Realty Income - 10-Q quarterly report FY

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC  20549

FORM 10-Q

[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2006, or

[  ] Transition report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934

COMMISSION FILE NUMBER 1-13374

REALTY INCOME CORPORATION

(Exact name of registrant as specified in its charter)

Maryland

(State or other jurisdiction of incorporation or organization)

33-0580106

(I.R.S. Employer Identification No.)

220 West Crest Street, Escondido, California  92025

(Address of principal executive offices)

(760) 741-2111

(Registrant’s telephone number)

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  [X]    NO  [  ]

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

Large accelerated filer [X]   Accelerated filer [  ]  Non-accelerated filer [  ]

There were 83,089,314 shares of common stock outstanding as of April 26, 2006.

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

REALTY INCOME CORPORATION

Form 10-Q

March 31, 2006

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1.    Financial Statements

REALTY INCOME CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

March 31, 2006 and December 31, 2005

(dollars in thousands, except per share data)

The accompanying notes to consolidated financial statements are an integral part of these statements.

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REALTY INCOME CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

For the three months ended March 31, 2006 and 2005

(dollars in thousands, except per share data)

(unaudited)

The accompanying notes to consolidated financial statements are an integral part of these statements.

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REALTY INCOME CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the three months ended March 31, 2006 and 2005

(dollars in thousands)(unaudited)

For supplemental disclosures, see note 11.

The accompanying notes to consolidated financial statements are an integral part of these statements.

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REALTY INCOME CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2006

(Unaudited)

1.                   Management Statement

The consolidated financial statements of Realty Income Corporation (“Realty Income”, the “Company”, “we” or “our”) were prepared from our books and records without audit and include all adjustments (consisting of only normal recurring accruals) necessary to present a fair statement of results for the interim periods presented. Certain of the 2005 balances have been reclassified to conform to the 2006 presentation. Readers of this quarterly report should refer to our audited financial statements for the year ended December 31, 2005, which are included in our 2005 Annual Report on Form 10-K, as certain disclosures that would substantially duplicate those contained in the audited financial statements have not been included in this report.

At March 31, 2006, we owned 1,667 properties, located in 48 states, containing over 14.2 million leasable square feet, along with 15 properties owned by our wholly-owned taxable REIT subsidiary, Crest Net Lease, Inc. (“Crest”). Crest 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 “Tax Code”).

2.                   Summary of Significant Accounting Policies and Procedures

A. The accompanying consolidated financial statements include the accounts of Realty Income, Crest and other entities for which we make operating and financial decisions (control), after elimination of all material intercompany balances and transactions. All of Realty Income and Crest’s subsidiaries are wholly-owned.

B. We have elected to be taxed as a Real Estate Investment Trust (“REIT”) under the Tax Code. We believe we have qualified and continue to qualify as a REIT. Under the REIT operating structure we are 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.

3.                   Retail Properties Acquired

We acquire land, buildings and improvements that are used by retail operators.

A. During the first three months of 2006, Realty Income and Crest invested $95.2 million, in aggregate, in 28 new retail properties and properties under development. These 28 properties are located in 10 states, will contain over 856,000 leasable square feet, and are 100% leased with an average initial lease term of 18.6 years.

In comparison, during the first three months of 2005, Realty Income and Crest invested $92.5 million, in aggregate, in 34 new retail properties and properties under development. Of the $92.5 million invested in the first quarter of 2005, $68.4 million was used to acquire 24 properties with existing leases on the properties. In accordance with SFAS 141, Realty Income recorded $6.9 million and Crest recorded $1.4 million as the value of in-place leases. In addition Realty Income recorded $657,000 and Crest recorded $35,000 as the value of below-market rents on these leases. These amounts are recorded to “other assets” and “other liabilities” on our consolidated balance sheet and are amortized over the lives of the respective leases. Such amounts recorded by Crest are included in the calculation of gain on sales of properties.

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B. During the first three months of 2006, Realty Income invested $87.8 million in 26 new retail properties and properties under development with an initial weighted average contractual lease rate of 8.6%. These 26 properties are located in 10 states, will contain over 790,000 leasable square feet, and are 100% leased with an average initial lease term of 18.5 years. The initial weighted average contractual lease rate is computed by dividing the estimated aggregate base rent for the first year of each lease by the estimated total cost of the properties.

In comparison, during the first three months of 2005, Realty Income invested $83.34 million in 31 new retail properties and properties under development with an initial weighted average contractual lease rate of 8.6%.

C. During the first three months of 2006, Crest invested $7.4 million in two new retail properties.

In comparison, during the first three months of 2005, Crest invested $9.14 million in three new retail properties and properties under development.

D. Crest’s property inventory at March 31, 2006 consisted of 15 properties with a total investment of $47.6 million and at December 31, 2005 consisted of 17 properties with a total investment of $45.7 million. These amounts are included on our consolidated balance sheets in “real estate held for sale, net.”

4.                   Credit Facility

We have a $300 million acquisition credit facility that expires in October 2008, unless extended as provided for in the agreement. Under the terms of the credit facility, which commenced in October 2005, the borrowing rate is 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 credit facility offers us other interest rate options as well.

The average borrowing rate on our credit facility during the first quarter of 2006 was 5.2%, compared to 3.5% in the first quarter of 2005 on our previous $250 million credit facility, which expired in October 2005. The increase in the average borrowing rate is due to an increase in LIBOR since the beginning of 2005. Our current credit facility is subject to various leverage and interest coverage ratio limitations. The Company is and has been in compliance with these covenants.

Our credit facility is unsecured and accordingly, we have not pledged any assets as collateral for this obligation.

5.                   Common Stock Offering

In March 2006, we issued 5.2 million shares of common stock at a price of $24.39 per share. The net proceeds of approximately $120.6 million were used to fund new property acquisitions and for other general corporate purposes.

6.                   Gain on Sales of Real Estate Acquired for Resale by Crest

During the first quarter of 2006, Crest sold four properties for $6.4 million, which resulted in a gain of $906,000. In comparison, during the first quarter of 2005, Crest sold six properties for $7.7 million, which resulted in a gain of $1.2 million. Crest’s gains on sales are reported before income taxes and are included in discontinued operations. As part of one sale in 2005, Crest provided buyer financing in the form of a $1.3 million promissory note, which was paid in full in February 2006.

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properties leased to regional and national retail chains. We have in-house acquisition, leasing, legal, retail research, 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 vacant properties and selective sales of properties.

In acquiring additional properties, we adhere 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 March 31, 2006, we owned a diversified portfolio:

•                  Of 1,667 retail properties;

•                  With an occupancy rate of 98.5%, or 1,642 properties occupied of the 1,667 properties in the portfolio;

•                  Leased to 103 different retail chains doing business in 29 separate retail industries;

•                  Located in 48 states;

•                  With over 14.2 million square feet of leasable space; and

•                  With an average leasable retail space per property of approximately 8,500 square feet.

Of the 1,667 properties in the portfolio, 1,660, or 99.6%, are single-tenant, retail properties and the remaining seven are multi-tenant, distribution and office properties. At March 31, 2006, 1,636, or 98.6%, of the 1,660 single-tenant properties were leased with a weighted average remaining lease term (excluding extension options) of approximately 12.4 years.

In addition, at March 31, 2006, our wholly-owned taxable REIT subsidiary, Crest Net Lease, Inc. (“Crest”) owned 15 properties with a total investment of $47.6 million, which are classified as held for sale. Crest 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 “Tax Code”).

We typically acquire retail 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.

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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.

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%.

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.

RECENT DEVELOPMENTS

Common Stock Issuance

In March 2006, we issued 5.2 million shares of common stock at a price of $24.39 per share. The net proceeds of approximately $120.6 million were used to fund new property acquisitions and for other general corporate purposes.

Universal Shelf Registration

In April 2006, we filed a shelf registration statement with the SEC, which will be effective for a term of three years. The securities covered by this registration statement include common stock, preferred stock, debt securities, or any combination of such securities. Realty Income may periodically offer one or more of these securities in amounts, prices and on terms to be announced when and if the securities are offered. The specifics of any future offerings, along with the use of proceeds of any securities offered, will be described in detail in a prospectus supplement, or other offering materials, at the time of any offering.

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Credit Ratings Upgrade

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.”

Acquisitions During the First Quarter of 2006

During the first quarter of 2006, Realty Income and Crest invested $95.2 million, in aggregate, in 28 new properties and properties under development. These 28 properties are located in 10 states and are 100% leased with an initial average lease term of 18.6 years. As described below, Realty Income acquired 26 properties and Crest acquired two properties.

Included in the $95.2 million is $87.8 million invested by Realty Income in 26 new properties and properties under development, with an initial weighted average contractual lease rate of 8.6%. These 26 properties are located in 10 states, are 100% leased with an initial average lease term of 18.5 years and will contain over 790,000 leasable square feet. The 26 new properties acquired by Realty Income are net-leased to five different retail chains in the home improvement, motor vehicle dealership, and restaurant industries.

Also included in the $95.2 million is $7.4 million invested by Crest in two new retail properties.

Of the $95.2 million Realty Income invested in real estate during the first quarter of 2006, $11.3 million was invested in four properties that were leased and under contract for development by the tenant at March 31, 2006 (with development costs funded by Realty Income). Rent on these properties is scheduled to begin at various times during the next twelve months.

At March 31, 2006, we also had outstanding commitments to pay estimated unfunded development costs totaling $34.7 million. These commitments are on properties acquired in 2005 and 2006.

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 the first quarter of 2006, we capitalized costs of $169,000 on existing properties in our portfolio, consisting of $122,000 for re-leasing costs and $47,000 for building improvements.

Net Income Available to Common Stockholders

Net income available to common stockholders was $22.5 million in the first quarter of 2006 versus $21.2 million in the same quarter of 2005, an increase of $1.3 million. On a diluted per common share basis, net income was $0.27 per share in both the first quarters of 2006 and 2005.

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 the first quarter of 2006 was $752,000 as compared to $822,000 for the first quarter of 2005.

Funds from Operations (FFO)

In the first quarter of 2006, our FFO increased by $4.1 million, or 13.1%, to $35.3 million versus $31.2 million in the first quarter of 2006. On a diluted per common share basis, FFO was $0.42 in the first quarter of 2006 compared to $0.39 for the first quarter of 2005, an increase of $0.03, or 7.7%.

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See our discussion of FFO later in this section for a reconciliation of net income available to common stockholders to FFO.

Crest Property Sales

During the first quarter of 2006, Crest sold four properties from its inventory for an aggregate of $6.4 million, which resulted in a gain of $906,000. Crest’s gains are included in “income from discontinued operations, real estate acquired for resale by Crest.”

Crest’s Property Inventory

Crest’s property inventory at March 31, 2006 totaled $47.6 million and at December 31, 2005 totaled $45.7 million.

Increases in Monthly Distributions to Common Stockholders

We continue our 37-year policy of paying distributions monthly. Monthly distributions per share were increased in April 2006 by $0.000625 to $0.116875. The increase in April 2006 was our 34th consecutive quarterly increase and the 38th increase in the amount of our dividend since our listing on the NYSE in 1994. In the first three months of 2006, we paid three monthly cash distributions per share in the amount of $0.11625, totaling $0.34875. In March 2006 and April 2006, we declared distributions of $0.116875 per share, which were paid on April 17, 2006 and will be paid on May 15, 2006, respectively.

The monthly distribution of $0.116875 per share represents a current annualized distribution of $1.4025 per share, and an annualized distribution yield of approximately 6.2% based on the last reported sale price of our common stock on the NYSE of $22.59 on April 27, 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.

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 March 31, 2006, we had cash and cash equivalents totaling $4.1 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 Acquisition 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 $300 million 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 April 27, 2006, we had a borrowing capacity of $256.4 million available on our credit facility and an outstanding balance of $43.6 million at an effective interest rate of 5.5%.

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.

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Mortgage Debt

We have no mortgage debt on any of our properties.

Universal Shelf Registration

In April 2006, we filed a shelf registration statement with the SEC, which will be effective for a term of three years. The securities covered by this registration statement include common stock, preferred stock, debt securities, or any combination of such securities. Realty Income may periodically offer one or more of these securities in amounts, prices and on terms to be announced when and if the securities are offered. The specifics of any future offerings, along with the use of proceeds of any securities offered, will be described in detail in a prospectus supplement, or other offering materials, at the time of any offering.

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 April 27, 2006, our total outstanding credit facility borrowings and outstanding notes were $799.5 million or approximately 27.2% of our total market capitalization of $2.94 billion. We define our total market capitalization at April 27, 2006 as the sum of:

•      Shares of our common stock outstanding of 89,089,314 multiplied by the last reported sales price of our common stock on the NYSE of $22.59 per share, or $2.01 billion;

•      Aggregate liquidation value of the Class D preferred stock of $127.5 million;

•      Outstanding borrowings of $43.6 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.

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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 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 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.

Distributions

Distributions are paid monthly to our common stockholders and Class D preferred stockholders if, and when declared by our Board of Directors.

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.

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).

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 Tax 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,

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except to the extent the REIT’s dividends are attributable to dividends received from taxable corporations (such as our taxable REIT subsidiary, Crest), 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.

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’s properties because they are held for sale.

Another significant judgment must be made as to, 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 three months ended March 31, 2006 to the three months ended March 31, 2005.

Rental Revenue

Rental revenue was $55.2 million for the first quarter of 2006 versus $46.5 million for the first quarter of 2005, an increase of $8.7 million, or 18.7%. The increase in rental revenue in the first quarter of 2006 is attributable to:

•      The 26 retail properties acquired by Realty Income in 2006, which generated $1.3 million in the first quarter;

•      The 135 retail properties acquired by Realty Income in 2005, which generated $7.8 million in the first

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quarter of 2006 compared to $828,000 in the first quarter of 2005, an increase of $7.0 million;

•      Same store rents generated on 1,446 properties during the first quarters of 2006 and 2005 increased by $308,000, or 0.7%, to $44.1 million from $43.8 million. These properties were leased during all of both quarters;

•      A decrease in straight-line rent and other non-cash adjustments to rent of $193,000 in the first quarter of 2006 as compared to the first quarter of 2005; and

•      An increase of $355,000 relating to the aggregate of (i) development properties acquired before 2005 that started paying rent in 2005, (ii) properties that were vacant during part of 2006 or 2005 and (iii) lease termination settlements. These items totaled $1.5 million in aggregate in the first quarter of 2006 compared to $1.1 million in the same quarter of 2005.

Of the 1,667 properties in the portfolio at March 31, 2006, 1,660, or 99.6%, are single-tenant properties and the remaining are multi-tenant properties. Of the 1,660 single-tenant properties, 1,636, or 98.6 %, 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 March 31, 2006. Of our 1,636 leased single-tenant, 1,505, 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 $132,000 in the first quarter of 2006 and $111,000 in the first quarter of 2005. Percentage rent in the first quarter of 2006 was less than 1% of rental revenue and we anticipate percentage rent to be less than 1% of rental revenue in 2006.

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 March 31, 2006, our portfolio of 1,667 retail properties was 98.5% leased with 25 properties available for lease, one of which is a multi-tenant property.

As of April 21, 2006, transactions to lease or sell five of the 25 properties available for lease at March 31, 2006 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 $4.1 million higher in the first quarter of 2006 than in the first quarter of 2005. Interest expense increased in 2006 primarily due to higher average outstanding balances, which was partially offset by slightly lower interest rates. We issued $100 million of 30-year bonds in March 2005 and $175 million of 12-year notes in September 2005, which contributed to the increase in average outstanding balances and slightly lower interest rates.

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The following is a summary of the components of our interest expense (dollars in thousands):

At April 27, 2006, the weighted average interest rate on our:

•      Credit facility borrowings of $43.6 million was 5.53%;

•      Notes payable of $755 million was 6.26%; and

•      Combined outstanding credit facility and notes of $798.6 million was 6.2%.

Interest Coverage Ratio

Our interest coverage ratio for the first quarter of 2006 was 3.7 times, and was 4.7 times for the first quarter of 2005. 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.

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General and Administrative Expenses

General and administrative expenses increased by $189,000, to $4.2 million, in the first quarter of 2006 as compared to $4.0 million in the first quarter of 2005. General and administrative expenses increased in 2006 primarily due to increases in payroll and employee benefit costs. In the first quarter of 2006, as a percentage of total revenue, general and administrative expenses decreased to 7.7% as compared to 8.7% in the first quarter of 2005.

As our property portfolio has grown and continues to grow, we have increased, and anticipate that we will continue to gradually increase the level of our staffing. We expect general and administrative expenses to continue to increase due to costs attributable to payroll, staffing costs and corporate governance.

In April 2006, we had 70 permanent employees and three temporary employees as compared to April 2005 when we had 67 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, bad debt expense, property inspections and title search fees. At March 31, 2006 and December 31, 2005, 25 properties were available for lease as compared to 33 at March 31, 2005.

Property expenses were $839,000 in the first quarter of 2006 and $845,000 in the first quarter of 2005.

Income Taxes

Income taxes were $231,000 in the first quarter of 2006 as compared to $198,000 in the first quarter of 2005. These amounts are for city and state income taxes paid by Realty Income. The increase in 2006 is due to an increase in rental revenue causing higher city and state income tax expense.

In addition, Crest incurred state and federal income taxes of $289,000 in the first quarter of 2006 as compared to $364,000 in the first quarter of 2005. The decrease in 2006 as compared to 2005 is due to lower taxable income. These income taxes are included in “income from discontinued operations, real estate acquired for resale by Crest.”

Discontinued Operations

Crest 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 as held for sale at the date of acquisition and do not depreciate them. The operation of Crest’s properties is classified as “income from discontinued operations, real estate acquired for resale by Crest.”

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Gain on Sales of Real Estate Acquired for Resale by Crest

During the first quarter of 2006, Crest sold four properties for $6.4 million, which resulted in a gain of $906,000. In comparison, during the first quarter of 2005, Crest sold six properties for $7.7 million, which resulted in a gain of $1.2 million. Crest’s gains on sales are reported before income taxes and are included in discontinued operations.

At March 31, 2006, Crest had $47.6 million invested in 15 properties, which are held for sale. Our goal is for Crest to carry an average inventory of approximately $20 to $25 million in real estate. Crest 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 without any property sales.

Gain on Sales of Investment Properties by Realty Income

During the first quarter of 2006, we sold five investment properties for $2.1 million, which resulted in a gain of $752,000. In comparison, during the first quarter of 2005, we sold four investment properties and a portion of land from one property for $6.6 million, which resulted in a gain of $822,000. These gains are 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 March 31, 2006, we classified real estate with a carrying amount of $48.4 million as held for sale on our balance sheet, which includes properties owned by Crest. 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.

Provision for Impairment

No provision for impairment was recorded in the first quarter 2006, compared to a provision of $16,000 taken on one property in the first quarter of 2005. This provision is included in “income from discontinued operations, real estate held for investment.”

Preferred Stock Dividends

We paid preferred stock cash dividends of $2.4 million in each of the first quarters of 2006 and 2005.

Net Income Available to Common Stockholders

Net income available to common stockholders was $22.5 million in the first quarter of 2006, an increase of $1.3 million as compared to $21.2 million in the first quarter of 2005.

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.

During the first quarter of 2006, the gain recognized from the sales of investment properties was $752,000, as compared to $822,000 for the first quarter of 2005.

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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, adequate access and proximity to a sufficient population base to constitute a suitable market or trade area for the retailer’s business.

Industry Diversification

The following table sets forth certain information regarding Realty Income’s property portfolio (excluding properties owned by Crest) 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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