Realty Income - 10-K annual report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC  20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2005

Commission File Number 1-13374

REALTY INCOME CORPORATION

(Exact name of registrant as specified in its charter)

220 West Crest Street, Escondido, California  92025

(Address of principal executive offices)

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

Securities registered pursuant to Section 12 (b) of the Act:

Securities registered pursuant to Section 12 (g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  ý  No  o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  YesoNo ý

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2).

Large accelerated filer ý  Accelerated filer o  Non-accelerated filer o

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

REALTY INCOME CORPORATION

Index to Form 10-K

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•                  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

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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.

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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

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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.

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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.

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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

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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

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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.

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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.

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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.

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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.

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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.

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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

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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.

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PART II

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.

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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.

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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%.

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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

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The following table summarizes the maturity of each of our obligations as of December 31, 2005 (dollars in millions):

Table of Obligations