Realty Income
Annual Report 2005

Plain-text annual report

R E A LTY I N C O M E ’ S M O NTH LY D IVI D E N D U N I V E RS ITY N e w Y o r k S t o c k E x c h a n g e “ O ” R E A L T Y I N C O M E 2 0 0 5 A N N U A L R E P O R T T H E C O L L E G E F O R I N C O M E I N V E S T O R S U N I V E R S I T Y M I S S I O N Monthly Dividend University (MDU) is an institution of higher learning that is dedicated to teaching investors about investing for dividend income and about Realty Income, The Monthly Dividend Company®. Upon the completion of course work, students will have a broad understanding and knowledge of the operations and performance of Realty Income during 2005, as well as how investing for dividend income may fit within their overall investment objectives. Undergraduate Curriculum Bachelor of Arts (BA) in Monthly Dividends Page 2 Psychology 101 “The Psychology of Investing for Income” Page 4 Math 101 “The Magic of Yield on Cost” Page 6 Philosophy 101 “The Philosophy of The Monthly Dividend Company®” Page 8 History 101 11-year Financial Performance Table Page 11 History 102 “The History of The Monthly Dividend Company®” Page 12 Modern History 101B “2005 Review (the short version)” Page 13 Objective Setting 101 “2006 Business Plan (the short version)” Page 14 Accounting 101 “Realty Income’s 2005 Operating Results and Financial Performance” Page 16 Real Estate 101 “Identifying and Acquiring Retail Properties” Page 18 Science 101 “The Science of Portfolio Management” Page 20 Economics 101 “The Economics of Capital Formation and Investor Returns” Graduate Curriculum Masters in Business Administration in Monthly Dividends (The MDU MBA) Page 23 Strategy 501 Page 35 Accounting 502 1 R E A LT Y I N C O M E P SYC H 1 0 1 “THE PSYCHOLOGY OF INVESTING FOR INCOME” BY VISITING STUDENT, MONTHLY DIVIDEND GIRL That’s not to say that there’s anything wrong with other investment styles, just as there’s nothing wrong with playing different sports. At different points in life we may have approached investing differently, just as we might have played different sports from the ones we play now. Right now we may find we’re at the point where we want to use our portfolio to produce a “retirement paycheck” to fund our income needs, to provide income while we pursue a new career, or replace salaried income while we engage in a wide variety of activi- ties. As such, it may be the time when we’re ready to become an income investor. Achieving the goals of the various investment styles requires a certain discipline. So, what are the goals of each of these investment strategies? Let’s run through growth and total return investing for a minute before focusing our atten- Thank you for attending Psychology 101 today. Class, here’s an tion on the subject of this class, which is the psychology of important question. What is the difference between investing for income investing. income and investing for other objectives? The simple answer is Investing for growth can be defined as “An investment that people who invest for income tend to want to own companies strategy to increase capital by buying stocks that an investor that pay dependable dividends, or to own bonds issued by thinks will go up in price.” Investing for growth can generally companies or government entities that pay interest. But the be simplified to the following: reality is, not only does the payment of income to investors set investing for income apart from other investing styles, it is • Buy low • Sell high the absolute need for income by these investors, to fund the • Buy and sell things you think will go up activities of their daily life, that truly differentiates them. • Make a lot of money to do something with later in life. “Investing for income” is where people get to when they have Investing for total return can be defined as “An investment spent enough time “paying their investment portfolio” and now strategy that seeks a return on investment that includes need “their investment portfolio to pay them!” income from interest or dividends as well as appreciation or By definition, income investors desire a cash return depreciation in the price of a security over a given period of rather than growth and a high dependable yield rather than an time.” Investing for total return can generally be simplified overall total return. Income investing is as different from to the following: growth or total return investing as baseball is different from tennis or golf. In all of these sports the idea is to get a ball • Buy Low • Sell High somewhere and win the game. In investing, the idea is to allo- • Get a little income while you are doing it cate capital carefully in order to achieve a certain objective. • Accumulate money to do something with later in life. In both cases, it is very important to know which game you are By contrast then, investing for income can be defined playing and then to effectively pursue a strategy that will as “An investment strategy which emphasizes current income allow you to win that game. Well, you get the idea. Income in the form of dividends from stocks or interest payments investors are just playing a different game, with different rules from bonds, rather than emphasizing growth.” Investing for than other investors. income could then be simplified to the following: R E A LT Y I N C O M E 2 • Buy investments that pay dependable income • Use the income to fund our current lifestyle • Receive income that increases over time • Hold these investments as long as they pay increasing income. As you can see, these are three very different invest- investors we understand that cashing in on that price appreci- ment styles and sets of goals. In the case of income investing, ation not only ends the dividend income stream we rely on, but we’re likely to hold our investments for a very long time. With also invites the tax man to the table. This is an unwelcome growth and total return investing, we must pay careful attention event that takes money out of our pockets and so the fact that to when we buy and sell so that we accumulate money to do the stock price has gone up tends to be irrelevant to us something else with later in life. because we own the stock for the increasing income it pro- As income investors, when the goal is to receive income vides over a prolonged period of time. In other words, we know for life, we will probably want the company providing the to stick to our game plan and stay with the program. income to, not only be in business for the foreseeable future, This is rather like the dairy farmer who owns a milk cow but to conduct their business in a manner that gives us a rel- that he hopes will produce milk for many years to come. He’s atively high degree of confidence in the dependability of the unlikely to be very concerned with what the price of beef is income being paid. We might tend to look for stable busi- doing after he buys his cow, since he’s in the business of nesses, generating dependable earnings, from which they producing milk from the cow he owns. The dairy farmer also can pay regular dividends or interest payments over a pro- knows he would just have to go out and buy another cow to longed period of time. Such performance is more likely to produce the milk he needs if he sold his milk cow. As income offer the stability and low degree of volatility that is important investors we are all like the dairy farmer because we’re in the to us as investors who rely on our investment income to fund business of keeping our cows and drinking the milk, rather our current activities. than turning our cows into hamburger! We also might tend to prefer receiving stock dividends So does this mean that income investing is a better over fixed interest payments. Dividends have the ability to investment strategy than any other. Not necessarily. It’s just grow and keep up with inflation in comparison to fixed interest different and whether or not we pursue an income strategy payments, which tend to remain constant through the life of depends on our needs. Again, we need to consider where we the investment. We would also, generally, prefer an income are in life, the risks we want to take and what we want to stream that consistently grows over time, because the longer achieve with the money we have to invest. It’s also important we hold our investment, the more money we receive. to understand that investing for income is fundamentally And most importantly, we also should understand that it different from investing for all other objectives. will take a certain amount of discipline to stick with our The secret to passing this class and investing wisely (Time investment choice. The investment landscape is filled with to take notes, Class) is to be able to identify which game you’re opinions, ideas and suggestions that can tempt us to go off playing, what the goals of that game are and to demonstrate our “game”. It may sometimes be tempting to follow the idea how well you achieve these goals. Here at good old Monthly or investment fad of the week, particularly if we’ve not only Dividend University (MDU) the answer is, of course, that we enjoyed steady dividends, but we’ve also seen our principal are all income investors, and monthly income investors to boot. increase over the years. But since we’re disciplined income Remember that and you’re sure to get an A+ on your final. (Disclosure: Monthly Dividend Girl is a visiting student who is also a shareholder of and head cheerleader for Realty Income.) 3 R E A LT Y I N C O M E M A T H 1 0 1 “THE MAGIC OF YIELD ON COST” BY PROFESSOR TOM A. LEWIS Welcome Class. I’m pleased that you’re here and interested in meet their income and financial goals once their earning learning about something that, I believe, is the “holy grail” of years are over. income investing. You’ve already learned the rules and psychol- “OK then, Investing for Income is for me” you might say. ogy of income investing, but now we need to get to the “Magic” But, how exactly can we measure the ongoing success of our of how to manage your investments so that you can obtain income investments. The answer is, of course, we measure investment income that lasts as long as you need it to last. success differently than how growth and total return investors The secret is in how we analyze our income investments. measure success in their portfolios. For income investors, Conventional financial advice has historically been to put measuring success involves the use of a great income investing together a portfolio that involves some income combined with metric. When this “Magic” metric is used in combination with a gradual drawing down of one’s principal. All of this is pred- a long-term outlook and a conservative orientation, we have a icated on an estimate as to how long one plans to live and how better chance of accurately measuring our results and obtain- much the cost of living will increase. ing the increasing income we need over time. Many Realty Building a retirement portfolio in this way can be fraught Income investors have achieved investment success by apply- with complications. Attempting to predict how long we’ll be ing this “holy grail” of income investing—Yield on Cost—in retired or what the cost of maintaining our style of living will measuring their investment results. be is difficult at best, particularly since people are living The formula for calculating Yield on Cost is relatively much longer than ever before. There is also the constant mon- simple. Divide your current annual dividend by the original itoring of the portfolio, making adjustments as needed, worry- cost you paid for your shares of stock and the result is your ing over such moves and paying the costs associated with Yield on Cost. For those of you who took basic algebra in high them. Add to this the tax ramifications of trading and it is school the formula would be: not surprising that a number of investors are challenged to “I suspect that many more investors will become shareholders of Realty Income once the Baby Boomers begin to look for more secure avenues of depositing their capital. Annuities are sound, but they yield too little for someone trying to fight inflation. Realty Income offers some- thing wonderful by means of dividends. Take the $1.11 dividend back in 2000 yielding about 11%. Now that old money is yielding 13.95% today, something no annuity or money market fund could come close to touching.” Michael Whitten 2nd Lieutenant, U.S. Army, (stationed in Germany), Shareholder and Yield on Cost Expert Current Annualized Dividend __________________________ = Yield on Cost Original Cost Per Share Pretty simple, huh? What this metric tells us, on any given day, is what our dividend yield is today on our original investment. As owners of Realty Income, for example, the dividend has been regularly increased over the past eleven years, so our income (and Yield on Cost) has continued to increase over time. This means that $10,000 invested in Realty Income shares in 1994, at $8.56 per share, today has a Yield on Cost of 16.3%, based on a current annualized dividend per share amount of $1.395. So, if we use our formula for Yield on Cost, our calculation would be: $1.395 (Our current annualized dividend) __________________________ = 16.3% (current yield $8.56 share price at 12/31/94 on cost for shares purchased in 1994) R E A LT Y I N C O M E 4 E X A M P L E : The chart above demonstrates the Yield on Cost based If the Yield on Cost has continually increased over the life of our on various dates of purchase and gives us an idea of what our investment, there is very little reason for us to sell our shares. yield on cost might be. But, more importantly, it demonstrates With this simple calculation we can easily determine how that the longer one owns shares of a company, where divi- well our income investments have performed for us when the dends are regularly increased, the yield on one’s original temptation arises to sell our source of dependable income. investment actually accelerates, over time. What a great way to measure the success of our invest- This leads us to a critical investment principle of holding ments! This is particularly true for an investor whose primary an income investment for the long-term. As long as the objective is to receive increasing dividend income over a long company continues to be a reliable producer of increasing period of time! income and maintains a conservative, long-term perspective, A new income investment paradigm, therefore, is to find the ideal would be to hold such an investment forever. investments that pay high quality, increasing income, and keep The lesson here is that, since our objective is to obtain them as long as they continue to produce a rising yield on cost increasing income over time, our best measure of success in over time. Once you’ve “got” this lesson, you’ll not only receive achieving this objective is to calculate our current Yield on Cost, an A in the class, but you’ll also be able to build and maintain for a specific investment, to see how it has increased over time. an income portfolio that is designed to last a lifetime. (Disclosure: Professor Lewis serves as adjunct professor in Math at MDU and moonlights as Realty Income’s Chief Executive Officer.) 5 R E A LT Y I N C O M E PH I LO S O PHY 1 0 1 “THE PHILOSOPHY OF THE MONTHLY DIVIDEND COMPANY®” BY PROFESSOR GARY M. MALINO Welcome to class, students. 20-year, net-lease agreements, where the retailer generally Today’s subject is the philoso- pays the property taxes, maintenance costs and property phy of The Monthly Dividend Company®. The faculty of insurance payments, as well as a monthly rental payment to Realty Income. This rental revenue has been a reliable gen- Monthly Dividend University erator of cash to pay monthly dividends to the Company’s strongly believe that a well shareholders over a long period of time. thought-out philosophy, which a company uses to guide its A second important point is the conservative operating focus of The Monthly Dividend Company®. Since the Company activities and operations, is was founded, it has never carried a mortgage on any of critical to its long-term success. I believe that The Monthly Dividend Company® is one of many such companies that the properties that it owns. In addition, Realty Income also focuses on maintaining a conservative balance sheet, prefer- operate their business in a manner consistent with their overall ring to fund most of its real estate acquisitions by issuing philosophy and this is one of the key reasons Realty Income additional shares of common stock. Keeping the amount of has been successful for many years. debt the Company carries at a modest amount, along with The philosophy of The Monthly Dividend Company® is, controlling operating expenses, frees up the majority of Realty quite simply, to provide all of its shareholders with increasing Income’s rental revenue for the payment of monthly dividends monthly dividends every month, year after year, for the rest to its shareholders. of their lives. This philosophy, simple as it may sound, colors The success of this methodology is demonstrated by the every decision the Company makes, dollar it spends, its payment of over 425 monthly dividends since the Company’s management discussions, and all of the employee’s activities founding in 1969, combined with 37 dividend increases since undertaken each day at Realty Income. Since the guiding the Company went public in 1994. This consistent record of principle of the Company is to provide income-focused dividend payments and increases earned Realty Income a investors with a check every month for the rest of their lives, the responsibility to act prudently and appropriately to accomplish this mission is the absolute priority for Realty Income employees. That being said, how does Realty Income go about achieving the objectives that result from this philosophy? The Company’s strategy of owning a sizable portfolio of properties, operated under long-term lease agreements with large retail chains, is the means to continuing to provide monthly dividends. These properties are leased to a large number of retail chains under 15- to R E A LT Y I N C O M E 6 spot in Mergent Inc.’s, Dividend Achiever Handbook in 2005 should know the Company is run specifically to meet the needs (Mergent’s Dividend Achiever is a guidebook that identifies of income-oriented investors. companies that have increased their annual dividend pay- Given all of this, how does the “faculty” of MDU view ments for ten or more consecutive years.) The Company is one their investment in Realty Income? of just 313 public companies that qualified for inclusion in We enjoy owning shares of Realty Income because it this prestigious guide to dividend-paying stocks, out of approx- provides us with increasing, spendable income that we look imately 10,000 plus North American-listed, dividend-paying forward to receiving for the rest of our lives. The shares that common stocks. In fact, Mergent also ranked Realty Income in we own are, generally, a large portion of our total assets and the top 50 for compound annual dividend growth. so we depend on this income to support our families. With Realty Income’s consistent operating strategy and dividend- that said, there is risk in any investment and we recommend paying track record is the day-to-day result of a philosophy that all shareholders (including MDU’s faculty and Realty rigorously applied. Since the philosophy of providing depend- Income’s management team) remain diversified and have a able monthly dividends is at the center of the Company’s wide variety of investments to generate the income they need. activities, a certain “point of view” is present at all times. We must also make sure that each of the companies we This point of view mandates that Company employees and depend upon to generate our income have an overriding phi- managers understand and place the needs of income losophy that supports the payment of dividends and that their investors ahead of all other considerations. This also means strategy and activities match our income needs. that, because the Company is focused on providing dependable That’s it for today’s lecture. Thanks for coming to class! monthly income over a prolonged period of time, it does not do other things that may temporarily be popular in the investment world but could distract them from their core mission. This philosophy also tends to keep Realty Income from focusing on activities that might boost short-term growth prospects at the expense of the Company’s long-term objectives. Because of this focus, owning shares of The Monthly Dividend Company® may not be for everyone. Students and investors should understand that Realty Income is an income investment and, therefore, pursues the goals and plays by the rules of income investing. Other types of investors, such as growth and total return investors, have much different goals than income investors. While shareholders, with verifying investment styles, can own Realty Income shares, they (Disclosure: Professor Malino is Chairperson of MDU’s Harley Davidson Club (“Lord help us!”) as well as President and Chief Operating Officer of Realty Income.) 7 R E A LT Y I N C O M E H I S T O RY 1 0 1 For the Years Ended December 31, 2005 2004 2003 Total revenue(1) Net income available to common stockholders Funds from operations (“FFO”)(2) Dividends paid to common stockholders Special dividend paid(3) AT Y E A R E N D Real estate at cost, before $ 197,733,000 $ 177,606,000 $ 150,370,000 89,716,000 129,647,000 90,168,000 118,181,000 76,722,000 103,366,000 108,575,000 97,420,000 83,842,000 accumulated depreciation(4) $ 2,096,156,000 $ 1,691,283,000 $ 1,533,182,000 1,646 13,448,600 156 1,533 11,986,100 194 1,404 11,350,800 302 $ 486,553,000 $ 215,314,000 $ 371,642,000 Number of properties Gross leasable square feet Properties acquired(5) Acquisition cost(5) Properties sold Number of retail industries Number of states Portfolio occupancy rate Remaining weighted average lease term in years P E R C O M M O N S H A R E D ATA(6) Net income (diluted) $ Funds from operations (“FFO”) Dividends paid Special dividend Annualized dividend amount(7) 23 29 48 98.5% 12.4 1.12 1.62 1.346 1.395 43 30 48 97.9% 12.0 1.15 1.50 1.241 1.32 $ Common shares outstanding 83,696,647 79,301,630 I N V E S T M E N T R E S U LT S Closing price on December 31, $ 21.62 $ Dividend yield (8)(9)(10) Total return to stockholder (10)(11) 5.3% -9.2% 25.29 6.2% 32.7% 35 28 48 98.1% 11.8 1.08 1.45 1.181 1.20 75,818,172 20.00 6.7% 21.0% $ $ (1) Total revenue includes amounts reclassified to income from discontinued operations, but excludes revenue from Crest Net Lease, a subsidiary of Realty Income. (2) Refer to Management’s Discussion and Analysis for FFO definition and reconciliation to net income available to common stockholders. (3) The 1994 special dividend reflects the final partnership distributions. (4) Does not include properties held for sale. (5) Includes properties acquired by Realty Income and Crest Net Lease. (6) All share and per share amounts reflect the 2-for-1 stock split on December 31, 2004. (7) Annualized dividend amount reflects the December declared dividend rate per share multiplied by twelve. R E A LT Y I N C O M E 8 2002 2001 2000 1999 1998 $ 137,600,000 $ 121,081,000 $ 116,310,000 $ 104,510,000 $ 85,132,000 68,954,000 93,539,000 57,846,000 76,378,000 45,076,000 67,239,000 41,012,000 65,917,000 41,304,000 62,799,000 78,042,000 64,871,000 58,262,000 55,925,000 52,301,000 $ 1,285,900,000 $ 1,178,162,000 $ 1,073,527,000 $ 1,017,252,000 $ 889,835,000 1,197 9,997,700 111 1,124 9,663,000 117 1,068 9,013,200 22 1,076 8,648,000 110 970 7,824,100 149 $ 139,433,000 $ 156,472,000 $ 98,559,000 $ 181,376,000 $ 193,436,000 35 26 48 97.7% 10.9 1.01 1.38 1.151 1.17 69,749,654 17.50 7.8% 26.9% $ $ $ $ 35 25 48 98.2% 10.4 0.99 1.30 1.121 1.14 21 24 46 97.7% 9.8 0.84 1.26 1.091 1.11 3 24 45 98.4% 10.7 0.76 1.23 1.043 1.08 5 22 45 99.5% 10.2 0.78 1.18 0.983 1.02 $ $ $ 65,658,222 53,127,038 53,644,328 53,634,206 14.70 9.0% 27.2% $ 12.4375 $ 10.3125 $ 12.4375 10.6% 31.2% 8.4% –8.7% 7.7% 5.5% (8) Dividend yield was calculated by dividing the dividend paid per share during the year by the closing share price on December 31 of the previous year. (9) Dividend yield excludes special dividends. (10)The 1994 dividend yield is based on the annualized dividends for the period from August 15, 1994 (the date of the consolidation of the predecessors to the Company) to December 31, 1994. The 1994 total return is based on the price change from the closing on October 18, 1994 (the Company’s first day of trading) to December 31, 1994 plus the annualized dividend yield. (11)Total return was calculated by dividing the net change in the share price during the year plus the dividends paid per share during the year by the closing share price on December 31 of the preceding year. 9 R E A LT Y I N C O M E 1997 1996 1995 1994 $ 67,897,000 $ 56,957,000 $ 51,555,000 $ 48,863,000 34,770,000 52,188,000 44,367,000 32,223,000 47,139,000 42,794,000 5,285,000 25,600,000 40,414,000 36,710,000 15,224,000 39,050,000 38,816,000 5,850,000 $ 699,797,000 $ 564,540,000 $ 515,426,000 $ 450,703,000 826 6,302,300 96 740 5,226,700 62 685 4,673,700 58 630 4,064,800 4 $ 142,287,000 $ 55,517,000 $ 65,393,000 $ 3,273,000 10 14 43 99.2% 9.8 0.74 1.11 0.946 0.96 $ 7 8 42 99.1% 9.5 0.70 1.04 0.931 .23 0.95 $ 3 7 42 99.3% 9.2 0.63 1.00 0.913 0.93 $ 5 5 41 99.4% 9.5 0.39 0.98 0.300 0.90 $ 51,396,928 45,959,074 45,952,474 39,004,182 $ 12.719 $ 11.9375 $ 11.25 $ 8.5625 7.9% 14.5% 8.3% 15.4% 10.7% 42.0% 9.9% 28.5% 1 0 R E A LT Y I N C O M E H I S T O R Y 1 0 2 “THE HISTORY OF THE MONTHLY DIVIDEND COMPANY®” BY PROFESSOR TERE H. MILLER Realty Income, also known as The Monthly Dividend Company®, was founded in 1969 by William and Joan Clark. The Company was originally formed to invest in high quality, commercial properties, leased to regional and national retail chains, under long-term leases that produced monthly rental income. The founding ideology, then, was to “preserve capital and to pro- duce monthly income” by owning these type of properties. For approximately 25 years, between 1969 and 1994, investors received regular monthly distributions from Realty • The Company increased revenues more than 305%, Income’s investment programs. Then, in August 1994, Realty from $49 million in 1994 to over $197 million as of the Income merged 25 programs into one entity, which began end of 2005. trading on the New York Stock Exchange in October of that Realty Income has enjoyed a relationship with many same year. shareholders who have owned shares since the early days of Since that time investors have continued to receive a the Company’s operations, as well as new income-oriented monthly dividend check from Realty Income. As you can see, shareholders who have been attracted to the Company’s not much has changed in 37 years. Realty Income has conservative track record and consistent monthly dividend. continued to pay monthly dividends and still focuses on the This loyal shareholder base continues to benefit from a strategy ongoing needs of income-oriented investors. And these divi- that has proved to be resilient throughout a variety of economic dends continue to be supported by the income generated conditions over the years. They’ve weathered everything from from retail properties that offer goods and services meeting high inflation to low inflation, recession to double digit “basic human needs.” economic growth, high interest rates to low interest rates and In 2005, Realty Income celebrated over One Billion high unemployment to strong employment. Through it all, year- Dollars in cash dividends paid and 11 very successful years of after year, the monthly check they rely on has been in the mail. trading on the New York Stock Exchange. The Company continues its successful operations, maintaining a legacy of conservative management and a focus on generating depend- able monthly income. Let’s take a look at the Company’s progress over the past eleven years: • Since 1994, the Company has, on average, raised the dividend approximately 5% every year and has grown the annualized dividend amount from $0.90 per share to $1.395 per share, an increase of 55%. • As of December 31, 2005 Realty Income has paid a total of $1.1 billion in dividends. • The size of the Company’s real estate portfolio, at cost, has grown from $451 million in 1994 to $2.1 billion today. • The number of retail properties owned has grown from 630 to 1,646. (Disclosure: Professor Miller heads up MDU’s annual walk-a-thon and serves as Vice President of Corporate Communications and Investor Relations of Realty Income.) 1 1 R E A LT Y I N C O M E M O D E R N H I ST O RY 1 0 1 B 2005 REVIEW (THE SHORT VERSION) GENERAL COMMENT: Another good year for the operations of The Monthly Dividend Company® FINANCIAL PERFORMANCE: • Revenue increased 13.2% to $196.7 million • FFO per share increased 8.0% to $1.62 DIVIDEND UPDATE: SHARE PRICE PERFORMANCE: RETURNS TO SHAREHOLDERS: • Paid 12 monthly dividends • Increased the dividend 5 times • Paid 425 consecutive monthly dividends since 1970 12/31/04 closing price: $25.29 12/31/05 closing price: $21.62 14.5% decrease Dividend yield of 5.3% Share price decrease of 14.5% Total return of -9.2% for 2005 TOTAL MARKET CAPITALIZATION: $2.8 billion on 12/31/05 BALANCE SHEET: Very strong PROPERTY MORTGAGE DEBT: Zero ($0) REAL ESTATE PORTFOLIO: 1,646 retail properties leased to 101 retailers in 29 retail categories located throughout 48 states PORTFOLIO OCCUPANCY: 98.5% on 12/31/05 PROPERTY ACQUISITIONS: 156 properties for $486.6 million Initial average lease term of 15.8 years R E A LT Y I N C O M E 1 2 O B J E C T I V E S E T T I N G 1 0 1 2006 BUSINESS PLAN * — PAY 12 MONTHLY DIVIDENDS — RAISE THE DIVIDEND — MAINTAIN A CONSERVATIVE BALANCE SHEET — MAINTAIN HIGH PORTFOLIO OCCUPANCY — ACQUIRE ADDITIONAL PROPERTIES — TELL MORE PEOPLE ABOUT THE MONTHLY DIVIDEND COMPANY® — REMAIN CONSERVATIVE * THIS BUSINESS PLAN WILL LOOK FAMILIAR TO MDU ALUMNI 1 3 R E A LT Y I N C O M E A C C O U N T I N G 1 0 1 REALTY INCOME’S 2005 OPERATING RESULTS AND FINANCIAL PERFORMANCE BY PROFESSOR MICHAEL R. PFEIFFER Realty Income’s senior management team is pleased to report also considered to be a good indicator of a company’s ability another successful and profitable year for the operations of The Monthly Dividend Company®. In fact, in many ways 2005 to pay dividends. A reconciliation of net income available to common shareholders to FFO per common share, is included in was the best year in the history of the Company. During the Management’s Discussion and Analysis of Financial Condition year, the Company enjoyed success in all areas of its business and Results of Operations on page 60. operations including, strong overall property portfolio perform- Net income available to common shareholders, as of ance, outstanding access to capital at attractive rates, as well December 31, 2005, was $89.7 million as compared to as a record number of property acquisitions, the highest in $90.2 million in 2004. On a diluted per common share basis, the history of the Company. As a result, Realty Income also net income was $1.12 per share in 2005 as compared to ended the year with record revenue, funds from operations $1.15 per share in 2004. (The calculation to determine net (FFO) and dividends. Revenue growth is an important objective of the Company because it is crucial to Realty Income’s ability to increase FFO and dividends. During 2005, revenue increased 13.2% to $196.7 million, as compared to $173.7 million during 2004. This revenue growth is primarily attributable to the high level of property acquisitions achieved in both 2004 and 2005. As of December 31, 2005, Realty Income and its Crest Net Lease subsidiary had acquired 156 new properties for $486.6 million. Realty Income invested $430.7 million in 135 properties, to be held for long-term investment in the Company’s core portfolio, income for a real estate company includes gains from the sales of investment properties and impairments. The amount of gains from property sales and impairments vary from year to year according to the timing of prop- erty sales. This variance can significantly impact net income.) Realty Income’s subsidiary company, Crest Net Lease, Inc., also contributed to Realty Income’s earnings growth during 2005. Crest was formed to capitalize on the oppor- tunities to acquire and sell retail properties for while Crest Net Lease acquired 21 properties for $55.9 million a profit. Crest’s primary purpose, however, has been to enable and these properties were marketed for resale. Realty Income’s Realty Income to complete the acquisition of large portfolios properties are located in 28 states, have an initial average lease of properties and then provide the vehicle to subsequently sell rate of 8.4% and an initial average lease term of 15.6 years. the properties that the Company does not plan to hold. While As a result of higher than average acquisition activity, FFO Crest has been successful in assisting Realty Income in its available to common shareholders also increased 9.6% to acquisition efforts, Crest has also added each year to Realty $129.6 million, as compared to $118.2 million during 2004. Income’s profitability. During 2005, Crest generated $2.8 million, On a diluted per common share basis, FFO increased 8.0% to or $0.03 per share, in FFO for Realty Income, in comparison $1.62 per share, as compared to $1.50 per share for 2004. to $7.8 million, or $0.10 per share, in FFO for Realty Income FFO is a common measurement for a real estate investment in 2004. At December 31, 2005 Crest held inventory of trust, or REIT. It is an alternative non-GAAP measure that is $45.7 million in 17 properties being marketed for sale. R E A LT Y I N C O M E 1 4 The Company continued to enjoy consistent performance The ongoing solid operating and financial performance of on the 1,646 properties that comprise Realty Income’s retail Realty Income has made possible the payment of 425 consec- real estate portfolio. Occupancy remained strong throughout utive dividends since 1969, 33 quarterly dividend increases 2005 and was 98.5% on December 31, 2005. During 37 years and a total of 37 increases in the amount of the monthly of operations, and through varying economic situations, the dividend since 1994. In addition, the amount of the annualized Company’s occupancy level at the end of each year has never dividend has increased from $0.90 per share in 1994 to $1.395 fallen below 97%. Such performance speaks to Realty per share, as of December 31, 2005, an increase of 55%. Income’s focus on acquiring properties where retailers provide Shareholders also received $1.34625 in dividends paid during basic human needs goods and services that consumers use every day. 2005 for a yield of 5.3% based on the closing share price of $25.29 on December 31, 2004. (Disclosure: Professor Pfeiffer coaches MDU’s swim team and also writes voluminous legal documents as Realty Income’s Executive Vice President, General Counsel and Secretary.) (1) Total revenue includes amounts reclassified to income from discontinued operations, but excludes revenue from Crest Net Lease. 1 5 R E A LT Y I N C O M E R E A L E S T A T E 1 0 1 “IDENTIFYING AND ACQUIRING RETAIL PROPERTIES” BY PROFESSOR KIM KUNDRAK investment criteria of Realty Income. This effort requires the ability to anticipate when certain retail industries require financing, to understand the financial requirements of various retail industries, and a thorough knowledge of the retailer’s operations and real estate. Over the years Realty Income has worked with a number of industries at opportune times, such as fast food restaurants in the 1970’s, child daycare in the 1980’s, the convenience store industry in the 1990’s, to mention just a few. Uncovering such opportunities continues to be a focus of the Company’s efforts. However, over the past few years, an environment of increased competition and decreasing lease yields has demanded greater emphasis on utilizing Realty Income’s size and cost-of-capital advantages, as well as its transaction expertise, in order to maintain the Company’s leadership in the sale-leaseback financing arena. The Company has also had to continually generate new strategies for acquiring properties and research additional When an investor purchases retail real estate for income, that industries to remain agile and successful in its acquisitions investor needs to ascertain both the feasibility of the property efforts. Realty Income’s acquisition officers are the driving as a retail location, as well as the financial and operational force in developing the Company’s new business. Seven real health of the prospective retail chain that will occupy the prop- estate and finance executives call on various, strategically erty. This analysis provides the individual real estate investor identified, retail chains and other entities to generate invest- with the confidence that lease payments will be made as ment opportunities throughout the year. Each of these pro- agreed. For a large real estate investment company like Realty fessionals is assigned either an area of the country for which Income, dedicated to providing dependable monthly income for they are responsible, or a particular industry segment in thousands of investors, this scrutiny is of the utmost impor- which they develop specific expertise. In all cases, these tance for long-term success. It is worth spending some class calling officers are the eyes and ears of the Company and the time to discuss how Realty Income identifies and analyzes retail first line of inquiry and information relative to generating real estate that will be a reliable generator of income. transactions for Realty Income. Acquiring quality retail properties begins with the Identifying new industries and retailers with whom to do Company’s ability to uncover a large number of potentially business every year is just one aspect of remaining competitive viable transactions from which it can select the properties it and supporting the Company’s ability to grow the real estate wishes to purchase. Finding these opportunities is a key component to Realty Income’s ability to continue to increase the size of the Company’s real estate portfolio and the rental revenue it generates. This process involves a tremendous amount of activity that focuses on identifying which retail industries will require capital over the coming years and, as such, wish to sell their properties in order to acquire that capital. Another activity involves identifying attractive retail chains, in select industries, that own the type of real estate the Company would like to purchase. And finally, Realty Income works with prospective retail chains to structure potential transactions that fit both the needs of the retailer and the R E A LT Y I N C O M E 1 6 portfolio. Assessing the feasibility of prospective properties is $430.7 million in 135 properties to be held for long-term the other critical function. Realty Income’s real estate investment in the Company’s core portfolio. These properties research group does the footwork, performing individual site are located in 28 states, have an initial average lease rate of and demographic analysis, assessing traffic flows, monitoring 8.4% and an initial average lease term of 15.6 years. They competitive operations and meeting with local market experts are leased to 13 different retail chains in seven retail indus- for every single property that the Company plans to purchase. tries. Crest Net Lease acquired 21 properties for $55.9 million Realty Income’s retail research group provides the com- and these properties were marketed for resale. These acqui- petitive, operational and financial review of prospective retail sitions contributed to increased lease revenue that generat- tenants. Since the Company is relying on these retailers to ed FFO per share growth during 2005. occupy its properties and pay rent for 15 to 20 years, selecting Realty Income usually counsels investors that this level of the right retail industries and chains is crucial. The retail acquisition activity is not something to be taken for granted. research group follows economic and industry trends on over The fact that the Company had a record year in 2005 does 29 different retail industries and scrutinizes operations of all not necessarily establish a trend that can be extrapolated into 101 retail chains in the Company’s current investment portfolio. the future. The environment for net-lease retail properties has They also meet with the man- agement of retail chains the Company is considering, assess their business plans, review their competitive position in the marketplace and make recommendations regarding the suitability of a particular industry or retail chain for the Company’s portfolio. The research assembled by both the real estate and retail become increasingly competi- tive over the years and the Company projects that this sit- uation is likely to continue into the foreseeable future. Additionally, in any given year it is the Company’s objective to buy ONLY the properties that meet its investment criteria and are considered suitable to generate long-term rental revenue from which to pay research group, combined with the acquisition prospects dividends. As such, acquisition volumes will vary considerably uncovered by the acquisitions team, provide the potential from year to year, depending on the ability of the Company investment packages for Realty Income’s Investment to find and acquire the properties that meet its stringent Committee to consider. The Investment Committee consists of investment requirements. the four senior executive officers of the Company. This With that said, however, Realty Income has been very active Committee meets one or more days each week to analyze in working with large companies that are in the process of every investment opportunity that has gone through the due acquiring other retailers, pursuing other growth initiatives, recap- diligence process. In 2005, the Investment Committee reviewed italizations, balance sheet restructurings or other financial about $2.8 billion in potential real estate acquisitions involving events where Realty Income’s acquisition of properties, to over 1,700 properties. This was not only the highest volume generate capital for the retailers, can be useful. The Company’s of potential transactions ever reviewed by the Company, but ability to purchase large portfolios of properties within a spe- this activity ultimately led to a record year for Realty Income’s cific time frame is a vital competitive advantage in these portfolio acquisitions department. types of transactions. So too is Realty Income’s 37 years of During 2005, Realty Income and its Crest Net Lease experience in sale-leaseback financing, its sizable resources, subsidiary acquired 156 properties for $486.6 million. Of access to capital and experienced management team that the 156 properties purchased, Realty Income invested seeks to add value to every transaction for its retail customers. (Disclosure: Professor Kundrak plays on MDU’s faculty basketball team and serves as Senior Vice President, Portfolio Acquisitions for Realty Income.) 1 7 R E A LT Y I N C O M E S C I E N C E 1 0 1 “THE SCIENCE OF PORTFOLIO MANAGEMENT” BY PROFESSOR RICHARD COLLINS their 15- to 20-year contractual lease agreements. The Company has always called this a fairly “simple concept.” Behind the scenes, however, there is a great deal that must be done to ensure that the Company’s portfolio of 1,646 properties continues to perform as desired. After all, the objective is for Realty Income to receive lease payments every month so that it can then pay dividends each month to its shareholders for a long period of time. There are several aspects to consistent portfolio performance that support the payment of monthly dividends. Effectively managing the portfolio, so that occupancy remains high, is one factor. Fortunately, Realty Income has enjoyed more than 97% occupancy throughout its 37 years of opera- tions. As of December 31, 2005, portfolio occu- pancy was 98.5% and there were just 25 proper- ties available for lease out of 1,646 properties in the portfolio. Diversification across 29 retail industries, 101 retail chains, and across 48 states is one reason why the Company has been able to maintain such high occupancy. Another reason is the Company’s focus on acquiring properties from retailers who provide basic human needs goods and services that consumers use every day. Both of these factors contribute to stable portfolio operations as well as to the safety of the dividend. What is the “Science of Portfolio Management”? At first A vital component to sustaining strong portfolio perform- glance, managing a net-leased property portfolio appears ance and high occupancy is retail research. The importance fairly straightforward. When a net-lease agreement is com- of such research cannot be overstated. Realty Income’s portfo- bined with a solid tenant, the result is a reliable income lio management team, as good as they are, are not magicians. stream, rather like combining hydrogen and oxygen to form They can’t turn a challenging retail tenant into a good performing water. Theoretically then, owning a portfolio of net-leased tenant, no matter how diligent they are. Thus, the foundation for properties is a simple proposition, right? ongoing solid portfolio operations is to purchase good properties To the extent that Realty Income’s properties and tenants with sound tenants in the first place. The retail research group have passed a rigorous due diligence process, the Company at Realty Income follows economic and industry trends on over enjoys a certain degree of confidence that its tenants will meet 29 different retail industries and scrutinizes operations of all R E A LT Y I N C O M E 1 8 PORTFOLIO OCCUPANCY 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 98.5% 97.9% 98.1% 97.7% 98.2% 97.7% 98.4% 99.5% 99.2% 99.1% 99.3% 99.4% As of December 31 options. The markets where Realty Income owns properties with leases scheduled to expire are also closely monitored to gauge whether or not it would be better to re-lease a property to the same tenant, to a new tenant or to sell a property when the lease expires. This proactive management contributed to the successful administration of 105 lease expirations dur- ing 2005. In addition, in 2005, same store rent increases for Realty Income’s portfolio were 0.8%. As proficient as Realty Income has been in keeping portfolio occupancy strong over the years, the Company has, once again, been fortunate that its retailers performed well during another year of economic uncertainty. As always, Realty Income’s man- agement stresses that there is the possibility that a tenant, no 101 retail chains in the Company’s portfolio. This research matter how strong or recession-proof it may seem to be, could team continuously monitors tenant financial health and pro- face unexpected financial difficulties and struggle to pay rent. vides the Company with the regular, in-depth, tenant financial This has happened in the past and will likely occur again in the analysis that is required to ensure the consistent payment of future. Realty Income views this as “business as usual” and rent every month. handles such events as routine occurrences when owning a Another important aspect of managing the Company’s large portfolio of properties. With 37 years of portfolio man- real estate assets is to know if a particular property should be agement experience behind them, however, Realty Income’s sold. This is not only a strategic option during investment per- management team has the know-how and resilience to work formance analysis, but it is also another source of capital for through a variety of economic challenges that may arise. the Company. Property sales occur when management believes sale proceeds can be reinvested at higher returns, the sale of a property enhances portfolio credit quality, or selling a property increases the average remaining lease term in the portfolio. During 2005, Realty Income sold 23 properties for $23.4 million, all of which met this criteria. The primary reason that the Company’s real estate portfolio has continued to perform well over the years, however, is the proactive management of the portfolio. Instead of waiting for a lease to expire to discover a retailer’s intentions, the portfolio management team enters into discussions, considerably in advance of the expiration date, to determine the Company’s (Disclosure: Professor Collins is coach of MDU’s racquetball squad and serves as Executive Vice President, Portfolio Management for Realty Income.) 1 9 R E A LT Y I N C O M E E C O N O M I C S 1 0 1 “THE ECONOMICS OF CAPITAL FORMATION AND INVESTOR RETURNS” BY PROFESSOR PAUL M. MEURER C A P I T A L F O R M A T I O N Realty Income uses its $300 million unsecured acquisi- tion credit facility, in the short term, to purchase properties so that the Company can efficiently acquire properties with no financing contingencies. The Company then permanently finances these acquisitions by issuing common or preferred stock or bonds and pays down the balance on its $300 mil- lion acquisition credit facility. The principle behind this pro- cedure is that permanently financing transactions on or soon after closing tends to minimize the amount of variable rate debt to which the Company is exposed. This strict, long-term Company policy has been instrumental in minimizing the impact rising interest rates might otherwise have had on Realty Income’s cash flow throughout its operating history. Another important point is that the Company owns all of its properties free and clear of property level encumbrances, i.e. without mortgages, so that more of the Company’s cash flow is available to pay dividends. During 2005, Realty Income took advantage of favorable market conditions to permanently fund its recent acquisitions. Since the Company was able to achieve attractive pricing for both its common stock and unsecured bonds, Realty Income found it advantageous to use both of these sources of capital The primary purpose of Realty Income’s capital markets during the year. activities is to permanently fund the Company’s new property Credit rating upgrades, received in 2003, facilitated the acquisitions. Since the growth of the Company’s real estate portfolio is a primary driver of growth in earnings and divi- dends, access to capital to fund new property acquisitions is critical to achieving that growth. And, assembling the most efficient capital structure, so that the company enjoys unin- terrupted access to cost-effective capital, is rather like select- advantageous pricing of a March 2005 offering of $100 mil- lion of 30-year, 5 7/8% unsecured bonds due in March 2035. Subsequently, a Fitch Ratings agency upgrade of Realty Income’s credit rating, in September 2005, was instrumental in attractively pricing a $175 million, 12-year, 5 3/8% unse- cured bond offering due in 2017. The Company’s senior unse- ing the right club to use when making an approach shot to the cured debt ratings from Fitch Ratings Credit Agency rose to green in golf. Too much club and you’ll overshoot the green, too little and you come up short, making it difficult to par the hole. For non-golfers, we’re talking about knowing how to use certain tools and understanding when to use them so that the desired outcome is achieved. Since the objective of a Company like Realty Income is to maintain the integrity of the cash flow used to pay dividends, a relatively conservative capital structure, in comparison to many other real estate companies, is what the Company strives for. Realty Income has a bias towards using common equity to fund acquisitions and carefully blends in other forms of capital to seek a balance between the best cost of capital and a conservative capital structure. Debt and preferred stock are generally used only when there are clear, cost-of-capital advantages. The bal- ance between different capital components is monitored at all times so that the Company’s conservative structure is maintained. R E A LT Y I N C O M E 2 0 BBB+ from BBB, and the Company’s preferred stock ratings decrease. Interestingly, strong performance in the Company’s increased to BBB from BBB–. operations every year may not correlate to the movement of Also in September 2005, Realty Income issued 4.1 million the stock price over the short term. For instance, since 1999 common shares priced at $23.79 per share raising gross pro- Realty Income’s annual Funds from Operations (FFO) per ceeds of approximately $97.5 million. The proceeds from all share growth rate was: 4.2% in 1999, 2.4% in 2000, 3.2% of these transactions were used to fund acquisitions and for in 2001, 6.2% in 2002, 5.1% in 2003, 3.4% in 2004 and other general corporate purposes. 8.0% in 2005. In comparison, the Company’s stock price per- The Company’s capital structure at the end of the year centage change in the same years has been: –17.9% in consisted of 64.0% in equity, 4.5% in preferred stock and 1999, 20.6% in 2000, 18.2% in 2001, 19.0% in 2002, 31.5% in debt (primarily long-term bonds.) According to 14.3% in 2003, 26.5% in 2004 and –14.5% in 2005. The certain research analysts, Realty Income ranks among the point is that over the long term Realty Income believes that top five in the real estate industry for balance sheet strength consistent increases in the Company’s operating perform- in comparison to all other REITs. Maintaining a conservative ance and dividends should lead to advances in the Company’s balance sheet is among Realty Income’s core operating share price over time. objectives. I N V E S T O R R E T U R N S To quote a well-known investor, Warren Buffett, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” In other words, if a company con- While the Company performed well, in terms of its capital mar- tinues to perform well over the long term, its share price kets activities, as well as all other facets of the Company’s should also tend to perform well over the long term. Thus, operations, unfortunately the price of its shares on the New short-term fluctuations, which oftentimes reflect emotional York Stock Exchange at the end of the year did not reflect the reactions to news or changes in investor sentiments tend to Company’s positive operating results. The Company’s closing even out if price performance is viewed over a longer period of price at the end of 2004 was $25.29 per share in comparison time. Since most shareholders generally own Realty Income to the closing stock price, as of December 31, 2005, of $21.62 in order to receive an increasing monthly dividend check, per share, a decrease of 14.5%. However, the dividends paid short-term stock price fluctuations are usually not a great con- increased 8.5% and shareholders received $1.34625 per cern, though it’s always more enjoyable to learn that the price share in dividends during 2005. went up rather than down for the year. When dividends paid are combined with the year-end For income investors, the most important information is share price, the total return for the year was –9.2%. This how much was paid in dividends during the year. Since divi- may be somewhat disappointing, but it’s important to realize dend increases continued throughout 2005, Realty Income’s that the Company believes there was no fundamental busi- annualized dividend amount per share has grown from $.90 per ness or operational cause for this moderate share price share in 1994 to $1.395 per share, as of December 31, 2005. YIELD COMPARISONS REALTY INCOME S&P 500 Dow Jones Industrial Dow Jones Utility Index 10-Year Treasury 1-Year CD As of December 31, 2005 6.50% 1.86% 2.31% 3.30% 4.40% 3.39% In addition the annualized dividend yield was 6.5% as of the end of 2005. By comparison, as of December 31, 2005, the 10-year Treasury was yielding 4.40%, the Dow Jones Utility Index was yielding 3.30%, the national average for a 1-year CD was 3.39%, the S&P 500 was yielding 1.86% and the Dow Jones Industrial average was yielding 2.31%. In comparison to all of these benchmarks, Realty Income represented an above average source of income for new income investors. Furthermore, for existing shareholders, the Yield on Cost, based on the price they paid for their shares at the time of purchase, continued to increase as the Company raised its dividend five times during 2005. (Disclosure: Professor Meurer also plays on MDU’s faculty basketball team and serves as Chief Financial Officer, Treasurer, and Executive Vice President of Realty Income.) 2 1 R E A LT Y I N C O M E F I N A N C I A L I N F O R M A T I O N BUSINESS DESCRIPTION THE COMPANY RECENT DEVELOPMENTS DISTRIBUTION POLICY BUSINESS PHILOSOPHY AND STRATEGY PROPERTIES CONSOLIDATED BALANCE SHEETS CONSOLIDATED STATEMENTS OF INCOME CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY CONSOLIDATED STATEMENTS OF CASH FLOWS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SELECTED FINANCIAL DATA CONTROLS AND PROCEDURES CONSOLIDATED QUARTERLY FINANCIAL DATA FORWARD-LOOKING STATEMENTS 23 23 24 25 26 29 35 36 37 38 39 49 51 63 64 66 68 REALTY INCOME CORPORATION AND SUBSIDIARIES B U S I N E S S D E S C R I P T I O N T H E C O M P A N Y In addition, our wholly-owned taxable REIT subsidiary, Crest Realty Income Corporation, The Monthly Dividend Company®, is a Net Lease, Inc., owned 17 properties with a total investment of Maryland corporation organized to operate as an equity real estate $45.7 million at December 31, 2005, which are classified as investment trust, or REIT. Our primary business objective is to held for sale. Crest Net was created to buy, own and sell proper- generate dependable monthly cash distributions from a consis- ties, primarily to individual investors, many of whom are involved tent and predictable level of funds from operations, or FFO per in tax-deferred exchanges under Section 1031 of the Internal share. The monthly distributions are supported by the cash flow Revenue Code of 1986, as amended, the “Code.” from our portfolio of retail properties leased to regional and We typically acquire retail store properties under long-term national retail chains. We have in-house acquisition, leasing, leases with retail chain store operators. These transactions gener- legal, retail and real estate research, portfolio management and ally provide capital to owners of retail real estate and retail chains capital markets expertise. Over the past 37 years, Realty Income for expansion or other corporate purposes. Our acquisition and and its predecessors have been acquiring and owning freestand- ing retail properties that generate rental revenue under long-term investment activities are concentrated in well-defined target mar- kets and generally focus on retailers providing goods and serv- lease agreements (primarily 15- to 20-years). ices that satisfy basic consumer needs. In addition, we seek to increase distributions to stockholders Our net-lease agreements generally: and FFO per share through both active portfolio management • Are for initial terms of 15 to 20 years; and the acquisition of additional properties. Our portfolio man- • Require the tenant to pay minimum monthly rents and agement focus includes: property operating expenses (taxes, insurance and mainte- • Contractual rent increases on existing leases; nance); and • Rent increases at the termination of existing leases when • Provide for future rent increases (typically subject to ceil- market conditions permit; and ings) based on increases in the consumer price index, • The active management of our property portfolio, includ- fixed increases, or to a lesser degree, additional rent cal- ing re-leasing of vacant properties and selective sales of culated as a percentage of the tenants’ gross sales above a properties. specified level. Our acquisition of additional properties adheres to a focused Realty Income commenced operations as a REIT on August 15, strategy of primarily acquiring properties that are: 1994 through the merger of 25 public and private real estate lim- • Freestanding, single-tenant, retail locations; ited partnerships with and into the Company. Each of the partner- • Leased to regional and national retail chains; and ships was formed between 1970 and 1989 for the purpose of • Leased under long-term, net-lease agreements. acquiring and managing long-term, net-leased properties. The six senior officers of Realty Income owned 1.3% of our At December 31, 2005, we owned a diversified portfolio: outstanding common stock with a market value of $25.1 million at • Of 1,646 retail properties; February 10, 2006. The directors and six senior officers of Realty • With an occupancy rate of 98.5%, or 1,621 properties Income, as a group, owned 2.7% of our outstanding common stock occupied of the 1,646 properties in the portfolio; with a market value of $51.6 million at February 10, 2006. • Leased to 101 different retail chains doing business in Realty Income’s common stock is listed on The New York Stock 29 separate retail industries; • Located in 48 states; Exchange (“NYSE”) under the ticker symbol “O.” Our central index key number is 726728 and cusip number is 756109-104. • With over 13.4 million square feet of leasable space; and Realty Income’s Class D cumulative redeemable preferred • With an average leasable retail space of 8,200 square feet. stock is listed on the NYSE under the ticker symbol “OprD” and Of the 1,646 properties in the portfolio, 1,641, or 99.7%, are Realty Income’s 8.25% Monthly Income Senior Notes, due single-tenant, retail properties and the remaining five are multi- 2008 are listed on the NYSE under the ticker symbol “OUI.” tenant, distribution and office properties. At December 31, 2005, The cusip number of these notes is 756109-203. its cusip number is 756109-609. 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. 2 3 R E A LT Y I N C O M E 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 employ- ees. The temporary employees have been working on a record Issuance of 30-Year Senior Unsecured Bonds In March 2005, Realty Income issued $100 million in aggregate principal amount of 30-year, 57/8% senior unsecured bonds due 2035. The price to the investor for the bonds was 98.296% of retention project that is expected to conclude during 2006. the principal amount for an effective yield of 5.998%. The net We maintain an Internet website at www.realtyincome.com. proceeds from the offering were used to repay borrowings under On our website we make available, free of charge, copies of our our unsecured acquisition credit facility and for other general cor- annual report on Form 10-K, quarterly reports on Form 10-Q, cur- porate purposes. rent 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. R E C E N T D E V E L O P M E N T S Credit Facility In June 2005, Realty Income entered into a new $300 million Acquisitions During 2005 During 2005, Realty Income and Crest Net invested, in aggre- gate, $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. acquisition credit facility to replace our existing $250 million Included in the $486.6 million is $430.7 million invested by acquisition credit facility that expired in October 2005. Under the terms of the new credit facility, which commenced in October Realty Income in 135 new properties and properties under devel- opment with an initial weighted average contractual lease rate of 2005, the borrowing rate was reduced to LIBOR (London 8.4%. These 135 properties are located in 28 states, are 100% Interbank Offered Rate) plus 65 basis points with a facility fee of leased with an initial average lease term of 15.6 years and will 15 basis points, for all-in drawn pricing of 80 basis points over contain over 1.7 million leasable square feet. The 135 new prop- LIBOR, based on our current credit ratings. The new credit facil- erties acquired by Realty Income are net-leased to 13 different ity offers us other interest rate options as well. The term of the retail chains in the convenience store, drug store, financial serv- new facility expires in October 2008, unless extended as provided ices, health and fitness, motor vehicle dealership, restaurant and in the agreement. theater industries. Common Stock Issuance In September 2005, we issued 4.1 million shares of common Included in the $486.6 million is $55.9 million invested by Crest Net in 21 new retail properties and properties under development. stock. The net proceeds of $92.7 million were used to fund new Of the $430.7 million Realty Income invested in real estate property acquisitions and for other general corporate purposes. during 2005, $43.9 million was invested in 10 properties that Credit Ratings Upgrade In September 2005, our credit ratings were upgraded by Fitch 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 vari- Ratings. Our senior unsecured debt rating was raised to BBB+ ous times during 2006. At December 31, 2005, we also had from BBB and our preferred stock rating was raised to BBB from committed to pay estimated unfunded development costs totaling BBB- with a stable outlook. $42.2 million. In February 2006, Moody’s Investors Service, Inc. affirmed its The initial weighted average contractual lease rate is com- ratings on our senior unsecured debt rating of Baa2 and our pre- puted as estimated contractual net operating income (in a net- ferred stock rating of Baa3 and raised the outlook to “positive” leased property this is equal to the base rent or, in the case of from “stable.” Issuance of 12-Year Senior Unsecured Notes In September 2005, Realty Income issued $175 million in aggre- gate principal amount of 12-year, 53/8% 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 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 percent- ages listed above. proceeds from the offering were used to repay borrowings under the Company’s unsecured acquisition credit facility, for property Investments in Existing Properties In 2005, we capitalized costs of $1.6 million on existing proper- acquisitions and for other general corporate purposes. Our out- ties in our portfolio, consisting of $570,000 for re-leasing costs standing notes and bonds are rated BBB+ by Fitch Ratings, Baa2 and $1.0 million for building improvements. by Moody’s Investors Service and BBB by Standard & Poor’s Ratings Group. R E A LT Y I N C O M E 2 4 Net Income Available to Common Stockholders Net income available to common stockholders was $89.7 million The monthly distribution of $0.11625 per share represents a current annualized distribution of $1.395 per share, and an in 2005 versus $90.2 million in 2004, a decrease of $452,000. annualized distribution yield of approximately 6.1% based on the On a diluted per common share basis, net income was $1.12 per last reported sale price of our common stock on the NYSE of share in 2005 as compared to $1.15 per share in 2004. $22.78 on February 10, 2006. Although we expect to continue The calculation to determine net income available to common our policy of paying monthly distributions, we cannot guarantee stockholders includes gains from the sale of investment proper- that we will maintain the current level of distributions, that we ties. The amount of gains varies from period to period based on will continue our pattern of increasing distributions per share, or the timing of property sales and can significantly impact net what the actual distribution yield will be in any future period. income available to common stockholders. The gain recognized from the sales of investment properties D I S T R I B U T I O N P O L I C Y during 2005 was $6.6 million as compared to $12.7 million dur- Distributions are paid monthly to our common stockholders and ing 2004. Class D preferred stockholders if, and when declared by our Board of Directors. The Class D preferred stockholders receive cumula- Funds from Operations (FFO) In 2005, our FFO increased by $11.4 million, or 9.6%, to tive distributions at a rate of 7.375% per annum on the $25 per share liquidation preference (equivalent to $1.84375 per annum $129.6 million versus $118.2 million in 2004. On a diluted per per share). common share basis, FFO was $1.62 in 2005 compared to $1.50 for 2004, an increase of $0.12, or 8.0%. In order to maintain our tax status as a REIT for federal income tax purposes, we generally are required to distribute div- See our discussion of FFO in the section entitled “Manage- idends to our stockholders aggregating annually at least 90% of ment’s Discussion and Analysis of Financial Condition and Results our REIT taxable income (determined without regard to the divi- of Operations” in this annual report, which includes a reconcilia- dends paid deduction and by excluding net capital gains) and we tion of net income available to common stockholders to FFO. are subject to income tax to the extent we distribute less than 100% of our REIT taxable income (including net capital gains). Crest Net Property Sales During 2005, Crest Net sold 12 properties from its inventory for In 2005, our cash distributions totaled $118.0 million, or approximately 113.2% of our estimated REIT taxable income of $23.5 million, which resulted in a gain of $3.3 million. $104.2 million. Our estimated REIT taxable income reflects non-cash deductions for depreciation and amortization. We Crest Net’s Property Inventory Crest Net’s property inventory at December 31, 2005 and intend to continue to make distributions to our stockholders that are sufficient to meet this distribution requirement and that will December 31, 2004 totaled $45.7 million and $10.1 million, reduce our exposure to income taxes. Our 2005 cash distribu- respectively, and is included in “real estate held for sale, net”, on tions to common stockholders totaled $108.6 million, represent- our consolidated balance sheets. ing 83.8% of our funds from operations available to common stockholders of $129.6 million. Increases in Monthly Cash Distributions to Common Stockholders We continue our 36-year policy of paying distributions monthly. 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 Monthly distributions per share were increased in April 2005 by and capital requirements, the annual distribution requirements $0.000625 to $0.110625, in July 2005 by $0.000625 to under the REIT provisions of the Code, our debt service require- $0.11125, in September 2005 by $0.00375 to $0.115, in ments and any other factors the Board of Directors may deem October 2005 by $0.000625 to $0.115625 and in January relevant. In addition, our credit facility contains financial covenants 2006 by $.000625 to $0.11625. The increase in January 2006 that could limit the amount of distributions payable by us in the was our 33rd consecutive quarterly increase and the 37th event of a deterioration in our results of operations or financial increase in the amount of our dividend since our listing on the condition, and which prohibit the payment of distributions on NYSE in 1994. In 2005, we paid the following monthly cash the common or preferred stock in the event that we fail to pay distributions per share: three in the amount of $0.11, three in the when due (subject to any applicable grace period) any principal amount of $0.110625, two in the amount of $0.11125, one in or interest on borrowings under our credit facility. 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. 2 5 R E A LT Y I N C O M E Distributions of our current and accumulated earnings and upper market retail chains typically consist of companies with profits for federal income tax purposes, generally will be taxable 500 or more locations, operating nationally, in a proven, mature to stockholders as ordinary income, except to the extent that we retail concept. Upper market retail chains generally have strong recognize capital gains and declare a capital gains dividend or operating histories and access to several sources of capital. that such amounts constitute “qualified dividend income” sub- Realty Income primarily focuses on acquiring properties ject to a reduced rate of tax. The maximum tax rate of non-cor- leased to middle market retail chains that we believe are attrac- porate taxpayers for “qualified dividend income” has generally tive for investment because: been reduced to 15% (for taxable years beginning after • They generally have overcome many of the operational and December 31, 2002). In general, dividends payable by REITs are managerial obstacles that can adversely affect venture not eligible for the reduced tax rate on corporate dividends, retailers; except to the extent the REIT’s dividends are attributable to div- • They typically require capital to fund expansion but have idends received from taxable corporations (such as our taxable more limited financing options; REIT subsidiary, Crest Net), to income that was subject to tax at • They generally have provided us with attractive risk- the corporate or REIT level (for example, if we distribute taxable adjusted returns over time since their financial strength income that we retained and paid tax on in the prior taxable year) has, in many cases, tended to improve as their businesses or, as discussed above, dividends properly designated by us as have matured; “capital gain dividends.” Distributions in excess of earnings • Their relatively large size allows them to spread corporate and profits generally will be treated as a non-taxable reduction in the stockholders’ basis in the stock. Distributions above that expenses across a greater number of stores; and • Middle market retailers typically have the critical mass to basis, generally, will be taxable as a capital gain. Approximately survive if a number of locations are closed due to under- 10.1% of the distributions, made or deemed to have been made performance. in 2005, to our common stockholders were classified as a return of capital for federal income tax purposes. We are unable to pre- We also focus on and have selectively made investments in dict the portion of future distributions that may be classified as properties of upper market retail chains. We believe upper market a return of capital. retail chains can be attractive for investment because: • They typically are of a higher credit quality; B U S I N E S S P H I L O S O P H Y A N D S T R A T E G Y • They usually are larger public and private retailers with Investment Philosophy We believe that owning an actively managed, diversified portfolio more commonly recognized brand names; • They utilize a larger building ranging in size from 10,000 of retail properties under long-term, net leases produces consis- to 50,000 square feet; and tent and predictable income. Under a net-lease agreement, the • They are able to grow because access to capital facilitates tenant agrees to pay monthly rent and property operating larger transaction sizes. expenses (taxes, maintenance and insurance) plus, typically, future rent increases (generally subject to ceilings) based on While our investment strategy focuses primarily on acquiring increases in the consumer price index, fixed increases, or to a properties leased to middle and upper market retail chains, we lesser degree, additional rent calculated as a percentage of the also selectively seek investment opportunities with venture mar- tenants’ gross sales above a specified level. We believe that a ket retail chains. Periodically, venture market opportunities arise portfolio of properties under long-term leases, coupled with the where we feel that the real estate used by the tenant is high tenant’s responsibility for property expenses, generally produces quality and can be purchased at favorable prices. To meet our a more predictable income stream than many other types of real stringent investment standards, however, venture retail compa- estate portfolios, while continuing to offer the potential for growth nies must have a well-defined retailing concept and strong finan- in rental income. Investment Strategy In identifying new properties for acquisition, our focus is gen- cial 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 erally on providing capital to retail chain owners and operators that have a service component because we believe the lease rev- by acquiring, then leasing back, retail store locations. We cate- enue from these types of businesses is more stable. Because of this gorize retail tenants as: 1) venture market, 2) middle market, and investment focus, for the quarter ended December 31, 2005, 3) upper market. Venture companies typically offer a new retail approximately 81.2% of our rental revenue was derived from retail- concept in one geographic region of the country and operate ers with a service component in their business. Furthermore, we between five and 50 retail locations. Middle market retail chains believe these service-oriented businesses would be difficult to typically have 50 to 500 retail locations, operations in more than duplicate over the Internet and that our properties continue to per- one geographic region, have been successful through one or more form well relative to competition from Internet businesses. economic cycles, and have a proven, replicable concept. The R E A LT Y I N C O M E 2 6 Credit Strategy We generally provide sale-leaseback financing to less than invest- The typical profile of companies whose properties have been approved for acquisition are those with 50 or more retail loca- ment grade retail chains. We typically acquire and lease back tions. Generally the properties: properties to regional and national retail chains and believe that • Are located in highly visible areas, within this market we can achieve an attractive risk-adjusted • Have easy access to major thoroughfares; and return on the financing we provide to retailers. Since 1970, our • Have attractive demographics. 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, We believe the principal financial obligations of most retailers regional and national chains are capturing market share through typically include their bank and other debt, payment obligations to service, quality control, economies of scale, advertising and the suppliers and real estate lease obligations. Because we typically selection of prime retail locations. We execute our acquisition own the land and building in which a tenant conducts its retail strategy by acting as a source of capital to regional and national business, we believe the risk of default on a retailers’ lease obli- retail chain store owners and operators, doing business in a gations is less than the retailers’ unsecured general obligations. It variety of industries, by acquiring and leasing back retail store has been our experience that since retailers must retain their locations. We undertake thorough research and analysis to profitable retail locations in order to survive, in the event of reor- identify appropriate industries, tenants and property locations for ganization they are less likely to reject a lease for a profitable loca- tion because this would terminate their right to use the property. investment. Our research expertise is instrumental to uncovering net-lease opportunities in markets where our real estate financing Thus, as the property owner, we believe we will fare better than program adds value. In selecting real estate for potential invest- unsecured creditors of the same retailer in the event of reorganiza- ment, we generally seek to acquire properties that have the tion. If a property is rejected by the tenant during reorganization, following characteristics: we own the property and can either lease it to a new tenant or sell • Freestanding, commercially-zoned property with a single the property. In addition, we believe that the risk of default on the tenant; real estate leases can be further mitigated by monitoring the per- • Properties that are important retail locations for regional formance of the retailers’ individual unit locations and considering and national retail chains; whether to sell locations that are weaker performers. • Properties that are located within attractive demographic In order to qualify for inclusion in our portfolio, new property areas relative to the business of their tenants, with high acquisitions must meet stringent investment and credit require- visibility and easy access to major thoroughfares; and ments. The properties must generate attractive current yields and • Properties that can be purchased with the simultaneous the tenant must meet our credit profile. We have established a execution or assumption of long-term, net-lease agree- three-part analysis that examines each potential investment ments, offering both current income and the potential for based on: rent increases. • Industry, company, market conditions and credit profile; • Location profitability, if profitability data is available; and • Overall real estate characteristics, including value and Portfolio Management Strategy The active management of the property portfolio is an essential comparative rental rates. 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 typi- cally includes regular review and analysis of: • The performance of various retail industries; and • The operation, management, business planning and financial condition of the tenants. 2 7 R E A LT Y I N C O M E We have an active portfolio management program that incor- total $300 million credit commitment of the credit facility. The porates the sale of assets when we believe the reinvestment of the credit facility has been, and is expected to be, used to acquire sales proceeds will generate higher returns, enhance the credit additional retail properties leased to regional and national retail quality of our real estate portfolio, or extend our average remain- chains under long-term, net-lease agreements. The credit facility ing lease term. At December 31, 2005, we classified real estate has also been used to provide capital to subsidiaries for the pur- with a carrying amount of $47.1 million as held for sale, which pose of funding the acquisition of properties. We regularly evalu- includes $45.5 million in properties owned by Crest Net. In addi- ate our credit facility and may seek to extend, renew or replace tion, $219,000 invested by Crest Net in real estate is included in our credit facility, to the extent we deem appropriate. other assets and was classified as intangible assets in accordance We use our credit facility for the short-term financing of new with Financial Accounting Standards Board Statement No. 141, property acquisitions. When outstanding borrowings under the Business Combinations. Additionally, we anticipate selling invest- credit facility reach a certain level (generally in the range of ment properties from our portfolio that have not yet been specif- $100 million to $200 million) and capital is available on accept- ically identified from which we anticipate receiving between able terms, we generally seek to refinance those borrowings with $15 million and $35 million in proceeds during the next the net proceeds of long-term or permanent financing, which may 12 months. We intend to invest these proceeds into new property include the issuance of common stock, preferred stock, convert- acquisitions. However, we cannot guarantee that we will sell prop- ible preferred stock, debt securities or convertible debt securities. erties during the next 12 months. Conservative Capital Structure We believe that our stockholders are best served by a conservative 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 securi- ties upon acceptable terms. capital structure. Therefore, we seek to maintain a conservative We are currently assigned investment grade corporate credit debt level on our balance sheet and solid interest and fixed ratings, on our senior unsecured notes, from Fitch Ratings, charge coverage ratios. At February 10, 2006, our total outstand- Moody’s Investors Service, Inc. and Standard & Poor’s Ratings ing credit facility borrowings and outstanding notes were Group. Currently, Fitch Ratings has assigned a rating of BBB+, $886.6 million or approximately 30.3% of our total market Moody’s has assigned a rating of Baa2 and Standard & Poor’s has capitalization of $2.92 billion. We calculate our total market assigned a rating of BBB to our senior notes. Moody’s rating has a capitalization at February 10, 2006 as the sum of: “positive” outlook and the other ratings have a “stable” outlook. • Shares of our common stock outstanding of 83,880,873 We have also been assigned investment grade credit ratings multiplied by the last reported sales price of our common from the same rating agencies on our preferred stock. Fitch stock on the NYSE of $22.78 per share, or $1.91 billion; Ratings has assigned a rating of BBB, Moody’s has assigned a rat- • Aggregate liquidation value of the Class D preferred stock ing of Baa3 and Standard & Poor’s has assigned a rating of BBB- of $127.5 million; to our preferred stock. Moody’s rating has a “positive” outlook and • Outstanding borrowings of $131.6 million on our credit the other ratings have a “stable” outlook. facility; and The credit ratings assigned to us could change based • Outstanding notes of $755.0 million. upon, among other things, our results of operations and finan- cial condition. Historically, we have met our long-term capital needs through We have no mortgage debt on any of our properties. 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 pre- No Off-Balance Sheet Arrangements or Unconsolidated Investments Realty Income and its subsidiaries have no unconsolidated or ferred stock or debt securities from time to time. We may issue off-balance sheet investments in “variable interest entities” common stock when we believe that our share price is at a level or off-balance sheet financing, nor do we engage in trading that allows for the proceeds of any offering to be invested into activities involving energy or commodity contracts or other additional properties on an accretive basis. In addition, we may derivative instruments. issue common stock to permanently finance properties that were As we have no joint ventures, off-balance sheet entities, or financed by our credit facility or debt securities. However, we can- mandatory redeemable preferred stock, our financial position and not assure you that we will have access to the capital markets at results of operations are currently not affected by Financial terms that are acceptable to us. We have a $300 million revolving, unsecured acquisition credit facility that expires in October 2008. At February 10, Accounting Standards Board Interpretation No. 46R, Consolidation of Variable Interest Entities and Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments 2006, the outstanding balance on the credit facility was with Characteristics of both Liabilities and Equity. $131.6 million, with an effective interest rate of approximately 5.2%. A commitment fee of 0.15% per annum accrues on the R E A LT Y I N C O M E 2 8 Competitive Strategy We believe that to successfully pursue our investment philosophy • MANAGEMENT SPECIALIZATION: We believe that our man- agement’s specialization in single-tenant retail properties, and strategy, we must seek to maintain the following competitive operated under net-lease agreements, is important to meet- advantages: ing our objectives. We plan to maintain this specialization • SIZE AND TYPE OF INVESTMENT PROPERTIES: We believe and will seek to employ and train high-quality professionals smaller ($500,000 to $10,000,000) net-leased retail in this specialized area of real estate ownership, finance properties represent an attractive investment opportunity and management. in today’s real estate environment. Due to the complexities • TECHNOLOGY: We intend to stay at the forefront of technol- of acquiring and managing a large portfolio of relatively ogy in our efforts to efficiently and economically carry out small assets, we believe these types of properties have our operations. We maintain sophisticated information sys- not experienced significant institutional ownership interest tems that allow us to analyze our portfolio’s performance or the corresponding yield reduction experienced by larger and actively manage our investments. We believe that income-producing properties. We believe the less intensive technology and information-based systems will play an day-to-day property management required by net-lease increasingly important role in our competitiveness as an agreements, coupled with the active management of a investment manager and source of capital to a variety of large portfolio of smaller properties, is an effective invest- industries and tenants. ment strategy. The tenants of our freestanding retail prop- erties generally provide goods and services that satisfy basic consumer needs. In order to grow and expand, they P R O P E R T I E S At December 31, 2005, we owned a diversified portfolio: generally need capital. Since the acquisition of real estate • Of 1,646 retail properties; is typically the single largest capital expenditure of many • With an occupancy rate of 98.5%, or 1,621 properties of these retailers, our method of purchasing the property occupied of the 1,646 properties in the portfolio; and then leasing it back, under a net-lease arrangement, • Leased to 101 different retail chains doing business in allows the retail chain to free up capital. INVESTMENT IN NEW RETAIL INDUSTRIES: Though we spe- • 29 separate retail industries; • Located in 48 states; cialize in single-tenant properties, we will seek to further • With over 13.4 million square feet of leasable space; and diversify our portfolio among a variety of retail industries. • With an average leasable retail space of 8,200 square feet. We believe diversification will allow us to invest in retail In addition to our real estate portfolio at December 31, 2005, industries that currently are growing and have character- our subsidiary, Crest Net had invested $45.7 million in a portfo- istics we find attractive. These characteristics include, but lio of 17 properties located in nine states. These properties are are not limited to, retail industries that are dominated by classified as held for sale. local store operators where regional and national chain At December 31, 2005, 1,617, or 98.2%, of our 1,646 retail store operators can increase market share and dominance properties were owned under net-lease agreements. Net leases by consolidating local operators and streamlining their typically require the tenant to be responsible for minimum operations, as well as capitalizing on major demographic monthly rent and property operating expenses including property shifts in a population base. taxes, insurance and maintenance. In addition, tenants are typi- • DIVERSIFICATION: Diversification of the portfolio by retail cally responsible for future rent increases (generally subject to industry type, tenant, and geographic location is key to our ceilings) based on increases in the consumer price index, fixed objective of providing predictable investment results for increases or, to a lesser degree, additional rent calculated as a our stockholders, therefore further diversification of our percentage of the tenants’ gross sales above a specified level. portfolio is a continuing objective. At December 31, 2005, Our net-leased retail properties primarily are leased to regional our retail property portfolio consisted of 1,646 properties and national retail chain store operators. Most buildings are single- located in 48 states, leased to 101 retail chains doing story structures with adequate parking on site to accommodate business in 29 industry segments. Each of the 29 indus- peak retail traffic periods. The properties tend to be on major try segments, represented in our property portfolio, indi- thoroughfares with relatively high traffic counts and adequate vidually accounted for no more than 17.8% of our rental access and proximity to a sufficient population base constituting a revenue for the quarter ended December 31, 2005. suitable market or trade area for the retailer’s business. 2 9 R E A LT Y I N C O M E 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: For the Quarter Ended Dec. 31, 2005 Percentage of Rental Revenue(1) For the Years Ended Dec. 31, 2005 Dec. 31, 2004 Dec. 31, 2003 Dec. 31, 2002 Dec. 31, 2001 Dec. 31, 2000 1.4% 1.6% 1.8% 2.1% 2.3% 2.4% 2.4% Industries Apparel stores Automotive collision services Automotive parts Automotive service Automotive tire services Book stores Business services Child care Consumer electronics Convenience stores Crafts and novelties Drug stores Entertainment Equipment rental services Financial services General merchandise Grocery stores Health and fitness Home furnishings Home improvement Motor vehicle dealerships Office supplies Pet supplies and services Private education Restaurants Shoe stores Sporting goods Theaters Travel plazas Video rental Other Totals 1.2 3.4 7.0 6.5 0.3 0.1 11.8 1.2 17.8 0.4 3.0 1.9 0.3 0.1 0.5 0.6 3.3 3.4 1.0 2.9 1.6 1.2 0.7 9.9 0.0 3.1 9.9 0.3 2.3 2.9 1.3 3.4 7.6 7.2 0.3 0.1 12.7 1.3 18.7 0.4 2.8 2.1 0.4 0.1 0.5 0.7 3.7 3.7 1.1 2.6 1.5 1.3 0.8 9.4 0.3 3.4 5.2 0.3 2.5 3.0 1.0 3.8 7.7 7.8 0.3 0.1 14.4 2.1 19.2 0.5 0.1 2.3 0.3 0.1 0.4 0.8 4.0 4.1 1.0 0.6 1.6 1.4 1.1 9.7 0.3 3.4 3.5 0.4 2.8 3.4 0.3 4.5 8.3 3.1 0.4 0.1 17.8 3.0 13.3 0.6 0.2 2.6 0.2 — 0.5 0.4 3.8 4.9 1.1 — 1.9 1.7 1.2 — 4.9 7.0 2.7 0.4 0.1 — 5.7 5.7 2.6 0.4 0.1 — 6.0 5.8 2.3 0.5 0.1 20.8 23.9 24.7 3.3 9.1 0.4 0.2 2.3 — — 0.5 0.5 3.8 5.4 1.2 — 2.1 1.7 1.3 4.0 8.4 0.4 0.2 1.8 — — 0.6 0.6 3.6 6.0 1.3 — 2.2 1.6 1.5 4.9 8.4 0.4 0.2 2.0 — — 0.6 0.6 2.4 5.8 2.0 — 2.3 1.5 1.4 11.8 13.5 12.2 12.3 0.9 3.8 4.1 0.3 3.3 3.8 0.8 4.1 3.9 — 3.3 4.4 0.7 0.9 4.3 — 3.7 5.2 0.8 — 2.7 — 3.9 6.0 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% (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. R E A LT Y I N C O M E 3 0 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): Industry Tenants Providing Services Automotive collision services Automotive service Child care Entertainment Equipment rental services Financial services Health and fitness Private education Theaters Other Tenants Selling Goods and Services Automotive parts (with installation) Automotive tire services Business services Convenience stores Home improvement Motor vehicle dealerships Pet supplies and services Restaurants Travel plazas Video rental Tenants Selling Goods Apparel stores Automotive parts Book stores Consumer electronics Crafts and novelties Drug stores General merchandise Grocery stores Home furnishings Home improvement Office supplies Pet supplies Shoe stores Sporting goods Totals Number of Properties 11 219 270 9 2 4 15 5 29 8 572 30 102 1 394 3 15 9 250 1 34 839 5 74 2 22 4 29 12 6 39 15 10 2 2 13 235 1,646 Rental Revenue for the Quarter Ended Dec. 31, 2005(1) $ 672 3,757 6,319 1,016 150 53 1,775 381 5,305 1,532 $ 20,960 583 3,471 32 9,572 73 1,566 615 5,292 170 1,235 $ 22,609 775 1,242 149 636 211 1,630 257 347 1,814 465 844 37 — 1,687 $ 10,094 $ 53,663 Percentage of of Rental Revenue 1.2% 7.0 11.8 1.9 0.3 0.1 3.3 0.7 9.9 2.9 39.1 1.1 6.5 0.1 17.8 0.1 2.9 1.1 9.9 0.3 2.3 42.1 1.4 2.3 0.3 1.2 0.4 3.0 0.5 0.6 3.4 0.9 1.6 0.1 0.0 3.1 18.8 100.0% (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. 3 1 R E A LT Y I N C O M E 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): Total Number of Leases Expiring(1) 109 121 104 89 69 44 44 74 48 87 17 22 23 95 82 126 96 234 57 63 2 2 1 3 2 2 1 Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2028 2030 2033 2034 2037 2043 Total Portfolio Rental Revenue for the Quarter Ended 12/31/05(2) % of Rental Revenue Number of Leases Expiring $ 2,373 4.6% 2,265 2,334 1,963 1,527 1,662 1,379 3,251 2,007 1,654 513 1,527 1,090 4,480 2,603 4,082 2,592 6,440 1,707 5,273 89 54 21 357 230 325 13 4.4 4.5 3.8 2.9 3.2 2.7 6.3 3.9 3.2 1.0 2.9 2.1 8.7 5.0 7.9 5.0 12.4 3.3 10.2 0.2 0.1 * 0.7 0.4 0.6 * 50 87 66 29 43 34 42 66 36 68 15 18 23 94 81 126 95 233 57 63 2 2 1 3 2 2 — Initial Expirations(3) Subsequent Expirations(4) Rental Revenue for the Quarter Ended 12/31/05 % of Total Rental Revenue $ 1,111 2.2% 1,662 1,634 694 1,072 1,439 1,329 3,039 1,752 1,200 431 1,459 1,090 4,342 2,593 4,082 2,591 6,414 1,707 5,273 89 54 21 357 230 325 — 3.2 3.2 1.3 2.0 2.8 2.6 5.9 3.4 2.3 0.8 2.8 2.1 8.4 5.0 7.9 5.0 12.4 3.3 10.2 0.2 0.1 * 0.7 0.4 0.6 — Rental Revenue for the Quarter Ended 12/31/05 % of Total Rental Revenue $ 1,262 2.4% 603 700 1,269 455 223 50 212 255 454 82 68 — 138 10 — 1 26 — — — — — — — — 13 1.2 1.3 2.5 0.9 0.4 0.1 0.4 0.5 0.9 0.2 0.1 — 0.3 * — * * — — — — — — — — * Number of Leases Expiring 59 34 38 60 26 10 2 8 12 19 2 4 — 1 1 — 1 1 — — — — — — — — 1 Totals 1,617 $ 51,811 100.0% 1,338 $ 45,990 88.8% 279 $ 5,821 11.2% *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. R E A LT Y I N C O M E 3 2 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): State Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming Totals/Average *Less than 0.1% Number of Properties 17 2 70 8 61 46 16 16 128 103 14 55 37 12 20 15 14 24 37 13 20 38 32 2 13 15 10 26 7 28 50 5 105 20 17 81 1 55 7 98 182 6 1 62 37 2 16 2 Percent Leased 94% 100 100 88 100 100 100 100 99 99 93 100 95 92 90 100 100 100 100 100 100 89 94 100 100 100 100 100 100 96 100 100 100 95 100 100 100 100 100 100 98 100 100 100 100 0 94 100 Approximate Leasable Square Feet 146,600 128,500 335,500 48,800 1,057,100 385,700 245,600 29,100 1,252,600 699,300 91,900 696,200 349,600 63,800 188,300 51,900 65,200 218,800 203,100 81,600 337,100 205,200 244,500 30,000 104,500 191,000 89,600 200,100 53,300 386,300 322,800 31,900 661,500 99,300 253,300 481,300 3,500 215,800 18,300 451,400 1,835,500 35,100 2,500 431,900 243,900 16,800 153,700 9,300 1,646 99% 13,448,600 Rental Revenue For the Quarter Ended Dec 31, 2005(1) Percentage of Rental Revenue $ 419 259 1,900 139 4,044 1,785 929 338 4,958 2,733 371 3,184 1,516 181 515 320 285 1,182 994 300 1,278 711 784 79 436 837 358 1,069 152 1,871 1,470 35 2,520 685 587 2,269 29 1,416 30 2,199 4,859 108 22 2,309 783 — 370 45 $ 53,663 0.8% 0.5 3.5 0.3 7.5 3.3 1.7 0.6 9.2 5.1 0.7 5.9 2.8 0.3 1.0 0.6 0.5 2.2 1.9 0.6 2.4 1.3 1.5 0.1 0.8 1.6 0.7 2.0 0.3 3.5 2.7 * 4.7 1.3 1.1 4.2 0.1 2.6 0.1 4.1 9.1 0.2 * 4.3 1.5 0.0 0.7 0.1 100.0% (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. 3 3 R E A LT Y I N C O M E Description of Leasing Structure At December 31, 2005, 1,617 single tenant and certain other Certain Properties Under Development Of the 135 properties Realty Income acquired in 2005, all were retail properties or 98.2% of our 1,646 properties were net leased. occupied at December 31, 2005, except for 10 properties that In most cases, the leases: were leased and being developed. In the case of development • Are for initial terms of 15 to 20 years; properties, we either enter into an agreement with a retail chain • Require the tenants to pay minimum monthly rents and where the retailer retains a contractor to construct the improve- property operating expenses (taxes, insurance and mainte- ments and we fund the costs of that development, or we fund a nance); and developer who constructs the improvements. In either case, there • Provide for future rent increases (typically subject to ceil- is an executed lease with a retail tenant at the time of the land ings) based on increases in the consumer price index, purchase (with a fixed rent commencement date) and there is a fixed increases, or to a lesser degree, additional rent based requirement to complete the construction in a timely basis and upon the tenants’ gross sales above a specified level. within a specific budget, typically within eight months after we Where leases provide for rent increases based on increases purchase the land. The tenant or developer generally is required in the consumer price index, generally these increases to pay construction cost overruns to the extent that they exceed become part of the new permanent base rent. Where the construction budget by more than a predetermined amount. leases provide for percentage rent, this additional rent is We also enter into a lease with the tenant at the time we purchase typically payable only if the tenants’ gross sales, for a the land, which generally requires the tenant to begin paying base given period (usually one year), exceed a specified level and is then typically calculated as a percentage of only the rent when the store opens for business. The base rent is calcu- lated by multiplying a predetermined capitalization rate by our amount of gross sales in excess of that level. total investment in the property including the land cost for the Matters Pertaining to Certain Properties and Tenants Of the 25 properties available for lease or sale at December 31, property, construction costs and capitalized interest. In 2005, Realty Income acquired 21 development properties. Crest Net did not acquire any development property in 2005. Both Realty 2005; all but one are single-tenant properties. At December 31, Income and Crest Net will continue to pursue development oppor- 2005, 17 of our properties under lease were unoccupied and tunities under similar arrangements in the future. available for sublease by the tenants, all of which were current with their rent and other obligations. During 2005, each of our tenants accounted for less than 10% of our rental revenue. Risk Factors For a full description of the risk factors associated with the Company, see Item 1A “Risk Factors” in our Form 10-K for the fiscal year ended December 31, 2005. R E A LT Y I N C O M E 3 4 REALTY INCOME CORPORATION AND SUBSIDIARIES C O N S O L I D A T E D B A L A N C E S H E E T S December 31, 2005 and 2004 (dollars in thousands, except per share data) 2005 2004 Assets Real estate, at cost: Land Buildings and improvements Less accumulated depreciation and amortization Net real estate held for investment Real estate held for sale, net Net real estate Cash and cash equivalents Accounts receivable Goodwill Other assets Total assets Liabilities and Stockholders’ Equity Distributions payable Accounts payable and accrued expenses Other liabilities Line of credit payable Notes payable Total liabilities Commitments and contingencies $ 746,016 1,350,140 2,096,156 (341,193) 1,754,963 47,083 1,802,046 65,704 5,044 17,206 30,988 $ 624,558 1,066,725 1,691,283 (301,728) 1,389,555 17,155 1,406,710 2,141 4,075 17,206 12,183 $ 1,920,988 $ 1,442,315 $ 10,121 20,391 9,562 136,700 755,000 931,774 $ 9,115 9,579 6,286 23,600 480,000 528,580 Stockholders’ equity: Preferred stock and paid in capital, par value $1.00 per share, 20,000,000 shares authorized, 5,100,000 shares issued and outstanding 123,804 123,787 Common stock and paid in capital, par value $1.00 per share, in 2005 there were 200,000,000 shares authorized and 83,696,647 issued and outstanding and in 2004 there were 100,000,000 shares authorized and 79,301,630 issued and outstanding Distributions in excess of net income Total stockholders’ equity Total liabilities and stockholders’ equity 1,134,300 (268,890) 989,214 $ 1,920,988 1,038,973 (249,025) 913,735 $ 1,442,315 The accompanying notes to consolidated financial statements are an integral part of these statements. 3 5 R E A LT Y I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES C O N S O L I D A T E D S T A T E M E N T S O F I N C O M E Years Ended December 31, 2005, 2004 and 2003 (dollars in thousands, except per share data) Revenue Rental Other Expenses Interest Depreciation and amortization General and administrative Property Income taxes Income from continuing operations Income from discontinued operations: Real estate acquired for resale by Crest Real estate held for investment Net income Preferred stock cash dividends Excess of redemption value over carrying value of preferred shares redeemed (see note 7C and 7D) Basic Diluted Net income available to common stockholders per common share: Basic and diluted Weighted average common shares outstanding: Basic Diluted 2005 2004 2003 $ 196,322 354 196,676 $ 172,714 1,033 173,747 $ 142,888 590 143,478 40,949 46,438 15,421 3,838 813 107,459 89,217 2,781 7,121 9,902 99,119 (9,403) — $ $ 1.00 1.00 34,132 39,874 13,119 3,069 699 90,893 82,854 7,847 12,696 20,543 103,397 (9,455) (3,774) $ 90,168 $ $ 0.89 0.89 26,413 32,231 10,616 2,439 501 72,200 71,278 4,588 10,569 15,157 86,435 (9,713) — $ 76,722 $ $ 0.87 0.86 $ 1.12 $ 1.15 $ 1.08 79,950,255 80,208,593 78,518,296 78,598,788 71,128,282 71,222,628 Net income available to common stockholders $ 89,716 Income from continuing operations per common share: The accompanying notes to consolidated financial statements are an integral part of these statements. R E A LT Y I N C O M E 3 6 REALTY INCOME CORPORATION AND SUBSIDIARIES C O N S O L I D A T E D S T A T E M E N T S O F S T O C K H O L D E R S ’ E Q U I T Y Years Ended December 31, 2005, 2004 and 2003 (dollars in thousands) Shares of Preferred Stock Common Stock Preferred Stock and Paid In Capital Common Stock and Paid In Capital Distributions In Excess of Net Income Total Balance, December 31, 2002 4,125,700 69,749,654 $ 99,368 $ 855,818 $ (232,731) $ 722,455 Net income Distributions paid and payable Shares issued in stock offerings, net of offering costs of $5,854 Deferred stock compensation — — — — — 5,750,000 — 318,518 — — — — — — 86,435 (94,336) 86,435 (94,336) 110,842 2,370 — — 110,842 2,370 Balance, December 31, 2003 4,125,700 75,818,172 99,368 969,030 (240,632) 827,766 Net income Distributions paid and payable Shares issued in stock offerings, net of offering costs of $3,682 Shares issued in stock offerings, net of offering costs of $4,187 Preferred shares redeemed Deferred stock compensation — — — — — 3,200,000 — — — — — 103,397 103,397 (108,016) (108,016) 67,918 — 67,918 5,100,000 (4,125,700) — — 123,787 (99,368) — — — 123,787 (3,774) (103,142) — 283,458 — 2,025 — 2,025 Balance, December 31, 2004 5,100,000 79,301,630 123,787 1,038,973 (249,025) 913,735 Net income Distributions paid and payable Shares issued in stock offerings, net of offering costs of $4,980 Deferred stock compensation — — — — — 4,100,000 — 295,017 — — 17 — — — 99,119 99,119 (118,984) (118,984) 92,659 2,668 — — 92,676 2,668 Balance, December 31, 2005 5,100,000 83,696,647 $ 123,804 $ 1,134,300 $ (268,890) $ 989,214 The accompanying notes to consolidated financial statements are an integral part of these statements. 3 7 R E A LT Y I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES C O N S O L I D A T E D S T A T E M E N T S O F C A S H F L O W S Years Ended December 31, 2005, 2004 and 2003 (dollars in thousands) 2005 2004 2003 $ 99,119 $ 103,397 $ 86,435 46,438 39,874 32,231 Cash Flows from Operating Activities Net income Adjustments to net income: Depreciation and amortization Income from discontinued operations: Real estate acquired for resale by Crest Real estate held for investment Cash from discontinued operations: Real estate acquired for resale by Crest Real estate held for investment Investments in real estate acquired for resale by Crest Intangibles acquired in connection with acquisition of real estate acquired for resale by Crest Proceeds from sales of real estate acquired for resale Amortization of deferred stock compensation Amortization of stock option costs Gain on sale of real estate held for investment Provision for impairment on real estate Changes in assets and liabilities: Accounts receivable and other assets Accounts payable, accrued expenses and other liabilities Net cash provided by operating activities Cash Flows from Investing Activities Proceeds from sales of investment properties: Acquisition of and additions to investment properties Intangibles acquired in connection with acquisition of real estate held for investment Net cash used in investing activities Cash Flows from Financing Activities Borrowings from lines of credit Payments under lines of credit Proceeds from note offerings, net Proceeds from common stock offerings, net Cash distributions to common stockholders Cash dividends to preferred stockholders Proceeds from preferred stock offerings, net Redemption of preferred stock Proceeds from other stock issuances Net cash provided by (used in) financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year (2,781) (7,121) (510) 809 (54,110) (1,780) 22,195 2,155 12 (18) 151 (3,292) 8,290 109,557 22,300 (417,347) (9,494) (404,541) 400,300 (287,200) 270,266 92,659 (108,575) (9,403) — — 500 358,547 63,563 2,141 (7,847) (12,696) (2,407) 3,509 (21,787) — 74,995 1,426 14 (185) — 1,094 (1,050) 178,337 (4,588) (10,569) (1,629) 6,339 (87,384) — 45,226 940 11 — — 1,751 5,194 73,957 34,601 (195,470) 20,773 (280,587) — — (160,869) (259,814) 280,400 (283,200) (28) 67,918 (97,420) (9,063) 123,787 (103,142) 584 (20,164) (2,696) 4,837 360,600 (443,900) 246,367 110,842 (83,842) (9,713) — — 1,419 181,773 (4,084) 8,921 $ 4,837 Cash and cash equivalents, end of year $ 65,704 $ 2,141 For supplemental disclosures, see note 12. The accompanying notes to consolidated financial statements are an integral part of these statements. R E A LT Y I N C O M E 3 8 REALTY INCOME CORPORATION AND SUBSIDIARIES N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S December 31, 2005, 2004 and 2003 Earnings and profits that determine the taxability of distribu- 1 . O R G A N I Z A T I O N A N D O P E R A T I O N tions to stockholders differ from net income reported for financial reporting purposes due to differences in the estimated useful Realty Income Corporation (“Realty Income,” the “Company,” lives and methods used to compute depreciation and the carry- “we” or “our”) is organized as a Maryland corporation. We invest ing value (basis) on the investments in properties for tax purposes, in commercial retail real estate and have elected to be taxed as a among other things. real estate investment trust (“REIT”). The following reconciles our net income available to common At December 31, 2005, we owned 1,646 properties in 48 stockholders to taxable income for 2005 (dollars in thousands) states containing over 13.4 million leasable square feet, plus an (unaudited): additional 17 properties owned by our wholly-owned taxable REIT subsidiary, Crest Net Lease, Inc. (“Crest Net”). Crest Net was cre- Net income available to common stockholders $ 89,716 ated to buy, own and sell properties, primarily to individual investors, many of whom are involved in tax-deferred exchanges, Tax loss on the sale of real estate less than book gains under Section 1031 of the Internal Revenue Code of 1986, as Elimination of net revenue and expenses amended (“the Code”). from Crest Net A 2-for-1 stock split was declared in November 2004 and Dividends received from Crest Net became effective after the market closed on December 31, 2004. Preferred dividends not deductible for tax (7,260) (718) 1,410 9,403 Common stockholders received an additional share of common Depreciation and amortization timing differences 11,546 stock for each share they owned. The increase in the number of common shares outstanding and all per common share data has Impairment losses Other adjustments 186 (77) been adjusted for the stock split. 2 . S U M M A R Y O F S I G N I F I C A N T A C C O U N T I N G P O L I C I E S A N D P R O C E D U R E S Federal Income Taxes. We have elected to be taxed as a REIT under the Code. We believe we have qualified and continue to qualify as a REIT. As a REIT, we will be permitted to deduct dis- tributions paid to our stockholders and, generally, will not be required to pay federal corporate income taxes on such income. Accordingly, no provision has been made for federal income taxes in the accompanying consolidated financial statements, except for federal income taxes of Crest Net, which totaled $760,000 in 2005, $2.8 million in 2004 and $1.8 million in 2003. These taxes are included in “income from discontinued operations, real estate acquired for resale by Crest.” Estimated taxable net income, before our dividend paid deduction $ 104,206 Net Income Per Common Share. Basic net income per common share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during each period. Diluted net income per common share is computed by dividing the amount of net income available to common stockholders for the period by the number of common shares that would have been outstanding assuming the issuance of common shares for all potentially dilutive common shares out- standing during the reporting period. The following is a reconciliation of the denominator of the basic net income per common share computation to the denomi- nator of the diluted net income per common share computation, for the years ended December 31: 2005 2004 2003 Weighted average shares used for basic net income per share computation 79,950,255 78,518,296 71,128,282 Incremental shares from share based compensation 258,338 80,492 94,346 Adjusted weighted average shares used for diluted net income per share computation 80,208,593 78,598,788 71,222,628 In 2005, 2004 and 2003, no stock options were anti-dilutive. In 2005, we had 305,476 nonvested shares from share based compensation that were anti-dilutive. No nonvested shares were anti-dilutive in 2004 or 2003. 3 9 R E A LT Y I N C O M E Discontinued Operations. In accordance with Financial Accounting The following is a summary of Realty Income’s “income from Standards Board Statement No. 144, Accounting for the Impairment discontinued operations from real estate held for investment” for or Disposal of Long-Lived Assets (“SFAS 144”), Realty Income’s the years ended December 31, 2005, 2004 and 2003 (dollars operations from four investment properties classified as held in thousands): for sale at December 31, 2005, plus properties sold in 2005, 2004 and 2003, were reported as discontinued operations. Their respective results of operations were reclassified to “income from discontinued operations, real estate held for investment.” We classify properties as held for sale in accordance with SFAS 144. We do not depreciate properties that are classified as held for sale. Crest Net acquires properties with the intention of reselling them rather than holding them for investment and operating the properties. Consequently, we classify properties acquired by Crest Net as held for sale at the date of acquisition and do not depre- ciate them. In accordance with SFAS 144, the operations of Crest Net’s properties are classified as “income from discontinued operations, real estate acquired for resale by Crest.” No debt was assumed by buyers of our investment properties or repaid as a result of our investment property sales and we have elected not to allocate interest expense to discontinued operations related to real estate held for investment. In accordance with Emerging Issues Task Force No. 87-24, we allocate interest expense related to borrowings specifically attributable to Crest Net properties. The interest expense amounts allocated to the Crest Net properties are included in “income from discontinued operations, real estate acquired for resale by Crest.” The following is a summary of Crest Net’s “income from discontinued operations, real estate acquired for resale” for the years ended December 31, 2005, 2004 and 2003 (dollars in thousands): Crest Net’s income from discontinued operations, real estate acquired for resale Gain on sales of real estate 2005 2004 2003 acquired for resale $ 3,291 $ 10,254 $ 6,217 Rental revenue Interest expense 2,085 (1,139) 2,304 (674) 1,724 (561) General and administrative expense Property expenses Income taxes Income from discontinued operations, real estate acquired for resale (453) (60) (943) (464) (93) (3,480) (566) (24) (2,202) by Crest $ 2,781 $ 7,847 $ 4,588 Realty Income’s income from discontinued operations from real estate held for investment Gain on sales of 2005 2004 2003 investment properties $ 6,573 $ 12,543 $ 7,156 Rental revenue Other revenue Depreciation and amortization Property expenses 1,073 3,927 6,845 2 (226) (266) 117 (984) (534) 46 (1,684) (552) Provisions for impairments (35) (2,373) (1,242) Income from discontinued operations, real estate held for investment $ 7,121 $ 12,696 $ 10,569 The following is a summary of our total income from discon- tinued operations for the years ended December 31, 2005, 2004 and 2003 (dollars in thousands): Total income from discontinued operations 2005 2004 2003 Income from discontinued operations: Real estate acquired for resale by Crest $ 2,781 $ 7,847 $ 4,588 Real estate held for investment 7,121 12,696 10,569 Income from discontinued operations $ 9,902 $ 20,543 $ 15,157 Per common share, basic and diluted $ 0.12 $ 0.26 $ 0.21 Leases. All leases are accounted for as operating leases. Under this method, lease payments that have fixed and determinable rent increases are recognized on a straight-line basis over the lease term. Any rental revenue contingent upon a tenant’s sales is rec- ognized only after the tenant exceeds their sales breakpoint. Rental increases based upon changes in the consumer price indexes are recognized only after the changes in the indexes have occurred and are then applied according to the lease agreements. Principles of Consolidation. The accompanying consolidated financial statements include the accounts of Realty Income, Crest Net and other entities for which we make operational and financial decisions (control), after elimination of all material intercompany balances and transactions. All of Realty Income’s and Crest Net’s subsidiaries are wholly-owned. Cash Equivalents. We consider all short-term, highly liquid invest- ments that are readily convertible to cash and have an original maturity of three months or less at the time of purchase to be cash equivalents. R E A LT Y I N C O M E 4 0 Gain on Sales of Properties. We recognize gains on sales of prop- The fair value of the tangible assets of an acquired property erties in accordance with Statement No. 66, Accounting for Sales (which includes land and buildings/improvements) is determined of Real Estate. by valuing the property as if it were vacant, and the “as-if-vacant” value is then allocated to land and buildings/improvements based Depreciation and Amortization. Depreciation of buildings and on our determination of the relative fair value of these assets. Our improvements are computed using the straight-line method over determinations are based on a real estate appraisal for each prop- an estimated useful life of 25 years. erty, generated by an independent appraisal firm, which considered estimates of carrying costs during the expected lease-up periods, Maintenance and Repairs. Expenditures for maintenance and current market conditions, as well as costs to execute similar repairs are expensed as incurred. Replacements and betterments leases. In allocating the fair value to identified intangibles for are capitalized. above-market or below-market leases, an amount is recorded based on the present value of the difference between (i) the Provisions for Impairments. We review long-lived assets for impair- contractual amount to be paid pursuant to the in-place lease and ment whenever events or changes in circumstances indicate that (ii) our estimate of fair market lease rate for the corresponding the carrying amount of an asset may not be recoverable. in-place lease, measured over a period equal to the remaining Generally, a provision is made for impairment if estimated future non-cancelable term of the lease. operating cash flows (undiscounted and without interest charges) Capitalized above-market lease values are amortized as a plus estimated disposition proceeds (undiscounted) are less than the current book value. Impairment loss is measured as the reduction of rental income over the remaining non-cancelable terms of the respective leases. Capitalized below-market lease amount by which the current book value of the asset exceeds the values are amortized as an increase to rental income over the fair value of the asset. If a property is held for sale, it is carried remaining non-cancelable terms of the respective leases and at the lower of cost or estimated fair value, less cost to sell. expected below market renewal option periods. Provisions for impairment of $186,000 were recorded in The aggregate value of other acquired intangible assets con- 2005 on four retail properties, of which two were sold during sists of the value of in-place leases and tenant relationships. These 2005. These properties were classified in the following indus- are measured by the excess of the purchase price paid for a prop- tries: one in child care and three in restaurant. erty, after adjusting for above or below market lease value, less the Provisions for impairment of $2.4 million were recorded in estimated fair value of the property “as if vacant,” determined as 2004 on six retail properties, of which five were sold during 2004. set forth above. The value of in-place leases, exclusive of the value These properties were classified in the following industries: one of above-market and below-market in-place leases, is amortized in automotive service, one in child care, two in consumer electron- to expense over the remaining non-cancelable periods of the ics, one in convenience store and one in restaurant. respective leases. If a lease were to be terminated prior to its Provisions for impairment of $1.2 million were recorded in stated expiration, all unamortized amounts relating to that lease 2003 on 11 retail properties, all of which were sold during 2003. would be recorded to revenue or expense as appropriate. These properties were classified in the following industries: one in automotive service, three in child care, one in consumer elec- Stock Option Plan. Effective January 1, 2002, we adopted the tronics, three in home improvement and three in restaurant. fair value recognition provisions of FASB Statement No. 123, All of these provisions for impairment are included in income Accounting for Stock-Based Compensation, and starting from discontinued operations, real estate held for investment on January 1, 2002 expensed costs for all stock option awards our consolidated statements of income, except for $151,000 in granted, modified, or settled. Stock option awards under the 2005 which is included in property expenses. plan vest over periods ranging from one to five years. Acquired In-place Leases. In accordance with Financial Accounting Standards Board Statement No. 141, Business Combinations, (“SFAS 141”) the fair value of the real estate acquired with in- place operating leases is allocated to the acquired tangible assets, consisting of land, building and improvements, and identified intangible assets and liabilities, consisting of the value of above- market and below-market leases, the value of in-place leases and tenant relationships, based in each case on their fair values. 4 1 R E A LT Y I N C O M E The following table illustrates the effect on net income 3 . R E T A I L P R O P E R T I E S A C Q U I R E D available to common stockholders and earnings per share if the We acquire land, buildings and improvements that are used by fair value method had been applied to all outstanding and retail operators. unvested stock option awards in each period (dollars in thousands, except per share amounts): Net income available to common stockholders, 2005 2004 2003 as reported $ 89,716 $ 90,168 $ 76,722 Add: Stock option-based compensation expense included in reported net income 12 14 11 Deduct: Total stock option- based compensation expense determined under fair value method for all awards Pro forma net income available to common (12) (14) (27) A. During 2005, Realty Income and Crest Net, in aggregate, invested $486.6 million in 156 new retail properties and proper- ties under development. These 156 properties are located in 30 states, will contain over 1.9 million leasable square feet and are 100% leased with an average initial lease term of 15.8 years. Of the $486.6 million invested, $95.1 million was used to acquire 34 properties with existing leases on the properties. In accordance with SFAS 141, Realty Income recorded $10.1 mil- lion and Crest Net recorded $1.8 million as the value of in-place leases and Realty Income recorded $183,000 as the value of above-market rents. In addition, Realty Income recorded $756,000 and Crest Net recorded $66,000 as the value of below-market rents on these leases. The amounts recorded by Realty Income are included in “other assets” and “other liabili- ties” on our consolidated balance sheet and are amortized over the lives of the respective leases. Due to property sales, of the amounts recorded by Crest Net, only $219,000 of in-place stockholders $ 89,716 $ 90,168 $ 76,706 lease value is included in our consolidated balance sheet at Net income available to common stockholders per common share: As reported—basic and diluted $ 1.12 $ 1.15 $ 1.08 Pro forma—basic and diluted $ 1.12 $ 1.15 $ 1.08 Goodwill. Goodwill is tested for impairment annually as well as when events or circumstances occur indicating that our goodwill might be impaired. We did not record any new goodwill or impair- ment on our existing goodwill during 2005, 2004 or 2003. Use of Estimates. The consolidated financial statements were pre- pared in conformity with U.S. generally accepted accounting prin- ciples, which requires management to make estimates and assumptions that affect the reported amounts of assets and liabil- ities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Reclassifications. Certain of the 2004 and 2003 balances have been reclassified to conform to the 2005 presentation. December 31, 2005. Crest Net does not amortize the value of in-place leases because its properties are held for sale. In comparison, during 2004, Realty Income and Crest Net, in aggregate, invested $215.3 million in 194 new retail properties and properties under development. These 194 properties are located in 19 states, contain approximately 972,000 leasable square feet and are 100% leased with an average initial lease term of 17.5 years. B. During 2005, Realty Income invested $430.7 million in 135 new retail properties and properties under development, with an initial weighted average contractual lease rate of 8.4%. These 135 properties are located in 28 states, will contain over 1.7 mil- lion leasable square feet and are 100% leased with an average initial lease term of 15.6 years. In comparison, during 2004, Realty Income invested $193.8 million in 172 new retail properties and properties under development, with an initial weighted average contractual lease rate of 9.5%. These 172 properties are located in 18 states, contain over 913,000 leasable square feet and are 100% leased with an average initial lease term of 17.5 years. C. During 2005, Crest Net invested $55.9 million in 21 new retail properties and properties under development. In comparison, during 2004, Crest Net invested $21.5 million in 22 new retail properties and properties under development. D. Crest Net’s property inventory at December 31, 2005 consisted of 17 properties with a total investment of $45.7 million and at December 31, 2004 consisted of eight properties with a total investment of $10.1 million. These amounts are included on our consolidated balance sheets in “real estate held for sale, net”, except for $219,000 of intangible assets at December 31, 2005 which are included in other assets. R E A LT Y I N C O M E 4 2 4 . C R E D I T F A C I L I T Y In January 1999, we issued $20 million of 8% senior unse- In June 2005, Realty Income entered into a new $300 million cured notes due 2009 (the “2009 Notes”). Interest on the 2009 acquisition credit facility to replace our existing $250 million Notes is payable semiannually. acquisition credit facility that expired in October 2005. Under the terms of the new credit facility, which commenced in October In October 1998, we issued $100 million of 81/4% Monthly Income Senior Notes due 2008 (the “2008 Notes”). In May 2005, the borrowing rate was reduced to LIBOR (London 1998, we entered into a treasury interest rate lock agreement Interbank Offered Rate) plus 65 basis points with a facility fee of associated with the 2008 Notes. In settlement of the agreement, 15 basis points, for all-in drawn pricing of 80 basis points over we made a payment of $8.7 million in 1998. The payment on the LIBOR, based on our current credit ratings. The new credit facil- agreement is being amortized over 10 years (the life of the 2008 ity offers us other interest rate options as well. The term of the Notes) as a yield adjustment to interest expense. After taking into new facility expires in October 2008, unless extended as provided effect the results of a treasury interest rate lock agreement, the in the agreement. The average borrowing rate on our credit facilities during 2005 was 4.3%, compared to 2.4% in 2004 and 2.2% in 2003. Our current credit facility is, and previous credit facili- effective rate to us on the 2008 Notes is 9.12%. Interest on the 2008 Notes is payable monthly. The 2008 Notes are unsecured. In May 1997, we issued $110 million of 73/4% senior unse- cured notes due 2007 (the “2007 Notes”). In December 1996, ties were, subject to various leverage and interest coverage ratio we entered into a treasury interest rate lock agreement associated limitations. The Company is and has been in compliance with with the 2007 Notes. In settlement of the agreement, we received these covenants. In 2005, 2004 and 2003, interest of $1.9 million, $531,000 $1.1 million in 1997. The payment received on the agreement is being amortized over 10 years (the life of the 2007 Notes) as and $697,000, respectively, was capitalized with respect to prop- a yield adjustment to interest expense. After taking into effect the erties under development. results of a treasury interest rate lock agreement, the effective Our credit facility is unsecured and accordingly, we have not interest rate to us on the 2007 Notes is 7.62%. Interest on the pledged any assets as collateral for this obligation. 2007 Notes is payable semiannually. 5 . N O T E S P A Y A B L E In September 2005, we issued $175 million in aggregate principal amount of 5 3/8% senior unsecured notes due 2017 (the “2017 Notes”). The price to the investor for the 2017 Notes was 99.974% Interest incurred on the 2017 Notes, 2035 Bonds, 2015 Notes, 2013 Notes, 2009 Notes, 2008 Notes and 2007 Notes col- lectively for each of the years ended December 31, 2005, 2004 and 2003 was $39.5 million, $32.0 million and $23.6 million, respectively. The interest rate on each of these notes is fixed. of the principal amount for an effective yield of 5.378%. The net Our outstanding notes are unsecured and accordingly, we proceeds of $173.2 million from this offering were used to repay have not pledged any assets as collateral for these or any other borrowings under our unsecured acquisition credit facility, to fund obligations. new property acquisitions and for other general corporate purposes. All of these notes contain various covenants, including: (i) a Interest on the 2017 Notes is paid semiannually. limitation on incurrence of any debt which would cause our debt In March 2005, we issued $100 million in aggregate princi- pal amount of 5 7/8% senior unsecured bonds due 2035 (the “2035 Bonds”). The price to the investor for the 2035 Bonds was to total adjusted assets ratio to exceed 60%; (ii) a limitation on incurrence of any secured debt which would cause our secured debt to total adjusted assets ratio to exceed 40%; (iii) a limitation 98.296% of the principal amount for an effective yield of on incurrence of any debt which would cause our debt service cov- 5.998%. The net proceeds of $97.0 million from this offering erage ratio to be less than 1.5 times; and (iv) the maintenance at were used to repay borrowings under our acquisition credit facil- all times of total unencumbered assets not less than 150% of our ity and for other general corporate purposes. Interest on the 2035 outstanding unsecured debt. We have been in compliance with Bonds is paid semiannually. these covenants since each of the notes were issued. In November 2003, we issued $150 million of 51/2% senior unsecured notes due 2015 (the “2015 Notes”). The price to the investor for the 2015 notes was 99.508% of the principal amount for an effective yield of 5.557%. The net proceeds from this offering were used to acquire new retail properties and to repay borrowings under our unsecured acquisition credit facility. Interest on the 2015 Notes is payable semiannually. In March 2003, we issued $100 million of 5 3/8% senior unsecured notes due 2013 (the “2013 Notes”). The price to the investor for the 2013 notes was 99.509% of the principal amount for an effective yield of 5.439%. The net proceeds from this offering were used to repay borrowings under our unsecured acquisition credit facility. Interest on the 2013 Notes is payable semiannually. 4 3 R E A LT Y I N C O M E The following table summarizes the maturity of our notes The following presents the federal income tax characterization payable as of December 31, 2005 (dollars in millions): of distributions paid or deemed to be paid to common stockholders Year of Maturity 2006 2007 2008 2009 2010 Thereafter Totals Notes $ — 110.0 100.0 20.0 for the years ended December 31: Ordinary income $ 1.210091 $ 1.18315 $ 1.10529 2005 2004 2003 Nontaxable distributions 0.136159 0.05810 0.07596 — Capital gain — — — 525.0 $ 755.0 Totals $ 1.346250 $ 1.24125 $ 1.18125 6 . C O M M O N S T O C K O F F E R I N G S At December 31, 2005, a distribution of $0.11625 per com- mon share was payable and was paid in January 2006. At A. In September 2005, we issued 4.1 million shares of common December 31, 2004, a distribution of $0.11 per common share stock at a price of $23.79 per share. The net proceeds of was payable and was paid in January 2005. $92.7 million were used to fund new property acquisitions and for other general corporate purposes. B. In May 2004, we issued 4.0 million shares of 7.375% Monthly Income Class D cumulative redeemable preferred stock, with a B. In March 2004, we issued 3.2 million shares of common stock liquidation value of $25 per share. All of these shares are out- at a price of $22.375 per share. The net proceeds of $67.9 mil- standing. The net proceeds of $96.4 million from this issuance lion were used to repay a portion of our acquisition credit facility were used to redeem a portion of the outstanding Class B and borrowings, which had been used to acquire 112 convenience Class C preferred stock, repay borrowings outstanding under our store properties in March 2004. $250 million acquisition credit facility and for other general cor- porate purposes. Beginning May 27, 2009, the Class D preferred C. In October 2003, we issued 5.75 million shares of common shares are redeemable at our option for $25 per share. Dividends stock at a price of $20.295 per share. The net proceeds of of $0.1536459 per share are paid monthly in arrears on the Class $110.8 million were used to repay a portion of our acquisition D preferred stock. credit facility. 7 . D I S T R I B U T I O N S P A I D A N D P A Y A B L E In October 2004, we issued an additional 1.1 million shares of Class D preferred stock for $25.4311 per share. The net pro- ceeds of $27.4 million were used to repay borrowings under our A. We pay monthly cash distributions to our common stockhold- $250 million acquisition credit facility. ers. The following is a summary of monthly distributions paid per We paid or accrued dividends to holders of our Class D preferred common share for the years ended December 31: stock totaling $9.4 million in 2005 and $4.8 million in 2004. 2005 2004 2003 The dividends paid per share to our Class D preferred stockholders for 2005 of $1.84375 and for 2004 of $1.01406 were character- $ 0.110000 $ 0.100000 $ 0.097500 ized for federal income tax purposes as ordinary income. Month January February March April May June July August September October November December 0.110000 0.110000 0.110625 0.110625 0.110625 0.111250 0.111250 0.115000 0.115625 0.115625 0.115625 0.100000 0.100000 0.100625 0.100625 0.100625 0.101250 0.101250 0.108750 0.109375 0.109375 0.109375 0.097500 0.097500 0.098125 0.098125 0.098125 0.098750 0.098750 0.098750 0.099375 0.099375 0.099375 Total $ 1.346250 $ 1.241250 $ 1.181250 C. In May 1999, we issued 2,760,000 shares of 93/8% Class B cumulative redeemable preferred stock, of which 2,745,700 shares were outstanding in 2003 and a portion of 2004. On June 6, 2004, all of the outstanding Class B preferred shares were redeemed. We paid dividends to holders of our Class B preferred stock totaling $2.8 million during the first two quarters of 2004 and $6.4 million in 2003. The dividends paid per share to our Class B Preferred stockholders in 2004 of $1.01563 and in 2003 of $2.34375 were characterized for federal income tax purposes as ordinary income. In addition, when our Class B preferred stock was redeemed in 2004, we incurred a non-cash charge of $2.4 million repre- senting the Class B preferred stock original issuance costs that were paid in 1999. R E A LT Y I N C O M E 4 4 D. In July 1999, we issued 1,380,000 shares of 91/2% Class C cumulative redeemable preferred stock, all of which were out- B. Major Tenants—No individual tenant’s rental revenue, including percentage rents, represented more than 10% of our total revenue standing in 2003 and for a portion of 2004. On July 30, 2004, for each of the years ended December 31, 2005, 2004 or 2003. all of the outstanding Class C preferred shares were redeemed. We paid monthly dividends to holders of our Class C preferred stock totaling $1.9 million during the first seven months of 2004 9 . G A I N O N S A L E S O F R E A L E S T A T E A C Q U I R E D F O R R E S A L E B Y C R E S T N E T and $3.3 million in 2003. The dividends paid per share to our In 2005, Crest Net sold 12 properties for $23.5 million, which Class C preferred stockholders in 2004 of $1.37882 and in resulted in a gain of $3.3 million. As part of one sale in 2005, Crest 2003 of $2.375 were characterized for federal income tax pur- Net provided buyer financing in the form of a $1.3 million promis- poses as ordinary income. sory note. This note was paid in full in February 2006. In 2004, In addition, when our Class C preferred stock was redeemed Crest Net sold 51 properties for $75.0 million, which resulted in a in 2004, we incurred a non-cash charge of $1.4 million repre- gain of $10.3 million. In 2003, Crest Net sold 27 properties for senting the Class C preferred stock original issuance costs that $45.2 million, which resulted in a gain of $6.2 million. were paid in 1999. 8 . O P E R A T I N G L E A S E S 1 0 . G A I N O N S A L E S O F I N V E S T M E N T P R O P E R T I E S B Y R E A L T Y I N C O M E A. At December 31, 2005, we owned 1,646 properties in 48 In 2005, we sold 23 investment properties and sold a portion of states, excluding 17 properties owned by Crest Net. Of these 1,646 properties, 1,641 are single-tenant retail locations and the the land from two properties for $23.4 million, which resulted in a gain of $6.6 million. This gain is included in discontinued oper- remainder are multi-tenant, distribution and office locations. At ations, except for $18,000 that is included in other revenue. December 31, 2005, 25 properties were vacant and available In 2004, we sold or exchanged 43 investment properties and for lease or sale. sold a portion of the land from four properties for $35.4 million, Substantially all leases are net leases where the tenant pays which resulted in a gain of $12.7 million. Of this gain, $12.5 mil- property taxes and assessments, maintains the interior and lion is included in discontinued operations and $185,000 is exterior of the building and leased premises, and carries insur- included in other revenue. Included in the 43 properties was one ance coverage for public liability, property damage, fire and property leased by one of our tenants that we exchanged for extended coverage. another property owned by that tenant (see note 12E). Percentage rent for 2005, 2004 and 2003 was $1.2 million, During 2003, we sold or exchanged 35 investment properties $1.3 million and $1.2 million, respectively, including amounts and exchanged three excess land parcels (from three properties) for recorded to discontinued operations. $23.1 million, which resulted in a gain of $7.2 million. This gain is At December 31, 2005, minimum future annual rents to be included in discontinued operations. Included in the 35 properties received on the operating leases are as follows (dollars in thousands): was one property leased by one of our tenants that we exchanged for another property owned by that tenant (see note 12F). For the years ending December 31, 2006 2007 2008 2009 2010 Thereafter Total $ 212,994 1 1 . F A I R V A L U E O F 203,830 194,904 185,524 178,848 F I N A N C I A L I N S T R U M E N T S We believe that the carrying values reflected in the consolidated balance sheets at December 31, 2005 and 2004 reasonably approximate the fair values for cash and cash equivalents, 1,686,908 accounts receivable, and all liabilities, due to their short-term $ 2,663,008 nature, except for the line of credit payable and notes payable. In making these assessments, we used estimates. The fair value of the line of credit payable approximates its carrying value because its terms are similar to those available in the market place at December 31, 2005. The estimated fair value of the notes payable at December 31, 2005 is $755.0 million and at December 31, 2004 is $500.9 million, based upon the closing market price per note or indicative price per each note at December 31, 2005 and 2004, respectively. 4 5 R E A LT Y I N C O M E 1 2 . S U P P L E M E N T A L D I S C L O S U R E S G. In 2003, non-cash additions to properties resulted in an O F C A S H F L O W I N F O R M A T I O N increase in buildings of $1.7 million, an increase in real estate Interest paid in 2005 was $36.4 million, in 2004 was $31.3 mil- held for sale, net of $289,000 and an increase in other liabili- lion and in 2003 was $32.5 million. ties of $2.0 million. Income taxes paid by Realty Income and Crest Net in 2005 were $1.4 million, in 2004 were $6.9 million and in 2003 were H. Stock based compensation resulted in the following (dollars in $0.8 million. thousands): The following non-cash investing and financing activities are included in the accompanying consolidated financial statements: 2005 2004 2003 A. In 2005, noncash additions to properties resulted in an increase in buildings of $5.4 million, an increase in accounts payable of I. Distributions payable on our balance sheets is comprised of $5.1 million. the following accrued distributions (dollars in thousands): Deferred stock compensation $ 2,168 $ 1,441 $ 951 B. In 2005, Crest Net sold a property for $2.8 million and issued 2005 2004 a mortgage note of $1.3 million, which was paid in full in Common stock distributions $ 9,729 $ 8,723 February 2006 and is included in other assets on our consoli- Preferred stock dividends 392 392 dated balance sheet. C. In June 2004, when our Class B preferred stock was redeemed, we incurred a non-cash charge of $2.4 million for the excess of redemption value over the carrying value. D. In July 2004, when our Class C preferred stock was redeemed, we incurred a non-cash charge of $1.4 million for the excess of redemption value over the carrying value. 1 3 . E M P L O Y E E B E N E F I T P L A N We have a 401(k) plan covering substantially all of our employees. Under our 401(k) plan, employees may elect to make contribu- tions to the plan up to a maximum of 60% of their compensation, subject to limits under the IRS Code. We match 50% of our employee’s contributions, up to 3% of the employee’s compen- sation. Our aggregate matching contributions each year have been immaterial to our results of operations. E. In 2004, we exchanged one of our properties for a different 1 4 . C O M M O N S T O C K I N C E N T I V E P L A N property that was leased to the same tenant. As part of this transaction, land was reduced by $160,000, building was increased by $78,000, and accumulated depreciation was decreased by $82,000. F. In 2003, we exchanged excess land parcels from three differ- ent properties leased by one of our tenants for land (with improve- ments) owned by that same tenant. In 2003, we also exchanged one property leased by one of our tenants for another property owned by that tenant. As part of these transactions, accumu- lated depreciation was decreased by $64,000 and gain on sale of $64,000 was recognized. In 2003, our Board of Directors adopted and our stockholders approved the 2003 Incentive Award Plan of Realty Income Corporation to enable us to attract and retain the services of directors, employees and consultants considered essential to our long-term success, by offering them an opportunity to own stock in Realty Income and/or rights that will reflect our growth, devel- opment and financial success. The 2003 Incentive Award Plan of Realty Income Corporation was amended and restated by our Board of Directors on February 21, 2006. Under the terms of this plan, the aggregate number of shares of our common stock sub- ject to options, stock purchase rights, stock appreciation rights and other awards will be no more than 3,428,000 shares. The maximum number of shares, which may be subject to options, stock purchase rights, stock appreciation rights and other awards granted under the plan to any individual in any calendar year may not exceed 1,600,000 shares. This plan has a term of 10 years from the date it was adopted by our Board of Directors, which was March 12, 2003. In 1993, our Board of Directors approved a stock incentive plan (the “Stock Plan”), which expired in 2004. Stock options are granted with an exercise price equal to the underlying stock’s fair market value at the date of grant. Stock options expire ten years from the date they are granted and vest over service periods of one, three, four and five years. No stock options were granted in 2005, 2004 or 2003. R E A LT Y I N C O M E 4 6 The following table summarizes our stock option activity for the years 2005, 2004 and 2003: 2005 2004 2003 Number of Shares Weighted Average Exercise Price Number of Shares Weighted Average Exercise Price Number of Shares Weighted Average Exercise Price Outstanding, beginning of year 176,130 $ 13.01 247,756 $ 12.53 380,480 $ 12.01 Options granted Options exercised Options canceled — (40,352) (430) — 12.93 14.70 — (67,648) (3,978) — 11.16 14.70 — (130,126) (2,598) — 10.97 14.70 Outstanding, end of year 135,348 $ 13.02 176,130 $ 13.01 247,756 $ 12.53 Options exercisable, end of year 119,924 153,206 207,324 At December 31, 2005, the options outstanding under the Stock Plan had exercise prices ranging from $10.63 to $14.70, with a weighted average price of $13.02, and expiration dates ranging from June 2007 to December 2011 with a weighted average remain- ing term of 3.3 years. At December 31, 2005, the options exercisable under the Stock Plan had exercise prices ranging from $10.63 to $14.70 with a weighted average price of $12.87. Cash received from the exercise of options is included in deferred stock compen- sation on our consolidated statements of stockholders’ equity. The following table summarizes our nonvested common stock grant activity for the years 2005, 2004 and 2003. The grants vest over periods ranging from five to 10 years. 2005 2004 2003 Number of Shares 626,868 306,241 (92,811) (51,576) Weighted Average Grant Price $ 14.98 25.20 16.69 17.31 Number of Shares 475,174 218,180 (64,116) (2,370) Weighted Average Grant Price $ 13.70 19.94 15.16 18.65 Number of Shares 332,584 189,732 (45,802) (1,340) Weighted Average Grant Price $ 12.43 17.59 13.69 16.92 Outstanding nonvested shares, beginning of year Shares granted Shares vested Shares forfeited Outstanding nonvested shares, end of year 788,722 $ 17.83 626,868 $ 14.98 475,174 $ 13.70 4 7 R E A LT Y I N C O M E 1 5 . S T O C K H O L D E R R I G H T S P L A N Assets In 1998, our Board of Directors adopted a Stockholder Rights Plan As of December 31, 2005 2004 (the “Rights Plan”) that was to expire in July 2008. The Rights Segment net real estate: Plan was canceled by the Board of Directors in February 2005. 1 6 . S E G M E N T I N F O R M A T I O N Apparel stores Automotive parts Automotive service We evaluate performance and make resource allocation deci- Automotive tire services sions on an industry by industry basis. For financial reporting Child care purposes, we have grouped our tenants into 30 industry and Consumer electronics activity segments (including properties owned by Crest Net that Convenience stores are grouped together). All of the properties are incorporated into one of the applicable segments. Because almost all of our leases require the tenant to pay operating expenses, revenue is the only component of segment profit and loss we measure. Drug stores Entertainment Health and fitness Home furnishings The following tables set forth certain information regarding the Home improvement properties owned by us, classified according to the business of the Motor vehicle dealerships respective tenants as of December 31, 2005 (dollars in thousands): Office supplies For the years ended December 31, Segment rental revenue: Revenue Pet supplies and services Restaurants 2005 2004 2003 Sporting goods Theaters Video rental 11 other non-reportable Apparel stores $ 3,100 $ 3,100 $ 3,158 Automotive parts 6,718 6,716 6,694 Automotive service 14,970 13,329 12,085 Automotive tire services Child care Consumer electronics 14,112 24,918 2,606 13,510 24,898 3,176 4,528 24,664 3,364 Other intangible assets— Drug stores Other intangible assets— Convenience stores 36,624 33,293 18,492 Theaters $ 21,688 $ 22,492 39,319 106,833 129,314 102,228 23,408 342,404 65,846 35,402 87,426 55,728 17,846 71,035 22,852 17,152 163,811 57,913 250,214 33,163 41,153 109,836 133,296 109,523 25,320 321,746 2,320 35,400 58,647 57,588 18,156 40,786 22,305 16,795 116,534 59,535 51,837 34,277 Drug stores Entertainment Health and fitness Home furnishings Home improvement Motor vehicle dealerships Office supplies Pet supplies 5,593 4,081 7,212 7,346 2,130 5,060 2,996 243 3,997 6,919 7,276 2,115 859 2,868 243 3,869 5,638 7,378 2,265 51 2,865 and services 2,587 2,511 2,564 Restaurants Sporting goods Theaters Video rental 11 other non-reportable 18,329 16,466 16,264 6,747 10,139 4,942 5,939 6,052 4,959 5,664 6,015 4,806 segments 16,112 14,488 12,281 Reconciling items— Interest and other 354 1,033 590 Total revenue $ 196,676 $ 173,747 $ 143,478 segments 158,464 129,164 Total segment net real estate 1,802,046 1,406,710 8,489 1,419 109,034 — — 35,605 Other corporate assets Total assets $ 1,920,988 $ 1,442,315 1 7 . C O M M I T M E N T S A N D C O N T I N G E N C I E S In the ordinary course of our business, we are party to various legal actions which we believe are routine in nature and inciden- tal to the operation of our business. We believe that the outcome of the proceedings will not have a material adverse effect upon our consolidated financial statements taken as a whole. At December 31, 2005, we have committed to pay estimated unfunded development costs of $42.2 million on properties under development. We also have contingent payments for tenant improvements and leasing costs of $456,000. In 2004, we recorded impairment of $716,000 on one prop- erty to reduce its carrying value to zero. This property is classified as held for sale. This impairment was the result of a title insurance company failing to timely record a deed on this property. It is likely that through our tenant’s bankruptcy proceedings, our title to this property will be divested. We believe that we have a strong claim against the title insurance company and others for the loss of the current fair market value of the property, rent which we may be required to repay to the tenant, and direct and incidental costs incurred. Our claim against the title insurance company and others is estimated to be between $750,000 and $1.3 million, which is not reflected in our consolidated financial statements as this represents a contingent gain. R E A LT Y I N C O M E 4 8 REALTY INCOME CORPORATION AND SUBSIDIARIES R E P O R T S O F I N D E P E N D E N T R E G I S T E R E D P U B L I C A C C O U N T I N G F I R M The Board of Directors and Stockholders Realty Income Corporation: We have audited the accompanying consolidated balance sheets In our opinion, the consolidated financial statements referred to of Realty Income Corporation and subsidiaries as of December 31, above present fairly, in all material respects, the financial position of 2005 and 2004, and the related consolidated statements of Realty Income Corporation and subsidiaries as of December 31, income, stockholders’ equity, and cash flows for each of the years 2005 and 2004, and the results of their operations and their in the three-year period ended December 31, 2005. These con- cash flows for each of the years in the three-year period ended solidated financial statements are the responsibility of Realty December 31, 2005, in conformity with U.S. generally accepted Income Corporation’s management. Our responsibility is to express accounting principles. an opinion on these consolidated financial statements based on We also have audited, in accordance with the standards of the our audits. Public Company Accounting Oversight Board (United States), the We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). effectiveness of Realty Income Corporation’s internal control over financial reporting as of December 31, 2005, based on Those standards require that we plan and perform the audit to criteria established in Internal Control-Integrated Framework obtain reasonable assurance about whether the financial state- issued by the Committee of Sponsoring Organizations of the ments are free of material misstatement. An audit includes Treadway Commission (COSO), and our report dated February 21, examining, on a test basis, evidence supporting the amounts 2006 expressed an unqualified opinion on management’s assess- and disclosures in the financial statements. An audit also ment of, and the effective operation of, internal control over includes assessing the accounting principles used and significant financial reporting. estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. San Diego, California February 21, 2006 4 9 R E A LT Y I N C O M E The Board of Directors and Stockholders Realty Income Corporation: We have audited management’s assessment, included in the Because of its inherent limitations, internal control over finan- accompanying Management’s Report on Internal Control Over cial reporting may not prevent or detect misstatements. Also, pro- Financial Reporting, that Realty Income Corporation main- jections of any evaluation of effectiveness to future periods are tained effective internal control over financial reporting as of subject to the risk that controls may become inadequate because December 31, 2005, based on criteria established in Internal of changes in conditions, or that the degree of compliance with Control-Integrated Framework issued by the Committee of the policies or procedures may deteriorate. Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, management’s assessment that Realty Income Realty Income Corporation’s management is responsible for main- Corporation maintained effective internal control over financial taining effective internal control over financial reporting and for reporting as of December 31, 2005, is fairly stated, in all mate- its assessment of the effectiveness of internal control over financial rial respects, based on criteria established in Internal Control- reporting. Our responsibility is to express an opinion on manage- Integrated Framework issued by the Committee of Sponsoring ment’s assessment and an opinion on the effectiveness of Realty Organizations of the Treadway Commission (COSO). Also, in our Income Corporation’s internal control over financial reporting opinion, Realty Income Corporation maintained, in all material based on our audit. respects, effective internal control over financial reporting as of We conducted our audit in accordance with the standards of December 31, 2005, based on criteria established in Internal the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). obtain reasonable assurance about whether effective internal con- We also have audited, in accordance with the standards of the trol over financial reporting was maintained in all material Public Company Accounting Oversight Board (United States), respects. Our audit included obtaining an understanding of inter- the consolidated financial statements of Realty Income nal control over financial reporting, evaluating management’s Corporation and subsidiaries as of December 31, 2005 and assessment, testing and evaluating the design and operating effec- 2004, and for each of the years in the three-year period ended tiveness of internal control, and performing such other proce- December 31, 2005, and our report dated February 21, 2006 dures as we considered necessary in the circumstances. We expressed an unqualified opinion on those consolidated financial believe that our audit provides a reasonable basis for our opinion. statements. San Diego, California February 21, 2006 A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. R E A LT Y I N C O M E 5 0 REALTY INCOME CORPORATION AND SUBSIDIARIES M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S O F F I N A N C I A L C O N D I T I O N A N D R E S U L T S O F O P E R A T I O N S G E N E R A L intend to retain an appropriate amount of cash as working capi- Realty Income Corporation, The Monthly Dividend Company®, is a tal. At December 31, 2005, we had cash and cash equivalents Maryland corporation organized to operate as an equity real estate totaling $65.7 million. investment trust, or REIT. Our primary business objective is to We believe that our cash and cash equivalents on hand, cash generate dependable monthly cash distributions from a consis- provided from operating activities and borrowing capacity is suf- tent and predictable level of funds from operations, or FFO per ficient to meet our liquidity needs for the foreseeable future. We share. The monthly distributions are supported by the cash flow intend, however, to use additional sources of capital to fund prop- from our portfolio of retail properties leased to regional and erty acquisitions and to repay our credit facility. 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 $300 Million Credit Facility We have a $300 million revolving, unsecured acquisition credit and its predecessors have been acquiring and owning freestand- ing retail properties that generate rental revenue under long-term facility that expires in October 2008. Realty Income’s current investment grade credit ratings provide for financing under the lease agreements (primarily 15- to 20-years). credit facility at the London Interbank Offered Rate, commonly In addition, we seek to increase distributions to stockholders referred to as LIBOR, plus 65 basis points with a facility fee of 15 and FFO per share through both active portfolio management basis points, for all-in drawn pricing of 80 basis points over and the acquisition of additional properties. At December 31, LIBOR. At February 10, 2006, we had a borrowing capacity of 2005, we owned a diversified portfolio: • Of 1,646 retail properties; $168.4 million available on our credit facility and an outstanding balance of $131.6 million at an effective interest rate of 5.2%. • With an occupancy rate of 98.5%, or 1,621 properties The credit facility is expected to be used to acquire additional occupied of the 1,646 properties in the portfolio; retail properties and for other corporate purposes. Any additional • Leased to 101 different retail chains doing business in borrowings will increase our exposure to interest rate risk. 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. 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 state- Of the 1,646 properties in the portfolio, 1,641, or 99.7%, are ment with the SEC registering the issuance, from time to time, of single-tenant, retail properties and the remaining five are multi- up to $800 million in aggregate value of common stock, preferred tenant, distribution and office properties. At December 31, stock and debt securities. At February 10, 2006, $227.9 million 2005, 1,617, or 98.5%, of the 1,641 single-tenant properties remained available for issuance under our universal shelf registra- were leased with a weighted average remaining lease term tion statement. (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 Issuance of Common Stock in 2005 In September 2005, Realty Income issued 4.1 million shares of $45.7 million at December 31, 2005, which are classified as common stock. The net proceeds of approximately $92.7 million held for sale. Crest Net was created to buy, own and sell proper- from this offering were used to fund new property acquisitions ties, primarily to individual investors, many of whom are involved and for other general corporate purposes. in tax-deferred exchanges under Section 1031 of the Internal Revenue Code of 1986, as amended. L I Q U I D I T Y A N D C A P I T A L R E S O U R C E S Cash Reserves Realty Income is organized to operate as an equity REIT that Issuance of 12-Year Senior Unsecured Notes In September 2005, Realty Income issued $175 million in aggre- gate principal amount of 12-year, 53/8% 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 pro- acquires and leases properties and distributes to stockholders, in ceeds from the offering were used to repay borrowings under the the form of monthly cash distributions, a substantial portion of its Company’s unsecured acquisition credit facility, for property acqui- net cash flow generated from leases on its retail properties. We sitions and for other general corporate purposes. 5 1 R E A LT Y I N C O M E Issuance of 30-Year Senior Unsecured Bonds In March 2005, Realty Income issued $100 million in aggregate principal amount of 30-year, 57/8% 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 cor- porate purposes. BBB- to our preferred stock. Moody’s rating has a “positive” out- look 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 53/8%, 12-year, senior unsecured notes due 2017. Interest on these notes is paid semiannually. Conservative Capital Structure We believe that our stockholders are best served by a conservative In March 2005, we issued $100 million of 57/8%, 30-year, senior unsecured bonds due 2035. Interest on these bonds is capital structure. Therefore, we seek to maintain a conservative paid semiannually. debt level on our balance sheet and solid interest and fixed charge coverage ratios. At February 10, 2006, our total outstand- In November 2003, we issued $150 million of 5 1/2%, 12-year, senior unsecured notes due 2015 (the “2015 Notes”). ing credit facility borrowings and outstanding notes were Interest on the 2015 Notes is paid semiannually. $886.6 million or approximately 30.3% of our total market capitalization of $2.92 billion. We calculate our total market In March 2003, we issued $100 million of 53/8%, 10-year, senior unsecured notes due 2013 (the “2013 Notes”). Interest capitalization at February 10, 2006 as the sum of: on the 2013 Notes is paid semiannually. • Shares of our common stock outstanding of 83,880,873 In January 1999, we issued $20 million of 8% senior unse- multiplied by the last reported sales price of our common cured notes due 2009 (the “2009 Notes”). Interest on the 2009 stock on the NYSE of $22.78 per share, or $1.91 billion; Notes is payable semiannually. • 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. In October 1998, we issued $100 million of 81/4% Monthly Income Senior Notes due 2008 (the “2008 Notes”). Interest on the 2008 Notes is payable monthly. The 2008 Notes are unsecured. In May 1997, we issued $110 million of 73/4% senior unse- cured notes due 2007 (the “2007 Notes”). Interest on the 2007 Notes is payable semiannually. Historically, we have met our long-term capital needs through All of these notes contain various covenants, including: (i) a the issuance of common stock, preferred stock and long-term limitation on incurrence of any debt which would cause our debt unsecured notes and bonds. Over the long term, we believe that to total adjusted assets ratio to exceed 60%; (ii) a limitation on the majority of our future securities issuances should be in the incurrence of any secured debt which would cause our secured form of common stock, however, we may issue additional pre- debt to total adjusted assets ratio to exceed 40%; (iii) a limitation ferred stock or debt securities from time to time. We may issue on incurrence of any debt which would cause our debt service common stock when we believe that our share price is at a level coverage ratio to be less than 1.5 times; and (iv) the maintenance that allows for the proceeds of any offering to be accretively at all times of total unencumbered assets not less than 150% of invested into additional properties. In addition, we may issue our outstanding unsecured debt. We have been in compliance common stock to permanently finance properties that were with these covenants since each of the notes were issued. financed by our credit facility or debt securities. However, we can- The following is a summary of the key financial covenants not assure you that we will have access to the capital markets at to our senior unsecured notes. The actual amounts are as of terms that are acceptable to us. December 31, 2005. Credit Agency Ratings We are currently assigned investment grade corporate credit rat- Note Covenants Required Actual Limitation on Incurrence ings, on our senior unsecured notes, from Fitch Ratings, Moody’s of Total Debt ≤ 60% Investors Service, Inc. and Standard & Poor’s Ratings Group. Limitation on Incurrence 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 of Secured Debt Debt Service Coverage Maintenance of Total Unencumbered Assets ≤ 40% ≥ 1.5 x ≥ 150% of Unsecured Debt 40.0% 0.0% 4.4 x 250% from the same rating agencies on our preferred stock. Fitch All of our outstanding notes have fixed interest rates. Our Ratings has assigned a rating of BBB, Moody’s has assigned a credit facility interest rate is variable. rating of Baa3 and Standard & Poor’s has assigned a rating of R E A LT Y I N C O M E 5 2 The following table summarizes the maturity of each of our obligations as of December 31, 2005 (dollars in millions): Table of Obligations Year of Maturity Credit Facility(1) 2006 2007 2008 2009 2010 Thereafter Totals $ — — 136.7 — — — Notes $ — 110.0 100.0 20.0 — 525.0 $ 136.7 $ 755.0 Interest(2) $ 54.2 48.6 43.5 29.0 28.9 257.3 $ 461.5 Other(3) $ 42.7 Totals $ 96.9 — — — — — 158.6 280.2 49.0 28.9 782.3 $ 42.7 $ 1,395.9 (1)The credit facility balance was $131.6 million as of February 10, 2006. (2)Interest on credit facility and notes has been calculated based on outstanding balances as of December 31, 2005 through their respective maturity dates. (3)Other consists of $42.2 million of estimated unfunded costs on properties under development and $456,000 of contingent payments for tenant improvements and leasing costs. Our credit facility and note obligations are unsecured. Accordingly, we have not pledged any assets as collateral for Included in the $486.6 million is $430.7 million invested by Realty Income in 135 new properties and properties under devel- these obligations. opment with an initial weighted average contractual lease rate of 8.4%. These 135 properties are located in 28 states, are 100% Preferred Stock Outstanding In May and October 2004, we issued an aggregate of 5.1 million leased with an initial average lease term of 15.6 years and will contain over 1.7 million leasable square feet. The 135 new prop- shares of 7.375% Class D cumulative redeemable preferred erties acquired by Realty Income are net-leased to 13 different stock. Beginning May 27, 2009, shares of Class D preferred stock retail chains in the convenience store, drug store, financial serv- are redeemable at our option for $25.00 per share, plus any ices, health and fitness, motor vehicle dealership, restaurant and accrued and unpaid dividends. Dividends on shares of Class D theater industries. At December 31, 2005, 10 new properties preferred are paid monthly in arrears. No Off-Balance Sheet Arrangements or Unconsolidated Investment Realty Income and its subsidiaries have no unconsolidated or acquired during 2005 were leased and under contract for devel- opment by the tenant (with development costs funded by Realty Income) with rent scheduled to begin at various times during the next 12 months. Included in the $486.6 million is $55.9 million invested off-balance sheet investments in “variable interest entities” or by Crest Net in 21 new retail properties and properties under off-balance sheet financing, nor do we engage in trading activ- development. ities involving energy or commodity contracts or other derivative Of the $430.7 million Realty Income invested in real estate instruments. during 2005, $43.9 million was invested in properties under As we have no joint ventures, off-balance sheet entities, or development with rent scheduled to begin at various times during mandatory redeemable preferred stock, our financial position or 2006. At December 31, 2005, we also had committed to pay results of operations are currently not affected by Financial estimated unfunded development costs totaling $42.2 million. Accounting Standard Board Interpretation No. 46R, Consolidation The initial weighted average contractual lease rate is com- of Variable Interest Entitiesand Statement of Financial Accounting puted as estimated contractual net operating income (in a net- Standard No. 150, Accounting for Certain Financial Instruments leased property this is equal to the base rent or, in the case of with Characteristics of both Liabilities and Equity. properties under development, the estimated base rent under the Acquisitions During 2005 During 2005, Realty Income and Crest Net invested, in aggre- 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 gate, $486.6 million in 156 new properties and properties under actual return on the funds invested will remain at the percent- development. These 156 properties are located in 30 states and ages listed above. 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. Investments in Existing Properties In 2005, we capitalized costs of $1.6 million on existing proper- ties in our portfolio, consisting of $570,000 for re-leasing costs and $1.0 million for building improvements. 5 3 R E A LT Y I N C O M E Sales of Investment Properties During 2005, we sold 23 properties and sold a portion of land 2006 by $.000625 to $0.11625. The increase in January 2006 was our 33rd consecutive quarterly increase and the 37th from two properties for an aggregate of $23.4 million, which increase in the amount of our dividend since our listing on the resulted in a gain on sales of $6.6 million. This gain is included NYSE in 1994. In 2005, we paid the following monthly cash in discontinued operations, except for $18,000 that is included distributions per share: three in the amount of $0.11, three in the in other revenue. The 23 properties sold consisted of one automo- amount of $0.110625, two in the amount of $0.11125, one in tive service store, two automotive tire service locations, seven the amount of $0.115, and three in the amount of $0.115625 child care facilities, two consumer electronics stores, one conven- totaling $1.34625. In December 2005, January 2006 and ience store, one motor vehicle dealership, one private education February 2006, we declared distributions of $0.11625 per share, facility, seven restaurants, and one property classified as “other.” which were paid on January 17, 2006 and February 15, 2006 The net proceeds from the sale of these properties were used to and will be paid on March 15, 2006, respectively. repay outstanding indebtedness on our credit facility and to invest The monthly distribution of $0.11625 per share represents a in new properties. current annualized distribution of $1.395 per share, and an annualized distribution yield of approximately 6.1% based on the Crest Net Property Sales During 2005, Crest Net, our wholly-owned subsidiary, sold 12 last reported sale price of our common stock on the NYSE of $22.78 on February 10, 2006. Although we expect to continue properties from its inventory for $23.5 million, which resulted in our policy of paying monthly distributions, we cannot guarantee a gain of $3.3 million. Crest Net’s Property Inventory Crest Net’s property inventory totaled $45.7 million at December 31, 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. 2005 as compared to $10.1 million at December 31, 2004. R E S U L T S O F O P E R A T I O N S Crest Net’s properties are included in “real estate held for sale, net”, on our consolidated balance sheets. Critical Accounting Policies Our consolidated financial statements have been prepared in The financial statements of Crest Net are consolidated into accordance with U.S. generally accepted accounting principles Realty Income’s financial statements. All material intercompany (“GAAP”). Our consolidated financial statements are the basis for transactions have been eliminated in consolidation. our discussion and analysis of financial condition and results of operations. Preparing our consolidated financial statements Increases in Monthly Cash Distributions to Common Stockholders We continue our 36-year policy of paying distributions monthly. 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 esti- Monthly distributions per share were increased in April 2005 by mates and assumptions in an appropriate manner and in a way $0.000625 to $0.110625, in July 2005 by $0.000625 to that accurately reflects our financial condition. We continually $0.11125, in September 2005 by $0.00375 to $0.115, in test and evaluate these estimates and assumptions using our October 2005 by $0.000625 to $0.115625 and in January 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 proper- ties. Depreciation of buildings and improvements is computed using the straight-line method over an estimated useful life of 25 years. If we use a shorter or longer estimated useful life it could have a material impact on our results of operations. We believe that 25 years is an appropriate estimate of useful life. No depreciation has been recorded on Crest Net’s properties because they are held for sale. Another significant judgment that must be made is, if and when the impairment losses should be taken on our properties when events or change in circumstances indicate that the carrying amount of the asset may not be recoverable. Generally, a provision is made for impairment loss if estimated future operating cash flows (undiscounted and without interest charges) plus estimated R E A LT Y I N C O M E 5 4 disposition proceeds (undiscounted) are less than the current Of the 1,646 properties in the portfolio at December 31, book value. Impairment losses are measured as the amount by 2005, 1,641, or 99.7%, are single-tenant properties and the which the current book value of the asset exceeds the fair value remaining properties are multi-tenant, distribution and office of the asset. If a property is held for sale, it is carried at the properties. Of the 1,641 single-tenant properties, 1,617, or lower of carrying cost or estimated fair value, less costs to sell. 98.5 %, were net leased with a weighted average remaining The carrying value of our real estate is the largest component lease term (excluding rights to extend a lease at the option of the of our consolidated balance sheet. If events should occur that tenant) of approximately 12.4 years at December 31, 2005. Of require us to reduce the carrying value of our real estate by our 1,617 leased single-tenant and certain other properties, recording provisions for impairment losses, it could have a 1,488, or 92.0%, were under leases that provide for increases in material impact on our results of operations. rents through: • Base rent increases tied to a consumer price index with The following is a comparison of our results of operations for the years ended December 31, 2005, 2004 and 2003. adjustment ceilings; • Fixed increases; Rental Revenue Rental revenue was $196.3 million for 2005 versus $172.7 mil- lion for 2004, an increase of $23.6 million, or 13.7%. Rental • 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. revenue was $142.9 million in 2003. The increase in rental rev- enue in 2005 compared to 2004 is primarily attributable to: Percentage rent, which is included in rental revenue, was $1.2 million in 2005, $1.3 million in 2004 and $1.1 million in • The 135 retail properties acquired by Realty Income in 2003. Percentage rent in 2005 was less than 1% of rental rev- 2005, which generated $12.1 million in 2005; enue and we anticipate percentage rent to be less than 1% of • The 172 retail properties acquired by Realty Income in rental revenue in 2006. 2004, which generated $17.1 million in 2005 compared to As of February 10, 2006, transactions to lease or sell 6 of $9.4 million in 2004, an increase of $7.7 million; the 25 properties available for lease at December 31, 2005 were • Same store rents generated on 1,269 properties during under way or completed. We anticipate these transactions will be 2005 and 2004 increased by $1.3 million, or 0.8%, to completed during the next several months, although we cannot $158.1 million from $156.8 million. These properties guarantee that all of these properties can be leased or sold within were leased during all of both 2005 and 2004; this period. It has been our experience that approximately 1% to • An increase in straight-line rent and other non-cash adjust- 3% of our property portfolio will be unleased at any given time, ments to rent of $1.5 million in 2005 as compared to however, we cannot assure you that the number of properties 2004; and available for lease will not exceed these levels. • An increase of $807,000 relating to the aggregate of (i) development properties acquired before 2004 that started paying rent in 2004, (ii) properties that were vacant dur- ing part of 2005 or 2004 and (iii) lease termination settle- ments. These items in aggregate totaled $5.2 million in 2005 and $4.4 million in 2004. Realty Income acquired 135 retail properties in 2005, exclud- ing Crest Net acquisitions, and as a result, our 2005 operating results included less than a full year of rental revenue from these properties. Accordingly, we anticipate that the contribution to rental revenue from these 135 properties will increase in 2006, because there will be a full year of rent from these properties. Our portfolio of retail real estate, leased primarily to regional and national chains under net leases, continues to perform well and provides dependable lease revenue supporting the payment of monthly dividends to our stockholders. At December 31, 2005, our portfolio of 1,646 retail properties was 98.5% leased with 25 properties available for lease, one of which is a multi- tenant property. 5 5 R E A LT Y I N C O M E Interest Expense Interest expense was $6.8 million higher in 2005 than in calculation used by other companies and, therefore, comparabil- ity may be limited. This information should not be considered as 2004 primarily due to higher average outstanding balances. an alternative to any GAAP liquidity measures. Interest expense was $26.4 million in 2003. The following The following is a reconciliation of net cash provided is a summary of the five components of our interest expense by operating activities to our interest coverage amount (dollars in thousands): (dollars in thousands): 2005 2004 2003 2005 2004 2003 Interest on our credit facility and notes $ 40,968 $ 32,442 $ 24,962 Interest included in discontinued operations from real estate acquired for resale by Crest (1,139) (674) (561) Amortization of settlements on treasury lock 756 498 756 508 756 507 agreements Credit facility commitment fees Amortization of credit facility origination costs and deferred bond financing costs Interest capitalized Net cash provided by operating activities Interest expense Interest expense included in discontinued operations(1) Income taxes Income taxes included in discontinued $ 109,557 $ 178,337 $ 73,957 40,949 34,132 26,413 1,139 813 674 699 561 501 operations(1) 943 3,480 2,202 Investment in real estate acquired for resale(1)(2) 55,890 21,787 87,384 1,752 (1,886) 1,631 (531) 1,446 (697) Proceeds from sales of real estate Interest expense $ 40,949 $ 34,132 $ 26,413 acquired for resale(1) (22,195) (74,995) (45,226) Credit facilities and notes outstanding Average outstanding balances 2005 2004 2003 (in thousands) $ 647,301 $ 498,220 $ 389,517 Average interest rates 6.33% 6.51% 6.41% Gain on sales of real estate acquired for resale(1) Amortization of deferred 3,291 10,254 6,217 stock compensation (2,155) (1,426) (940) Amortization of stock option costs (12) (14) (11) Changes in assets and liabilities: Accounts receivable Interest on outstanding credit facilities and notes increased by and other assets 3,292 (1,094) (1,751) $8.5 million in 2005 as compared to 2004 primarily due to Accounts payable, higher average outstanding note balances in 2005. accrued expenses At February 10, 2006 the weighted average interest rate on our: other liabilities (8,290) 1,050 (5,194) • Credit facility borrowings of $131.6 million was 5.2%; Interest coverage • Notes payable of $755.0 million was 6.3%; and amount $ 183,222 $ 172,884 $ 144,113 • Combined outstanding credit facility and notes of Divided by interest $886.6 million was 6.1%. Interest Coverage Ratio Our interest coverage ratio for 2005 was 4.4 times, for 2004 was 5.0 times and for 2003 was 5.3 times. Interest coverage ratio is calculated as: the interest coverage amount (as calculated in the following table) divided by interest expense, including interest recorded to discontinued operations. We consider interest coverage ratio to be an appropriate supplemental measure of a company’s ability to meet its interest expense obligations. Our calculation of interest coverage ratio may be different from the expense(3) $ 42,088 $ 34,806 $ 26,974 Interest coverage ratio 4.4 5.0 5.3 (1)Crest Net activities. (2)The 2005 amount includes intangibles recorded in connection with acquisitions of real estate acquired for resale. (3)Includes interest expense recorded to “income from discontinued operations, real estate acquired for resale by Crest.” R E A LT Y I N C O M E 5 6 Fixed Charge Coverage Ratio Our fixed charge coverage ratio for 2005 was 3.6 times, for 2004 At February 10, 2006, we had 69 permanent employees and four temporary employees as compared to February 15, 2005 was 3.9 times and for 2003 was 3.9 times. Fixed charge cover- when we had 64 permanent employees and six temporary age ratio is calculated in exactly the same manner as interest employees. The temporary employees have been working on a coverage ratio, except that preferred stock dividends are also added record retention project that is expected to conclude in 2006. to the denominator. We consider fixed charge coverage ratio to be an appropriate supplemental measure of a company’s ability to make its interest and preferred stock dividend payments. Our Property Expenses Property expenses are broken down into costs associated with calculation of the fixed charge coverage ratio may be different non-net leased multi-tenant properties, unleased single-tenant from the calculation used by other companies and, therefore, properties and general portfolio expenses. Expenses related to the comparability may be limited. This information should not be multi-tenant and unleased single-tenant properties include, but considered as an alternative to any GAAP liquidity measures. are not limited to, property taxes, maintenance, insurance, utili- ties, property inspections, bad debt expense and legal fees. General portfolio costs include, but are not limited to, insurance, 2004 2003 legal, property inspections and title search fees. At December 31, Interest coverage amount divided by interest expense plus preferred stock dividends (dollars in thousands) 2005 Interest coverage amount $ 183,222 $ 172,884 $ 144,113 Divided by interest expense plus preferred stock dividends(1)(2) $ 51,491 $ 44,261 $ 36,687 Fixed charge coverage ratio 3.6 3.9 3.9 (1)Excludes the Class B and Class C preferred stock non-cash charge of $3,774 in 2004 for excess of redemption value over carrying value of preferred shares redeemed. (2)Includes interest expense recorded to “income from discontinued operations, real estate acquired for resale by Crest.” 2005, 25 properties were available for lease, as compared to 32 at December 31, 2004 and 26 at December 31, 2003. Property expenses were $3.8 million in 2005, $3.1 million in 2004 and $2.4 million in 2003. The $769,000 increase in prop- erty expenses in 2005 is primarily attributable to an increase in costs associated with vacant properties and bad debt expense. Income Taxes Income taxes were $813,000 in 2005 as compared to $699,000 in 2004 and $501,000 in 2003. These amounts are for city and state income taxes paid by Realty Income. The increases in 2005 and 2004 are due to an increase in rental revenue causing higher city and state income tax expense. Depreciation and Amortization Depreciation and amortization was $46.4 million in 2005 versus In addition, Crest Net incurred state and federal income taxes of $943,000 in 2005 as compared to $3.5 million in 2004 and $39.9 million in 2004 and $32.2 million in 2003. The increases $2.2 million in 2003. The decrease in 2005 over the 2004 and in depreciation and amortization in 2005 and 2004 are due to 2003 amounts are due to lower taxable income, primarily attrib- the acquisition of properties in 2005, 2004 and 2003, which utable to lower gain on sales of real estate acquired for re-sale. was partially offset by property sales in these years. These amounts are included in “income from discontinued oper- ations from real estate acquired for resale by Crest.” General and Administrative Expenses General and administrative expenses increased by $2.3 million to $15.4 million in 2005 versus $13.1 million in 2004. General Discontinued Operations Crest Net acquires properties with the intention of reselling them and administrative expenses were $10.6 million in 2003. In rather than holding them as investments and operating the prop- 2005, general and administrative expenses as a percentage of erties. Consequently, we classify properties acquired by Crest total revenue increased to 7.8% as compared to 7.6% in 2004 Net as held for sale at the date of acquisition and do not depre- and 7.4% in 2003. General and administrative expenses ciate them. The operations of Crest Net’s properties are classified increased primarily due to increases in costs of corporate insur- as “income from discontinued operations, real estate acquired for ance, payroll, employee benefits, corporate governance and resale by Crest.” Sarbanes-Oxley Act of 2002 compliance costs. As our property portfolio has grown and continues to grow, we have increased, and anticipate that we will continue to increase, the level of our staffing. We expect general and administrative expenses to moderately increase due to costs attributable to pay- roll, staffing costs and corporate governance. 5 7 R E A LT Y I N C O M E The following is a summary of Crest Net’s “income from discon- The following is a summary of our total discontinued opera- tinued operations, real estate acquired for resale” for the years ended tions for the years ended December 31, 2005, 2004 and 2003 December 31, 2005, 2004 and 2003 (dollars in thousands): (dollars in thousands): Crest Net’s income from discontinued operations, real estate acquired for resale Gain on sales of real estate 2005 2004 2003 acquired for resale $ 3,291 $ 10,254 $ 6,217 2,085 (1,139) 2,304 (674) 1,724 (561) (453) (60) (464) (93) (566) (24) (943) (3,480) (2,202) Rental revenue Interest expense General and administrative expense Property expenses Income taxes Income from discontinued operations, real estate acquired for resale by Crest $ 2,781 $ 7,847 $ 4,588 Per common share, basic and diluted $ 0.03 $ 0.10 $ 0.06 Total income from discontinued operations 2005 2004 2003 Income from discontinued operations: Real estate acquired for resale by Crest $ 2,781 $ 7,847 $ 4,588 Real estate held for investment 7,121 12,696 10,569 Income from discontinued operations $ 9,902 $ 20,543 $ 15,157 Per common share, basic and diluted $ 0.12 $ 0.26 $ 0.21 Gain on Sales of Real Estate Acquired for Resale by Crest Net (included in discontinued operations) In 2005 Crest Net sold 12 properties for $23.5 million, which resulted in a gain of $3.3 million. In 2004, Crest Net sold 51 properties for $75.0 million, which resulted in a gain of $10.3 million. In 2003, Crest Net sold 27 properties for Realty Income’s operations from four properties listed as held $45.2 million, which resulted in a gain of $6.2 million. All gains for sale at December 31, 2005, plus properties sold in 2005, on sales of real estate acquired for resale are reported before 2004 and 2003 have been classified as discontinued operations. income taxes. The following is a summary of our discontinued operations from At December 31, 2005, Crest Net had $45.7 million invested real estate held for investment for the years ended December 31, in 17 properties, which are held for sale. Our goal is for Crest 2005, 2004 and 2003 (dollars in thousands): 2005 2004 2003 properties held in inventory and the cost of capital used to Net to carry an average inventory of approximately $20 to $25 million in real estate. Crest Net generates an earnings spread on the difference between the lease payments it receives on the acquire properties. It is our belief that at this level of inventory, rental revenue will exceed the ongoing operating expenses of Crest Net without any property sales. Realty Income’s income from discontinued operations from real estate held for investment Gain on sales of investment properties $ 6,573 $ 12,543 $ 7,156 Rental revenue Other revenue Depreciation and amortization Property expenses 1,073 3,927 6,845 2 (226) (266) 117 (984) (534) 46 (1,684) (552) Provisions for impairments (35) (2,373) (1,242) Income from discontinued operations, real estate held for investment Per common share, $ 7,121 $ 12,696 $ 10,569 basic and diluted $ 0.09 $ 0.16 $ 0.15 R E A LT Y I N C O M E 5 8 Gain on Sales of Investment Properties by Realty Income (included in discontinued operations) In 2005, we sold 23 investment properties and sold a portion of Preferred Stock Cash Dividends and Redemption Charge We had preferred stock cash dividends of $9.4 million in 2005 as compared to $9.5 million in 2004 and $9.7 million in 2003. the land from two properties for $23.4 million and recognized a When we redeemed our Class B preferred stock in June 2004 gain on sales of $6.6 million. This gain is included in discon- and our Class C preferred stock in July 2004, we incurred non- tinued operations, except for $18,000 that is included in other cash charges of $2.4 million and $1.4 million, respectively, for revenue. In 2004, we sold or exchanged 43 investment properties the excess of redemption value over the carrying value. These and sold a portion of the land from four properties for a total of non-cash charges represent the Class B and Class C preferred $35.4 million and recognized a gain of $12.7 million. This gain stock original issuance costs that were paid in 1999 and recorded is included in discontinued operations, except for $185,000 as a reduction to net income available to common stockholders that is included in other revenue. In 2003, we sold or exchanged when the shares were redeemed. These non-cash charges equated 35 properties and exchanged three excess land parcels (from to $0.05 per common share in 2004. three properties) for $23.1 million and recognized a gain of $7.2 million, which is included in discontinued operations. We have an active portfolio management program that incor- Net Income Available to Common Stockholders Net income available to common stockholders in 2005 decreased porates the sale of assets when we believe the reinvestment of the by $452,000 to $89.7 million as compared to $90.2 million in sale proceeds will generate higher returns, enhance the credit 2004. Net income available to common stockholders in 2003 was quality of our real estate portfolio or extend our average remain- ing lease term. At December 31, 2005, we classified real estate $76.7 million. The calculation to determine net income available to common with a carrying amount of $47.1 million as held for sale, which stockholders includes gains from the sale of properties. The includes $45.5 million in properties owned by Crest Net. In addi- amount of gains varies from period to period based on the timing tion, $219,000 invested by Crest Net in real estate is included in of property sales and can significantly impact net income avail- other assets and was classified as intangible assets. Additionally, able to common stockholders. we anticipate selling investment properties from our portfolio that The gain recognized from the sales of investment properties have not yet been specifically identified from which we anticipate during 2005 was $6.6 million as compared to $12.7 million dur- receiving between $15 million and $35 million in proceeds dur- ing 2004 and $7.2 million in 2003. The gain recognized from ing the next 12 months. We intend to invest these proceeds into the sale of properties acquired for re-sale during 2005 was new property acquisitions. However, we cannot guarantee that $3.3 million as compared to $10.3 million during 2004 and we will sell properties during the next 12 months. $6.2 million during 2003. Provisions for Impairments Provisions for impairments of $186,000 were recorded in 2005 on four properties as compared to $2.4 million in 2004 on six properties and $1.2 million on 11 properties in 2003. These pro- visions are included in “income from discontinued operations, real estate held for investment”, except for $151,000 in 2005, which is included in property expenses. 5 9 R E A LT Y I N C O M E F U N D S F R O M O P E R A T I O N S ( F F O ) A V A I L A B L E T O C O M M O N S T O C K H O L D E R S We define FFO, a non-GAAP measure, consistent with the National Association of Real Estate Investment Trust’s defini- FFO for 2005 increased by $11.4 million, or 9.6%, to tion, as net income available to common stockholders, plus $129.6 million as compared to $118.2 million in 2004 and depreciation and amortization of real estate assets, reduced by $103.4 million in 2003. The following is a reconciliation of net gains on sales of investment property and extraordinary items. income available to common stockholders (which we believe is We consider FFO to be an appropriate supplemental measure the most comparable Generally Accepted Accounting Principles of a REIT’s operating performance as it is based on a net income (“GAAP”) measure) to FFO, information regarding cash distribu- analysis of property portfolio performance that excludes non-cash tions paid and the diluted weighted average number of shares items such as depreciation. The historical accounting convention outstanding for 2005, 2004 and 2003 (dollars in thousands): used for real estate assets requires straight-line depreciation of Net income available to common stockholders 2005 2004 2003 buildings and improvements, which implies that the value of real estate assets diminishes predictably over time. Since real estate values historically rise and fall with market conditions, presenta- tions of operating results for a REIT, using historical accounting for $ 89,716 $ 90,168 $ 76,722 depreciation, could be less informative. The use of FFO is recom- Depreciation and amortization: mended by the REIT industry as a supplemental performance Continuing operations 46,438 39,874 32,231 measure. In addition, FFO is used as a measure of our compliance Discontinued operations Depreciation of furniture, 226 984 1,683 Presentation of this information is intended to assist the reader in comparing the operating performance of different REITs, with the financial covenants of our credit facility. fixtures and equipment (142) (117) (114) although it should be noted that not all REITs calculate FFO the Gain on sales of investment properties: same way, so comparisons with other REITs may not be meaning- ful. Furthermore, FFO is not necessarily indicative of cash flow Continuing operations (18) (185) — available to fund cash needs and should not be considered as (6,573) (12,543) (7,156) performance. In addition, FFO should not be considered as an an alternative to net income as an indication of Realty Income’s Discontinued operations Total funds from alternative to reviewing our cash flows from operating, investing and financing activities as a measure of liquidity, of our ability to make cash distributions or of our ability to pay interest payments. operations $ 129,647 $ 118,181 $ 103,366 FFO per common share, basic $ 1.62 $ 1.51 $ 1.45 FFO per common share, diluted $ 1.62 $ 1.50 $ 1.45 Cash distributions paid to common stockholders $ 108,575 $ 97,420 $ 83,842 FFO in excess of distributions to common stockholders Basic weighted average number of shares $ 21,072 $ 20,761 $ 19,524 outstanding 79,950,255 78,518,296 71,128,282 Diluted weighted average number of shares outstanding 80,208,593 78,598,788 71,222,628 R E A LT Y I N C O M E 6 0 Other Non-Cash Items and Capitalized Expenditures The following information includes non-cash items and capital- I M P A C T O F I N F L A T I O N Tenant leases generally provide for limited increases in rent as a ized expenditures on existing properties in our portfolio. These result of increases in the tenants’ sales volumes, increases in the items are not included in the adjustments to net income available consumer price index, and/or fixed increases. We expect that to common stockholders to arrive at FFO. Analysts and investors inflation will cause these lease provisions to result in rent often request this supplemental information. increases over time. During times when inflation is greater than increases in rent, as provided for in the leases, rent increases may For the years ended (dollars in thousands) 2005 2004 2003 not keep up with the rate of inflation. Provisions for impairments $ 186 $ 2,373 $ 1,242 Amortization of settlements on treasury lock agreements(1) 756 756 756 Amortization of deferred note financing costs(2) 1,034 913 725 Amortization of deferred stock compensation and stock option costs 2,167 1,440 951 Capitalized leasing costs and commissions (570) (323) (392) Capitalized building improvements Straight line rent(3) Preferred stock origination (1,017) (1,360) (789) 99 (264) 275 costs write-off(4) — 3,774 — (1)The settlements on the treasury lock agreements resulted from an inter- est rate risk prevention strategy that was used by the Company in 1997 and 1998, which correlated to pending issuances of senior note securi- ties. We have not employed this strategy since 1998. (2)Amortization of deferred note financing costs includes the amortization of costs incurred and capitalized when our notes were issued in May 1997, October 1998, January 1999, March 2003, November 2003, March 2005 and September 2005. These costs are being amortized over the lives of these notes. No costs associated with our credit facility agree- ments or annual fees paid to credit rating agencies have been included. (3)A negative amount indicates that our straight-line rent was greater than our actual cash rent collected. A positive amount indicates that our straight-line rent was less than our actual cash rent collected. (4)Represents the Class B and Class C preferred stock non-cash charges for the excess of redemption value over the carrying value. Approximately 98.2%, or 1,617, of the 1,646 properties in the portfolio are leased to tenants under net leases where the ten- ant is responsible for property costs and expenses. Net leases tend to reduce our exposure to rising property expenses due to inflation. Inflation and increased costs may have an adverse impact on our tenants if increases in their operating expenses exceed increases in revenue. I M P A C T O F A C C O U N T I N G P R O N O U N C E M E N T S In December 2004, the FASB issued Statement No. 123R, Share-Based Payments. Statement No. 123R requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based compensation issued to employees. We adopted Statement No. 123R on January 1, 2006. The impact of adopting Statement No. 123R was not material to our financial position or results of operations. In December 2004, the FASB issued Statement No. 153, Exchanges of Nonmonetary Assets, an Amendment of APB No. 29. Statement No. 153 amends APB Opinion No. 29 and states that companies will no longer be permitted to use the “similar productive assets” concept to account for nonmonetary exchanges at book value with no gain being recognized. An exchange must be accounted for at fair value if the exchange has commercial substance and fair value is determinable. We adopted Statement No. 153 on January 1, 2006. The impact of adopting Statement No. 153 was not material to our financial position or results of operations. In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of Statement No. 143, Accounting for Asset Retirement Obligations. Interpretation No. 47 requires companies to recognize a liability for the fair value of a legal obligation to perform asset-retirement activities that are conditional on a future event if the amount can be reasonably estimated. We adopted Interpretation No. 47 in the fourth quarter of 2005. The impact of adopting Interpretation No. 47 was not material to our finan- cial position or results of operations. 6 1 R E A LT Y I N C O M E Q U A N T I T A T I V E A N D Q U A L I T A T I V E D I S C L O S U R E S A B O U T M A R K E T R I S K We are exposed to interest rate changes primarily as a result of our credit facility and long-term notes used to maintain liquidity and expand our real estate investment portfolio and operations. Our interest rate risk management objective is to limit the impact of inter- est rate changes on earnings and cash flow and to lower our overall borrowing costs. To achieve these objectives we issue long-term notes, primarily at fixed rates, and may selectively enter into derivative financial instruments, such as interest rate lock agreements, interest rate swaps and caps in order to mitigate our interest rate risk on a related financial instrument. We were not a party to any derivative financial instruments at December 31, 2005. We do not enter into any transactions for speculative or trading purposes. Our interest rate risk is monitored using a variety of techniques. The following table presents by year of expected maturity, the prin- cipal amounts, average interest rates, fair values as of December 31, 2005. This information is presented to evaluate the expected cash flows and sensitivity to interest rate changes (dollars in millions): Expected Maturity Data Year of maturity 2006 2007(1) 2008(2)(3) 2009(4) 2010 Thereafter(5) Totals Fair Value(6) (1) $110 million matures in May 2007. (2) $100 million matures in October 2008. Average interest rate on fixed rate debt — 7.75% 8.25% 8.00% — 5.51% 6.26% Fixed rate debt $ — 110.0 100.0 20.0 — 525.0 $ 755.0 $ 755.0 Average interest rate on variable rate debt — — 5.03% — — — 5.03% Variable rate debt $ — — 136.7 — — — $ 136.7 $ 136.7 (3) The credit facility expires in October 2008. The credit facility balance as of February 10, 2006 was $131.6 million. (4) $20 million matures in January 2009. (5) $100 million matures in March 2013, $150 million matures in November 2015, $175 million matures in September 2017 and $100 million matures in March 2035. (6) We base the fair value of the fixed rate debt at December 31, 2005 on the closing market price or indicative price per each note. The fair value of the variable rate debt approximates its carrying value because its terms are similar to those available in the market place at December 31, 2005. The table incorporates only those exposures that exist as of December 31, 2005; it does not consider those exposures or positions that could arise after that date. As a result, our ultimate realized gain or loss, with respect to interest rate fluctuations, would depend on the exposures that arise during the period, our hedging strategies at the time, and interest rates. All of our outstanding notes and bonds have fixed interest rates. Our credit facility interest rate is variable. Based on our credit facility balance at December 31, 2005, a 1% change in interest rates would change our interest costs by $1.4 million per year. R E A LT Y I N C O M E 6 2 REALTY INCOME CORPORATION AND SUBSIDIARIES S E L E C T E D F I N A N C I A L D A T A (not covered by Report of Independent Registered Public Accounting Firm) (dollars in thousands, except for per share data) As of or for the years ended December 31, 2005 2004 2003 2002 2001 Total assets (book value) Cash and cash equivalents Lines of credit and notes payable Total liabilities Total stockholders’ equity Net cash provided by operating activities Net change in cash and cash equivalents Total revenue Income from continuing operations Income from discontinued operations Net income Preferred stock cash dividends Excess of redemption value over carrying value of preferred shares redeemed Net income available to common stockholders Cash distributions paid to common stockholders Ratio of earnings to fixed charges(1) Ratio of earnings to combined fixed charges and preferred stock cash dividends(1) Basic net income per common share Diluted net income per common share $ 1,920,988 $ 1,442,315 $ 1,360,257 $ 1,080,230 $ 1,003,708 65,704 891,700 931,774 989,214 109,557 63,563 196,676 89,217 9,902 99,119 (9,403) — 89,716 108,575 3.2 times 2,141 503,600 528,580 913,735 178,337 (2,696) 173,747 82,854 20,543 103,397 (9,455) (3,774) 90,168 97,420 4,837 506,400 532,491 827,766 73,957 (4,084) 143,478 71,278 15,157 86,435 (9,713) — 76,722 83,842 8,921 339,700 357,775 722,455 124,807 6,454 128,145 64,373 14,294 78,667 (9,713) — 68,954 78,042 2,467 315,300 331,915 671,793 90,035 (1,348) 109,807 56,892 10,666 67,558 (9,712) — 57,846 64,871 3.9 times 4.1 times 4.3 times 3.5 times 2.6 times 3.1 times 3.0 times 3.0 times 2.6 times 1.12 1.12 1.15 1.15 1.24125 1.25125 1.08 1.08 1.18125 1.18375 1.02 1.01 1.15125 1.15375 0.99 0.99 1.12125 1.12375 Cash distributions paid per common share 1.346250 Cash distributions declared per common share 1.352500 Basic weighted average number of common shares outstanding 79,950,255 78,518,296 71,128,282 67,867,498 58,450,718 Diluted weighted average number of common shares outstanding 80,208,593 78,598,788 71,222,628 67,976,314 58,562,240 (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 73/8% Class D preferred stock in October 2004. 6 3 R E A LT Y I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES C O N T R O L S A N D P R O C E D U R E S C H A N G E S I N A N D D I S A G R E E M E N T S W I T H A C C O U N T A N T S O N A C C O U N T I N G A N D F I N A N C I A L D I S C L O S U R E Management’s Report on Internal Control Over Financial Reporting Internal control over financial reporting refers to the process We have had no disagreements with our independent auditors on designed by, or under the supervision of, our Chief Executive accountancy or financial disclosure, nor have we changed Officer and Chief Financial Officer, and effected by our board of accountants in the two most recent fiscal years. C O N T R O L S A N D P R O C E D U R E S directors, management and other personnel, to provide reason- able assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in Evaluation of Disclosure Controls and Procedures. We maintain dis- accordance with generally accepted accounting principles, and closure controls and procedures (as defined in Securities includes those policies and procedures that: Exchange Act 1934 Rules 13a-14(c) and 15d-14(c)) that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and (1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of reported within the time periods specified in the Securities and the assets of the Company; Exchange Commission’s rules and forms, and that such informa- tion is accumulated and communicated to our management, (2) Provide reasonable assurance that transactions are recorded including our Chief Executive Officer and Chief Financial Officer, as necessary to permit preparation of financial statements in as appropriate, to allow timely decisions regarding required dis- accordance with generally accepted accounting principles, and closure. In designing and evaluating the disclosure controls and that receipts and expenditures of the Company are being made procedures, management recognized that any controls and proce- only in accordance with authorizations of management and direc- dures, no matter how well designed and operated, can provide tors of the Company; and only reasonable assurance of achieving the desired control objec- tives, and management necessarily was required to apply its judg- (3) Provide reasonable assurance regarding prevention or timely detec- ment in evaluating the cost-benefit relationship of possible tion of unauthorized acquisition, use or disposition of the Company’s controls and procedures. assets that could have a material effect on the financial statements. As of and for the year ended December 31, 2005, we carried out an evaluation, under the supervision and with the participation Management is responsible for establishing and maintaining of management, including our Chief Executive Officer and Chief adequate internal control over financial reporting for the Company. Financial Officer, of the effectiveness of the design and operation Management has used the framework set forth in the report of our disclosure controls and procedures. Based on the foregoing, entitled “Internal Control—Integrated Framework” published by our Chief Executive Officer and Chief Financial Officer concluded the Committee of Sponsoring Organizations (“COSO”) of the that our disclosure controls and procedures were effective. Treadway Commission to evaluate the effectiveness of the Company’s internal control over financial reporting. Management has concluded that the Company’s internal control over financial report- ing was effective as of the end of the most recent fiscal year. KPMG LLP has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting. Submitted on February 21, 2006 by, Thomas A Lewis, Chief Executive Officer and Vice Chairman Paul M. Meurer, Chief Financial Officer, Executive Vice President and Treasurer R E A LT Y I N C O M E 6 4 Changes in Internal Controls. There have not been any significant Certifications. Tom Lewis, Realty Income’s Chief Executive Officer, changes in our internal controls or in other factors that could sig- Certified to the NYSE in 2005, pursuant to Section 303A. 12(a) of nificantly affect these controls subsequent to the date of their the NYSE’s Listing Standards, that he was not aware of any viola- evaluation. There were no material weaknesses, and therefore no tion of the NYSE corporate governance listing standards by Realty corrective actions were taken. Income. Furthermore, Realty Income filed with the SEC, as exhibits to its Annual Report on Form 10-K for the year ended December 31, Limitations on the Effectiveness of Controls. Internal control over 2005, the certifications by Tom Lewis and Paul Meurer, Realty financial reporting cannot provide absolute assurance of achiev- Income’s Chief Executive Officer and Chief Financial Officer, respec- ing financial reporting objectives because of its inherent limita- tively, required under Section 302 of the Sarbanes-Oxley Act. tions. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possi- ble to design into the process safeguards to reduce, though not eliminate, this risk. 6 5 R E A LT Y I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES C O N S O L I D A T E D Q U A R T E R L Y F I N A N C I A L D A T A (dollars in thousands, except per share data) (not covered by Report of Independent Registered Public Accounting Firm) 2005(1) Total revenue Interest expense Depreciation and amortization expense Other expenses Income from continuing operations Income from discontinued operations Net income Net income available to common stockholders Basic and diluted net income per common share First Quarter Second Quarter Third Quarter Fourth Quarter Year(2) $ 46,579 $ 47,367 $49,080 $ 53,650 $ 196,676 9,058 10,760 5,117 21,644 1,859 23,503 21,152 9,793 11,194 4,900 21,480 3,186 24,666 22,315 10,228 11,266 5,386 22,200 922 23,122 20,771 11,869 13,218 4,670 23,893 3,935 27,828 25,477 40,949 46,438 20,072 89,217 9,902 99,119 89,716 0.27 0.28 0.26 0.31 1.12 Dividends paid per common share 0.330000 0.331875 0.337500 0.346875 1.346250 2004(1) Total revenue Interest expense Depreciation and amortization expense Other expenses Income from continuing operations Income from discontinued operations Net income Net income available to common stockholders Basic and diluted net income per common share $ 41,232 $ 43,646 $ 43,563 $ 45,306 $ 173,747 8,476 9,504 4,003 19,249 5,602 24,851 22,423 8,505 9,968 4,190 20,983 5,805 26,788 21,446 8,553 10,120 4,118 20,772 4,431 25,203 21,988 8,599 10,283 4,573 21,851 4,705 26,556 24,312 34,132 39,874 16,887 82,854 20,543 103,397 90,168 0.29 0.27 0.28 0.31 1.15 Dividends paid per common share 0.300000 0.301875 0.311250 0.328125 1.241250 (1)The consolidated quarterly financial data includes revenues and expenses from our continuing and discontinued operations. The results of operations related to certain properties, that have been classified as held for sale or have been disposed of, have been reclassified to income from discontinued operations. Therefore, some of the information may not agree to our previously filed 10-Qs. (2)Amounts for each period are calculated independently. The sum of the quarters may differ from the annual amount. R E A LT Y I N C O M E 6 6 M A R K E T F O R R E G I S T R A N T ’ S C O M M O N E Q U I T Y A N D R E L A T E D S T O C K H O L D E R M A T T E R S 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. 2005 First quarter Second quarter Third quarter Fourth quarter Total 2004 First quarter Second quarter Third quarter Fourth quarter Total Price Per Share of Common Stock High $ 25.61 25.69 25.65 23.97 $ 22.48 22.33 22.70 26.08 Low $ 22.00 22.50 22.00 21.08 $ 19.70 17.69 19.71 22.48 Distributions Declared(1) $ 0.330625 0.332500 0.341875 0.347500 $ 1.352500 $ 0.300625 0.302500 0.319375 0.328750 $ 1.251250 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 com- mon shares outstanding after the stock split is reflected for all periods presented and all per share data has been adjusted for the stock split. 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. 6 7 R E A LT Y I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES F O R W A R D - L O O K I N G S T A T E M E N T S This annual report contains forward-looking statements within Additional factors that may cause risks and uncertainties the meaning of Section 27A of the Securities Act and Section include those discussed in the sections entitled “Business” 21E of the Exchange Act. When used in this annual report, the and “Management’s Discussion and Analysis of Financial words “estimated”, “anticipated” and similar expressions are Condition and Results of Operations” in this annual report. intended to identify forward-looking statements. Forward-looking Readers are cautioned not to place undue reliance on forward- statements are subject to risks, uncertainties, and assumptions looking statements, which speak only as of the date that this about Realty Income Corporation, including, among other things: annual report was prepared. We undertake no obligation to pub- • Our anticipated growth strategies; licly release the results of any revisions to these forward-looking • Our intention to acquire additional properties and the tim- statements that may be made to reflect events or circumstances ing of these acquisitions; after the date of this annual report or to reflect the occurrence of • Our intention to sell properties and the timing of these unanticipated events. In light of these risks and uncertainties, the forward-looking events discussed in this annual report might not occur. property sales; • Our intention to re-lease vacant properties; • Anticipated trends in our business, including trends in the market for long-term net-leases of freestanding, single- tenant retail properties; • Future expenditures for development projects; and • Profitability of our subsidiary, Crest Net Lease, Inc. Future events and actual results, financial and otherwise, may differ materially from the results discussed in the forward-look- ing statements. In particular, some of the factors that could cause actual results to differ materially are: • Our continued qualification as a real estate investment trust; • General business and economic conditions; • Competition; • Fluctuating interest rates; • Access to debt and equity capital markets; • Other risks inherent in the real estate business including tenant defaults, potential liability relating to environ- mental matters, illiquidity of real estate investments and potential damages from natural disasters; • Impairments in the value of our real estate assets; • Changes in the tax laws of the United States of America; • The outcome of any legal proceeding to which we are a party; and • Acts of terrorism and war. R E A LT Y I N C O M E 6 8 S E N I O R M A N A G E M E N T T E A M Back row, left to right: Richard G. Collins, Kim S. Kundrak, Tere H. Miller, Paul M. Meurer, Michael R. Pfeiffer Front row, left to right: Thomas A. Lewis, Gary M. Malino B O A R D O F D I R E C T O R S Back row, left to right: Roger P. Kuppinger, Kathleen R. Allen, Ph.D., Willard H. Smith, Jr., Michael D. McKee, Ronald L. Merriman Front row, left to right: Donald R. Cameron, Thomas A. Lewis, William E. Clark, Jr. C O M P A N Y I N F O R M A T I O N E X E C U T I V E O F F I C E R S Thomas A. Lewis Vice Chairman of the Board of Directors, Chief Executive Officer Gary M. Malino President and Chief Operating Officer Paul M. Meurer Executive Vice President, Chief Financial Officer and Treasurer Michael R. Pfeiffer Executive Vice President, General Counsel and Secretary Richard G. Collins Executive Vice President, Portfolio Management Kim S. Kundrak Senior Vice President, Portfolio Acquisitions Gregory J. Fahey Vice President, Controller Robert J. Israel Vice President, Research Laura S. King Vice President, Assistant General Counsel and Assistant Secretary Tere H. Miller Vice President, Corporate Communications Michael K. Press Vice President, Financial Institutions Mitchell N. White Vice President, Business Development Cary J. Wenthur Vice President, Acquisitions Director Theresa M. Casey Associate Vice President, Information Technologies Jill M. Cossaboom Associate Vice President, Assistant Controller Kristin K. Ferrell Associate Vice President, Portfolio Management S U B S I D I A R Y C O M P A N Y Crest Net Lease, Inc. Richard G. Collins President Pete L. Oakley Senior Vice President, Chief Operating Officer e r a l K m o T y b s n o i t a r t s u l l I ; A C , o g e i D n a S , a r e t a P y b d e c u d o r P d n a d e n g i s e D D I R E C T O R S William E. Clark, Jr. Chairman of the Board of Directors Thomas A. Lewis Vice Chairman of the Board of Directors and Chief Executive Officer, Realty Income Corporation Kathleen R. Allen, Ph.D. Director, Center of Technology Commercialization, Marshall School of Business University of Southern California Donald R. Cameron Lead Independent Director President, Cameron, Murphy & Spangler, Inc. Roger P. Kuppinger Private Investment Banker and Financial Advisor Michael D. McKee Vice Chairman, Chief Operating Officer, The Irvine Company Ronald L. Merriman Consultant, Merriman Partners Willard H. Smith, Jr. Retired Managing Director, Merrill Lynch & Co. I N D E P E N D E N T R E G I S T E R E D P U B L I C A C C O U N T I N G F I R M KPMG LLP San Diego, California T R A N S F E R A G E N T The Bank of New York For shareholder administration and account information please call this toll-free number: 1-877-218-2434 or email your question to: shareowner-svcs@bankofny.com or write to: Shareholder Relations Department P.O. Box 11258 Church Street Station New York, NY 10286 F O R A D D I T I O N A L C O R P O R A T E I N F O R M A T I O N Call the Realty Income Investor Hotline: For automated shareholder information please call: 888-811-2001 Visit the Realty Income Corporate web site at: www.realtyincome.com Contact your financial advisor or contact Realty Income at: telephone: 760-741-2111 email: ir@realtyincome.com Copies of Realty Income’s 10-K report are available upon written request to: R E A L T Y I N C O M E C O R P O R A T I O N Attention: Investor Relations 220 West Crest Street Escondido, CA 92025-1707 I I R E A LT Y I N C O M E W E L C O M E T O M O N T H L Y D I V I D E N D U N I V E R S I T Y ! Monthly Dividend Girl and Friends Visit Monthly Dividend University R E A LT Y I N C O M E I I 

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