at December 31, 2005 were underway or completed. We anticipate these transactions will be completed during the next several months, although we cannot guarantee that all of these properties can be leased or sold within this period. It has been our experience that approximately 1% to 3% of our property portfolio will be unleased at any given time; however, we cannot assure you that the number of properties available for lease will not exceed these levels.
Interest Expense
Interest expense was $6.8 million higher in 2005 than in 2004 primarily due to higher average outstanding balances. Interest expense was $26.4 million in 2003. The following is a summary of the five components of our interest expense (dollars in thousands):
Interest on outstanding credit facilities and notes increased by $8.5 million in 2005 as compared to 2004 primarily due to higher average outstanding note balances in 2005.
At February 10, 2006 the weighted average interest rate on our:
• Credit facility borrowings of $131.6 million was 5.2%;
• Notes payable of $755.0 million was 6.3%; and
• Combined outstanding credit facility and notes of $886.6 million was 6.1%.
Interest Coverage Ratio
Our interest coverage ratio for 2005 was 4.4 times, for 2004 was 5.0 times and for 2003 was 5.3 times. Interest coverage ratio is calculated as: the interest coverage amount (as calculated in the following table) divided by interest expense, including interest recorded to discontinued operations. We consider interest coverage ratio to be an appropriate supplemental measure of a company’s ability to meet its interest expense obligations. Our calculation of interest coverage ratio may be different from the calculation used by other companies and, therefore, comparability may be limited. This information should not be considered as an alternative to any GAAP liquidity measures.
The following is a reconciliation of net cash provided by operating activities to our interest coverage amount (dollars in thousands):
(1) Crest Net activities.
(2) The 2005 amount includes intangibles recorded in connection with acquisitions of real estate acquired for resale.
(3) Includes interest expense recorded to “income from discontinued operations, real estate acquired for resale by Crest.”
Fixed Charge Coverage Ratio
Our fixed charge coverage ratio for 2005 was 3.6 times, for 2004 was 3.9 times and for 2003 was 3.9 times. Fixed charge coverage ratio is calculated in exactly the same manner as interest coverage ratio, except that preferred stock dividends are also added to the denominator. We consider fixed charge coverage ratio to be an appropriate supplemental measure of a company’s ability to make its interest and preferred stock dividend payments. Our calculation of the fixed charge coverage ratio may be different from the calculation used by other companies and, therefore, comparability may be limited. This information should not be considered as an alternative to any GAAP liquidity measures.
Interest coverage amount divided by interest expense plus preferred stock dividends (dollars in thousands):
(1) Excludes the Class B and Class C preferred stock non-cash charge of $3,774 in 2004 for excess of redemption value over carrying value of preferred shares redeemed.
(2) Includes interest expense recorded to “income from discontinued operations, real estate acquired for resale by Crest.”
Depreciation and Amortization
Depreciation and amortization was $46.4 million in 2005 versus $39.9 million in 2004 and $32.2 million in 2003. The increases in depreciation and amortization in 2005 and 2004 are due to the acquisition of properties in 2005, 2004 and 2003, which was partially offset by property sales in these years.
General and Administrative Expenses
General and administrative expenses increased by $2.3 million to $15.4 million in 2005 versus $13.1 million in 2004. General and administrative expenses were $10.6 million in 2003. In 2005, general and administrative expenses as a percentage of total revenue increased to 7.8% as compared to 7.6% in 2004 and 7.4% in 2003. General and administrative expenses increased primarily due to increases in costs of corporate insurance, payroll, employee benefits, corporate governance and Sarbanes-Oxley Act of 2002 compliance costs.
As our property portfolio has grown and continues to grow, we have increased, and anticipate that we will continue to increase, the level of our staffing. We expect general and administrative expenses to moderately increase due to costs attributable to payroll, staffing costs and corporate governance.
At February 10, 2006, we had 69 permanent employees and four temporary employees as compared to February 15, 2005 when we had 64 permanent employees and six temporary employees. The temporary employees have been working on a record retention project that is expected to conclude in 2006.
Property Expenses
Property expenses are broken down into costs associated with non-net leased multi-tenant properties, unleased single-tenant properties and general portfolio expenses. Expenses related to the multi-tenant and unleased single-tenant properties include, but are not limited to, property taxes, maintenance, insurance, utilities, property inspections, bad debt expense and legal fees. General portfolio costs include, but are not limited to, insurance, legal, property inspections and title search fees. At December 31, 2005, 25 properties were available for lease, as compared to 32 at December 31, 2004 and 26 at December 31, 2003.
Property expenses were $3.8 million in 2005, $3.1 million in 2004 and $2.4 million in 2003. The $769,000 increase in property expenses in 2005 is primarily attributable to an increase in costs associated with vacant properties and bad debt expense.
Income Taxes
Income taxes were $813,000 in 2005 as compared to $699,000 in 2004 and $501,000 in 2003. These amounts are for city and state income taxes paid by Realty Income. The increases in 2005 and 2004 are due to an increase in rental revenue causing higher city and state income tax expense.
In addition, Crest Net incurred state and federal income taxes of $943,000 in 2005 as compared to $3.5 million in 2004 and $2.2 million in 2003. The decrease in 2005 over the 2004 and 2003 amounts are due to lower taxable income, primarily attributable to lower gain on sales of real estate acquired for re-sale. These amounts are included in “income from discontinued operations from real estate acquired for resale by Crest.”
Discontinued Operations
Crest Net acquires properties with the intention of reselling them rather than holding them as investments and operating the properties. Consequently, we classify properties acquired by Crest Net as held for sale at the date of acquisition and do not depreciate them. The operations of Crest Net’s properties are classified as “income from discontinued operations, real estate acquired for resale by Crest.”
The following is a summary of Crest Net’s “income from discontinued operations, real estate acquired for resale” for the years ended December 31, 2005, 2004 and 2003 (dollars in thousands):
Realty Income’s operations from four properties listed as held for sale at December 31, 2005, plus properties sold in 2005, 2004 and 2003 have been classified as discontinued operations. The following is a summary of our discontinued operations from real estate held for investment for the years ended December 31, 2005, 2004 and 2003 (dollars in thousands):
The following is a summary of our total discontinued operations for the years ended December 31, 2005, 2004 and 2003 (dollars in thousands):
Gain on Sales of Real Estate Acquired for Resale by Crest Net
(included in discontinued operations)
In 2005 Crest Net sold 12 properties for $23.5 million, which resulted in a gain of $3.3 million. In 2004, Crest Net sold 51 properties for $75.0 million, which resulted in a gain of $10.3 million. In 2003, Crest Net sold 27 properties for $45.2 million, which resulted in a gain of $6.2 million. All gains on sales of real estate acquired for resale are reported before income taxes.
At December 31, 2005, Crest Net had $45.7 million invested in 17 properties, which are held for sale. Our goal is for Crest Net to carry an average inventory of approximately $20 to $25 million in real estate. Crest Net generates an earnings spread on the difference between the lease payments it receives on the properties held in inventory and the cost of capital used to acquire properties. It is our belief that at this level of inventory, rental revenue will exceed the ongoing operating expenses of Crest Net without any property sales.
Gain on Sales of Investment Properties by Realty Income
(included in discontinued operations)
In 2005, we sold 23 investment properties and sold a portion of the land from two properties for $23.4 million and recognized a gain on sales of $6.6 million. This gain is included in discontinued operations, except for $18,000 that is included in other revenue. In 2004, we sold or exchanged 43 investment properties and sold a portion of the land from four properties for a total of $35.4 million and recognized a gain of $12.7 million. This gain is included in discontinued operations, except for $185,000 that is included in other revenue. In 2003, we sold or exchanged 35 properties and exchanged three excess land parcels (from three properties) for $23.1 million and recognized a gain of $7.2 million, which is included in discontinued operations.
We have an active portfolio management program that incorporates the sale of assets when we believe the reinvestment of the sale proceeds will generate higher returns, enhance the credit quality of our real estate portfolio or extend our average remaining lease term. At December 31, 2005, we classified real estate with a carrying amount of $47.1 million as held for sale, which includes $45.5 million in properties owned by Crest Net. In addition, $219,000 invested by Crest Net in real estate is included in other assets and was classified as intangible assets. Additionally, we anticipate selling investment properties from our portfolio that have not yet been specifically identified from which we anticipate receiving between $15 million and $35 million in proceeds during the next 12 months. We intend to invest these proceeds into new property acquisitions. However, we cannot guarantee that we will sell properties during the next 12 months.
Provisions for Impairments
Provisions for impairments of $186,000 were recorded in 2005 on four properties as compared to $2.4 million in 2004 on six properties and $1.2 million on 11 properties in 2003. These provisions are included in “income from discontinued operations, real estate held for investment”, except for $151,000 in 2005, which is included in property expenses.
Preferred Stock Cash Dividends and Redemption Charge
We had preferred stock cash dividends of $9.4 million in 2005 as compared to $9.5 million in 2004 and $9.7 million in 2003.
When we redeemed our Class B preferred stock in June 2004 and our Class C preferred stock in July 2004, we incurred non-cash charges of $2.4 million and $1.4 million, respectively, for the excess of redemption value over the carrying value. These non-cash charges represent the Class B and Class C preferred stock original issuance costs that were paid in 1999 and recorded as a reduction to net income available to common stockholders when the shares were redeemed. These non-cash charges equated to $0.05 per common share in 2004.
Net income available to common stockholders
Net income available to common stockholders in 2005 decreased by $452,000 to $89.7 million as compared to $90.2 million in 2004. Net income available to common stockholders in 2003 was $76.7 million.
The calculation to determine net income available to common stockholders includes gains from the sale of properties. The amount of gains varies from period to period based on the timing of property sales and can significantly impact net income available to common stockholders.
The gain recognized from the sales of investment properties during 2005 was $6.6 million as compared to $12.7 million during 2004 and $7.2 million in 2003. The gain recognized from the sale of properties acquired for re-sale during 2005 was $3.3 million as compared to $10.3 million during 2004 and $6.2 million during 2003.
FUNDS FROM OPERATIONS (FFO)
AVAILABLE TO COMMON STOCKHOLDERS
FFO for 2005 increased by $11.4 million, or 9.6%, to $129.6 million as compared to $118.2 million in 2004 and $103.4 million in 2003. The following is a reconciliation of net income available to common stockholders (which we believe is the most comparable Generally Accepted Accounting Principles (“GAAP”) measure) to FFO, information regarding cash distributions paid and the diluted weighted average number of shares outstanding for 2005, 2004 and 2003 (dollars in thousands):
We define FFO, a non-GAAP measure, consistent with the National Association of Real Estate Investment Trust’s definition, as net income available to common stockholders, plus depreciation and amortization of real estate assets, reduced by gains on sales of investment property and extraordinary items.
We consider FFO to be an appropriate supplemental measure of a REIT’s operating performance as it is based on a net income analysis of property portfolio performance that excludes non-cash items such as depreciation. The historical accounting convention used for real estate assets requires straight-line depreciation of buildings and improvements, which implies that the value of real estate assets diminishes predictably over time. Since real estate values historically rise and fall with market conditions, presentations of operating results for a REIT, using historical accounting for depreciation, could be less informative. The use of FFO is recommended by the REIT industry as a supplemental performance measure. In addition, FFO is used as a measure of our compliance with the financial covenants of our credit facility.
Presentation of this information is intended to assist the reader in comparing the operating performance of different REITs, although it should be noted that not all REITs calculate FFO the same way, so comparisons with other REITs may not be meaningful. Furthermore, FFO is not necessarily indicative of cash flow available to fund cash needs and should not be considered as an alternative to net income as an indication of Realty Income’s performance. In addition, FFO should not be considered as an alternative to reviewing our cash flows from operating, investing and financing activities as a measure of liquidity, of our ability to make cash distributions or of our ability to pay interest payments.
Other Non-Cash Items and Capitalized Expenditures
The following information includes non-cash items and capitalized expenditures on existing properties in our portfolio. These items are not included in the adjustments to net income available to common stockholders to arrive at FFO. Analysts and investors often request this supplemental information.
(1) The settlements on the treasury lock agreements resulted from an interest rate risk prevention strategy that was used by the Company in 1997 and 1998, which correlated to pending issuances of senior note securities. We have not employed this strategy since 1998.
(2) Amortization of deferred note financing costs includes the amortization of costs incurred and capitalized when our notes were issued in May 1997, October 1998, January 1999, March 2003, November 2003, March 2005 and September 2005. These costs are being amortized over the lives of these notes. No costs associated with our credit facility agreements or annual fees paid to credit rating agencies have been included.
(3) A negative amount indicates that our straight-line rent was greater than our actual cash rent collected. A positive amount indicates that our straight-line rent was less than our actual cash rent collected.
(4) Represents the Class B and Class C preferred stock non-cash charges for the excess of redemption value over the carrying value.
IMPACT OF INFLATION
Tenant leases generally provide for limited increases in rent as a result of increases in the tenants’ sales volumes, increases in the consumer price index, and/or fixed increases. We expect that inflation will cause these lease provisions to result in rent increases over time. During times when inflation is greater than increases in rent, as provided for in the leases, rent increases may not keep up with the rate of inflation.
Approximately 98.2%, or 1,617, of the 1,646 properties in the portfolio are leased to tenants under net leases where the tenant is responsible for property costs and expenses. Net leases tend to reduce our exposure to rising property expenses due to inflation. Inflation and increased costs may have an adverse impact on our tenants if increases in their operating expenses exceed increases in revenue.
IMPACT OF ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued Statement No. 123R, Share-Based Payments. Statement No. 123R requires companies to recognize in the income statement the grant-date fair value of stock options and other
equity-based compensation issued to employees. We adopted Statement No. 123R on January 1, 2006. The impact of adopting Statement No. 123R was not material to our financial position or results of operations.
In December 2004, the FASB issued Statement No. 153, Exchanges of Nonmonetary Assets, an Amendment of APB No. 29. Statement No. 153 amends APB Opinion No. 29 and states that companies will no longer be permitted to use the “similar productive assets” concept to account for nonmonetary exchanges at book value with no gain being recognized. An exchange must be accounted for at fair value if the exchange has commercial substance and fair value is determinable. We adopted Statement No. 153 on January 1, 2006. The impact of adopting Statement No. 153 was not material to our financial position or results of operations.
In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of Statement No. 143, Accounting for Asset Retirement Obligations. Interpretation No. 47 requires companies to recognize a liability for the fair value of a legal obligation to perform asset-retirement activities that are conditional on a future event if the amount can be reasonably estimated. We adopted Interpretation No. 47 in the fourth quarter of 2005. The impact of adopting Interpretation No. 47 was not material to our financial position or results of operations.
Item 7A:
Item 7A: Quantitative and Qualitative Disclosures about Market Risk
We are exposed to interest rate changes primarily as a result of our credit facility and long-term notes used to maintain liquidity and expand our real estate investment portfolio and operations. Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flow and to lower our overall borrowing costs. To achieve these objectives we issue long-term notes, primarily at fixed rates, and may selectively enter into derivative financial instruments, such as interest rate lock agreements, interest rate swaps and caps in order to mitigate our interest rate risk on a related financial instrument. We were not a party to any derivative financial instruments at December 31, 2005. We do not enter into any transactions for speculative or trading purposes.
Our interest rate risk is monitored using a variety of techniques. The following table presents by year of expected maturity, the principal amounts, average interest rates, fair values as of December 31, 2005. This information is presented to evaluate the expected cash flows and sensitivity to interest rate changes (dollars in millions):
Expected Maturity Data
(1) $110 million matures in May 2007.
(2) $100 million matures in October 2008.
(3) The credit facility expires in October 2008. The credit facility balance as of February 10, 2006 was $131.6 million.
(4) $20 million matures in January 2009.
(5) $100 million matures in March 2013, $150 million matures in November 2015, $175 million matures in September 2017 and $100 million matures in March 2035.
(6) We base the fair value of the fixed rate debt at December 31, 2005 on the closing market price or indicative price per
each note. The fair value of the variable rate debt approximates its carrying value because its terms are similar to those available in the market place at December 31, 2005.
The table incorporates only those exposures that exist as of December 31, 2005; it does not consider those exposures or positions that could arise after that date. As a result, our ultimate realized gain or loss, with respect to interest rate fluctuations, would depend on the exposures that arise during the period, our hedging strategies at the time, and interest rates.
All of our outstanding notes and bonds have fixed interest rates. Our credit facility interest rate is variable. Based on our credit facility balance at December 31, 2005, a 1% change in interest rates would change our interest costs by $1.4 million per year.
Item 8:
Item 8: Financial Statements and Supplementary Data
A.
Reports of Independent Registered Public Accounting Firm
B.
Consolidated Balance Sheets,
December 31, 2005 and 2004
C.
Consolidated Statements of Income,
Years ended December 31, 2005, 2004 and 2003
D.
Consolidated Statements of Stockholders’ Equity,
Years ended December 31, 2005, 2004 and 2003
E.
Consolidated Statements of Cash Flows,
Years ended December 31, 2005, 2004 and 2003
F.
Notes to Consolidated Financial Statements
G.
Consolidated Quarterly Financial Data
(unaudited) for 2005 and 2004
H.
Schedule III Real Estate and Accumulated Depreciation
Schedules not filed: All schedules, other than that indicated in the Table of Contents, have been omitted as the required information is either not material, inapplicable or the information is presented in the financial statements or related notes.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Realty Income Corporation:
We have audited the accompanying consolidated financial statements of Realty Income Corporation and subsidiaries as listed in the accompanying table of contents. In connection with our audits of the consolidated financial statements, we also have audited the financial statement Schedule III as listed in the accompanying table of contents. These consolidated financial statements and financial statement schedule are the responsibility of Realty Income Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Realty Income Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Realty Income Corporation’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 21, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Realty Income Corporation:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Realty Income Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Realty Income Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of Realty Income Corporation’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Realty Income Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Realty Income Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Realty Income Corporation and subsidiaries as listed in the accompanying table of contents and our report dated February 21, 2006 expressed an unqualified opinion on those consolidated financial statements.
REALTY INCOME CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2005 and
(dollars in thousands, except per share data)
The accompanying notes to consolidated financial statements are an integral part of these statements.
REALTY INCOME CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2005, 2004 and 2003
(dollars in thousands, except per share data)
The accompanying notes to consolidated financial statements are an integral part of these statements.
REALTY INCOME CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Years Ended December 31, 2005, 2004 and 2003
(dollars in thousands)
The accompanying notes to consolidated financial statements are an integral part of these statements.
REALTY INCOME CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2005, 2004 and 2003
(dollars in thousands)
For supplemental disclosures, see note 12.
The accompanying notes to consolidated financial statements are an integral part of these statements.
REALTY INCOME CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
1. Organization and Operation
Realty Income Corporation (“Realty Income,” the “Company,” “we” or “our”) is organized as a Maryland corporation. We invest in commercial retail real estate and have elected to be taxed as a real estate investment trust (“REIT”).
At December 31, 2005, we owned 1,646 properties in 48 states containing over 13.4 million leasable square feet, plus an additional 17 properties owned by our wholly-owned taxable REIT subsidiary, Crest Net Lease, Inc. (“Crest Net”). Crest Net was created to buy, own and sell properties, primarily to individual investors, many of whom are involved in tax-deferred exchanges, under Section 1031 of the Internal Revenue Code of 1986, as amended (“the Code”).
A 2-for-1 stock split was declared in November 2004 and became effective after the market closed on December 31, 2004. Common stockholders received an additional share of common stock for each share they owned. The increase in the number of common shares outstanding and all per common share data has been adjusted for the stock split.
2. Summary of Significant Accounting Policies and Procedures
Federal Income Taxes. We have elected to be taxed as a REIT under the Code. We believe we have qualified and continue to qualify as a REIT. As a REIT, we will be permitted to deduct distributions paid to our stockholders and, generally, will not be required to pay federal corporate income taxes on such income. Accordingly, no provision has been made for federal income taxes in the accompanying consolidated financial statements, except for federal income taxes of Crest Net, which totaled $760,000 in 2005, $2.8 million in 2004 and $1.8 million in 2003. These taxes are included in “income from discontinued operations, real estate acquired for resale by Crest.”
Earnings and profits that determine the taxability of distributions to stockholders differ from net income reported for financial reporting purposes due to differences in the estimated useful lives and methods used to compute depreciation and the carrying value (basis) on the investments in properties for tax purposes, among other things.
The following reconciles our net income available to common stockholders to taxable income for 2005 (dollars in thousands) (unaudited):
Net Income Per Common Share. Basic net income per common share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during each period. Diluted net income per common share is computed by dividing the amount of net income available to common stockholders for the period by the number of common shares that would have been outstanding assuming the issuance of common shares for all potentially dilutive common shares outstanding during the reporting period.
The following is a reconciliation of the denominator of the basic net income per common share computation to the denominator of the diluted net income per common share computation, for the years ended December 31:
In 2005, 2004 and 2003, no stock options were anti-dilutive. In 2005, we had 305,476 nonvested shares from share based compensation that were anti-dilutive. No nonvested shares were anti-dilutive in 2004 or 2003.
Discontinued Operations. In accordance with Financial Accounting Standards Board Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), Realty Income’s operations from four investment properties classified as held for sale at December 31, 2005, plus properties sold in 2005, 2004 and 2003, were reported as discontinued operations. Their respective results of operations were reclassified to “income from discontinued operations, real estate held for investment.” We classify properties as held for sale in accordance with SFAS 144. We do not depreciate properties that are classified as held for sale.
Crest Net acquires properties with the intention of reselling them rather than holding them for investment and operating the properties. Consequently, we classify properties acquired by Crest Net as held for sale at the date of acquisition and do not depreciate them. In accordance with SFAS 144, the operations of Crest Net’s properties are classified as “income from discontinued operations, real estate acquired for resale by Crest.”
No debt was assumed by buyers of our investment properties or repaid as a result of our investment property sales and we have elected not to allocate interest expense to discontinued operations related to real estate held for investment.
In accordance with Emerging Issues Task Force No. 87-24, we allocate interest expense related to borrowings specifically attributable to Crest Net properties. The interest expense amounts allocated to the Crest Net properties are included in “income from discontinued operations, real estate acquired for resale by Crest.”
The following is a summary of Crest Net’s “income from discontinued operations, real estate acquired for resale” for the years ended December 31, 2005, 2004 and 2003 (dollars in thousands):
The following is a summary of Realty Income’s “income from discontinued operations from real estate held for investment” for the years ended December 31, 2005, 2004 and 2003 (dollars in thousands):
The following is a summary of our total income from discontinued operations for the years ended December 31, 2005, 2004 and 2003 (dollars in thousands):
Leases. All leases are accounted for as operating leases. Under this method, lease payments that have fixed and determinable rent increases are recognized on a straight-line basis over the lease term. Any rental revenue contingent upon a tenant’s sales is recognized only after the tenant exceeds their sales breakpoint. Rental increases based upon changes in the consumer price indexes are recognized only after the changes in the indexes have occurred, and then applied according to the lease agreements.
Principles of Consolidation. The accompanying consolidated financial statements include the accounts of Realty Income, Crest Net and other entities for which we make operational and financial decisions (control), after elimination of all material intercompany balances and transactions. All of Realty Income’s and Crest Net’s subsidiaries are wholly-owned.
Cash Equivalents. We consider all short-term, highly liquid investments that are readily convertible to cash and have an original maturity of three months or less at the time of purchase to be cash equivalents.
Gain on Sales of Properties. We recognize gains on sales of properties in accordance with Statement No. 66, Accounting for Sales of Real Estate.
Depreciation and Amortization. Depreciation of buildings and improvements are computed using the straight-line method over an estimated useful life of 25 years.
Maintenance and Repairs. Expenditures for maintenance and repairs are expensed as incurred. Replacements and betterments are capitalized.
Provisions for Impairments. We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Generally, a provision is made for impairment if estimated future operating cash flows (undiscounted and without interest charges) plus estimated disposition proceeds (undiscounted) are less than the current book value. Impairment loss is measured as the amount by which the current book value of the asset exceeds the fair value of the asset. If a property is held for sale, it is carried at the lower of cost or estimated fair value, less cost to sell.
Provisions for impairment of $186,000 were recorded in 2005 on four retail properties, of which two were sold during 2005. These properties were classified in the following industries: one in child care and three in restaurant.
Provisions for impairment of $2.4 million were recorded in 2004 on six retail properties, of which five were sold during 2004. These properties were classified in the following industries: one in automotive service, one in child care, two in consumer electronics, one in convenience store and one in restaurant.
Provisions for impairment of $1.2 million were recorded in 2003 on 11 retail properties, all of which were sold during 2003. These properties were classified in the following industries: one in automotive service, three in child care, one in consumer electronics, three in home improvement and three in restaurant.
All of these provisions for impairment are included in income from discontinued operations, real estate held for investment on our consolidated statements of income, except for $151,000 in 2005 which is included in property expenses.
Acquired In-place Leases. In accordance with Financial Accounting Standards Board Statement No. 141, Business Combinations, (“SFAS 141”) the fair value of the real estate acquired with in-place operating leases is allocated to the acquired tangible assets, consisting of land, building and improvements, and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases, the value of in-place leases and tenant relationships, based in each case on their fair values.
The fair value of the tangible assets of an acquired property (which includes land and buildings/improvements) is determined by valuing the property as if it were vacant, and the “as-if-vacant” value is then allocated to land and buildings/improvements based on our determination of the relative fair value of these assets. Our determinations are based on a real estate appraisal for each property, generated by an independent appraisal firm, which considered estimates of carrying costs during the expected lease-up periods, current market conditions, as well as costs to execute similar leases. In allocating the fair value to identified intangibles for above-market or below-market leases, an amount is recorded based on the present value of the difference between (i) the contractual amount to be paid pursuant to the in-place lease and (ii) our estimate of fair market lease rate for the corresponding in-place lease, measured over a period equal to the remaining non-cancelable term of the lease.
Capitalized above-market lease values are amortized as a reduction of rental income over the remaining non-cancelable terms of the respective leases. Capitalized below-market lease values are amortized as an increase to rental income over the remaining non-cancelable terms of the respective leases and expected below market renewal option periods.
The aggregate value of other acquired intangible assets consists of the value of in-place leases and tenant relationships. These are measured by the excess of the purchase price paid for a property, after adjusting for above or below market lease value, less the estimated fair value of the property “as if vacant,” determined as set forth above. The value of in-place leases, exclusive of the value of above-market and below-market in-place leases, is amortized to expense over the remaining non-cancelable periods of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts relating to that lease would be recorded to revenue or expense as appropriate.
Stock Option Plan. Effective January 1, 2002, we adopted the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, and starting January 1, 2002 expensed costs for all stock option awards granted, modified, or settled. Stock option awards under the plan vest over periods ranging from one to five years.
The following table illustrates the effect on net income available to common stockholders and earnings per share if the fair value method had been applied to all outstanding and unvested stock option awards in each period (dollars in thousands, except per share amounts):
Goodwill. Goodwill is tested for impairment annually as well as when events or circumstances occur indicating that our goodwill might be impaired. We did not record any new goodwill or impairment on our existing goodwill during 2005, 2004 or 2003.
Use of Estimates. The consolidated financial statements were prepared in conformity with U.S. generally accepted accounting principles, which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Reclassifications. Certain of the 2004 and 2003 balances have been reclassified to conform to the 2005 presentation.
3. Retail Properties Acquired
We acquire land, buildings and improvements that are used by retail operators.
A. During 2005, Realty Income and Crest Net in aggregate invested $486.6 million in 156 new retail properties and properties under development. These 156 properties are located in 30 states, will contain over 1.9 million leasable square feet and are 100% leased with an average initial lease term of 15.8 years.
Of the $486.6 million invested, $95.1 million was used to acquire 34 properties with existing leases on the properties. In accordance with SFAS 141, Realty Income recorded $10.1 million and Crest Net recorded $1.8 million as the value of in-place leases and Realty Income recorded $183,000 as the value of above-market rents. In addition, Realty Income recorded $756,000 and Crest Net recorded $66,000 as the value of below-market rents on these leases. The amounts recorded by Realty Income are included in “other assets” and “other liabilities” on our consolidated balance sheet and are amortized over the lives of the respective leases. Due to property sales, of the amounts recorded by Crest Net, only $219,000 of in-place lease value is included in our consolidated balance sheet at December 31, 2005. Crest Net does not amortize the value of in-place leases because its properties are held for sale.
In comparison, during 2004, Realty Income and Crest Net in aggregate invested $215.3 million in 194 new retail properties and properties under development. These 194 properties are located in 19 states, contain approximately 972,000 leasable square feet and are 100% leased with an average initial lease term of 17.5 years.
B. During 2005, Realty Income invested $430.7 million in 135 new retail properties and properties under development, with an initial weighted average contractual lease rate of 8.4%. These 135 properties are located in 28 states, will contain over 1.7 million leasable square feet and are 100% leased with an average initial lease term of 15.6 years.
In comparison, during 2004, Realty Income invested $193.8 million in 172 new retail properties and properties under development, with an initial weighted average contractual lease rate of 9.5%. These 172 properties are located in 18 states, contain over 913,000 leasable square feet and are 100% leased with an average initial lease term of 17.5 years.
C. During 2005, Crest Net invested $55.9 million in 21 new retail properties and properties under development.
In comparison, during 2004, Crest Net invested $21.5 million in 22 new retail properties and properties under development.
D. Crest Net’s property inventory at December 31, 2005 consisted of 17 properties with a total investment of $45.7 million and at December 31, 2004 consisted of eight properties with a total investment of $10.1 million. These amounts are included on our consolidated balance sheets in “real estate held for sale, net”, except for $219,000 of intangible assets at December 31, 2005 which are included in other assets.
4. Credit Facility
In June 2005, Realty Income entered into a new $300 million acquisition credit facility to replace our existing $250 million acquisition credit facility that expired in October 2005. Under the terms of the new credit facility, which commenced in October 2005, the borrowing rate was reduced to LIBOR (London Interbank Offered Rate) plus 65 basis points with a facility fee of 15 basis points, for all-in drawn pricing of 80 basis points over LIBOR, based on our current credit ratings. The new credit facility offers us other interest rate options as well. The term of the new facility expires in October 2008, unless extended as provided in the agreement.
The average borrowing rate on our credit facilities during 2005 was 4.3%, compared to 2.4% in 2004 and 2.2% in 2003. Our current credit facility is, and previous credit facilities were, subject to various leverage and interest coverage ratio limitations. The Company is and has been in compliance with these covenants.
In 2005, 2004 and 2003, interest of $1.9 million, $531,000 and $697,000, respectively, was capitalized with respect to properties under development.
Our credit facility is unsecured and accordingly, we have not pledged any assets as collateral for this obligation.
5. Notes Payable
In September 2005, we issued $175 million in aggregate principal amount of 5-3/8% senior unsecured notes due 2017 (the “2017 Notes”). The price to the investor for the 2017 Notes was 99.974% of the principal amount for an effective yield of 5.378%. The net proceeds of $173.2 million from this offering were used to repay borrowings under our unsecured acquisition credit facility, to fund new property acquisitions and for other general corporate purposes. Interest on the 2017 Notes is paid semiannually.
In March 2005, we issued $100 million in aggregate principal amount of 5-7/8% senior unsecured bonds due 2035 (the “2035 Bonds”). The price to the investor for the 2035 Bonds was 98.296% of the principal amount for an effective yield of 5.998%. The net proceeds of $97.0 million from this offering were used to repay borrowings under our acquisition credit facility and for other general corporate purposes. Interest on the 2035 Bonds is paid semiannually.
In November 2003, we issued $150 million of 5-1/2% senior unsecured notes due 2015 (the “2015 Notes”). The price to the investor for the 2015 notes was 99.508% of the principal amount for an effective yield of 5.557%. The net proceeds from this offering were used to acquire new retail properties and to repay borrowings under our
unsecured acquisition credit facility. Interest on the 2015 Notes is payable semiannually.
In March 2003, we issued $100 million of 5-3/8% senior unsecured notes due 2013 (the “2013 Notes”). The price to the investor for the 2013 notes was 99.509% of the principal amount for an effective yield of 5.439%. The net proceeds from this offering were used to repay borrowings under our unsecured acquisition credit facility. Interest on the 2013 Notes is payable semiannually.
In January 1999, we issued $20 million of 8% senior unsecured notes due 2009 (the “2009 Notes”). Interest on the 2009 Notes is payable semiannually.
In October 1998, we issued $100 million of 8-1/4% Monthly Income Senior Notes due 2008 (the “2008 Notes”). In May 1998, we entered into a treasury interest rate lock agreement associated with the 2008 Notes. In settlement of the agreement, we made a payment of $8.7 million in 1998. The payment on the agreement is being amortized over 10 years (the life of the 2008 Notes) as a yield adjustment to interest expense. After taking into effect the results of a treasury interest rate lock agreement, the effective rate to us on the 2008 Notes is 9.12%. Interest on the 2008 Notes is payable monthly. The 2008 Notes are unsecured.
In May 1997, we issued $110 million of 7-3/4% senior unsecured notes due 2007 (the “2007 Notes”). In December 1996, we entered into a treasury interest rate lock agreement associated with the 2007 Notes. In settlement of the agreement, we received $1.1 million in 1997. The payment received on the agreement is being amortized over 10 years (the life of the 2007 Notes) as a yield adjustment to interest expense. After taking into effect the results of a treasury interest rate lock agreement, the effective interest rate to us on the 2007 Notes is 7.62%. Interest on the 2007 Notes is payable semiannually.
Interest incurred on the 2017 Notes, 2035 Bonds, 2015 Notes, 2013 Notes, 2009 Notes, 2008 Notes and 2007 Notes collectively for each of the years ended December 31, 2005, 2004 and 2003 was $39.5 million, $32.0 million and $23.6 million, respectively. The interest rate on each of these notes is fixed.
Our outstanding notes are unsecured and accordingly, we have not pledged any assets as collateral for these or any other obligations.
All of these notes contain various covenants, including: (i) a limitation on incurrence of any debt which would cause our debt to total adjusted assets ratio to exceed 60%; (ii) a limitation on incurrence of any secured debt which would cause our secured debt to total adjusted assets ratio to exceed 40%; (iii) a limitation on incurrence of any debt which would cause our debt service coverage ratio to be less than 1.5 times; and (iv) the maintenance at all times of total unencumbered assets not less than 150% of our outstanding unsecured debt. We have been in compliance with these covenants since each of the notes were issued.
The following table summarizes the maturity of our notes payable as of December 31, 2005 (dollars in millions):
6. Common Stock Offerings
A. In September 2005, we issued 4.1 million shares of common stock at a price of $23.79 per share. The net proceeds of $92.7 million were used to fund new property acquisitions and for other general corporate purposes.
B. In March 2004, we issued 3.2 million shares of common stock at a price of $22.375 per share. The net proceeds of $67.9 million were used to repay a portion of our acquisition credit facility borrowings, which had been used to acquire 112 convenience store properties in March 2004.
C. In October 2003, we issued 5.75 million shares of common stock at a price of $20.295 per share. The net proceeds of $110.8 million were used to repay a portion of our acquisition credit facility.
7. Distributions Paid and Payable
A. We pay monthly cash distributions to our common stockholders. The following is a summary of monthly distributions paid per common share for the years ended December 31:
The following presents the federal income tax characterization of distributions paid or deemed to be paid to common stockholders for the years ended December 31:
At December 31, 2005, a distribution of $0.11625 per common share was payable and was paid in January 2006. At December 31, 2004, a distribution of $0.11 per common share was payable and was paid in January 2005.
B. In May 2004, we issued 4.0 million shares of 7.375% Monthly Income Class D cumulative redeemable preferred stock, with a liquidation value of $25 per share. All of these shares are outstanding. The net proceeds of $96.4 million from this issuance were used to redeem a portion of the outstanding Class B and Class C preferred stock, repay borrowings outstanding under our $250 million acquisition credit facility and for other general corporate purposes. Beginning May 27, 2009, the Class D preferred shares are redeemable at our option for $25.00 per share. Dividends of $0.1536459 per share are paid monthly in arrears on the Class D preferred stock.
In October 2004, we issued an additional 1.1 million shares of Class D preferred stock for $25.4311 per share. The net proceeds of $27.4 million were used to repay borrowings under our $250 million acquisition credit facility.
We paid or accrued dividends to holders of our Class D preferred stock totaling $9.4 million in 2005 and $4.8 million in 2004. The dividends paid per share to our Class D Preferred stockholders for 2005 of $1.84375 and for 2004 of $1.01406 were characterized for federal income tax purposes as ordinary income.
C. In May 1999, we issued 2,760,000 shares of 9-3/8% Class B cumulative redeemable preferred stock, of which 2,745,700 shares were outstanding in 2003 and a portion of 2004. On June 6, 2004, all of the outstanding Class B preferred shares were redeemed. We paid dividends to holders of our Class B preferred stock totaling $2.8 million during the first two quarters of 2004 and $6.4 million in 2003. The dividends paid per share to our Class B Preferred stockholders in 2004 of $1.01563 and in 2003 of $2.34375 were characterized for federal income tax purposes as ordinary income.
In addition, when our Class B preferred stock was redeemed in 2004, we incurred a non-cash charge of $2.4 million representing the Class B preferred stock original issuance costs that were paid in 1999.
D. In July 1999, we issued 1,380,000 shares of 9-1/2% Class C cumulative redeemable preferred stock, all of which were outstanding in 2003 and for a portion of 2004. On July 30, 2004, all of the outstanding Class C preferred shares were redeemed. We paid monthly dividends to holders of our Class C preferred stock totaling $1.9 million during the first seven months of 2004 and $3.3 million in 2003. The dividends paid per share to our Class C Preferred stockholders in 2004 of $1.37882 and in 2003 of $2.375 were characterized for federal income tax purposes as ordinary income.
In addition, when our Class C preferred stock was redeemed in 2004, we incurred a non-cash charge of $1.4 million representing the Class C preferred stock original issuance costs that were paid in 1999.
8. Operating Leases
A. At December 31, 2005, we owned 1,646 properties in 48 states, excluding 17 properties owned by Crest Net. Of these 1,646 properties, 1,641 are single-tenant retail locations and the remainder are multi-tenant, distribution and office locations. At December 31, 2005, 25 properties were vacant and available for lease or sale.
Substantially all leases are net leases where the tenant pays property taxes and assessments, maintains the interior and exterior of the building and leased premises, and carries insurance coverage for public liability, property damage, fire and extended coverage.
Percentage rent for 2005, 2004 and 2003 was $1.2 million, $1.3 million and $1.2 million, respectively, including amounts recorded to discontinued operations.
At December 31, 2005, minimum future annual rents to be received on the operating leases are as follows (dollars in thousands):
B. Major Tenants - No individual tenant’s rental revenue, including percentage rents, represented more than 10% of our total revenue for each of the years ended December 31, 2005, 2004 or 2003.
9. Gain on Sales of Real Estate Acquired for Resale by Crest Net
In 2005, Crest Net sold 12 properties for $23.5 million, which resulted in a gain of $3.3 million. As part of one sale in 2005, Crest Net provided buyer financing in the form of a $1.3 million promissory note. This note was paid in full in February 2006. In 2004, Crest Net sold 51 properties for $75.0 million, which resulted in a gain of $10.3 million. In 2003, Crest Net sold 27 properties for $45.2 million, which resulted in a gain of $6.2 million.
10. Gain on Sales of Investment Properties by Realty Income
In 2005, we sold 23 investment properties and sold a portion of the land from two properties for $23.4 million, which resulted in a gain of $6.6 million. This gain is included in discontinued operations, except for $18,000 that is included in other revenue.
In 2004, we sold or exchanged 43 investment properties and sold a portion of the land from four properties for $35.4 million, which resulted in a gain of $12.7 million. Of this gain, $12.5 million is included in discontinued operations and $185,000 is included in other revenue. Included in the 43 properties was one property leased by one of our tenants that we exchanged for another property owned by that tenant (see note 12E).
During 2003, we sold or exchanged 35 investment properties and exchanged three excess land parcels (from three properties) for $23.1 million, which resulted in a gain of $7.2 million. This gain is included in discontinued operations. Included in the 35 properties was one property leased by one of our tenants that we exchanged for another property owned by that tenant (see note 12F).
11. Fair Value of Financial Instruments
We believe that the carrying values reflected in the consolidated balance sheets at December 31, 2005 and 2004 reasonably approximate the fair values for cash and cash equivalents, accounts receivable, and all liabilities, due to their short-term nature, except for the line of credit payable and notes payable. In making these assessments, we used estimates. The fair value of the line of credit payable approximates its carrying value because its terms are similar to those available in the market place at December 31, 2005. The estimated fair value of the notes payable at December 31, 2005 is $755.0 million and at December 31, 2004 is $500.9 million, based upon the closing market price per note or indicative price per each note at December 31, 2005 and 2004, respectively.
12. Supplemental Disclosures of Cash Flow Information
Interest paid in 2005 was $36.4 million, in 2004 was $31.3 million and in 2003 was $32.5 million.
Income taxes paid by Realty Income and Crest Net in 2005 were $1.4 million, in 2004 were $6.9 million and in 2003 were $0.8 million.
The following non-cash investing and financing activities are included in the accompanying consolidated financial statements:
A. In 2005, noncash additions to properties resulted in an increase in buildings of $5.4 million, an increase in accounts payable of $5.1 million.
B. In 2005, Crest Net sold a property for $2.8 million and issued a mortgage note of $1.3 million, which was paid in full in February 2006 and is included in other assets on our consolidated balance sheet.
C. In June 2004, when our Class B preferred stock was redeemed, we incurred a non-cash charge of $2.4 million for the excess of redemption value over the carrying value.
D. In July 2004, when our Class C preferred stock was redeemed, we incurred a non-cash charge of $1.4 million for the excess of redemption value over the carrying value.
E. In 2004, we exchanged one of our properties for a different property that was leased to the same tenant. As part of this transaction, land was reduced by $160,000, building was increased by $78,000, and accumulated depreciation was decreased by $82,000.
F. In 2003, we exchanged excess land parcels from three different properties leased by one of our tenants for land (with improvements) owned by that same tenant. In 2003, we also exchanged one property leased by one of our tenants for another property owned by that tenant. As part of these transactions, accumulated depreciation was decreased by $64,000 and gain on sale of $64,000 was recognized.
G. In 2003, non-cash additions to properties resulted in an increase in buildings of $1.7 million, an increase in real estate held for sale, net of $289,000 and an increase in other liabilities of $2.0 million.
H. Stock based compensation resulted in the following (dollars in thousands):
I. Distributions payable on our balance sheets is comprised of the following accrued distributions (dollars in thousands):
13. Employee Benefit Plan
We have a 401(k) plan covering substantially all of our employees. Under our 401(k) plan, employees may elect to make contributions to the plan up to a maximum of 60% of their compensation, subject to limits under the IRS Code. We match 50% of our employee’s contributions, up to 3% of the employee’s compensation. Our aggregate matching contributions each year have been immaterial to our results of operations.
14. Common Stock Incentive Plan
In 2003, our Board of Directors adopted and our stockholders approved the 2003 Incentive Award Plan of Realty Income Corporation to enable us to attract and retain the services of directors, employees and consultants considered essential to our long-term success by offering them an opportunity to own stock in Realty Income and/or rights that will reflect our growth, development and financial success. The 2003 Incentive Award Plan of Realty Income Corporation was amended and restated by our Board of Directors on February 21, 2006. Under the terms of this plan, the aggregate number of shares of our common stock subject to options, stock purchase rights, stock appreciation rights and other awards will be no more than 3,428,000 shares. The maximum number of shares, which may be subject to options, stock purchase rights, stock appreciation rights and other awards granted under the plan to any individual in any calendar year may not exceed 1,600,000 shares. This plan has a term of 10 years from the date it was adopted by our Board of Directors, which was March 12, 2003.
In 1993, our Board of Directors approved a stock incentive plan (the “Stock Plan”), which expired in 2004.
Stock options are granted with an exercise price equal to the underlying stock’s fair market value at the date of grant. Stock options expire ten years from the date they are granted and vest over service periods of one, three, four and five years. No stock options were granted in 2005, 2004 or 2003.
The following table summarizes our stock option activity for the years 2005, 2004 and 2003:
At December 31, 2005, the options outstanding under the Stock Plan had exercise prices ranging from $10.63 to $14.70, with a weighted average price of $13.02, and expiration dates ranging from June 2007 to December 2011 with a weighted average remaining term of 3.3 years. At December 31, 2005, the options exercisable under the Stock Plan had exercise prices ranging from $10.63 to $14.70 with a weighted average price of $12.87. Cash received from the exercise of options is included in deferred stock compensation on our consolidated statements of stockholders’ equity.
The following table summarizes our nonvested common stock grant activity for the years 2005, 2004 and 2003. The grants vest over periods ranging from five to 10 years.
15. Stockholder Rights Plan
In 1998, our Board of Directors adopted a Stockholder Rights Plan (the “Rights Plan”) that was to expire in July 2008. The Rights Plan was canceled by the Board of Directors in February 2005.
16. Segment Information
We evaluate performance and make resource allocation decisions on an industry by industry basis. For financial reporting purposes, we have grouped our tenants into 30 industry and activity segments (including properties owned by Crest Net that are grouped together). All of the properties are incorporated into one of the applicable segments. Because almost all of our leases require the tenant to pay operating expenses, revenue is the only
component of segment profit and loss we measure.
The following tables set forth certain information regarding the properties owned by us, classified according to the business of the respective tenants as of December 31, 2005 (dollars in thousands):
17. Commitments and Contingencies
In the ordinary course of our business, we are party to various legal actions which we believe are routine in nature and incidental to the operation of our business. We believe that the outcome of the proceedings will not have a material adverse effect upon our consolidated financial statements taken as a whole.
At December 31, 2005, we have committed to pay estimated unfunded development costs of $42.2 million on properties under development. We also have contingent payments for tenant improvements and leasing costs of $456,000.
In 2004, we recorded impairment of $716,000 on one property to reduce its carrying value to zero. This property is classified as held for sale. This impairment was the result of a title insurance company failing to timely record a deed on this property. It is likely that through our tenant’s bankruptcy proceedings, our title to this property will be divested. We believe that we have a strong claim against the title insurance company and others for the loss of the current fair market value of the property, rent which we may be required to repay to the tenant, and direct and incidental costs incurred. Our claim against the title insurance company and others is estimated to be between $750,000 and $1.3 million, which is not reflected in our consolidated financial statements as this represents a contingent gain.
REALTY INCOME CORPORATION AND SUBSIDIARIES
CONSOLIDATED QUARTERLY FINANCIAL DATA
(dollars in thousands, except per share data)
(not covered by Report of Independent Registered Public Accounting Firm)
(1) The consolidated quarterly financial data includes revenues and expenses from our continuing and discontinued operations. The results of operations related to certain properties, that have been classified as held for sale or have been disposed of, have been reclassified to income from discontinued operations. Therefore, some of the information may not agree to our previously filed 10-Qs.
(2) Amounts for each period are calculated independently. The sum of the quarters may differ from the annual amount.
Item 9:
Item 9: Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
We have had no disagreements with our independent auditors on accountancy or financial disclosure, nor have we changed accountants in the two most recent fiscal years.
Item 9A:
Item 9A: Controls and Procedures
Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and procedures (as defined in Securities Exchange Act 1934 Rules 13a-14(c) and 15d-14(c)) that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of and for the year ended December 31, 2005, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.
Management’s Report on Internal Control Over Financial Reporting.
Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and procedures that:
(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;
(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company.
Management has used the framework set forth in the report entitled “Internal Control-Integrated Framework” published by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission to evaluate the effectiveness of the Company’s internal control over financial reporting. Management has concluded that the Company’s internal control over financial reporting was effective as of the end of the most recent fiscal year. KPMG LLP has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting.
Submitted on February 21, 2006 by,
Thomas A Lewis, Chief Executive Officer and Vice Chairman
Paul M. Meurer, Chief Financial Office, Executive Vice President and Treasurer
Changes in Internal Controls. There have not been any significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. There were no material weaknesses, and therefore no corrective actions were taken.
Limitations on the Effectiveness of Controls. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
Item 9B:
Item 9B: Other Information
This item is not applicable.
PART III
Item 10:
Item 10: Directors and Executive Officers of the Registrant
The information set forth under the captions “Director Nominees” and “Officers of the Company” and “Compliance with Federal Securities Laws” will be included in the definitive proxy statement for the 2006 Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A. The Annual Meeting of Stockholders is presently scheduled to be held on May 16, 2006.
Item 11:
Item 11: Executive Compensation
The information set forth under the caption “Executive Compensation” will be included in the definitive proxy statement for the 2006 Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A.
Item 12:
Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” will be included in the definitive proxy statement for the 2006 Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A.
Item 13:
Item 13: Certain Relationships and Related Transactions
The information set forth under the caption “Certain Transactions” will be included in the definitive proxy statement for the 2006 Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A.
PART IV
Item 14:
Item 14: Principal Accountant Fees and Services
The information set forth under the caption “Principal Accountant Fees and Services” will be included in the definitive proxy statement for the 2006 Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A.
Item 15:
Item 15: Exhibits and Financial Statement Schedules
A. The following documents are filed as part of this report.
2. Financial Statement Schedule. Reference is made to page of this report for Schedule III Real Estate and Accumulated Depreciation (electronically filed with the Securities and Exchange Commission, but not included herein).
Schedules not Filed: All schedules, other than those indicated in the Table of Contents, have been omitted as the required information is either not material, inapplicable or the information is presented in the financial statements or related notes.
3. Exhibits
Articles of Incorporation and By-Laws
3.1
Articles of Incorporation of the Company, as amended by amendment No. 1 dated May 10, 2005 and amendment No. 2 dated May 10, 2005 (filed as exhibit 3.1 to Realty Income’s Form 10-Q dated June 30, 2005, and incorporated herein by reference).
3.2
Bylaws of the Company, as amended by amendment No. 1 dated March 20, 2000 and amendment No. 2 dated June 15, 2005 (filed as exhibit 3.2 to Realty Income’s Form 10-Q dated June 30, 2005, and incorporated herein by reference).
3.3
Articles of Incorporation of the Company (filed as Appendix B to the Company’s Proxy Statement dated March 28, 1997 (“1997 Proxy Statement”) and incorporated herein by reference).
3.4
Bylaws of the Company (filed as Appendix C to the Company’s 1997 Proxy Statement and incorporated herein by reference).
3.5
Articles Supplementary of the Class A Junior Participating Preferred Stock of Realty Income Corporation (filed as an exhibit to Realty Income’s registration statement on Form 8-A, dated June 26, 1998, and incorporated herein by reference).
3.6
Articles Supplementary to the Articles of Incorporation of Realty Income Corporation classifying and designating the Class B Preferred Stock (filed as exhibit 4.1 to the Company’s Form 8-K dated May 24, 1999 and incorporated herein by reference).
3.7
Articles Supplementary to the Articles of Incorporation of Realty Income Corporation classifying and designating the Class C Preferred Stock (filed as exhibit 4.1 to the Company’s Form 8-K dated July 29, 1999 and incorporated herein by reference).
3.8
Amendment to the Bylaws of the Company (filed as exhibit 3.6 to the Company’s Form 10 Q for the period ended June 30, 2003 and incorporated herein by reference).
3.9
Articles Supplementary to the Articles of Incorporation of Realty Income Corporation classifying and designating the Class D Preferred Stock (filed as exhibit 3.8 to the Company’s Form 8-A filed on May 25, 2004 and incorporated herein by reference).
3.10
Articles Supplementary to the Articles of Incorporation of Realty Income Corporation classifying and designating the Class D Preferred Stock (filed as exhibit 3.1 to the Company’s Form 8-K filed on October 19, 2004 and incorporated herein by reference).
Instruments defining the rights of security holders, including indentures
4.1
Pricing Committee Resolutions and Form of 7.75% Notes due 2007 (filed as Exhibit 4.2 to the Company’s Form 8-K dated May 5, 1997 and incorporated herein by reference).
4.2
Indenture dated as of May 6, 1997 between the Company and The Bank of New York (filed as Exhibit 4.1 to the Company’s Form 8-K dated May 5, 1997 and incorporated herein by reference).
4.3
First Supplemental Indenture dated as of May 28, 1997, between the Company and The Bank of New York (filed as Exhibit 4.3 to the Company’s Form 8-B and incorporated herein by reference).
4.4
Rights Agreement, dated as of June 25, 1998, between Realty Income Corporation and The Bank of New York (filed as an exhibit to the Company’s registration statement on Form 8-A, dated June 26, 1998, and incorporated herein by reference).
4.5
Pricing Committee Resolutions (filed as exhibit 4.2 the Company’s Form 8-K, dated October 27, 1998 and incorporated herein by reference).
4.6
Form of 8.25% Notes due 2008 (filed as exhibit 4.3 to Company’s Form 8-K, dated October 27, 1998 and incorporated herein by reference).
4.7
Indenture dated as of October 28, 1998 between Realty Income and The Bank of New York (filed as exhibit 4.1 to the Company’s Form 8-K, dated October 27, 1998 and incorporated herein by reference).
4.8
Pricing Committee Resolutions and Form of 8% Notes due 2009 (filed as exhibit 4.2 to Realty Income’s Form 8-K, dated January 21, 1999 and incorporated herein by reference).
4.9
Form of 5-3/8% Senior Notes due 2013 (filed as exhibit 4.2 to the Company’s Form 8-K, dated March 5, 2003 and incorporated herein by reference).
4.10
Officer’s Certificate pursuant to sections 201, 301 and 303 of the Indenture dated October 28, 1998 between the Company and The Bank of New York, as Trustee, establishing a series of securities entitled 5-3/8% Senior Notes due 2013 (filed as exhibit 4.3 to Realty Income’s Form 8-K, dated March 5, 2003 and incorporated herein by reference).
4.11
Form of 5-1/2% Senior Notes due 2015 (filed as exhibit 4.2 to the Company’s Form 8-K, dated November 19, 2003 and incorporated herein by reference).
4.12
Officer’s Certificate pursuant to sections 201, 301 and 303 of the Indenture dated October 28, 1998 between the Company and The Bank of New York, as Trustee, establishing a series of securities entitled 5-1/2% Senior Notes due 2015 (filed as exhibit 4.3 to the Company’s Form 8-K, dated November 19, 2003 and incorporated herein by reference).
4.13
Amendment No. 1 to Rights Agreement between Realty Income Corporation and The Bank of New York, dated February 25, 2005 (filed as exhibit 4.1 to the Company’s Form 8-K, dated February 25, 2005 and incorporated herein by reference).
4.14
Form of 5-7/8% Senior Notes due 2035 (filed as exhibit 4.2 to the Company’s Form 8-K, dated March 8, 2005 and incorporated herein by reference).
4.15
Officer’s Certificate pursuant to section 301 of the Indenture dated October 28, 1998 between the Company and The Bank of New York, as Trustee, establishing a series of securities entitled 5-7/8% Senior Debentures due 2035 (filed as exhibit 4.3 to the Company’s Form 8-K, dated March 8, 2005 and incorporated herein by reference).
4.16
Form of 5-3/8% Senior Notes due 2017 (filed as exhibit 4.2 to the Company’s Form 8-K, dated September 8, 2005 and incorporated herein by reference).
4.17
Officer’s Certificate pursuant to section 301 of the Indenture dated October 28, 1998 between the Company and The Bank of New York, as Trustee, establishing a series of securities entitled 5-3/8% Senior Notes due 2017 (filed as exhibit 4.3 to the Company’s Form 8-K, dated September 8, 2005 and incorporated herein by reference).
Material Contracts
10.1
$300 million Credit Agreement dated June 17, 2005 (filed as exhibit 10.1 to the Company’s Form 8-K filed on June 20, 2005 and incorporated herein by reference).
10.2
Form indemnification agreement between the Company and each executive officer and each director of the Board of Directors of the Company (filed as exhibit 10.1 to the Company’s Form 8-K filed on August 26, 2005 and incorporated herein by reference).
10.3
Stock Option and Incentive Plan (filed as Exhibit 4.1 to the Company’s Registration Statement on Form S-8 (registration number 33-95708) and incorporated herein by reference).
10.4
First Amendment to the 1994 Stock Option and Incentive Plan, dated June 12, 1997 (filed as Exhibit 10.9 to the Company’s Form 8-B and incorporated herein by reference).
10.5
Second Amendment to the 1994 Stock Option and Incentive Plan, dated December 16, 1997, (filed as Exhibit 10.9 to the Company’s Form 10-K dated December 31, 1997 and incorporated herein by reference).
10.6
Management Incentive Plan, (filed as Exhibit 10.10 to the Company’s Form 10-K dated December 31, 1997 and incorporated herein by reference).
10.7
Form of Nonqualified Stock Option Agreement for Independent Directors, (filed as Exhibit 10.11 to the Company’s Form 10-K dated December 31, 1997 and incorporated herein by reference).
10.8
Form of Employment Agreement between the Company and its Executive Officers (incorporated by reference to the Company’s Form 8-B12B dated July 29, 1997 and incorporated herein by reference).
10.9
Form of Restricted Stock Agreement between the Company and Executive Officers (filed as exhibit 10.11 to the Company’s Form 8-K dated January 1, 2005 and incorporated herein by reference).
*10.10
Stock Incentive Award Plan of Realty Income Corporation, as amended and restated February 21, 2006.
Statement of Ratios
*12.1
Statement re computation of ratios.
Subsidiaries and Consent
*21.1
Subsidiaries of the Company as of January 1, 2006.
*23.1
Consent of Independent Registered Public Accounting Firm.
Certifications
*31.1
Section 302 Certifications as filed by the Chief Executive Officer pursuant to SEC release No. 33-8212 and 34-47551.
*31.2
Section 302 Certifications as filed by the Chief Financial Officer pursuant to SEC release No. 33-8212 and 34-47551.
*32
Section 906 Certifications as furnished by the Chief Executive Officer and the Chief Financial Officer pursuant to SEC release No. 33-8212 and 34-47551.
* Filed herewith.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
REALTY INCOME CORPORATION
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
REALTY INCOME CORPORATION AND SUBSIDIARIES
SCHEDULE III REAL ESTATE AND ACCUMULATED DEPRECIATION