Realty Income
Annual Report 2006

Plain-text annual report

REALTY INCOME 2 0 0 6 A N N U A L R E P O R T What a great year for the Monthly Dividend Company! To mark the end of a truly great year, we submit “The Monthly Dividend Land Game”, a whimsical way to celebrate the accomplishments of 2006 and remind us that accumulating assets to provide for retirement income is a goal we all share. In the imaginary world of Monthly Dividend Land, you accumulate Realty Income shares at every twist and turn on the road that leads to monthly dividends for life. We hope you enjoy this playful reminder that we understand how important dependable monthly income is to our shareholders—many of whom rely on a monthly dividend check from Realty Income to meet their monthly financial obligations. And, all kidding aside, we’re very serious about continuing to be a solid source of monthly income for our shareholders. The more shares you have, the bigger the monthly check! THE MONTHLY DIVIDEND LAND G A M E 1. Use 1 die. 2. Person who is youngest at heart goes first. 3. Use the game piece of your choice to proceed around the game board by using the die and instructions along the road. 4. Keep track of the share awards along the way. 5. The one who has the most number of shares at the end of the road wins a lifetime of monthly dividends (Well, not really, it’s just a game). 6. All players must reach the finish line to determine I N S T R U C T I O N S who wins. G A M E P I E C E S (Push out at perforation and fold ends back to form a stand) Monthly Dividend Girl Paycheck Bear Elephant Tiger Bull THE MONTHLY DIVIDEND LAND G A M E I N S T R U C T I O N S R E A LTY I N C O M E 2 TABLE OF CONTENTS 2 0 0 6 R E V I E W ( T H E S H O R T V E R S I O N ) 2 0 0 7 B U S I N E S S P L A N R E L I A B L E F I N A N C I A L P E R F O R M A N C E M I S S I O N S TAT E M E N T C E O L E T T E R TO S H A R E H O L D E R S W H Y S U C H A G R E AT Y E A R I N 2 0 0 6 ? A B I G Y E A R F O R A C Q U I S I T I O N S A D D I T I O N A L M A R K E T P E N E T R AT I O N T H E C H A L L E N G E TO A DA P T O P P O R T U N I S T I C A C Q U I S I T I O N S I N V E S T I N S I Z E R E S E A R C H D R I V E S O U R E F F O R T S A C C E S S T O C A P I TA L W H Y A C C E S S TO C A P I TA L I S C R I T I C A L G R E AT Y E A R I N T H E C A P I TA L M A R K E T S A W O R D A B O U T C R E D I T R AT I N G S T H E I M P O R TA N C E O F C A P I TA L S T R U C T U R E O U R R E A L E S TAT E P O R T F O L I O T O DAY L E A S E E X P I R AT I O N S R E N T I N C R E A S E S R E TA I L E R O U T L O O K C R E S T N E T L E A S E H OW W E P E R F O R M E D — F I N A N C I A L LY S P E A K I N G R E V E N U E F U N D S F R O M O P E R AT I O N S N E T I N C O M E I N V E S T O R R E T U R N S W H O W E A R E A N D W H AT W E F O C U S O N W H E R E W E F I T I N T H E Q U E S T F O R I N C O M E S U M M A R Y O F 2 0 0 6 P E R F O R M A N C E A C O U P L E O F L A S T T H O U G H T S F I N A N C I A L I N F O R M AT I O N 1 R E A LTY I N C O M E 2 3 4 7 8 8 8 9 1 0 1 1 1 1 1 1 1 2 1 2 1 2 1 3 1 4 1 4 1 4 1 5 1 5 1 5 1 6 1 6 1 6 1 6 1 6 1 7 1 7 1 9 1 9 2 0 REVIEW (THE SHORT VERSION) GENERAL COMMENT: Another terrific year for The Monthly Dividend Company® DIVIDEND UPDATE: SHARE PRICE GROWTH: RETURNS TO SHAREHOLDERS: • Paid 12 monthly dividends • Increased the dividend 5 times • Paid 437 consecutive monthly dividends since 1970 12/31/05 closing price: $21.62 12/31/06 closing price: $27.70 28.1% increase Dividend yield of 6.7% Share price appreciation of 28.1% Total return of 34.8% for 2006 TOTAL MARKET CAPITALIZATION: $4.1 billion on 12/31/06 BALANCE SHEET: Very strong PROPERTY MORTGAGE DEBT: Zero ($0) REAL ESTATE PORTFOLIO: 1,955 retail properties leased to 103 retailers in 29 retail categories located throughout 48 states PORTFOLIO OCCUPANCY: 98.7% on 12/31/06 PROPERTY ACQUISITIONS: Bought 378 properties for $770 million! R E A LTY I N C O M E 2 BUSINESS PLAN P A Y 1 2 M O N T H LY D I V I D E N D S R A I S E T H E D I V I D E N D M A I N T A I N A C O N S E R V A T I V E B A L A N C E S H E E T M A I N T A I N H I G H P O R T F O L I O O C C U P A N C Y A C Q U I R E A D D I T I O N A L P R O P E R T I E S T E L L M O R E P E O P L E A B O U T T H E M O N T H LY D I V I D E N D C O M P A N Y ® R E M A I N C O N S E R V A T I V E 3 3 R E A LTY I N C O M E R E A LTY I N C O M E RELIABLE FINANCIAL PERFORMANCE For the Years Ended December 31, 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 Total revenue(1) Net income available to common stockholders Funds from operations (“FFO”)(2) Dividends paid to common stockholders Special dividend paid AT Y E A R E N D Real estate at cost, before accumulated depreciation(3) Number of properties Gross leasable square feet Properties acquired(4) Acquisition cost(4) 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(5) Net income (diluted) Funds from operations (“FFO”)(2) Dividends paid Special dividend Annualized dividend amount(6) Common shares outstanding I N V E S T M E N T R E S U LT S Closing price on December 31, Dividend yield (7)(8)(9) Total return to stockholder (9)(10) $ $ $ $ 2,743,973,000 1,955 16,740,100 378 769,900,000 13 29 48 98.7% $ 240,627,000 $ 197,733,000 $ 177,606,000 $ 150,370,000 $ 137,600,000 $ 121,081,000 $ 116,310,000 $ 104,510,000 $ 85,132,000 $ 67,897,000 $ 56,957,000 $ 51,555,000 $ 48,863,000 99,419,000 155,799,000 89,716,000 129,647,000 90,168,000 118,181,000 76,722,000 103,366,000 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 34,770,000 52,188,000 25,600,000 40,414,000 15,224,000 39,050,000 129,667,000 108,575,000 97,420,000 83,842,000 78,042,000 64,871,000 58,262,000 55,925,000 52,301,000 44,367,000 36,710,000 38,816,000 $ 2,096,156,000 1,646 13,448,600 156 486,553,000 23 29 48 98.5% $ $ 12.4 1.12 1.62 1.346 1.395 $ $ 1,691,283,000 1,533 11,986,100 194 215,314,000 43 30 48 97.9% $ 12.0 1.15 1.50 1.241 1.32 $ 1,533,182,000 $ 1,285,900,000 $ 1,178,162,000 $ 1,073,527,000 $ 1,017,252,000 $ 889,835,000 $ 699,797,000 $ 564,540,000 $ 515,426,000 $ 450,703,000 1,404 11,350,800 1,197 9,997,700 1,124 9,663,000 1,068 9,013,200 1,076 8,648,000 7,824,100 826 6,302,300 740 5,226,700 685 4,673,700 630 4,064,800 $ 371,642,000 $ 139,433,000 $ 156,472,000 $ 98,559,000 $ 181,376,000 $ 193,436,000 $ 142,287,000 $ 55,517,000 $ 65,393,000 $ 3,273,000 111 35 26 97.7% 10.9 1.01 1.38 1.151 1.17 117 35 25 98.2% 10.4 0.99 1.30 1.121 1.14 22 21 24 97.7% 9.8 0.84 1.26 1.091 1.11 110 3 24 98.4% 10.7 0.76 1.23 1.043 1.08 970 149 5 22 99.5% 10.2 0.78 1.18 0.983 1.02 96 10 14 99.2% 9.8 0.74 1.11 0.946 0.96 $ $ $ $ $ $ $ $ $ $ 302 35 28 4 98.1% 11.8 1.08 1.45 1.181 1.20 20.00 6 21.0% 32,223,000 47,139,000 42,794,000 5 62 7 8 99.1% 9.5 0.70 1.04 0.931 . 0.95 58 3 7 99.3% 9.2 0.63 1.00 0.913 0.93 4 5 5 99.4% 9.5 0.39 0.98 0.300 0.90 100,746,226 83,696,647 79,301,630 75,818,172 69,749,654 65,658,222 53,127,038 53,644,328 53,634,206 51,396,928 45,959,074 45,952,474 39,004,182 27.70 6.7% 34.8% $ 21.62 $ 5.3% -9.2% 25.29 6.2% 32.7% $ $ 17.50 $ 14.70 $ 12.4375 $ 10.3125 $ 12.4375 $ 12.719 $ 11.9375 $ 11.25 $ 8.5625 26.9% 27.2% 31.2% –8.7% 5.5% 14.5% 15.4% 42.0% 28.5% 12.9 1.11 1.73 1.437 1.518 (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) Does not include properties held for sale. (4) Includes properties acquired by Realty Income and Crest Net Lease. (5) All share and per share amounts reflect the 2-for-1 stock split on December 31, 2004. (6) Annualized dividend amount reflects the December declared dividend rate per share multiplied by twelve. R E A LTY I N C O M E 4 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 $ 150,370,000 $ 137,600,000 $ 121,081,000 $ 116,310,000 $ 104,510,000 $ 85,132,000 $ 67,897,000 $ 56,957,000 $ 51,555,000 $ 48,863,000 76,722,000 103,366,000 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 34,770,000 52,188,000 25,600,000 40,414,000 15,224,000 39,050,000 83,842,000 78,042,000 64,871,000 58,262,000 55,925,000 52,301,000 44,367,000 36,710,000 38,816,000 $ 1,533,182,000 1,404 11,350,800 302 371,642,000 35 28 48 98.1% $ 11.8 1.08 1.45 1.181 1.20 75,818,172 20.00 6.7% 21.0% $ $ $ $ 1,285,900,000 1,197 9,997,700 111 139,433,000 35 26 48 97.7% 10.9 1.01 1.38 1.151 1.17 69,749,654 17.50 7.8% 26.9% $ $ $ $ 1,178,162,000 1,124 9,663,000 117 156,472,000 35 25 48 98.2% $ $ 1,073,527,000 1,068 9,013,200 22 98,559,000 21 24 46 97.7% $ 1,017,252,000 1,076 8,648,000 110 181,376,000 3 24 45 98.4% $ $ 889,835,000 $ 699,797,000 $ 564,540,000 $ 515,426,000 $ 450,703,000 7,824,100 826 6,302,300 740 5,226,700 685 4,673,700 630 4,064,800 $ 193,436,000 $ 142,287,000 $ 55,517,000 $ 65,393,000 $ 3,273,000 10.4 0.99 1.30 1.121 1.14 $ 9.8 0.84 1.26 1.091 1.11 $ 10.7 0.76 1.23 1.043 1.08 65,658,222 53,127,038 53,644,328 53,634,206 51,396,928 45,959,074 45,952,474 39,004,182 14.70 9.0% 27.2% $ 12.4375 $ 10.3125 $ 12.4375 $ 12.719 $ 11.9375 $ 11.25 $ 8.5625 10.6% 31.2% 8.4% –8.7% 7.7% 5.5% 7.9% 14.5% 8.3% 15.4% 10.7% 42.0% 9.9% 28.5% $ $ 32,223,000 47,139,000 42,794,000 5 62 7 8 99.1% 9.5 0.70 1.04 0.931 . 0.95 970 149 5 22 4 99.5% 10.2 0.78 1.18 0.983 1.02 96 10 14 99.2% 9.8 0.74 1.11 0.946 0.96 58 3 7 99.3% 9.2 0.63 1.00 0.913 0.93 4 5 5 99.4% 9.5 0.39 0.98 0.300 0.90 $ $ $ $ $ (7) 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. (8) Dividend yield excludes special dividends. (9) 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. (10)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. 5 R E A LTY I N C O M E 1998 1997 1996 1995 1994 $ 85,132,000 $ 67,897,000 $ 56,957,000 $ 51,555,000 $ 48,863,000 41,304,000 62,799,000 34,770,000 52,188,000 52,301,000 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 $ 889,835,000 970 7,824,100 149 $ 193,436,000 5 22 45 99.5% $ 10.2 0.78 1.18 0.983 1.02 $ 699,797,000 826 6,302,300 96 $ 142,287,000 10 14 43 99.2% $ 9.8 0.74 1.11 0.946 0.96 $ 564,540,000 740 5,226,700 62 55,517,000 7 8 42 99.1% $ $ 9.5 0.70 1.04 0.931 .23 0.95 $ 515,426,000 685 4,673,700 58 65,393,000 3 7 42 99.3% $ $ 9.2 0.63 1.00 0.913 0.93 $ $ 450,703,000 630 4,064,800 4 3,273,000 5 5 41 99.4% $ 9.5 0.39 0.98 0.300 0.90 53,634,206 51,396,928 45,959,074 45,952,474 39,004,182 $ 12.4375 $ 12.719 $ 11.9375 $ 11.25 $ 8.5625 7.7% 5.5% 7.9% 14.5% 8.3% 15.4% 10.7% 42.0% 9.9% 28.5% 6 R E A LTY I N C O M E MISSION STATEMENT Realty Income is a New York Stock Exchange listed company dedicated to providing shareholders with dependable monthly income. The monthly dividend is supported by the cash flow from over 1,950 properties owned under long-term, net-lease agreements with leading regional and national retail chains. The Company is an active buyer of net-leased retail properties nationwide. O p e n H e r e 7 R E A LTY I N C O M E CEO LETTER TO SHAREHOLDERS What a Year! I am very pleased W H Y S U C H A G R E AT Y E A R I N 2 0 0 6 ? DEAR FELLOW SHAREHOLDERS, to report that The A Big Year for Acquisitions— Monthly Dividend The Same Underwriting Process Company® had an exceptional year in 2006! For the year ended December 31, 2006, Realty Income and During the year we made significant progress in virtually Crest invested $769.9 million in 378 new properties and all areas of the Company’s business, including strong properties under development. Realty Income invested portfolio performance, outstanding access to capital at $656.7 million in 322 new properties with an initial weighted attractive rates and a record number of profitable new average lease yield of 8.6%. The 322 new properties property acquisitions in both our core real estate portfolio acquired by Realty Income are located in 30 states and and in our Crest Net Lease, Inc. subsidiary (Crest). are 100% leased under net-lease agreements with an initial In short, your Company ended 2006 with record revenue, average lease length of 16.7 years. They are leased to 16 earnings and dividends paid to shareholders. During the year, revenue rose 22.5% to $240.1 million, funds from operations increased 20.2% to $155.8 million and common stock dividends paid increased 19.4% to $129.7 million, as compared to 2005. We also crossed the historical milestone of more than $1.2 billion in dividends paid to shareholders. Additionally, we substantially increased the size of our real estate portfolio by acquiring 378 new properties for $770 million and permanently financed these, and other properties acquired in late 2005, by raising over $900 million in five common stock, preferred stock and senior unsecured bond offerings. We also enjoyed healthy portfolio occupancy at year-end of 98.7%. different retail chains in 11 separate industries. Crest During 2006 we paid 12 monthly common stock divi- invested $113.2 million in 56 properties, all of which are dends and increased the dividend five times. The dividend being marketed for sale. grew from an annualized amount of $1.395 per share, at Since $770 million in property acquisitions is more the beginning of the year, to an annualized amount of than 3 1⁄2 times our average annual property acquisitions $1.518 as of December 31, 2006. The share over the last ten years, one might surmise that we did price of our common stock rose from something substantially different during 2006. Actually, $21.62, at the end of 2005, to a closing our investment strategy and underwriting standards price of $27.70 on December 31, 2006. remained exactly the same as in the past. As always, our Including dividends paid and the share price mission for each property acquisition is for the new asset increase, shareholders received an attractive to provide dependable cash flow to support the payment total return on their investment of 34.8%, for of monthly dividends. In order to do that, we perform the year ended December 31, 2006. extensive analysis on the individual retailer, their overall DURING THE YEAR, REVENUE ROSE 22.5% TO $240.1 MILLION, FUNDS FROM OPERATIONS INCREASED 20.2% TO $155.8 MILLION AND COMMON STOCK DIVIDENDS PAID INCREASED 19.4% TO $129.7 MILLION AS COMPARED TO 2005. R E A LTY I N C O M E 8 industry, the profitability of their stores and the individual react quickly, who deals with buyers in an honest and properties that we will be purchasing. This analysis is critical straightforward manner, and who, most importantly, shows to determining the appropriateness of each property up on time with cash in hand when it’s time to close. I can’t acquisition we make. say enough about how important these factors are to our As an active buyer of net lease retail real estate, a very long-term success and what a great job our acquisitions, large volume of properties for sale come to our attention research and legal teams have done in this area. each year. We know most of these opportunities won’t However, I think the primary reason we are seeing so meet our acquisition requirements and we attempt to many property acquisition opportunities right now is due quickly let the fine people who bring us these opportunities to the very high level of retail companies being bought know that they should look for another buyer. The transac- and sold, as well as the financial world’s realization that tions we see that might fit our requirements are presented these companies have a hidden treasure chest on their to our Research Department for analysis and then to our balance sheets. That treasure chest is their real estate. Investment Committee for consideration. During 2006, Many of these retailers own a large number of the stores our Investment Committee reviewed over $5 billion of they operate. Often, the value of their real estate, if sold, potential transactions and acquired $770 million in new is worth far more than the retail chain is being given credit properties, or about 15% of what we reviewed. We believe for as part of its stock market valuation. Astute manage- we remained disciplined in our review of each acquisition ment teams at many retail chains have realized that they can opportunity so that the properties we ultimately acquired add substantial value to their shareholders by selling these will provide us with the consistent cash flow we can use to properties to us, leasing them back, and then redeploying pay dividends for many years to come. By the way, the the capital into other profitable ventures. In addition, 15% purchased this year compares to buying 14%, 8%, potential buyers of these retail chains, such as private 26% and 11% of what we reviewed in each of the previous equity firms and other retailers, have realized they can use four years. In other words, during 2006 we ended up seeing the real estate of the retail chain they are acquiring to help a lot more real estate that would potentially meet our them fund their purchase of the business. needs, while buying about the same percentage of Fortunately, a few years back, we determined that properties we looked at last year and in previous years. these types of transactions would accelerate and we Additional Market Penetration— Large Portfolio Transactions allocated substantial resources and personnel to working on these large transactions. During 2006, these efforts continued to bear fruit and are primarily responsible for We believe there are several reasons we were presented our large volume of property acquisitions. with so many potential transactions last year. As an active The net-lease retail market continues to be highly buyer of net lease properties nationwide, with the ability competitive with multiple buyers for individual properties. to write checks for several hundred million dollars, we are Because of this competition, the pricing to acquire these a pretty good first stop for people looking to sell net-lease individual assets has been higher and their yields lower in retail properties. Additionally, our staff has worked recent years. Whenever we acquire a new property, it extremely hard to build a reputation as a buyer, who will comes with a long-term lease that requires monthly rent DURING 2006, WE INVESTED $770 MILLION IN 378 NEW PROPERTIES. 9 R E A LTY I N C O M E price and lease yield are an important component of the transaction, often, the most critical factor is the ability of the various parties to arrive at the table with cash and close the transaction on time. Since the focus in these transactions is multi-faceted and not just on yield and price, these larger transactions have offered us more attractive economics than buying properties one at a time in the retail marketplace and have allowed us to maintain profitable margins on new property acquisitions. The Challenge to Adapt Our market is always changing. Working with change to be paid, which gives us a return on our investment. For means that we must be responsive, agile and flexible. We example, let’s say that return is about 8 1⁄2% and increases must constantly adapt to change. This requires us to identify over time. The money we use to acquire the property is, new acquisition areas and opportunities so that we remain obviously, not free to us. Let’s say it costs us about 7%. competitive and obtain good lease yields. We must also The spread between the return from the property (8 1⁄2%) accomplish this while remaining conservative and staying and our cost of the money to buy it (7%) is how new true to our mission of providing monthly dividends for life property acquisitions add to our cash flow. So, if we invest to our shareholders. In the past, our ability to adapt has $100 million in new properties at an 8 1⁄2% yield ($8.5 million) been the secret to our continued growth and the means and the $100 million used to purchase the properties for us to acquire good real estate that is reasonably costs us 7% ($7 million), we end up with approximately priced, with attractive lease yields. $1.5 million in new cash flow ($8.5 million - $7 million = We strive to adapt to this constantly changing market- $1.5 million). You get the picture. place by trying many new things on a small level. In other Since the size of the spread between our yield and words, we slowly and deliberately investigate new indus- cost of capital contributes to the earnings growth of the tries and retailers. We conceive and test new transaction Company, it is important for us to be able to purchase structures. We survey the marketplace to determine what real estate with lease yields that are substantially higher than our focus should be, from year to year, and respond our cost of capital. It has been our experience with these accordingly. Our viewpoint is to always be guided by what larger, more complicated transactions that there are a will provide the dependable monthly dividends our variety of parameters that must be analyzed to determine shareholders require. Our path to integrating new ideas is the overall structure, optimal funding required, the source one of, first crawl, then walk, then run. We believe this of that funding, and the timing required to finance the purposeful approach has benefited our shareholders in final transaction. The sale-leaseback financing that we the long run, yet still provided us with provide is just one of many factors that must be a variety of new business areas considered. While the real estate purchase to pursue. R E A LTY I N C O M E 1 0 Opportunistic Acquisitions so we must continue to adapt so we Good examples of retail markets that exemplify this can keep growing. adaptive process include restaurants in the 60’s, with the birth of the fast food industry, child care in the 70’s, as Invest in Size many more women entered the work force, and child care, We have come to believe that again, in the 90’s, as a wave of consolidation hit the child when we find attractive areas in care industry, auto service stores in the 80’s, as the do-it- which to invest, we should be 4 0 0 a d v a n c e y o u r l s — B u y s e l Y o u i n e s a n d b u s s h a r e s s p a c e s 4 E L M D A G M yourself market grew, and convenience stores in the 90’s, prepared to make large commitments to these sectors. as the gasoline service station and convenience store For example, in recent years, we have made substantial industries realized economies of scale and profitability by property acquisitions in both the chain restaurant and combining their goods and services. This process has con- convenience store industries to capitalize on certain tinued over the last six years with profitable investments trends in these sectors. Large investments, like these, in the entertainment, theater, motor vehicle industry, auto from time to time may cause an industry to represent a collision, education, and a number of other new industries. higher percentage of our lease revenue than we would like Proactive research in a variety of industries provides us to sustain over a prolonged period of time. It is our policy with the in-depth analysis necessary to act quickly when to take advantage of these opportunities by periodically markets change and opportunities occur. As mentioned making large commitments and then to focus in other earlier, in larger transactions, such as mergers or private sectors, gradually bringing these concentrations back to equity transactions, the ability to move quickly and commit more comfortable levels. The diversification of lease to closing is critical to getting the transaction done. This revenue will remain an important part of our strategy so has been an important competitive advantage for us over that we have multiple sources of funds to support the the past several years. dividends we pay to our shareholders. Our objective is to This proactive analysis will continue to be important for keep individual industry levels at no more than 20% of future acquisitions. While never completely clear, our crystal total revenue and individual retail chain levels at no more ball is pointing us in the direction of industries that cater to than 10% of total revenue. (Actually, we prefer about half the large baby boomer generation, as well as the continuing of these amounts over the long term). While we may consolidation taking place in a number of retail sectors. slightly exceed these levels at a moment in time, to capitalize We will continue to dedicate substantial resources to on a particular opportunity, rest assured, we will then examining a wide variety of acquisition ideas we may be shift our investment focus so that we able to target in the future. You should know, however, that maintain appropriate diversification of for every idea that has worked for us, there have been four our revenue. or five ideas we have spent time on that went absolutely nowhere. A primary challenge for our management team, Research Drives our Efforts going forward, is to continue to seek out new opportunities Our research is the primary driver and ways to invest that will provide us with additional of all of our acquisition efforts. In particular, properties to purchase. The market will continue to change I cannot overstate the importance of this OUR VIEWPOINT IS TO ALWAYS BE GUIDED BY WHAT WILL PROVIDE THE DEPENDABLE MONTHLY DIVIDENDS OUR SHAREHOLDERS REQUIRE. 1 1 R E A LTY I N C O M E research effort when we are underwriting larger What is almost as transactions. Since we rely on the retailers that occupy important as what we our properties to pay rent for 15 to 20 years, selecting the bought this year are right retail chain is crucial. As such, extensive research the transactions we did and due diligence on each chain is undertaken, including: not do. Having a large company analysis, interviews with the management team, number of opportunities to closely examining the chain’s audited financial statements, choose from allows us to select along with reviewing a variety of internal operating metrics only those properties we wish to hold that can give us insight into the operations of the retailer. for the long term and will likely be the key In addition, a survey of all available external research is to our continued success. As always, the purpose of completed to augment our internal research expertise. additional property acquisitions is to increase the size of Finally, it is imperative that we have a solid understanding our real estate portfolio, thereby increasing lease revenue, of the historical financial performance of the industry, the which leads to higher funds from operations and makes it outlook for future operating performance, the competitive possible for us to increase the amount of the monthly environment within which the industry operates, as well dividend on a regular basis. as some indication of the challenges and opportunities that might impact the industry in the future. A C C E S S T O C A P I TA L Another critical metric that we use is to analyze the ratio Why Access to Capital is Critical between the cash flow the retailer produces on a particular As a Real Estate Investment Trust (REIT), Realty Income is location, divided by the amount of rent they are going to required to pay out the majority of its cash flow as divi- pay to us. This provides us with a “cash flow coverage” dends to shareholders. As such, we typically require access ratio that gives us insight into the property’s ability to pay to the public markets in order to generate capital to fund rent over a prolonged period of time. Strong cash flow the growth in the size of our real estate portfolio. We also coverage is fundamental to supporting the payment of seek to strategically time our issuance of new securities to monthly dividends and protects the Company in the event our property purchases so that the funds we raise are that there is a slowdown in a retailer’s business. In other promptly put to work and new acquisitions immediately words, it creates a “margin of safety” to make sure we contribute to our cash flow growth. receive our rent. Our experience has been that our We initially fund our purchases by utilizing our properties with strong cash flow coverage of rent have $300 million unsecured acquisition credit facility because been better able to weather the economic ups and downs this allows us to efficiently purchase properties without any that are inevitable. financing contingencies. When the credit facility reaches a As a final part of our research, our real estate research certain level, we then permanently finance these acquisitions, staff visits every single property under consideration, by issuing common or preferred stock or bonds, and pay compiling market analysis, competitor profiles, traffic down the balance on the short-term credit facility. This flows, economic data and comparative purchase price and tends to minimize the amount of variable rate debt we are rent studies for each location. Before we make the final exposed to and has been instrumental in decision to purchase a property, all of this research at the industry, retail chain and property level, is analyzed by our Investment Committee. (As a matter of fact, our 4-person Investment Committee, which includes the CEO, President, CFO and General Counsel spends most Fridays watching hundreds and hundreds and minimizing the impact rising interest rates might otherwise have had on our cash flow throughout our operating history. Great Year in the Capital Markets During 2006, Realty Income issued hundreds of videos of the properties we might acquire). 16.8 million common shares, 8.8 million R E A LTY I N C O M E 1 2 • In December 2006, we issued 8.8 million shares of 6.75% Monthly Income Class E perpetual preferred stock, generating gross proceeds of $220 million The capital we raised in 2006 permanently funded all of our property acquisitions and has positioned us well going into 2007. At year end, we have all of our $300 million acquisition credit facility available to fund acquisitions that we uncover throughout 2007. We would be remiss if we did not say how much we appreciate the hard work of the underwriters who helped us raise all of this capital. They included: Merrill Lynch as sole book-running manager and A.G. Edwards, Raymond preferred shares and $275 million in senior unsecured notes, James, and Wachovia as co-lead managers, Robert W. generating over $900 million in capital that immediately Baird & Co., Banc of America, Credit Suisse and JPMorgan adds to the Company’s earnings. as senior co-managers for our common stock offerings; This capital funded $770 million in acquisitions during Citigroup, Merrill Lynch, and Wachovia as co-books, A.G. 2006, the redemption of our $110 million, 7 3⁄4% unsecured Edwards and UBS Investment Bank as co-leads, and Banc notes due in 2007, and acquisitions made at the end of of America, Credit Suisse, Raymond James and RBC 2005. There was strong demand for all of these securities Capital Markets as senior co-managers for our preferred offerings and, in the case of the common and preferred stock offering; and Banc of America, Citigroup and Credit stock offerings, strong demand allowed us to issue more Suisse as joint book-running managers for our senior shares than originally targeted. unsecured notes offering. Other participants in our offerings Here is a brief summary of our capital markets activities throughout the year included: BB&T Capital Markets, Bank in 2006: of Montreal, Stifel Nicolaus, Bank of New York, and Wells • In March 2006, we issued 5.2 million shares of Fargo Securities. common stock priced at $24.39 per share, generating gross proceeds from the offering of approximately A Word about Credit Ratings $126.8 million We are pleased to report the following credit ratings on • In September 2006, we redeemed our $1 10 million, our corporate credit and senior unsecured debt: Fitch 7 3⁄4% unsecured notes due May 2007 Ratings Credit Agency: BBB+ stable outlook, Moody’s • In September 2006, we issued $275 million of 5.95%, Investors Services: Baa2 positive outlook and Standard & 10-year senior unsecured notes Poor’s Ratings Services: BBB positive outlook. During • In September 2006, we issued 4.7 million shares of 2006, both Moody’s Investors Services and Standard & common stock priced at $24.32, generating gross Poor’s Ratings Services revised Realty Income’s outlook to positive from stable. The rating agencies cited our proceeds from the offering of approximately $114.7 million • In October 2006, we issued 6.0 million shares of common stock priced at $26.40 per share, generating gross proceeds of approximately $158.4 million • In November 2006, our underwriters exercised the over- allotment option to purchase 900,000 shares of additional common stock related to the October 2006 offering, generating gross proceeds of approximately $23.8 million (1) Total revenue includes amounts reclassified to income from discontinued operations, but excludes revenue from Crest. 1 3 R E A LTY I N C O M E E M L D M A G Yo u re t i re — R e c e i ve 4 0 1 K ro l l ove r — B u y 5 0 0 s h a re s improved capacity to absorb The size of our real estate portfolio increased 19.0%, as larger, more concentrated compared to the size of the portfolio at the end of 2005. investments without com- This substantial increase was the result of $770 million promising our strong balance invested in 378 additional properties acquired by Realty sheet. As part of our capital markets activities, Income and its Crest subsidiary during the year. Of the we spend a good deal of time working with the various total 378 properties purchased, Realty Income invested rating agencies to keep them informed about the latest $656.7 million in 322 properties to be held for long-term developments of the Company. This is important as our investment in the Company’s core portfolio. These credit ratings determine the pricing of our preferred stock properties are located in 30 states, have an initial weighted and notes offerings. average lease rate of 8.6% and an initial average lease term of 16.7 years. They are leased to 16 different retail chains in The Importance of Capital Structure 11 retail industries. As of December 31, 2006, Realty Income’s capital During 2006, we also continued to proactively manage structure consisted of $2.8 billion, or 69% of common stock, our real estate portfolio. As part of our active portfolio $347.5 million, or 8% of preferred stock and $920 million, management, we sold 13 properties for $10.7 million, for or 23% of senior unsecured notes, for a total capitalization the year ended December 31, 2006. of approximately $4.1 billion. We had zero ($0) borrowings on An important aspect of effectively managing our assets our $300 million acquisition credit facility. This conservative is determining if a particular property we own should be capital structure has earned Realty Income the distinction sold. While our primary focus is to hold properties for the of being one of the top five in the real estate industry for income they produce, there are times when it is advanta- balance sheet strength during all of the years that research geous to sell a particular property. Property sales occur analysts have been reviewing and reporting these metrics. when we believe the sales proceeds can be reinvested at An important consideration in our capital raising activities higher returns, the sale of a property enhances portfolio is maintaining an optimum capital structure that facilitates credit quality, or selling a property increases the average a low cost-of-capital, while preserving the Company’s con- remaining lease term in the portfolio. All of the property servative balance sheet. Since our core objective is to sales completed in 2006 met these criteria. maintain the integrity of the cash flow used to pay divi- dends, we continue to believe that a conservative capital Lease Expirations structure is the best means to achieve this objective. This During 2006, 97 properties reached the end of their lease is why we have a bias towards using common equity to term, 77 properties had their leases renewed, 10 properties fund acquisitions. However, we attempt to carefully blend were leased to another tenant, 2 properties were sold at the in modest amounts of other types of capital when there end of the lease term and 8 properties are being marketed are clear, cost-of-capital advantages. This balance requires for lease or sale. constant monitoring so that we can maintain a conservative Fifteen to twenty-year leases, while longer than many capital structure over the long term. real estate leases, eventually do expire. With the real estate portfolio growth we’ve enjoyed in the past ten O U R R E A L E S TAT E P O R T F O L I O T O DAY years, our lease expirations are likely to increase in future As of December 31, 2006, we owned 1,955 retail properties years. We’ve had a good deal of experience with these located in 48 states leased to 103 different retail chains lease expirations, or lease rollovers, as doing business in 29 separate retail industries. Portfolio occupancy as of the end of the year was 98.7% and the average remaining lease term for properties in our portfolio was 12.9 years. we usually call them. Historically, the majority of leases that have come up for renewal have been in the child care industry, which was one of R E A LTY I N C O M E 1 4 our opportunistic acquisition discoveries back in the 80’s. we are just beginning to experi- If our past experience with lease renewals is a prologue ence the rent increases that were for the future, we can anticipate that: contractually agreed upon at 1. If a property is profitable and performing well, the lease origination and retailer will likely renew the lease at the existing rate we believe, over the or higher next several years, 2. If a property is a more marginal performer, the retailer our same store rent will likely renew the lease but ask for a slight increases will return to reduction in rent, or their historical level of 3. The retailer may opt not to renew the lease, in which increases. case we will either find another tenant or decide to sell the property. Retailer Outlook As in the past, our analysis and final decision, as to Our portfolio of retail real estate is currently performing which path to take, is based upon our desire to hold very well. We have no significant issues with the perform- properties for the long term to generate the highest ance of any of our current tenants and their ongoing ability amount of income possible in order to pay increasing to pay the rent they owe us. From time to time, however, monthly dividends. Rent Increases a particular retailer may hit a rough spot and struggle to pay rent. We view these occasional episodes as “business as usual” for an owner of a very large portfolio of single- Same store rents on 1,421 properties under lease for the tenant properties. In each of our 38 years of experience in entire year ended December 31, 2006 increased 0.7% to handling such situations, we have been fortunate to have $175.3 million from $174.0 million in 2005. To break down continually maintained portfolio occupancy above 97%. the same store rent increase results during 2006, we had In terms of what we see on the horizon for the broader 22 industries with increases in rents, five with flat same retail market, our crystal ball is a bit cloudy, but our best store rents and two with declining same store rents—so a guess, as of now, is that the retail market could experience pretty good result for 2006. some slowing during 2007. However, our long-term leases, Same store rent increases are comprised of a specific, strong cash-flow coverages at the store level, and focus identical, number of properties that are tracked quarter to on service-oriented retailers providing basic human needs quarter and year to year. Generally, we look for same store goods and services, should continue to serve us well. rents to increase 1% to 2% each year. This year we were Should the economy take a turn for the worse, which is obviously below that number. Generally, rent increases not widely anticipated by most pundits at this point in on our properties occur every five years. As such, there is time, there is always the possibility that some of our retail usually a considerable lag time between when we purchase operators could be impacted. This is something that we a property, when the rent increases occur and when the diligently monitor and are prepared to proactively manage property qualifies to be included in the should such situations arise. same store rent calculation. Given the large amount of property Crest Net Lease acquisitions we have Crest Net Lease, Inc. is Realty Income’s wholly-owned completed in recent subsidiary that was formed in 2000 for the purpose of years, the vast majority of acquiring properties for resale. The properties are primarily our properties have now sold in the 1031 tax-deferred exchange market. Crest been acquired since provides Realty Income with an important competitive 1997. Because of that advantage since its primary function is to assist Realty 1 5 R E A LTY I N C O M E Income in completing large portfolio transactions so that Realty Income can manage tenant level concentrations. During 2006, Crest acquired 56 properties for $113.2 million. These properties are being marketed for sale in accordance with Crest’s operating strategy. During 2006 Crest sold 13 properties for a gain on sales of $2.2 million. Crest’s inventory at December 31, 2006 was $137.5 million, which consists of 60 properties that are held for sale. While Crest helps Realty Income complete large port- folio transactions and does contribute to Realty Income’s earnings, its earnings contributions are relatively small and we do not rely on this more volatile income stream to pay our monthly dividends. H OW W E P E R F O R M E D — F I N A N C I A L LY S P E A K I N G Revenue common share, is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations on page 60. Realty Income’s subsidiary company, Crest, also con- tributed to Realty Income’s earnings growth during 2006. During 2006, revenue increased 22.5% to $240.1 million, Crest generated $1.4 million, or $0.02 per share, in FFO for as compared to $196.0 million during 2005. Revenue Realty Income, in comparison to $2.8 million, or $0.03 per growth, driven by portfolio acquisition growth, is an share, in FFO for Realty Income in 2005. important objective of ours because it is crucial to our ability to increase funds from operations and dividends. Net Income This year’s revenue growth is primarily attributable to the Net income available to common shareholders, as of high level of property acquisitions achieved in both 2005 December 31, 2006, was $99.4 million as compared to and 2006. Funds from Operations (FFO) $89.7 million in 2005. On a diluted per common share basis, net income was $1.1 1 per share in 2006 as compared to $1.12 per share in 2005. (The calculation to determine In 2006, FFO available to common shareholders also net income for a real estate company includes gains from increased 20.2% to $155.8 million, as compared to property sales and impairments, which vary from year to $129.6 million during 2005. On a diluted per common year according to the timing of property sales. This share basis, FFO increased 6.8% to $1.73 per share, as variance can significantly impact net income). compared to $1.62 per share for 2005. This increase in FFO and FFO per share is the result of higher than average I N V E S T O R R E T U R N S acquisition activity throughout the year. Through December 31, 2006, Realty Income had paid FFO is a common measure- a total of 437 consecutive monthly dividends and ment for a REIT. It is an alternative $1.2 billion in dividends since 1970. We have also increased non-GAAP measure that is the amount of the monthly dividend 42 times, of which considered to be a good 37 have been consecutive quarterly increases. This con- indicator of a company’s sistent record of dividend increases has resulted in a total ability to pay dividends. A rec- increase in our monthly dividend of 68.7%. In comparison, onciliation of net income Realty Income increased the amount of dividends paid available to common from $1.346 in 2005 to $1.437 in 2006, a total increase of shareholders to FFO per 6.8%. R E A LTY I N C O M E 1 6 In addition, we enjoyed an increase in the price of our environment in which we operate. Remaining conservative shares this year. At the end of 2005, our share price was in our operations and capital structure is vitally important $21.62 as compared to the closing price of $27.70 on December 31, 2006. Based on a share price increase of to realizing the mission of The Monthly Dividend Company®. We are guided by the need to generate 28.1% and a 2006 dividend yield of 6.7%, shareholders reliable revenue in every decision we make, whether it’s a enjoyed a total return during 2006 of 34.8%. decision to acquire a single property or a portfolio of properties, a decision as to what type of capital we use to W H O W E A R E A N D W H AT W E F O C U S O N fund property acquisitions or a decision as to how to The most important result of our accomplishments over the structure lease agreements so course of the year is that we were able to pay 12 monthly that our properties generate dividends and increase the dividend five times during 2006. increasing lease revenue over We know that the majority of our shareholders look to us to the long term. These day-to- provide monthly dividends that increase over time. Equally day operating decisions are all important is the fact that our efforts during 2006 also bode made with you, the monthly well for strong operating performance and further dividend dividend recipient, in mind. You Yo u r c h i l d e a r n s a c o l l e g e s c h o l a r s h i p — B u y 2 0 0 s h a r e s a n d a d v a n c e 2 s p a c e s E M L D M A G increases in 2007, as we receive a full year of lease pay- should also gain some comfort in knowing that this is also ments on the newly acquired properties. very much self serving as we own a lot of shares ourselves! Today, investors can choose from a variety of investments that produce income, but few of them are structured to W H E R E W E F I T I N T H E Q U E S T F O R I N CO M E pay dependable monthly dividends. Since we are one of Conversations on how to produce income are becoming the few remaining purveyors of monthly dividends, we increasingly prevalent as the “Baby Boomer” generation feel a certain responsibility to manage the Company so rapidly approaches traditional retirement age. These days, that we can continue to offer the monthly income upon more people are asking how to get income and taking the which so many of you have come to rely. This is always time to learn about income investments as they begin to uppermost in our minds as we navigate the competitive shift from growth-oriented investment portfolios to income-oriented investment portfolios. As The Monthly Dividend Company®, we believe it is important for people to under- stand the investment characteristics of our particular company, both in comparison to other income vehicles, and within our particular investment type. Investors can receive income from corporate bonds, preferred stocks, income-focused mutual funds, utility stocks, dividend-paying common stocks, annuities as well as from private real estate ownership and REITs, to mention just a few of the options available. In looking at these various sources of income, we believe that determining the reliability and safety of the source of the income is imperative. 1 7 R E A LTY I N C O M E E M L D M A G S p o u s e i s t h r i l l e d b y s c e n i c v i e w — 2 0 0 s h a r e a w a r d Since we are a REIT, our someone holds shares of Realty Income (or any other operating structure is specif- company that regularly increases their dividend), the ically designed to provide higher the yield on their original cost will be. This means dividend income. As a REIT, we are required to pay that regular dividend increases typically motivate long- out 90% of our income as dividends to shareholders. term ownership because it becomes increasingly difficult Since all REITs have this dividend requirement, does that to duplicate the income stream at one’s current yield on mean that all REIT dividends are alike? Not likely. cost. (Example: shares purchased on December 31, 2000 have a yield on cost of 12.2% on December 31, 2006). Dependable and rising dividends, provided by companies with a dedicated focus on maintaining a low-risk profile, could be of increasing importance to income investors in the coming years. We believe that companies with this focus and a disciplined management style could be in great demand. We also believe that the demand for monthly income is on the rise, based on the rising number of investment products being advertised today that promise dependable monthly income. Just as there are many types of real estate that REITs own, there are varying degrees of stability associated with While there are very few absolute certainties in life, it is the goal of The Monthly Dividend Company® to provide the lease revenue that supports the payment of dividends. shareholders with increasing monthly dividends every In Realty Income’s case, we generally have 15 to 20-year month, year after year, for the rest of their lives. Our lease contracts. Thus, we receive contractually agreed strategy of owning a sizable portfolio of retail properties, upon, long-term rents, which, if the properties are under- operated under long-term lease agreements with large written properly, tend to provide very stable lease revenue retail chains, is the means to continuing to provide monthly from which to pay dividends. This parallel between stable, dividends. This rental revenue has been a reliable generator long-term leases and dependable dividends is exemplified of cash to pay monthly dividends for the past 37 years. In by the Company’s 37-year dividend-paying history. As of addition, we have never carried a mortgage on any of the the end of 2006, we have paid 437 consecutive monthly properties that we own and we are focused on main- dividends. taining a conservative balance sheet. Keeping the amount In addition, Realty Income also has a history of providing of debt we carry at a modest amount and our properties shareholders with regular dividend increases. Most of our mortgage-free, along with controlling shareholders consider this to be the main reason to own shares. The metric that is commonly used to demonstrate the power of rising dividends is “Yield on Cost”. Simply stated, the longer expenses, frees up the majority of our rental revenue for the payment of monthly dividends to shareholders. We believe this operating philosophy distinguishes Realty Income as a conservative provider of monthly dividends. R E A LTY I N C O M E 1 8 S U M M A R Y O F 2 0 0 6 P E R F O R M A N C E Company®) will continue to be an important component • Portfolio occupancy remained high at 98.7% of our ability to access capital at attractive prices. We • Same store rents rose 0.7% will continue to work hard in this area as well. • Total acquisitions for Realty Income and Crest, As always, we’re grateful to the thousands of loyal combined, increased to 378 properties purchased for shareholders who, like us, have enjoyed years of monthly $769.9 million dividend checks. Again, we’d like to caution all investors — Realty Income acquired 322 properties for to remain diversified and rely on us for only a portion of $656.7 million at an 8.6% weighted average lease yield and an average lease length of 16.7 years their income needs. We will do our best to operate your Company in a prudent fashion so that the monthly — Crest acquired 56 properties for $113.2 million dividend checks keep on coming. • Accessed over $900 million in additional capital in five public market transactions • Properties continue to be held without mortgage debt Sincerely, • Property sales provided $10.7 million in additional Tom A. Lewis Chief Executive Officer proceeds for investment • Revenue increased 22.5% and FFO per diluted share increased 6.8% • The monthly dividend was increased five times during the year • Yield on cost continued to increase • Dividends paid increased 6.8% • Share price rose 28.1% • Total return to shareholders was 34.8% A C O U P L E O F L A S T T H O U G H T S This has been a very good year for The Monthly Dividend Company®. I’d like to caution you, however, that one year does not a trend make. The type of business transactions we did this year are notoriously difficult to execute, and they tend to be unpredictable and lumpy. We’ve made good progress in getting our name out to the private equity markets and various investment banking firms, but 2006 was a banner year for such transactions because of the waves of consolidation that are sweeping certain industries. It could be that this was only a moment in time. As such, we are already hard at work identifying new areas for investment. In addition, the record access to capital we enjoyed in 2006 was also a notable event in our Company’s history. The popularity of The Monthly Dividend Company® was evident amidst the solid demand for income in the overall marketplace. Our effort to keep the investing public informed about the benefit of monthly dividends (and The Monthly Dividend 1 9 R E A LTY I N C O M E FINANCIAL INFORMATION 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 PA N Y R E C E N T D E V E L O P M E N T S D I S T R I B U T I O N P O L I C Y B U S I N E S S P H I L O S O P H Y A N D S T R AT E G Y P R O P E R T I E S C O N S O L I DAT E D B A L A N C E S H E E T S C O N S O L I DAT E D S TAT E M E N T S O F I N C O M E C O N S O L I DAT E D S TAT E M E N T S O F S TO C K H O L D E R S ’ E Q U I T Y C O N S O L I DAT E D S TAT E M E N T S O F C A S H F L OW S N OT E S TO C O N S O L I DAT E D F I N A N C I A L S TAT E M E N T S 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 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 LY 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 LT S O F O P E R AT I O N S S E L E C T E D F I N A N C I A L DATA C O N T R O L S A N D P R O C E D U R E S C O N S O L I DAT E D Q U A R T E R LY F I N A N C I A L DATA M A R K E T P E R F O R M A N C E I N F O R M AT I O N F O R WA R D - L O O K I N G S TAT E M E N T S 2 1 2 1 2 2 2 4 2 4 2 8 3 4 3 5 3 6 3 7 3 8 4 9 5 1 6 3 6 4 6 6 6 7 6 8 R E A LTY I N C O M E 2 0 FINANCIAL INFORMATION 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 PA N Y R E C E N T D E V E L O P M E N T S D I S T R I B U T I O N P O L I C Y B U S I N E S S P H I L O S O P H Y A N D S T R AT E G Y P R O P E R T I E S C O N S O L I DAT E D B A L A N C E S H E E T S C O N S O L I DAT E D S TAT E M E N T S O F I N C O M E C O N S O L I DAT E D S TAT E M E N T S O F S TO C K H O L D E R S ’ E Q U I T Y C O N S O L I DAT E D S TAT E M E N T S O F C A S H F L OW S N OT E S TO C O N S O L I DAT E D F I N A N C I A L S TAT E M E N T S 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 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 LY 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 LT S O F O P E R AT I O N S S E L E C T E D F I N A N C I A L DATA C O N T R O L S A N D P R O C E D U R E S C O N S O L I DAT E D Q U A R T E R LY F I N A N C I A L DATA M A R K E T P E R F O R M A N C E I N F O R M AT I O N F O R WA R D - L O O K I N G S TAT E M E N T S 2 1 2 1 2 2 2 4 2 4 2 8 3 4 3 5 3 6 3 7 3 8 4 9 5 1 6 3 6 4 6 6 6 7 6 8 R E A LTY I N C O M E 2 0 REALTY INCOME CORPORATION AND SUBSIDIARIES BUSINESS DESCRIPTION THE COMPANY Realty Income Corporation, The Monthly Dividend Company®, remaining lease term (excluding extension options) of approximately 12.9 years. is a Maryland corporation organized to operate as an equity In addition, at December 31, 2006, our wholly-owned real estate investment trust, or REIT. Our primary business taxable REIT subsidiary, Crest Net Lease, Inc. (“Crest”), had objective is to generate dependable monthly cash distribu- invested $137.5 million in 60 properties, which are classified tions from a consistent and predictable level of funds from as held for sale. Crest was created to buy and sell properties, operations, or FFO per share. The monthly distributions are supported by the cash flow from our portfolio of retail prop- primarily to individual investors, many of whom are involved in tax-deferred exchanges under Section 1031 of the Internal erties leased to regional and national retail chains. We have Revenue Code of 1986, as amended (the “Tax Code”). in-house acquisition, leasing, legal, retail and real estate We typically acquire retail store properties under long-term research, portfolio management and capital markets expert- leases with retail chain store operators. These transactions ise. Over the past 38 years, Realty Income and its predeces- sors have been acquiring and owning freestanding retail generally provide capital to owners of retail real estate and retail chains for expansion or other corporate purposes. properties that generate rental revenue under long-term Our acquisition and investment activities are concentrated lease agreements (primarily 15 to 20 years). in well-defined target markets and generally focus on retail In addition, we seek to increase distributions to stock- chains providing goods and services that satisfy basic holders and FFO per share through both active portfolio consumer needs. management and the acquisition of additional properties. Our net-lease agreements generally: Our portfolio management focus includes: • Are for initial terms of 15 to 20 years; • Contractual rent increases on existing leases; • Require the tenant to pay minimum monthly rents and • Rent increases at the termination of existing leases property operating expenses (taxes, insurance and when market conditions permit; and maintenance); and • Active management of our property portfolio, including • Provide for future rent increases based on increases re-leasing vacant properties and selectively selling in the consumer price index, fixed increases, or, to a properties. In acquiring additional properties, we adhere to a focused strategy of primarily acquiring properties that are: • Freestanding, single-tenant, retail locations; Leased to regional and national retail chains; and • • lesser degree, additional rent calculated as a percent- age of the tenants’ gross sales above a specified level. Realty Income commenced operations as a REIT on August 15, 1994 through the merger of 25 public and private real estate limited partnerships with and into the Company. Leased under long-term, net-lease agreements. Each of the partnerships was formed between 1970 and 1989 for the purpose of acquiring and managing long-term, At December 31, 2006, we owned a diversified portfolio net-leased properties. of 1,955 retail properties: • With an occupancy rate of 98.7%, or 1,929 properties occupied of the 1,955 properties in the portfolio; Leased to 103 different retail chains doing business in • 29 separate retail industries; • Located in 48 states; The eight senior officers of Realty Income owned 1.3% of our outstanding common stock with a market value of $37.4 million at February 13, 2007. The directors and eight senior officers of Realty Income, as a group, owned 2.5% of our outstanding common stock with a market value of $72.6 million at February 13, 2007. • With over 16.7 million square feet of leasable space; Realty Income’s common stock is listed on The New York and Stock Exchange (“NYSE”) under the ticker symbol “O.” Our • With an average leasable retail space per property of central index key number is 726728 and cusip number is 8,600 square feet. 756109-104. Realty Income’s Class D cumulative redeemable preferred Of the 1,955 properties in the portfolio, 1,948, or 99.6%, stock is listed on the NYSE under the ticker symbol “OprD” are single-tenant, retail properties and the remaining seven and its cusip number is 756109-609. are multi-tenant, distribution and office properties. At Realty Income’s Class E cumulative redeemable preferred December 31, 2006, 1,923, or 98.7%, of the 1,948 single- stock is listed on the NYSE under the ticker symbol “OprE” tenant properties were leased with a weighted average and its cusip number is 756109-708. 2 1 R E A LTY I N C O M E Realty Income’s 8.25% Monthly Income Senior Notes, due Acquisition of $349 million of Buffets/Ryan’s 2008 are listed on the NYSE under the ticker symbol “OUI.” Restaurants on November 1, 2006 The cusip number of these notes is 756109-203. The 2006 acquisition amounts include Realty Income and In February 2007, we had 70 permanent employees as Crest’s aggregate investment of $349 million to acquire 144 compared to February 2006 when we had 69 permanent Buffets/Ryan’s restaurant properties. The properties are employees and four temporary employees. leased under 20-year, triple-net lease agreements. These We maintain an Internet website at www.realtyincome.com. properties were acquired subsequent to a merger between On our website we make available, free of charge, copies of Buffets, Inc. and Ryan’s Restaurant Group. our annual report on Form 10-K, quarterly reports on Form Of the 144 restaurant properties, 116 were acquired by 10-Q, current reports on Form 8 K, and amendments to those Realty Income and 28 were acquired by Crest. The rest- reports, as soon as reasonably possible after we electronically aurants have, on average, approximately 10,300 leasable file these reports with the SEC. None of the information on square feet and are situated on an average lot size of approx- our website is deemed to be part of this report. imately 2.86 acres. The properties are existing locations that, RECENT DEVELOPMENTS Acquisitions during 2006 During 2006, Realty Income and Crest invested $769.9 million, in aggregate, in 378 new properties and properties under development. These 378 properties are located in 30 states and are 100% leased with an initial average lease term of on average, have been operating for 11 years. Investments in Existing Properties In 2006, we capitalized costs of $964,000 on existing properties in our portfolio, consisting of $761,000 for re-leasing costs and $203,000 for building improvements. 17.1 years. As described below, Realty Income acquired 322 Net Income Available to Common Stockholders properties and Crest acquired 56 properties. Net income available to common stockholders was $99.4 million Included in the $769.9 million is $656.7 million invested in 2006 versus $89.7 million in 2005, an increase of $9.7 million. by Realty Income in 322 new properties and properties under On a diluted per common share basis, net income was $1.11 development, with an initial weighted average contractual per share in 2006 and $1.12 per share in 2005. lease rate of 8.6%. These 322 properties are located in 30 The calculation to determine net income available to states, are 100% leased with an initial average lease term of common stockholders includes gains from the sale of prop- 16.7 years and will contain over 3.3 million leasable square erties. The amount of gains varies from period to period feet. The 322 new properties acquired by Realty Income are based on the timing of property sales and can significantly net-leased to 16 different retail chains in the following 11 impact net income available to common stockholders. industries: automotive collision services, automotive tire The gain recognized from the sales of investment prop- services, convenience store, drug store, general merchan- erties during 2006 was $3.0 million as compared to $6.6 million dise, health and fitness, home improvement, motor vehicle for 2005. dealership, private education, restaurant, and theater. Also included in the $769.9 million is $113.2 million invested by Crest in 56 new retail properties. Funds from Operations (FFO) In 2006, our FFO increased by $26.2 million, or 20.2%, to At December 31, 2006, Realty Income had invested $155.8 million versus $129.6 million in 2005. On a diluted per $15.9 million in four properties that were leased and being common share basis, FFO was $1.73 in 2006 compared to developed by the tenant (with development costs funded by $1.62 for 2005, an increase of $0.11, or 6.8%. Realty Income). Rent on these properties is scheduled to See our discussion of FFO in the section entitled begin at various times during 2007. At December 31, 2006, “Management’s Discussion and Analysis of Financial Condition we had outstanding commitments to pay estimated unfunded development costs totaling approximately $16.4 million. The initial weighted average contractual lease rate is computed as estimated contractual net operating income (in a net-leased property this is equal to the base rent or, in the case of properties under development, the estimated base rent under the lease) for the first year of each lease, divided by the estimated total costs. Since it is possible that a tenant could default on the payment of contractual rent, we cannot assure you that the actual return on the funds invested will remain at the percentages listed above. and Results of Operations” in this annual report, which includes a reconciliation of net income available to common stockholders to FFO. Issuances of Common Stock In October and November 2006, we issued an aggregate of 6.9 million shares of common stock at a price of $26.40 per share. The net proceeds of approximately $173.2 million were used to fund a portion of the purchase price of the Buffets/Ryan’s properties and for other general corporate purposes. In September 2006, we issued 4.715 million shares of com- mon stock at a price of $24.32 per share. The net proceeds of approximately $109 million from this offering were used to R E A LTY I N C O M E 2 2 fund new property acquisitions, repay borrowings under our Crest Property Inventory credit facility and for other general corporate purposes. Crest’s property inventory at December 31, 2006 and In March 2006, we issued 5.2 million shares of common December 31, 2005 totaled $137.5 million and $45.7 million, stock at a price of $24.39 per share. The net proceeds of respectively, and is included in “real estate held for sale, approximately $120.5 million were used to fund new prop- net”, on our consolidated balance sheets. erty acquisitions and for other general corporate purposes. Issuance of Preferred Stock Increases in Monthly Distributions to Common Stockholders In December 2006, we issued 8.8 million shares of 63⁄4% We continue our 37-year policy of paying distributions Monthly Income Class E cumulative redeemable preferred monthly to our common stockholders. Monthly distributions stock, with a liquidation value of $25 per share. The net pro- per share were increased in April 2006 by $0.000625 to ceeds of $214 million from this issuance were used to repay $0.116875, in July 2006 by $0.000625 to $0.1175, in borrowings under our credit facility and for other general September 2006 by $0.00775 to $0.12525, in October 2006 corporate purposes. Beginning December 7, 2011, the Class by $0.000625 to $0.125875 and in January 2007 by E preferred shares are redeemable at our option for $25 per $0.000625 to $0.1265. The increase in January 2007 was our share. Dividends of $0.140625 per share are paid monthly in 37th consecutive quarterly increase and the 42nd increase in arrears on the Class E preferred stock. the amount of our dividend since our listing on the New York Stock Exchange, or NYSE, in 1994. In 2006, we paid the Credit Ratings Upgrades In February 2006, Moody’s Investors Service, Inc. affirmed following monthly cash distributions per share: three in the amount of $0.11625, three in the amount of $0.116875, two our senior unsecured debt rating of Baa2 and our preferred in the amount of $0.1175, one in the amount of $0.12525 stock rating of Baa3 and raised the outlook to “positive” and three in the amount of $0.125875, totaling $1.43725. from “stable.” In December 2006, January 2007 and February 2007, we In December 2006, Standard & Poor’s Ratings Group declared distributions of $0.1265 per share, which were paid affirmed our senior unsecured debt rating of BBB and our on January 16, 2007 and February 15, 2007 and will be paid preferred stock rating of BBB- and raised the outlook to on March 15, 2007, respectively. “positive” from “stable.” Redemption of 2007 Notes The monthly distribution of $0.1265 per share represents a current annualized distribution of $1.518 per share, and an annualized distribution yield of approximately 5.2% based on In September 2006, we redeemed all of our outstanding the last reported sale price of our common stock on the $110 million, 73⁄4%, unsecured notes due May 2007 (the NYSE of $29.09 on February 13, 2007. Although we expect “2007 Notes”). The 2007 Notes were redeemed at a to continue our policy of paying monthly distributions, we redemption price equal to 100% of the principal amount, cannot guarantee that we will maintain the current level of plus accrued and unpaid interest of $3.2 million and a make- distributions, that we will continue our pattern of increasing whole payment of $1.6 million. We recorded a loss on extin- distributions per share, or what the actual distribution yield guishment of debt totaling $1.6 million related to the will be in any future period. make-whole payment associated with the 2007 Notes. For 2006, the make-whole payment represented approximately $0.017 per share. Issuance of 10-Year Senior Unsecured Notes In September 2006, we issued $275 million, in aggregate principal amount of 5.95% senior unsecured notes due 2016 (the “2016 Notes”). The price to the investor for the 2016 Notes was 99.74% of the principal amount, for an effective yield of 5.985%. The net proceeds of approximately $271.9 million from this offering were used to redeem the 2007 Notes and for other general corporate purposes. Interest on the 2016 Notes is paid semiannually. Crest Property Sales During 2006, Crest sold 13 properties from its inventory for an aggregate of $22.4 million, which resulted in a gain of $2.2 million. Crest’s gains are included in “income from discon- tinued operations, real estate acquired for resale by Crest.” 2 3 R E A LTY I N C O M E DISTRIBUTION POLICY Distributions are paid monthly to our common stockholders received from taxable corporations (such as our taxable REIT subsidiary, Crest), to income that was subject to tax at the and Class D and Class E preferred stockholders if, and when corporate or REIT level (for example, if we distribute taxable declared by our Board of Directors. income that we retained and paid tax on in the prior taxable In order to maintain our tax status as a REIT for federal year) or, as discussed above, dividends properly designated income tax purposes, we generally are required to distribute by us as “capital gain dividends.” Distributions in excess of dividends to our stockholders aggregating annually at least earnings and profits generally will be treated as a non-taxable 90% of our REIT taxable income (determined without regard reduction in the stockholders’ basis in the stock. Distributions to the dividends paid deduction and by excluding net capital above that basis, generally, will be taxable as a capital gain. gains) and we are subject to income tax to the extent we Approximately 9.9% of the distributions to our common distribute less than 100% of our REIT taxable income (includ- stockholders, made or deemed to have been made in 2006, ing net capital gains). In 2006, our cash distributions totaled were classified as a return of capital for federal income tax $139.1 million, or approximately 113.3% of our estimated purposes. We are unable to predict the portion of future REIT taxable income of $122.8 million. Our estimated REIT distributions that may be classified as a return of capital. taxable income reflects non-cash deductions for depreciation and amortization. We intend to continue to make distri- butions to our stockholders that are sufficient to meet this distribution requirement and that will reduce our exposure to income taxes. Our 2006 cash distributions to common stock- BUSINESS PHILOSOPHY AND STRATEGY Investment Philosophy We believe that owning an actively managed, diversified portfolio of retail properties under long-term, net leases holders totaled $129.7 million, representing 83.2% of our produces consistent and predictable income. Net leases funds from operations available to common stockholders of typically require the tenant to be responsible for minimum $155.8 million. monthly rent and property operating expenses including The Class D preferred stockholders receive cumulative property taxes, insurance and maintenance. In addition, ten- distributions at a rate of 7.375% per annum on the $25 per ants are typically responsible for future rent increases based share liquidation preference (equivalent to $1.84375 per on increases in the consumer price index, fixed increases or, annum per share). The Class E preferred stockholders receive to a lesser degree, additional rent calculated as a percentage cumulative distributions at a rate of 6.75% per annum on the of the tenants’ gross sales above a specified level. We believe $25 per share liquidation preference (equivalent to $1.6875 that a portfolio of properties under long-term leases, coupled per annum per share). with the tenant’s responsibility for property expenses, gener- Future distributions will be at the discretion of our Board ally produces a more predictable income stream than many of Directors and will depend on, among other things, our other types of real estate portfolios, while continuing to offer results of operations, FFO, cash flow from operations, financial the potential for growth in rental income. condition and capital requirements, the annual distribution requirements under the REIT provisions of the Tax Code, our Investment Strategy debt service requirements and any other factors the Board of Directors may deem relevant. In addition, our credit facility contains financial covenants that could limit the amount of distributions payable by us in the event of a deterioration in our results of operations or financial condition, and which prohibit the payment of distributions on the common or In identifying new properties for acquisition, our focus is generally on providing capital to retail chain owners and operators by acquiring, then leasing back, retail store loca- tions. We categorize retail tenants as: 1) venture market, 2) middle market, and 3) upper market. Venture companies typically offer a new retail concept in one geographic region preferred stock in the event that we fail to pay when due of the country and operate between five and 50 retail (subject to any applicable grace period) any principal or locations. Middle market retail chains typically have 50 to interest on borrowings under our credit facility. 500 retail locations, operations in more than one geographic Distributions of our current and accumulated earnings region, have been successful through one or more economic and profits for federal income tax purposes, generally will cycles, and have a proven, replicable concept. The upper be taxable to stockholders as ordinary income, except to market retail chains typically consist of companies with 500 or the extent that we recognize capital gains and declare a capital gains dividend or that such amounts constitute more locations, operating nationally, in a proven, mature retail concept. Upper market retail chains generally have “qualified dividend income” subject to a reduced tax rate. strong operating histories and access to several sources The maximum tax rate of non-corporate taxpayers for “qualified dividend income” has generally been reduced to 15% (for taxable years beginning after December 31, 2002). In general, dividends payable by REITs are not eligible for the reduced tax rate on corporate dividends, except to the extent the REIT’s dividends are attributable to dividends of capital. R E A LTY I N C O M E 2 4 Realty Income primarily focuses on acquiring properties Historically, our investment focus has been on retail leased to middle market retail chains that we believe are industries that have a service component because we believe attractive for investment because: the lease revenue from these types of businesses is more • They generally have overcome many of the opera- stable. Because of this investment focus, for the quarter tional and managerial obstacles that can adversely ended December 31, 2006, approximately 80.9% of our affect venture retailers; rental revenue was derived from retailers with a service • They typically require capital to fund expansion but component in their business. Furthermore, we believe these have more limited financing options; service-oriented businesses would be difficult to duplicate • They generally have provided us with attractive risk- over the Internet and that our properties continue to perform adjusted returns over time since their financial well relative to competition from Internet businesses. strength has, in many cases, tended to improve as their businesses have matured; Credit Strategy • Their relatively large size allows them to spread corpo- We generally provide sale-leaseback financing to less than rate expenses across a greater number of stores; and investment grade retail chains. We typically acquire and lease • Middle market retailers typically have the critical mass back properties to regional and national retail chains and to survive if a number of locations are closed due to believe that within this market we can achieve an attractive underperformance. risk-adjusted return on the financing we provide to retailers. Since 1970, our overall weighted average occupancy rate at We also focus on, and have selectively made investments the end of each year has been 98.6%, and the occupancy rate in, properties of upper market retail chains. We believe upper at the end of each year has never been below 97.5%. market retail chains can be attractive for investment because: We believe the principal financial obligations of most • They typically are of a higher credit quality; retailers typically include their bank and other debt, payment • They usually are larger public and private retailers with obligations to suppliers and real estate lease obligations. more commonly recognized brand names; Because we typically own the land and building in which a • They utilize a larger building ranging in size from tenant conducts its retail business, we believe the risk of 10,000 to 50,000 square feet; and default on a retailers’ lease obligations is less than the retail- • They are able to grow because access to capital facili- ers’ unsecured general obligations. It has been our experi- tates larger transaction sizes. ence that since retailers must retain their profitable retail locations in order to survive, in the event of reorganization While our investment strategy focuses primarily on acquir- they are less likely to reject a lease for a profitable location ing properties leased to middle and upper market retail because this would terminate their right to use the property. chains, we also selectively seek investment opportunities with Thus, as the property owner, we believe we will fare better venture market retail chains. Periodically, venture market than unsecured creditors of the same retailer in the event of opportunities arise where we feel that the real estate used by reorganization. If a property is rejected by the tenant during the tenant is high quality and can be purchased at favorable reorganization, we own the property and can either lease it prices. To meet our stringent investment standards, however, to a new tenant or sell the property. In addition, we believe venture retail companies must have a well-defined retailing that the risk of default on the real estate leases can be further concept and strong financial prospects. These opportunities mitigated by monitoring the performance of the retailers’ are examined on a case by case basis and we are highly selec- tive in making investments in this area. individual unit locations and considering whether to sell locations that are weaker performers. In order to qualify for inclusion in our portfolio, new property acquisitions must meet stringent investment and credit requirements. The properties must generate attractive current yields and the tenant must meet our credit profile. We have established a three-part analysis that examines each potential investment based on: • • Industry, company, market conditions and credit profile; Location profitability, if profitability data is available; and • Overall real estate characteristics, including value and comparative rental rates. 2 5 R E A LTY I N C O M E The typical profile of companies whose properties have Portfolio Management Strategy been approved for acquisition are those with 50 or more The active management of the property portfolio is an retail locations. Generally the properties: • Are located in highly visible areas, essential component of our long-term strategy. We continually monitor our portfolio for any changes that could affect the • Have easy access to major thoroughfares; and performance of the industries, tenants and locations in which • Have attractive demographics. Acquisition Strategy 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 We seek to invest in industries in which several, well-organized, research, property due diligence and significant portfolio regional and national chains are capturing market share management activities. This monitoring typically includes through service, quality control, economies of scale, advertis- regular review and analysis of: ing and the selection of prime retail locations. We execute our • The performance of various retail industries; and acquisition strategy by acting as a source of capital to regional • The operation, management, business planning and and national retail chain store owners and operators, doing financial condition of the tenants. business in a variety of industries, by acquiring and leasing back retail store locations. We undertake thorough research We have an active portfolio management program that and analysis to identify appropriate industries, tenants and incorporates the sale of assets when we believe the reinvest- property locations for investment. Our research expertise is ment of the sales proceeds will generate higher returns, instrumental to uncovering net-lease opportunities in markets enhance the credit quality of our real estate portfolio, or where our real estate financing program adds value. In select- extend our average remaining lease term. At December 31, ing real estate for potential investment, we generally seek to 2006, we classified real estate with a carrying amount of acquire properties that have the following characteristics: $138 million as held for sale, which includes $137.5 million in • Freestanding, commercially-zoned property with a properties owned by Crest. Additionally, we anticipate selling single tenant; investment properties from our portfolio that have not yet • Properties that are important retail locations for been specifically identified from which we anticipate receiving regional and national retail chains; between $10 million and $35 million in proceeds during the • Properties that are located within attractive demo- next 12 months. We intend to invest these proceeds into new graphic areas relative to the business of their tenants, property acquisitions. However, we cannot guarantee that we with high visibility and easy access to major thorough- will sell properties during the next 12 months. fares; and • Properties that can be purchased with the simultane- Universal Shelf Registration ous execution or assumption of long-term, net-lease In April 2006, we filed a shelf registration statement with the agreements, offering both current income and the SEC, which is effective for a term of three years. In accordance potential for rent increases. with the SEC rules, the amount of securities to be issued pursuant to this shelf registration statement was not specified when it was filed. The securities covered by this registration statement include common stock, preferred stock, debt securities, or any combination of such securities. Realty Income may periodically offer one or more of these securities in amounts, prices and on terms to be announced when and if the securities are offered. The specifics of any future offerings, along with the use of proceeds of any securities offered, will be described in detail in a prospectus supplement, or other offering materials, at the time of any offering. As such, there is no specific limit to the dollar amount of new securities that can be issued under this new shelf registration before it expires in April 2009. The common stock issued in September 2006, October 2006 and November 2006, the 2016 Notes issued in September 2006 and the Class E preferred stock issued in December 2006 were issued pursuant to our universal shelf registration statement. R E A LTY I N C O M E 2 6 Conservative Capital Structure on acceptable terms, we generally seek to refinance those We believe that our stockholders are best served by a borrowings with the net proceeds of long-term or permanent conservative capital structure. Therefore, we seek to maintain financing, which may include the issuance of common stock, a conservative debt level on our balance sheet and solid preferred stock, convertible preferred stock, debt securities interest and fixed charge coverage ratios. At February 13, or convertible debt securities. We cannot assure you, however, 2007, our total outstanding credit facility borrowings and that we will be able to obtain any such refinancing or that outstanding notes were $920 million or approximately 21.9% market conditions prevailing at the time of refinancing will of our total market capitalization of $4.21 billion. We calculate enable us to issue equity or debt securities upon acceptable our total market capitalization at February 13, 2007 as the terms. sum of: We are currently assigned investment grade corporate • Shares of our common stock outstanding of credit ratings, on our senior unsecured notes, from Fitch 101,000,536 multiplied by the last reported sales price Ratings, Moody’s Investors Service, Inc. and Standard & of our common stock on the NYSE of $29.09 per Poor’s Ratings Group. Currently, Fitch Ratings has assigned share, or $2.94 billion; a rating of BBB+, Moody’s has assigned a rating of Baa2 • Aggregate liquidation value of the Class D preferred and Standard & Poor’s has assigned a rating of BBB to our stock of $127.5 million; senior notes. Moody’s and Standard & Poor’s ratings have • Aggregate liquidation value of the Class E preferred “positive” outlooks and Fitch has a “stable” outlook. stock of $220 million; and We have also been assigned investment grade credit • Outstanding notes of $920 million. ratings from the same rating agencies on our preferred stock. Fitch Ratings has assigned a rating of BBB, Moody’s has Historically, we have met our long-term capital needs assigned a rating of Baa3 and Standard & Poor’s has assigned through the issuance of common stock, preferred stock and a rating of BBB- to our preferred stock. Moody’s and long-term unsecured notes and bonds. Over the long term, Standard & Poor’s ratings have “positive” outlooks and Fitch we believe that the majority of our future securities issuances has a “stable” outlook. should be in the form of common stock, however, we may The credit ratings assigned to us could change based issue additional preferred stock or debt securities from time upon, among other things, our results of operations and finan- to time. We may issue common stock when we believe that cial condition. These ratings are subject to ongoing evaluation our share price is at a level that allows for the proceeds of any by credit rating agencies and we cannot assure you that any offering to be accretively invested into additional properties. such rating will not be changed or withdrawn by a rating In addition, we may issue common stock to permanently agency in the future if, in its judgment, circumstances warrant. finance properties that were financed by our credit facility or Moreover, a rating is not a recommendation to buy, sell or debt securities. However, we cannot assure you that we will hold our debt securities, preferred stock or common stock. have access to the capital markets at terms that are accept- We have no mortgage debt on any of our properties. able to us. We have a $300 million revolving, unsecured credit facility No Off-Balance Sheet Arrangements or that expires in October 2008. Realty Income’s current invest- Unconsolidated Investments ment grade credit ratings provide for financing under Realty Income and its subsidiaries have no unconsolidated the credit facility at the London Interbank Offered Rate, or off-balance sheet investments in “variable interest entities” commonly referred to as LIBOR, plus 65 basis points with a facility fee of 15 basis points, for all-in drawn pricing of 80 basis points over LIBOR. At February 13, 2007, we had borrowing capacity of $300 million available on our credit facility and no outstanding balance. The credit facility is expected to be used to acquire addi- tional retail properties and for other corporate purposes. Any additional borrowings will increase our exposure to interest rate risk. We have the right to request an increase in the borrowing capacity of the credit facility by up to $100 million, to a total borrowing capacity of $400 million. Any increase in the borrowing capacity is subject to approval by the lending banks of our credit facility. We use our credit facility for the short-term financing of new property acquisitions. When outstanding borrowings under the credit facility reach a certain level (generally in the range of $100 million to $200 million) and capital is available or off-balance sheet financing, nor do we engage in trading activities involving energy or commodity contracts or other derivative instruments. As we have no joint ventures, off-balance sheet entities, or mandatory redeemable preferred stock, our financial posi- tion and results of operations are currently not affected by Financial Accounting Standards Board Interpretation No. 46R, Consolidation of Variable Interest Entities and Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. 2 7 R E A LTY I N C O M E Competitive Strategy We believe that to successfully pursue our investment • MANAGEMENT SPECIALIZATION: We believe that our management’s specialization in single-tenant retail philosophy and strategy, we must seek to maintain the properties, operated under net-lease agreements, is following competitive advantages: important to meeting our objectives. We plan to main- • SIZE AND TYPE OF INVESTMENT PROPERTIES: We believe tain this specialization and will seek to employ and smaller ($500,000 to $10,000,000) net-leased retail train high-quality professionals in this specialized area properties represent an attractive investment oppor- of real estate ownership, finance and management. tunity in today’s real estate environment. Due to the • TECHNOLOGY: We intend to stay at the forefront of complexities of acquiring and managing a large port- technology in our efforts to efficiently and economi- folio of relatively small assets, we believe these types cally carry out our operations. We maintain sophisti- of properties have not experienced significant institu- cated information systems that allow us to analyze tional ownership interest or the corresponding yield our portfolio’s performance and actively manage reduction experienced by larger income-producing our investments. We believe that technology and properties. We believe the less intensive day-to-day information-based systems will play an increasingly property management required by net-lease agree- important role in our competitiveness as an invest- ments, coupled with the active management of a large ment manager and source of capital to a variety of portfolio of smaller properties, is an effective invest- industries and tenants. ment strategy. The tenants of our freestanding retail properties generally provide goods and services that satisfy basic consumer needs. In order to grow and PROPERTIES At December 31, 2006, we owned a diversified portfolio: expand, they generally need capital. Since the acqui- • Of 1,955 retail properties; sition of real estate is typically the single largest • With an occupancy rate of 98.7%, or 1,929 properties capital expenditure of many of these retailers, our occupied of the 1,955 properties in the portfolio; method of purchasing the property and then leasing it • Leased to 103 different retail chains doing business in back, under a net-lease arrangement, allows the retail 29 separate retail industries; chain to free up capital. INVESTMENT IN NEW RETAIL INDUSTRIES: Though we • • Located in 48 states; • With over 16.7 million square feet of leasable space; and specialize in single-tenant properties, we will seek to • With an average leasable retail space per property of further diversify our portfolio among a variety of retail approximately 8,600 square feet. industries. We believe diversification will allow us to invest in retail industries that currently are growing In addition to our real estate portfolio at December 31, and have characteristics we find attractive. These 2006, our subsidiary, Crest had invested $137.5 million in characteristics include, but are not limited to, retail 60 properties located in 15 states. These properties are industries that are dominated by local store operators classified as held for sale. where regional and national chain store operators can increase market share and dominance by consolidat- ing local operators and streamlining their operations, as well as capitalizing on major demographic shifts in a population base. • DIVERSIFICATION: Diversification of the portfolio by retail industry type, tenant, and geographic location is key to our objective of providing predictable invest- ment results for our stockholders, therefore further diversification of our portfolio is a continuing objective. At December 31, 2006, our retail property portfolio consisted of 1,955 properties located in 48 states, leased to 103 retail chains doing business in 29 industry segments. Each of the 29 industry segments, represented in our property portfolio, individually accounted for no more than 17.8% of our rental revenue for the quarter ended December 31, 2006. At December 31, 2006, 1,923, or 98.4%, of our 1,955 retail properties were leased under net-lease agreements. Net leases typically require the tenant to be responsible for minimum monthly rent and property operating expenses including property taxes, insurance and maintenance. In addi- tion, tenants are typically responsible for future rent increases based on increases in the consumer price index, fixed increases or, to a lesser degree, additional rent calculated as a percentage of the tenants’ gross sales above a specified level. Our net-leased retail properties primarily are leased to regional and national retail chain store operators. Most buildings are single-story structures with adequate parking on site to accommodate peak retail traffic periods. The properties tend to be on major thoroughfares with relatively high traffic counts, adequate access and proximity to a sufficient population base to constitute a suitable market or trade area for the retailer’s business. R E A LTY I N C O M E 2 8 Industry Diversification The following table sets forth certain information regarding Realty Income’s property portfolio (excluding properties owned by Crest) classified according to the business of the respective tenants, expressed as a percentage of our total rental revenue: For the Quarter Ended Dec. 31, 2006 Percentage of Rental Revenue(1) For the Years Ended Dec. 31, 2006 Dec. 31, 2005 Dec. 31, 2004 Dec. 31, 2003 Dec. 31, 2002 Dec. 31, 2001 2.3% 1.7% 1.6% 1.8% 2.1% 2.3% 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 *Less than 0.1% 1.2 2.7 5.4 6.2 0.2 * 8.9 1.0 14.1 0.3 2.8 1.4 0.2 0.1 0.8 0.8 4.1 2.8 4.2 3.4 1.2 0.9 0.8 1.3 2.8 6.9 6.1 0.2 0.1 10.3 1.1 16.1 0.4 2.9 1.6 0.2 0.1 0.6 0.7 4.3 3.1 3.4 3.4 1.3 1.1 0.8 17.8 11.9 — 2.6 9.4 0.3 1.8 2.3 — 2.9 9.6 0.3 2.1 2.7 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 20.8 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 — 5.7 5.7 2.6 0.4 0.1 23.9 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 11.8 13.5 12.2 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 5.2 100.0% 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. 2 9 R E A LTY I N C O M E Service Category Diversification The following table sets forth certain information regarding the properties owned by Realty Income (excluding properties owned by Crest) at December 31, 2006, 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 Sporting goods Totals *Less than 0.1% Number of Properties Rental Revenue for the Quarter Ended Dec. 31, 2006(1) Percentage of of Rental Revenue 13 219 268 8 2 4 16 6 31 10 577 30 149 1 393 1 21 9 471 1 34 1,110 6 73 2 21 4 34 25 7 40 31 10 2 13 268 1,955 $ 825 1.2% 3,689 6,063 970 150 84 2,760 574 6,409 1,531 23,055 583 4,229 32 9,611 1,154 2,348 595 12,158 170 1,235 32,115 1,567 1,214 159 678 212 1,943 518 557 1,905 1,684 788 37 1,769 13,031 $ 68,201 5.4 8.9 1.4 0.2 0.1 4.1 0.8 9.4 2.3 33.8 0.9 6.2 * 14.1 1.7 3.4 0.9 17.8 0.3 1.8 47.1 2.3 1.8 0.2 1.0 0.3 2.8 0.8 0.8 2.8 2.5 1.2 * 2.6 19.1 100.0% (1)Includes rental revenue for all properties owned by Realty Income at December 31, 2006, including revenue from properties reclassified to discontinued operations of $8. R E A LTY I N C O M E 3 0 Lease Expirations The following table sets forth certain information regarding Realty Income’s property portfolio (excluding properties owned by Crest) regarding the timing of the initial lease term expirations (excluding extension options) on our 1,923 net leased, single-tenant retail properties as of December 31, 2006 (dollars in thousands): Total Portfolio Rental Revenue for the Quarter Ended % of Total Rental 12/31/06(2) Revenue Total Number of Leases Expiring(1) 139 117 107 74 81 47 75 48 90 112 23 23 94 82 145 97 233 59 68 182 12 5 2 3 2 2 1 $ 2,624 4.0% 2,568 2,330 2,680 3,175 1,407 3,411 1,996 1,968 1,823 1,638 1,068 4,651 3,200 5,977 2,597 6,453 1,851 6,317 6,810 440 95 240 357 230 325 13 3.9 3.5 4.1 4.8 2.1 5.1 3.0 3.0 2.8 2.5 1.6 7.0 4.8 9.0 3.9 9.7 2.8 9.5 10.3 0.7 0.1 0.4 0.5 0.4 0.5 * Year 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2030 2033 2034 2037 2043 Initial Expirations(3) Subsequent Expirations(4) Rental Revenue for the Quarter Ended % of Total Rental 12/31/06 Revenue Number of Leases Expiring Number of Leases Expiring 92 63 33 36 46 43 67 36 65 111 19 23 93 80 144 95 232 59 64 180 12 5 2 3 2 2 — $ 1,795 2.7% 1,551 789 2,011 1,672 1,354 3,196 1,755 1,409 1,796 1,570 1,068 4,457 3,167 5,240 2,597 6,427 1,851 6,254 6,771 440 95 240 357 230 325 — 2.4 1.2 3.1 2.5 2.0 4.8 2.6 2.2 2.7 2.4 1.6 6.7 4.8 7.9 3.9 9.7 2.8 9.4 10.2 0.7 0.1 0.4 0.5 0.4 0.5 — 47 54 74 38 35 4 8 12 25 1 4 — 1 2 1 2 1 — 4 2 — — — — — — 1 Rental Revenue for the Quarter Ended % of Total Rental 12/31/06 Revenue $ 829 1.3% 1,017 1,541 669 1,503 53 215 241 559 27 68 — 194 33 737 — 26 — 63 39 — — — — — — 13 1.5 2.3 1.0 2.3 0.1 0.3 0.4 0.8 0.1 0.1 — 0.3 * 1.1 — * — 0.1 0.1 — — — — — — * Totals 1,923 $ 66,244 100.0% 1,607 $ 58,417 88.2% 316 $ 7,827 11.8% *Less than 0.1% (1)Excludes six multi-tenant properties and 26 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 $8 from properties reclassified to discontinued operations and excludes revenue of $1,957 from six multi-tenant properties and from 26 vacant unleased properties at December 31, 2006. (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. 3 1 R E A LTY I N C O M E State Diversification The following table sets forth certain state-by-state information regarding Realty Income’s property portfolio (excluding properties owned by Crest) as of December 31, 2006 (dollars in thousands): Approximate Rental Revenue Leasable For the Quarter Ended Dec 31, 2006(1) Square Feet Number of Properties 61 2 71 15 61 47 16 15 151 127 14 62 46 19 29 22 32 25 37 20 21 70 61 2 17 15 10 25 7 28 60 5 109 24 19 84 1 59 7 126 202 6 1 67 37 2 17 1 Percent Leased 98% 100 100 100 98 96 100 100 99 99 100 100 96 100 90 95 100 100 100 100 100 96 98 100 100 100 100 100 100 96 100 100 100 100 100 100 100 100 100 100 98 83 100 100 100 50 94 100 422,900 128,500 344,500 94,500 1,101,900 418,200 245,600 27,700 1,374,600 910,700 91,900 769,200 471,500 138,600 562,200 111,500 186,600 230,000 203,100 158,300 359,200 353,800 634,800 30,000 190,100 191,000 95,400 194,500 53,300 419,400 433,000 31,900 704,900 133,300 294,800 521,500 3,500 250,700 18,300 607,800 2,274,700 35,100 2,500 485,900 243,900 23,200 157,400 4,200 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% Percentage of Rental Revenue 1.8% 0.4 2.9 1.5 5.8 2.6 1.5 0.5 8.1 5.0 0.5 5.1 2.8 0.6 1.4 0.9 1.1 1.8 1.5 0.8 1.9 1.9 2.8 0.1 0.9 1.3 0.6 2.1 0.2 3.0 2.8 0.1 3.9 0.8 1.2 3.6 * 2.3 0.1 4.1 13.9 0.1 * 3.7 1.1 * 0.9 * 100.0% $ 1,255 271 1,989 1,041 3,929 1,776 1,019 316 5,509 3,430 369 3,501 1,878 391 947 600 757 1,197 999 573 1,278 1,317 1,919 77 608 849 383 1,440 159 2,022 1,874 68 2,671 552 842 2,449 29 1,531 76 2,816 9,480 96 22 2,497 751 30 600 18 $ 68,201 1,955 99% 16,740,100 (1)Includes rental revenue for all properties owned by Realty Income at December 31, 2006, including revenue from properties reclassified to discontinued operations of $8. R E A LTY I N C O M E 3 2 Description of Leasing Structure At December 31, 2006, 1,923 single tenant and certain other Certain Properties Under Development Of the 322 properties Realty Income acquired in 2006, all retail properties, or 98.4% of our 1,955 properties were net were occupied at December 31, 2006, except for four prop- leased. In most cases, the leases: • Are for initial terms of 15 to 20 years; • Require the tenants to pay minimum monthly rents and property operating expenses (taxes, insurance and maintenance); and erties that were leased and being developed. In the case of development properties, we either enter into an agreement with a retail chain where the retailer retains a contractor to construct the building and we fund the costs of that devel- opment, or we fund a developer who constructs the building. • Provide for future rent increases based on increases in In either case, there is an executed lease with a retail tenant the consumer price index, fixed increases, or to a lesser at the time of the land purchase (with a fixed rent com- degree, additional rent calculated as a percentage of mencement date) and there is a requirement to complete the the tenants’ gross sales above a specified level. Where construction in a timely basis and within a specific budget, leases provide for rent increases based on increases in the consumer price index, generally these increases typically within eight months after we purchase the land. The tenant or developer generally is required to pay construction become part of the new permanent base rent. Where cost overruns to the extent that they exceed the construction leases provide for percentage rent, this additional rent budget by more than a predetermined amount. We also is typically payable only if the tenants’ gross sales, for enter into a lease with the tenant at the time we purchase the a given period (usually one year), exceed a specified level and is then typically calculated as a percentage of land, which generally requires the tenant to begin paying base rent when the store opens for business. The base rent only the amount of gross sales in excess of that level. is calculated by multiplying a predetermined capitalization rate by our total investment in the property including the Matters Pertaining to Certain Properties and Tenants land cost for the property, construction costs and capitalized Of the 26 properties available for lease or sale at December interest. In 2006, Realty Income acquired 15 development 31, 2006, all are single-tenant properties except one. At properties. Crest did not acquire any development property December 31, 2006, 16 of our properties under lease were in 2006. Both Realty Income and Crest will continue to pursue unoccupied and available for sublease by the tenants, all of development opportunities under similar arrangements in which were current with their rent and other obligations. the future. During 2006, 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, 2006. 3 3 R E A LTY I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2006 and 2005 (dollars in thousands, except per share data) 2006 2005 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, net 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 $ 958,770 1,785,203 2,743,973 (396,854) 2,347,119 137,962 2,485,081 10,573 5,953 17,206 27,695 $ 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 $ 2,546,508 $ 1,920,988 $ 15,096 27,004 8,416 — 920,000 970,516 $ 10,121 20,391 9,562 136,700 755,000 931,774 Stockholders’ equity: Preferred stock and paid in capital, par value $1.00 per share, 20,000,000 shares authorized, 13,900,000 and 5,100,000 shares issued and outstanding in 2006 and 2005, respectively Common stock and paid in capital, par value $1.00 per share, 200,000,000 shares authorized, 100,746,226 and 83,696,647 shares issued and outstanding in 2006 and 2005, respectively Distributions in excess of net income Total stockholders’ equity Total liabilities and stockholders’ equity 337,781 123,804 1,540,365 (302,154) 1,575,992 $ 2,546,508 1,134,300 (268,890) 989,214 $ 1,920,988 The accompanying notes to consolidated financial statements are an integral part of these statements. R E A LTY I N C O M E 3 4 REALTY INCOME CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 2006, 2005 and 2004 (dollars in thousands, except per share data) Revenue Rental Other Expenses Interest Depreciation and amortization General and administrative Property Income taxes Provisions for impairment Loss on extinguishment of debt 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) Net income available to common stockholders Amounts available to common stockholders per common share, basic and diluted: Income from continuing operations Net income Weighted average common shares outstanding: Basic Diluted 2006 2005 2004 $ 238,058 2,042 240,100 $ 195,666 354 196,020 $ 172,033 1,029 173,062 51,363 59,492 17,539 3,339 747 — 1,555 134,035 106,065 1,402 3,314 4,716 110,781 (11,362) — $ 99,419 $ $ 1.05 1.11 89,766,714 89,917,554 40,949 46,206 15,421 3,731 813 151 — 107,271 88,749 2,781 7,589 10,370 99,119 (9,403) — $ 89,716 $ $ 0.99 1.12 79,950,255 80,208,593 34,132 39,696 13,119 3,058 699 716 — 91,420 81,642 7,847 13,908 21,755 103,397 (9,455) (3,774) $ 90,168 $ $ 0.87 1.15 78,518,296 78,598,788 The accompanying notes to consolidated financial statements are an integral part of these statements. 3 5 R E A LTY I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Years Ended December 31, 2006, 2005 and 2004 (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, 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 Share-based compensation — — — — — 3,200,000 — — — — — 103,397 103,397 (108,016) (108,016) 67,918 — 67,918 5,100,000 (4,125,700) — — — 283,458 123,787 (99,368) — — — 2,025 — (3,774) — 123,787 (103,142) 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 Share-based 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 Net income Distributions paid and payable Shares issued in stock offerings, — — — — net of offering costs of $20,911 — 16,815,000 — — — Shares issued in stock offering, net of offering costs of $6,023 Share-based compensation 8,800,000 — — 234,579 213,977 — — — 110,781 110,781 (144,045) (144,045) 402,745 — 3,320 — — — 402,745 213,977 3,320 Balance, December 31, 2006 13,900,000 100,746,226 $ 337,781 $ 1,540,365 $ (302,154) $ 1,575,992 The accompanying notes to consolidated financial statements are an integral part of these statements. R E A LTY I N C O M E 3 6 REALTY INCOME CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2006, 2005 and 2004 (dollars in thousands) 2006 2005 2004 $ 110,781 $ 99,119 $ 103,397 59,492 46,206 Cash Flows from Operating Activities Net income Adjustments to net income: Depreciation and amortization Income from discontinued operations: Real estate acquired for resale Real estate held for investment Gain on reinstatement of property carrying value Gain on sale of real estate held for investment Amortization of stock compensation Amortization of stock option costs Provisions for impairment on real estate held for investment Cash from discontinued operations: Real estate acquired for resale Real estate held for investment Investment in real estate acquired for resale Intangibles acquired in connection with acquisition of real estate acquired for resale Proceeds from sales of real estate acquired for resale Collection of mortgage note receivable by Crest Change 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: Continuing operations Discontinued operations Acquisition of and additions to investment properties Intangibles acquired in connection with acquisitions of investment properties Net cash used in investing activities Cash Flows from Financing Activities Borrowings from lines of credit Payments under lines of credit Proceeds from common stock offerings, net Proceeds from notes issued, net Principal payment on notes Proceeds from preferred stock offerings, net Redemption of preferred stock Cash distributions to common stockholders Cash dividends to preferred stockholders Proceeds from other common 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 (1,402) (3,314) (716) — 2,928 23 — 371 410 (113,166) — 22,405 1,333 4,418 3,382 86,945 2 9,804 (654,149) (937) (645,280) 523,200 (659,900) 402,745 271,883 (110,000) 213,977 — (129,667) (9,403) 369 503,204 (55,131) 65,704 Cash and cash equivalents, end of year $ 10,573 For supplemental disclosures, see note 13. The accompanying notes to consolidated financial statements are an integral part of these statements. 3 7 R E A LTY I N C O M E (2,781) (7,589) — (18) 2,155 12 151 (510) 1,509 (54,110) (1,780) 22,195 — (3,292) 8,290 109,557 109 22,191 (417,347) (9,494) (404,541) 400,300 (287,200) 92,659 270,266 — — — (108,575) (9,403) 500 358,547 63,563 2,141 $ 65,704 39,696 (7,847) (13,908) — (185) 1,426 14 716 (2,407) 4,184 (21,787) — 74,995 — 1,094 (1,051) 178,337 426 34,175 (195,470) — (160,869) 280,400 (283,200) 67,918 (28) — 123,787 (103,142) (97,420) (9,063) 584 (20,164) (2,696) 4,837 $ 2,141 REALTY INCOME CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006, 2005 and 2004 1. ORGANIZATION AND OPERATION Realty Income Corporation (“Realty Income,” the “Company,” Earnings and profits that determine the taxability of distributions to stockholders differ from net income reported for financial reporting purposes due to differences in the estimated useful lives and methods used to compute “we” or “our”) is organized as a Maryland corporation. We depreciation and the carrying value (basis) on the investments invest in commercial retail real estate and have elected to be in properties for tax purposes, among other things. taxed as a real estate investment trust (“REIT”). At December 31, 2006, we owned 1,955 properties, located in 48 states, containing over 16.7 million leasable square feet, along with 60 properties owned by our wholly- owned taxable REIT subsidiary, Crest Net Lease, Inc. (“Crest”). Crest was created to buy and sell properties, primarily to individual investors, many of whom are involved in tax- deferred exchanges, under Section 1031 of the Internal Revenue Code of 1986, as amended (the “Tax Code”). A 2-for-1 stock split was declared in November 2004 and became effective after the market closed on December 31, 2004. Common stockholders received an additional share of common stock for each share they owned. The increase in the number of common shares outstanding and all per common share data has been adjusted for the stock split. Information with respect to number of properties, square feet, average initial lease term and weighted average contractual lease rate is unaudited. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND PROCEDURES Federal Income Taxes. We have elected to be taxed as a Real Estate Investment Trust (“REIT”) under the Tax Code. We believe we have qualified and continue to qualify as a REIT. Under the REIT operating structure, we are permitted to deduct distributions paid to our stockholders and gener- ally 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 consoli- dated financial statements, except for federal income taxes of Crest, which totaled $396,000 in 2006, $760,000 in 2005 and $2.8 million in 2004 and are included in “income from discontinued operations, real estate acquired by Crest.” The following reconciles our net income available to common stockholders to taxable income for 2006 (dollars in thousands) (unaudited): Net income available to common stockholders $ 99,419 Tax loss on the sale of real estate less than book gains Elimination of net revenue and expenses from Crest Dividends received from Crest Preferred dividends not deductible for tax (3,529) 2,440 500 11,362 Depreciation and amortization timing differences 16,612 Adjustment for straight-line rent Adjustment for a decrease in prepaid rent Other adjustments Estimated taxable net income, before our (1,515) (1,681) (816) dividend paid deduction $ 122,792 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 net income available to common stockholders for the period by the number of common shares that would have been outstanding assuming the issuance of common shares for all potentially dilutive common shares outstanding during the reporting period. The following is a reconciliation of the denominator of the basic net income per common share computation to the denominator of the diluted net income per common share computation, for the years ended December 31: 2006 2005 2004 Weighted average shares used for the basic net income per share computation 89,766,714 79,950,255 78,518,296 Incremental shares from share-based compensation 150,840 258,338 80,492 Adjusted weighted average shares used for diluted net income per share computation 89,917,554 80,208,593 78,598,788 In 2006, 2005 and 2004, no stock options were anti-dilutive. We had nonvested shares from share-based compensation that were anti-dilutive of 235,035 in 2006 and 305,476 in 2005. No nonvested shares were anti-dilutive in 2004. R E A LTY I N C O M E 3 8 Discontinued Operations. In accordance with Financial Accounting Standards Board Statement No. 144, Accounting The following is a summary of Realty Income’s “income from discontinued operations, from real estate held for for the Impairment or Disposal of Long-Lived Assets (“SFAS investment” for the years ended December 31 (dollars 144”), Realty Income’s operations from one investment in thousands): property classified as held for sale at December 31, 2006, plus investment properties sold in 2006, 2005 and 2004, are reported as discontinued operations. Their respective results of operations have been reclassified to “income from discon- tinued 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 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 as held for sale at the date of acquisition and do not depreciate them. In accordance with SFAS 144, the operations of Crest’s properties are classified as “income from discontin- ued operations, real estate acquired for resale by Crest.” No debt was assumed by buyers of our investment prop- erties or repaid as a result of our investment property sales and we have elected not to allocate interest expense to discon- tinued operations related to real estate held for investment. We allocate interest expense related to borrowings specifically attributable to Crest’s properties. The interest expense amounts allocated to the Crest properties are included in “income from discontinued operations, real estate acquired for resale by Crest.” The following is a summary of Crest’s “income from discontinued operations, real estate acquired for resale” for the years ended December 31 (dollars in thousands): Realty Income’s income from discontinued operations, real estate held for investment Gain on sales of investment properties $ 3,036 492 Rental revenue Other revenue Depreciation and amortization (116) 34 Property expenses Provisions for impairment (116) (16) Income from discontinued operations, real estate 2006 2005 2004 $ 6,573 $ 12,543 4,608 1,729 2 (458) (222) (35) 121 (1,162) (545) (1,657) held for investment $ 3,314 $ 7,589 $ 13,908 The following is a summary of our total income from dis- continued operations for the years ended December 31 (dol- lars in thousands, except per share data): Total income from discontinued operations 2006 2005 2004 Income from discontinued operations: Real estate acquired for resale by Crest $ 1,402 $ 2,781 $ 7,847 Real estate held for investment Income from discontinued 3,314 7,589 13,908 operations $ 4,716 $ 10,370 $ 21,755 Crest’s income from discontinued operations, real estate acquired for resale Gain on sales of real estate acquired for resale Rental revenue Interest expense General and 2006 2005 2004 Per common share, basic and diluted $ 0.05 $ 0.13 $ 0.28 $ 2,219 $ 3,291 $ 10,254 5,080 2,085 (3,708) (1,139) 2,304 (674) The per share amounts for “income from discontinued operations” above and the “income from continuing opera- tions” and “net income” reported on the consolidated state- ment of income have each been calculated independently. administrative expense Property expenses (440) (67) Provisions for impairment (1,188) (453) (60) — (464) (93) — Income taxes (494) (943) (3,480) Income from discontinued operations, real estate acquired for resale by Crest $ 1,402 $ 2,781 $ 7,847 Revenue Recognition and Accounts Receivable. All leases are accounted for as operating leases. Under this method, lease payments that have fixed and determinable rent increases are recognized on a straight-line basis over the lease term. Any rental revenue contingent upon a tenant’s sales is recognized only after the tenant exceeds their sales breakpoint. Rental increases based upon changes in the consumer price indexes are recognized only after the changes in the indexes have occurred and are then applied according to the lease agreements. 3 9 R E A LTY I N C O M E We recognize an allowance for doubtful accounts relating to accounts receivable for amounts deemed uncollectible. Provisions for Impairment. We review long-lived assets for impairment whenever events or changes in circumstances We consider tenant specific issues such as financial stability indicate that the carrying amount of an asset may not be and ability to pay rent when determining collectibility of recoverable. Generally, a provision is made for impairment if accounts receivable and appropriate allowances to record. The allowance for doubtful accounts was $705,000 and $577,000 at December 31, 2006 and 2005, respectively. Principles of Consolidation. The accompanying consoli- dated financial statements include the accounts of Realty Income, Crest and their wholly-owned subsidiaries, after estimated future operating cash flows (undiscounted and without interest charges) plus estimated disposition proceeds (undiscounted) are less than the current book value. Impairment loss is measured as the amount by which the current book value of the asset exceeds the fair value of the asset. If a property is held for sale, it is carried at the lower of cost or estimated fair value, less estimated cost to sell. elimination of all material intercompany balances and Realty Income recorded a provision for impairment of transactions. All of Realty Income’s and Crest’s subsidiaries are wholly-owned. $16,000 in 2006 on one retail investment property in the restaurant industry. The provision for impairment is included Cash Equivalents. We consider all short-term, highly liquid investments that are readily convertible to cash and have an original maturity of three months or less at the time of purchase to be cash equivalents. in discontinued operations. Realty Income recorded provisions for impairment of $186,000 in 2005 on four retail properties, of which two have been sold. These properties were classified in the following industries: one in child care and three in restaurant. Realty Income recorded provisions for impairment of Gain on Sales of Properties. We recognize gains on sales of $2.4 million in 2004 on six retail properties, of which five properties in accordance with Statement No. 66, Accounting have been sold. These properties were classified in the for Sales of Real Estate. following industries: one in automotive service, one in child care, two in consumer electronics, one in convenience store Depreciation and Amortization. Lands, buildings and and one in restaurant. improvements are recorded at cost and stated at cost. Major Provisions for impairment recorded on investment replacements and betterments, which improve or extend the properties by Realty Income are included on our consolidated life of the asset, are capitalized and depreciated over their statements of income in “income from discontinued opera- estimated useful lives, while ordinary repairs and mainte- tions, real estate held for investment”, except for $151,000 in nance are expensed as incurred. Buildings and improvements 2005 and $716,000 in 2004 which are included in provisions that are under redevelopment, or are being developed, are for impairment. carried at cost and no depreciation is recorded on these Crest recorded provisions for impairment of $1.2 million assets. Additionally, amounts essential to the development of in 2006 on three retail properties, which are held for resale the property, such as pre-construction costs, development costs, construction costs, interest costs and other costs incurred during the period of development are capitalized. We cease capitalization when the property is available for at December 31, 2006. No provisions for impairment were recorded by Crest in 2005 and 2004. Provisions for impair- ment recorded by Crest are included in “income from discon- tinued operations, real estate acquired for resale by Crest” occupancy upon substantial completion of tenant improve- on our consolidated statements of income. ments, but in any event no later than one year from the completion of major construction activity. Acquired In-place Leases. In accordance with Financial Properties are depreciated using the straight-line method Accounting Standards Board Statement No. 141, Business over the estimated useful lives of the assets. The estimated Combinations (“SFAS 141”), the fair value of the real estate useful lives are as follows: Buildings Building improvements Tenant improvements and 25 years 4 to 15 years 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 The shorter of the term of the leases, the value of in-place leases and tenant relationships, lease commissions related lease or useful life based in each case on their fair values. The fair value of the tangible assets of an acquired property (which includes land and buildings/improvements) is determined by valuing the property as if it were vacant, and the “as-if-vacant” value is then allocated to land and buildings/improvements based on our determination of the relative fair value of these assets. Our determinations are R E A LTY I N C O M E 4 0 based on a real estate appraisal for each property, generated by an independent appraisal firm, which consider estimates of carrying costs during the expected lease-up periods, current market conditions, as well as costs to execute similar leases. In allocating the fair value to identified intangibles for above-market or below-market leases, an amount is recorded based on the present value of the difference between (i) the contractual amount to be paid pursuant to the in-place lease and (ii) our estimate of fair market lease rate for the corresponding in-place lease, measured over a Other Assets. Other assets consist of the following at December 31 (in thousands): Deferred bond financing costs $ 10,868 $ 8,999 2006 2005 Value of in-place and above-market leases Prepaid expenses Settlements on treasury lock agreements period equal to the remaining term of the lease. Unamortized credit line fees Capitalized above-market lease values are amortized as a Corporate assets, net of accumulated reduction of rental income over the remaining terms of the respective leases. Capitalized below-market lease values are depreciation and amortization 463 454 Escrow deposits for Section 1031 amortized as an increase to rental income over the remaining tax-deferred exchanges terms of the respective leases and expected below market Other items 10,430 3,271 1,629 954 9,909 3,379 2,346 1,473 — 80 3,070 1,358 $ 27,695 $ 30,988 renewal option periods. The aggregate value of other acquired intangible assets consists of the value of in-place leases and tenant relation- ships. These are measured by the excess of the purchase price paid for a property, after adjusting for above or below market lease value, less the estimated fair value of the prop- erty “as if vacant,” determined as set forth above. The value of in-place leases, exclusive of the value of above-market and below-market in-place leases, is amortized to expense over the remaining periods of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts relating to that lease would be recorded to revenue or expense as appropriate. Share-Based Compensation. Effective January 1, 2002, we adopted the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, and starting January 1, 2002, expensed costs for all stock option awards granted, modified, or settled. Stock option awards under the plan vest over periods ranging from one to five years. For the years ended December 31, 2006, 2005 and 2004, respectively, there is no difference between the stock option-based compensation expense included in reported net income and that expense determined under the fair value method for all awards. Effective January 1, 2006, we adopted FASB 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. Goodwill. Goodwill is tested for impairment during the second quarter of each year as well as when events or circumstances occur indicating that our goodwill might be impaired. We did not record any new goodwill or impairment on our existing goodwill during 2006, 2005 or 2004. Use of Estimates. The consolidated financial statements were prepared in conformity with U.S. generally accepted account- ing principles, which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabili- ties 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 2005 and 2004 balances have been reclassified to conform to the 2006 presentation. 3. RETAIL PROPERTIES ACQUIRED We acquire land, buildings and improvements that are used by retail operators. A. During 2006, Realty Income and Crest invested $769.9 million, in aggregate, in 378 new retail properties and properties under development. These 378 properties are located in 30 states, will contain over 3.8 million leasable square feet, and are 100% leased with an average initial lease term of 17.1 years. Of the $769.9 million invested in 2006, $6.0 million was used to acquire one property with an existing lease already in-place with a retail tenant. In accordance with SFAS 141, Realty Income recorded $1.6 million as the value of the in-place lease and $628,000 as the value of below-market rents. These amounts are recorded to “other assets” and “other liabilities”, respectively, on our consolidated balance sheet and are amortized over the lives of the respective lease. In comparison, during 2005, Realty Income and Crest invested $486.6 million, in aggregate, in 156 new retail proper- ties and properties under development. These 156 new retail properties are located in 30 states, contain over 1.9 million leasable square feet and are 100% leased with an average lease term of 15.8 years. Of the $486.6 million invested in 2005, $95.1 million was used to acquire 34 properties with 4 1 R E A LTY I N C O M E existing leases already in-place with existing retail tenants. In accordance with SFAS 141, Realty Income recorded October 2005. The increase in the average borrowing rate is due to an increase in LIBOR since the beginning of 2005. $10.1 million and Crest recorded $1.8 million as the value of Our current credit facility is subject to various leverage and in-place leases and Realty Income recorded $183,000 as the interest coverage ratio limitations. The Company is and has value of above-market rents. In addition, Realty Income recorded $756,000 and Crest recorded $66,000 as the value of below-market rents on these leases. These amounts were recorded to “other assets” and “other liabilities”, respectively, on our consolidated balance sheet and are amortized over the lives of the respective leases. The amounts recorded by Crest been in compliance with these covenants. Our credit facility is unsecured and accordingly, we have not pledged any assets as collateral for this obligation. 5. NOTES PAYABLE In September 2006, we issued $275 million in aggregate are included in the calculation of gain on sales of real estate principal amount of 5.95% senior unsecured notes due 2016 when the properties were sold during 2006 and 2005. B. During 2006, Realty Income invested $656.7 million in 322 new retail properties and properties under development, with an initial weighted average contractual lease rate of 8.6%. (the “2016 Notes”). The price to the investor for the 2016 Notes was 99.74% of the principal amount for an effective yield of 5.985%. Interest on the 2016 Notes is paid semiannu- ally. The net proceeds of approximately $271.9 million from this offering were used for other general corporate purposes These 322 properties are located in 30 states, will contain and to redeem the outstanding $110 million 7 3⁄4% unsecured over 3.3 million leasable square feet and are 100% leased with an average initial lease term of 16.7 years. The initial notes due May 2007 (the “2007 Notes”), which were issued in May 1997. weighted average contractual lease rate is computed by In September 2006, we redeemed all of our outstanding dividing the estimated aggregate base rent for the first year 2007 Notes at a redemption price equal to 100% of the of each lease by the estimated total cost of the properties. principal amount, plus accrued and unpaid interest of In comparison, during 2005, Realty Income invested $3.2 million and a make-whole payment of $1.6 million. $430.7 million in 135 new retail properties and properties We recorded a loss on extinguishment of debt totaling under development, with an initial weighted average con- $1.6 million related to the make-whole payment associated tractual lease rate of 8.4%. These 135 properties are located with the 2007 Notes. For 2006, the make-whole payment in 28 states, contain over 1.7 million leasable square feet represented approximately $0.017 per share. and are 100% leased with an average initial lease term of In September 2005, we issued $175 million in aggregate 15.6 years. principal amount of 5 3⁄8% senior unsecured notes due 2017 (the “2017 Notes”). The price to the investor for the 2017 C. During 2006, Crest invested $113.2 million in 56 new Notes was 99.974% of the principal amount for an effec- retail properties and properties under development. In tive yield of 5.378%. The net proceeds of approximately comparison, during 2005, Crest invested $55.9 million in 21 $173.2 million from this offering were used to repay borrow- new retail properties and properties under development. ings under our unsecured acquisition credit facility, to fund D. Crest’s property inventory at December 31, 2006 purposes. Interest on the 2017 Notes is paid semiannually. consisted of 60 properties with a total investment of In March 2005, we issued $100 million in aggregate $137.5 million and at December 31, 2005 consisted of 17 principal amount of 5 7⁄8% senior unsecured bonds due 2035 properties with a total investment of $45.7 million. These (the “2035 Bonds”). The price to the investor for the 2035 amounts are included on our consolidated balance sheets Bonds was 98.296% of the principal amount for an effective new property acquisitions and for other general corporate in “real estate held for sale, net.” 4. CREDIT FACILITY We have a $300 million revolving acquisition credit facility that expires in October 2008, unless extended as provided for in the agreement. Under the terms of the credit facility, which commenced in October 2005, the borrowing rate is LIBOR (London Interbank Offered Rate) plus 65 basis points with a facility fee of 15 basis points, for all-in drawn pricing of 80 basis points over LIBOR, based on our current credit ratings. The credit facility offers us other interest rate options as well. The average borrowing rate on our credit facilities during 2006 was 5.7%, compared to 4.3% in 2005 and 2.4% in 2004 on our previous $250 million credit facility, which expired in yield of 5.998%. The net proceeds of approximately $97 million from this offering were used to repay borrowings under our acquisition credit facility and for other general corporate pur- poses. Interest on the 2035 Bonds is paid semiannually. In November 2003, we issued $150 million of 5 1⁄2% senior unsecured notes due 2015 (the “2015 Notes”). 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”). Interest on the 2013 Notes is payable semiannually. In January 1999, we issued $20 million of 8% senior unsecured notes due 2009 (the “2009 Notes”). Interest on the 2009 Notes is payable semiannually. R E A LTY I N C O M E 4 2 In October 1998, we issued $100 million of 8 1⁄4% Monthly Income Senior Notes due 2008 (the “2008 Notes”). In May B. In September 2006, we issued 4.715 million shares of common stock at a price of $24.32 per share. The net proceeds of 1998, we entered into a treasury interest rate lock agreement approximately $109 million from this offering were used to associated with the 2008 Notes. In settlement of the agree- fund new property acquisitions, repay borrowings under our ment, we made a payment of $8.7 million in 1998. The payment on the agreement is being amortized over 10 years (the life of the 2008 Notes) as a yield adjustment to interest expense. credit facility and for other general corporate purposes. C. In March 2006, we issued 5.2 million shares of common After taking into effect the results of a treasury interest rate stock at a price of $24.39 per share. The net proceeds of lock agreement, the effective rate to us on the 2008 Notes is 9.12%. Interest on the 2008 Notes is payable monthly. The approximately $120.5 million were used to fund new prop- erty acquisitions and for other general corporate purposes. 2008 Notes are unsecured. Interest incurred on the 2016 Notes, 2017 Notes, 2035 D. In September 2005, we issued 4.1 million shares of common Bonds, 2015 Notes, 2013 Notes, 2009 Notes, 2008 Notes and 2007 Notes (redeemed in September 2006) collectively stock at a price of $23.79 per share. The net proceeds of $92.7 million were used to fund new property acquisitions for each of the years ended December 31, 2006, 2005 and and for other general corporate purposes. 2004 was $49.6 million, $39.5 million and $32.0 million, respectively. In addition, when the 2007 Notes were redeemed, we paid a $1.6 million make-whole payment, which is classified as “loss on extinguishment of debt” on our E. In March 2004, we issued 3.2 million shares of common stock at a price of $22.375 per share. The net proceeds of $67.9 million were used to repay a portion of our acquisition consolidated statements of income. The interest rate on each credit facility borrowings, which had been used to acquire of these notes is fixed. 112 convenience store properties in March 2004. Our outstanding notes are unsecured and accordingly, we have not pledged any assets as collateral for these or any other obligations. All of these notes contain various covenants, including: 7. PREFERRED STOCK OFFERINGS AND REDEMPTIONS A. In December 2006, we issued 8.8 million shares of 6 3⁄4% (i) a limitation on incurrence of any debt which would cause Monthly Income Class E cumulative redeemable preferred our debt to total adjusted assets ratio to exceed 60%; stock, with a liquidation value of $25 per share. The net (ii) a limitation on incurrence of any secured debt which proceeds of $214 million from this issuance were used to would cause our secured debt to total adjusted assets ratio repay borrowings under our credit facility and for other to exceed 40%; (iii) a limitation on incurrence of any debt general corporate purposes. Beginning December 7, 2011, which would cause our debt service coverage ratio to be less the Class E preferred shares are redeemable at our option for than 1.5 times; and (iv) the maintenance at all times of total $25 per share. Dividends of $0.140625 per share are paid unencumbered assets not less than 150% of our outstanding monthly in arrears on the Class E preferred stock. unsecured debt. We have been in compliance with these covenants since each of the notes were issued. The following table summarizes the maturity of our notes payable as of December 31, 2006 (dollars in millions): Year of Maturity (1) 2008 2009 After 2011 Totals Notes $ 100.0 20.0 800.0 $ 920.0 (1)There are no maturities in 2007, 2010 or 2011. 6. COMMON STOCK OFFERINGS A. In October and November 2006, we issued an aggregate of 6.9 million shares of common stock at a price of $26.40 per share. The net proceeds of approximately $173.2 million were used to fund a portion of the purchase price of the Buffets/Ryan’s properties and for other general corporate purposes. B. In May 2004, we issued 4.0 million shares of 7 3⁄8% Monthly Income Class D cumulative redeemable preferred stock, with a liquidation value of $25 per share. The net proceeds of $96.4 million from this issuance were used to redeem a portion of the outstanding Class B and Class C preferred stock, repay borrowings outstanding under our $250 million acquisition credit facility and for other general corporate purposes. Beginning May 27, 2009, the Class D preferred shares are redeemable at our option for $25.00 per share. Dividends of $0.1536459 per share are paid monthly in arrears on the Class D preferred stock. In October 2004, we issued an additional 1.1 million shares of Class D preferred stock for $25.4311 per share. The net proceeds of $27.4 million were used to repay borrowings under our $250 million acquisition credit facility. C. When our Class B preferred stock was redeemed in 2004, we incurred a non-cash charge of $2.4 million representing the Class B preferred stock original issuance costs that were paid in 1999. 4 3 R E A LTY I N C O M E D. When our Class C preferred stock was redeemed in 2004, we incurred a non-cash charge of $1.4 million representing the Class C preferred stock original issuance costs that were paid in 1999. 8. DISTRIBUTIONS PAID AND PAYABLE A. Common Stock. We pay monthly cash distributions to $1.01406 were characterized for federal income tax purposes as ordinary income. In May 1999, we issued 2.76 million shares of 9 3⁄8% Class B cumulative redeemable preferred stock, of which 2,745,700 shares were outstanding for 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 our common stockholders. The following is a summary of preferred stock totaling $2.8 million during the first two monthly distributions paid per common share for the years ended December 31: Month January February March April May June July August September October November December 2006 2005 2004 $ 0.116250 $ 0.110000 $ 0.100000 0.116250 0.116250 0.116875 0.116875 0.116875 0.117500 0.117500 0.125250 0.125875 0.125875 0.125875 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 Total $ 1.437250 $ 1.346250 $ 1.241250 The following presents the federal income tax charac- terization of distributions paid or deemed to be paid per common share for the years ended December 31: quarters of 2004. The dividends paid per share to our Class B preferred stockholders in 2004 of $1.01563 were character- ized for federal income tax purposes as ordinary income. In July 1999, we issued 1.38 million shares of 9 1⁄2% Class C cumulative redeemable preferred stock, all of which were outstanding for a portion of 2004. On July 30, 2004, all of the outstanding Class C preferred shares were redeemed. We paid monthly dividends to holders of our Class C preferred stock totaling $1.9 million during the first seven months of 2004. The dividends paid per share to our Class C preferred stockholders in 2004 of $1.37882 were characterized for federal income tax purposes as ordinary income. 9. OPERATING LEASES A. At December 31, 2006, we owned 1,955 properties in 48 states, excluding 60 properties owned by Crest. Of these 1,955 properties, 1,948, or 99.6%, are single-tenant, retail properties and the remaining seven are multi-tenant, distribution and office properties. At December 31, 2006, 26 properties were vacant and available for lease or sale. Substantially all leases are net leases where the tenant pays property taxes and assessments, maintains the interior Ordinary 2006 2005 2004 and exterior of the building and leased premises, and carries insurance coverage for public liability, property damage, fire income $ 1.2945466 $ 1.210091 $ 1.18315 and extended coverage. Nontaxable distributions 0.1427034 0.136159 0.05810 Capital gain — — — Totals $ 1.4372500 $ 1.346250 $ 1.24125 Percentage rent for 2006, 2005 and 2004 was $1.1 million, $1.2 million and $1.3 million, respectively, including amounts recorded to discontinued operations. At December 31, 2006, minimum future annual rents to be received on the operating leases are as follows (dollars in thousands): At December 31, 2006, a distribution of $0.1265 per common share was payable and was paid in January 2007. At For the years ending December 31, December 31, 2005, a distribution of $0.11625 per common share was payable and was paid in January 2006. B. Preferred Stock. Dividends of $0.140625 per share are paid monthly in arrears on the Class E preferred stock. We declared dividends to holders of our Class E preferred stock totaling $1.6 million in 2006. The first Class E dividend was paid in January 2007. Dividends of $0.1536459 per share are paid monthly in arrears on the Class D preferred stock. We declared dividends to holders of our Class D preferred stock totaling $9.8 million in 2006, $9.4 million in 2005 and $4.8 million in 2004. The dividends paid per share to our Class D preferred stockholders for 2006 and 2005 of $1.84375 and for 2004 of 2007 2008 2009 2010 2011 Thereafter Total $ 268,536 257,072 246,422 238,635 231,051 2,252,524 $ 3,494,240 B. Major Tenants—No individual tenant’s rental revenue, including percentage rents, represented more than 10% of our total revenue for each of the years ended December 31, 2006, 2005 or 2004. R E A LTY I N C O M E 4 4 10. GAIN ON SALES OF REAL ESTATE ACQUIRED FOR RESALE BY CREST In 2006, Crest sold 13 properties for $22.4 million, which 13. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Interest paid in 2006 was $52.4 million, in 2005 was resulted in a gain of $2.2 million. In 2005, Crest sold 12 prop- $36.4 million and in 2004 was $31.3 million. erties for $23.5 million, which resulted in a gain of $3.3 million. As part of one sale in 2005, Crest provided buyer financing in the form of a $1.3 million promissory note. This note was paid Interest capitalized to properties under development in 2006 was $2.2 million, in 2005 was $1.9 million and in 2004 was $531,000. in full in February 2006. In 2004, Crest sold 51 properties for Income taxes paid by Realty Income and Crest in 2006 $75 million, which resulted in a gain of $10.3 million. Crest’s were $775,000, in 2005 were $1.4 million and in 2004 were gains on sales are reported before income taxes and are $6.9 million. included in discontinued operations. 11. GAIN ON SALES OF INVESTMENT PROPERTIES BY REALTY INCOME In 2006, we sold or exchanged 13 investment properties for The following non-cash investing and financing activities are included in the accompanying consolidated financial statements: A. Stock based compensation for 2006 was $3.0 million, for $10.7 million, which resulted in a gain of $3.0 million, which 2005 was $2.2 million and for 2004 was $1.4 million. is included in discontinued operations. In 2005, we sold 23 investment properties and sold a portion of the land from two properties for $23.4 million, B. In 2006, we exchanged one of our properties for a different property that was leased to the same tenant. As part of this which resulted in a gain of $6.6 million. This gain is included transaction, accumulated depreciation was reduced by in discontinued operations, except for $18,000 that is $67,000 and a gain of $67,000 was recorded. The original included in other revenue. cost of, and the value received for, the property exchanged In 2004, we sold or exchanged 43 investment properties was $900,000. This transaction had no impact to land or and sold a portion of the land from four properties for building and improvements. $35.4 million, which resulted in a gain of $12.7 million. Of this gain, $12.5 million is included in discontinued operations and C. In 2006, we received shares of a public company as $185,000 is included in other revenue. Included in the 43 settlement of a bankruptcy claim associated with a former properties was one property leased by one of our tenants tenant. We recorded a value of $207,000, which is in other that we exchanged for another property owned by that revenue, based on the closing market price of these shares tenant (see note 13-H). 12. FAIR VALUE OF FINANCIAL INSTRUMENTS We believe that the carrying values reflected in the consoli- on December 31, 2006 and included them in other assets on our consolidated balance sheet at December 31, 2006. The shares were sold in January 2007. dated balance sheets at December 31, 2006 and 2005 reasonably approximate the fair values for cash and cash D. In 2005, Crest sold a property for $2.8 million and issued a mortgage note of $1.3 million, which was paid in full in equivalents, accounts receivable, and all liabilities, due to February 2006 and is included in other assets on our their short-term nature, except for the line of credit payable December 31, 2005 consolidated balance sheet. 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 the balance sheet date. The estimated fair value of the notes payable at E. In 2004, we recorded an impairment of $716,000 on one property to reduce its carrying value to zero. This loss was the result of a dispute with the original owner and tenant in their bankruptcy proceeding. Our title insurance company failed December 31, 2006 is $921.9 million and at December 31, to timely record the deed on this property upon our original 2005 is $755.0 million, based upon the closing market price acquisition, which resulted in a claim by the bankruptcy per note, or indicative price per each note, at December 31, 2006 and 2005, respectively. trustee that Realty Income did not have legal title to the property. In the second quarter of 2006, this issue was resolved and we obtained title to the property. At that time, we reinstated the original carrying value adjusted for depre- ciation on our balance sheet and recorded other revenue of $716,000. We also reversed accrued liabilities and property expenses of $133,000 associated with this property. As part of the settlement, these costs became the responsibility of the title insurance company. 4 5 R E A LTY I N C O M E F. In June 2004, when our Class B preferred stock was redeemed, we incurred a non-cash charge of $2.4 million for 14. EMPLOYEE BENEFIT PLAN We have a 401(k) plan covering substantially all of our the excess of redemption value over the carrying value. employees. Under our 401(k) plan, employees may elect to G. 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. make contributions to the plan up to a maximum of 60% of their compensation, subject to limits under the IRS Code. We match 50% of our employee’s contributions, up to 3% of the employee’s compensation. Our aggregate matching contributions each year have been immaterial to our results H. In 2004, we exchanged one of our properties for a different of operations. 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. 15. COMMON STOCK INCENTIVE PLAN In 2003, our Board of Directors adopted, and our stockholders approved, the 2003 Incentive Award Plan of Realty Income Corporation (the “Stock Plan”) to enable us to attract and I. Accrued costs on properties under development resulted retain the services of directors, employees and consultants, in an increase in buildings and accounts payable of $1.7 million considered essential to our long-term success, by offering in 2006. In 2005, non-cash additions to properties resulted them an opportunity to own stock in Realty Income and/or in an increase in buildings of $5.4 million and an increase in accounts payable of $5.1 million. rights that will reflect our growth, development and financial success. The Stock Plan was amended and restated by our Board of Directors in February 2006. Under the terms of J. Distributions payable on our balance sheets is comprised this plan, the aggregate number of shares of our common of the following declared distributions (dollars in thousands): stock subject to options, stock purchase rights (SPR), stock Common stock distributions $ 12,745 $ 9,729 Preferred stock dividends 2,351 392 2006 2005 appreciation rights (SAR) and other awards will be no more than 3,428,000 shares. The maximum number of shares that 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. To date, we have not issued any SPR or SAR. The amount of share-based compensation costs charged against income during 2006 were $3.0 million, during 2005 were $2.2 million and during 2004 were $1.4 million. Stock options were 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 2006, 2005 or 2004. R E A LTY I N C O M E 4 6 The following table summarizes our stock option activity for the years ended December 31: 2006 2005 Number of shares Weighted average exercise price Number of shares Weighted average exercise price Outstanding options, beginning of year 135,348 $ 13.02 Options exercised Options forfeited (28,696) (284) 12.86 14.70 176,130 (40,352) (430) $ 13.01 12.93 14.70 2004 Weighted average exercise price $ 12.53 11.16 14.70 Number of shares 247,756 (67,648) (3,978) Outstanding options, end of year 106,368 $ 13.06 135,348 $ 13.02 176,130 $ 13.01 Options exercisable, end of year 106,368 $ 13.06 119,924 $ 12.87 153,206 $ 12.75 At December 31, 2006, the options outstanding and exercisable had exercise prices ranging from $10.63 to $14.70, with a weighted average price of $13.06, and expiration dates ranging from June 2007 to December 2011 with a weighted average remaining term of 2.6 years. The total intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004 was $268,000, $377,000 and $480,000, respectively. The total intrinsic value of options vested during the years ended December 31, 2006, 2005 and 2004 was $143,000, $67,000 and $101,000, respectively. The aggregate intrinsic value of options outstanding was $1.6 million, $1.2 million and $2.2 million at December 31, 2006, 2005 and 2004, respectively. The aggregate intrinsic value of options exercisable at December 31, 2006, 2005 and 2004 was $1.6 million, $1.1 million and $1.9 million, respectively. The intrinsic value of a stock option is the amount by which the market value of the underlying stock at December 31 of each year exceeds the price of the option. The market value of the Company’s stock was $27.70, $21.62 and $25.29 at December 31, 2006, 2005 and 2004, respectively. The following table summarizes our common stock grant activity under our Stock Plan for the years 2006, 2005 and 2004. The grants vest over periods ranging from immediately to 10 years. 2006 2005 Number of shares Weighted average grant price(1) Number of shares Weighted average grant price(1) Number of shares 2004 Weighted average grant price(1) 788,722 210,332 (125,879) (4,449) $ 17.83 21.72 20.39 21.35 626,868 306,241 (92,811) (51,576) $ 14.98 25.20 16.69 17.31 475,174 218,180 (64,116) (2,370) $ 13.70 19.94 15.16 18.65 868,726 $ 17.96 788,722 $ 17.83 626,868 $ 14.98 Outstanding nonvested shares, beginning of year Shares granted Shares vested Shares forfeited Outstanding nonvested shares, end of year (1)Grant date fair value. During 2006, we granted 210,332 shares of common The effect of pre-vesting forfeitures on our recorded stock under the Stock Plan. These shares vest over the following expense has historically been negligible. Any future pre-vesting service periods: 16,000 vested upon issuance, 4,000 vest forfeitures are also expected to be negligible, and we will over a service period of one year, 4,000 vest over a service record the benefit related to such forfeitures as they occur. period of four years, 15,000 vest over a service period of five Under the terms of the Stock Plan, we pay non-refundable years and 171,332 vest over a service period of 10 years. dividends to the holders of our nonvested shares. Under As of December 31, 2006, the remaining unamortized Statement No. 123R, the dividends paid to holders of these stock compensation expense totaled $15.6 million, which is nonvested shares should be charged as compensation being amortized on a straight-line basis over the service period of each applicable award. The amount of share-based compensation is based on the fair value of the stock at the grant date. We define the grant date as the date the recipient and the Company have a mutual understanding of the key terms and conditions of the award and the recipient of the grant begins to benefit from, or be adversely affected by, subsequent changes in the price of the shares. expense to the extent that they relate to nonvested shares that do not, or are not, expected to vest. Given the negligible historical and prospective forfeiture rate determined by us, we did not record any amount to compensation expense, related to dividends paid, for 2006, nor do we expect to record any amounts in future periods. 4 7 R E A LTY I N C O M E 16. SEGMENT INFORMATION We evaluate performance and make resource allocation decisions on an industry by industry basis. For financial reporting purposes, we have grouped our tenants into 30 industry and activity segments (including properties owned by Crest that are grouped together). All of the properties are incorporated into one of the applicable segments. Because almost all of our leases require the tenant to pay operating expenses, revenue is the only component of segment profit and loss we measure. The following tables set forth certain information regarding the properties owned by us, classified according to the business of the respective tenants as of December 31, 2006 (dollars in thousands): For the years ended December 31, Segment rental revenue: $ Automotive parts Revenue 2006 2005 2004 As of December 31, 2006 2005 Segment net real estate: Automotive parts $ 37,608 $ 39,550 Assets Automotive service Automotive tire services Child care Convenience stores Drug stores Health and fitness Home furnishings Home improvement Motor vehicle dealerships Restaurants Sporting goods Theaters Crest 17 other non-reportable 104,089 211,784 96,263 335,169 78,347 102,718 54,376 71,474 104,122 540,136 56,291 272,135 137,439 108,036 127,879 101,950 342,734 65,846 87,426 56,218 17,846 71,035 166,231 57,913 250,214 45,509 6,716 $ 6,750 $ 6,744 segments 283,130 263,659 Automotive service 16,495 15,083 13,320 Total segment net real estate 2,485,081 1,802,046 Automotive tire services Child care Convenience stores Drug stores Health and fitness Home furnishings Home improvement Motor vehicle dealerships Restaurants Sporting goods Theaters 17 non-reportable segments(1) Other revenue 14,501 24,649 38,284 6,986 10,212 7,463 7,996 8,217 28,292 6,829 22,905 38,513 2,042 13,821 24,819 36,712 5,593 7,212 7,346 2,129 5,060 17,988 6,747 10,139 36,267 354 13,346 24,787 33,409 243 6,919 7,327 2,115 859 16,196 5,939 6,052 34,777 1,029 Total revenue $ 240,100 $ 196,020 $ 173,062 (1)Crest’s revenues appear in “income from discontinued operations, real estate acquired for resale by Crest” and is not included in this table. Other intangible assets— Drug stores 7,629 8,489 Other intangible assets— Theaters Other corporate assets 2,801 50,997 1,419 109,034 Total assets $ 2,546,508 $ 1,920,988 17. COMMITMENTS AND CONTINGENCIES In the ordinary course of our business, we are party to various legal actions which we believe are routine in nature and incidental to the operation of our business. We believe that the outcome of the proceedings will not have a material adverse effect upon our consolidated financial position or results of operations. At December 31, 2006, we have committed to pay estimated unfunded development costs of $16.4 million on properties under development. In addition, we have contingent payments for tenant improvements and leasing costs of $806,000 as well as a $6.0 million commitment to fund the construction costs of two buildings, which are not currently under construction, and for which construction is dependent upon the tenant’s commitment to build the buildings prior to September 30, 2007. R E A LTY I N C O M E 4 8 REALTY INCOME CORPORATION AND SUBSIDIARIES REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders Realty Income Corporation: We have audited the accompanying consolidated balance In our opinion, the consolidated financial statements sheets of Realty Income Corporation and subsidiaries as of referred to above present fairly, in all material respects, the December 31, 2006 and 2005, and the related consolidated financial position of Realty Income Corporation and subsidiaries statements of income, stockholders’ equity, and cash flows as of December 31, 2006 and 2005, and the results of their for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity are the responsibility of Realty Income Corporation’s manage- with U.S. generally accepted accounting principles. ment. Our responsibility is to express an opinion on these We also have audited, in accordance with the standards of consolidated financial statements based on our audits. the Public Company Accounting Oversight Board (United We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Realty Income Corporation’s internal control over financial reporting as of December 31, States). Those standards require that we plan and perform 2006, based on criteria established in Internal Control— the audit to obtain reasonable assurance about whether the Integrated Framework issued by the Committee of Sponsoring financial statements are free of material misstatement. An Organizations of the Treadway Commission (COSO), and our audit includes examining, on a test basis, evidence supporting report dated February 20, 2007 expressed an unqualified the amounts and disclosures in the financial statements. opinion on management’s assessment of, and the effective An audit also includes assessing the accounting principles operation of, internal control over financial reporting. used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. San Diego, California February 20, 2007 4 9 R E A LTY I N C O M E The Board of Directors and Stockholders Realty Income Corporation: We have audited management’s assessment, included in the principles, and that receipts and expenditures of the company accompanying Management’s Report on Internal Control are being made only in accordance with authorizations of over Financial Reporting, that Realty Income Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of Internal Control-Integrated Framework issued by the the company’s assets that could have a material effect on Committee of Sponsoring Organizations of the Treadway the financial statements. Commission (COSO). Realty Income Corporation’s manage- Because of its inherent limitations, internal control over ment is responsible for maintaining effective internal control financial reporting may not prevent or detect misstatements. over financial reporting and for its assessment of the Also, projections of any evaluation of effectiveness to future effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the assessment and an opinion on the effectiveness of Realty degree of compliance with the policies or procedures Income Corporation’s internal control over financial reporting may deteriorate. based on our audit. In our opinion, management’s assessment that Realty We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United Income Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly States). Those standards require that we plan and perform stated, in all material respects, based on criteria established the audit to obtain reasonable assurance about whether in Internal Control—Integrated Framework issued by the effective internal control over financial reporting was main- Committee of Sponsoring Organizations of the Treadway tained in all material respects. Our audit included obtaining Commission (COSO). Also, in our opinion, Realty Income an understanding of internal control over financial reporting, Corporation maintained, in all material respects, effective evaluating management’s assessment, testing and evaluating internal control over financial reporting as of December 31, the design and operating effectiveness of internal control, 2006, based on criteria established in Internal Control— and performing such other procedures as we considered Integrated Framework issued by the Committee of Sponsoring necessary in the circumstances. We believe that our audit Organizations of the Treadway Commission (COSO). provides a reasonable basis for our opinion. We also have audited, in accordance with the standards of A company’s internal control over financial reporting is a the Public Company Accounting Oversight Board (United process designed to provide reasonable assurance regarding States), the consolidated financial statements of Realty the reliability of financial reporting and the preparation of Income Corporation and subsidiaries as of December 31, financial statements for external purposes in accordance with 2006 and 2005, and for each of the years in the three-year 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 period ended December 31, 2006, and our report dated February 20, 2007 expressed an unqualified opinion on those consolidated financial statements. San Diego, California February 20, 2007 R E A LTY I N C O M E 5 0 REALTY INCOME CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Realty Income Corporation, The Monthly Dividend Company®, LIQUIDITY AND CAPITAL RESOURCES Cash Reserves is a Maryland corporation organized to operate as an equity Realty Income is organized to operate as an equity REIT real estate investment trust, or REIT. Our primary business that acquires and leases properties and distributes to objective is to generate dependable monthly cash distribu- stockholders, in the form of monthly cash distributions, a tions from a consistent and predictable level of funds from substantial portion of its net cash flow generated from leases operations, or FFO per share. The monthly distributions are on its retail properties. We intend to retain an appropriate supported by the cash flow from our portfolio of retail amount of cash as working capital. At December 31, 2006, properties leased to regional and national retail chains. We we had cash and cash equivalents totaling $10.6 million. have in-house acquisition, leasing, legal, retail research, real We believe that our cash and cash equivalents on hand, estate research, portfolio management and capital markets cash provided from operating activities and borrowing expertise. Over the past 38 years, Realty Income and its predecessors have been acquiring and owning freestanding capacity, is sufficient to meet our liquidity needs for the foreseeable future. We intend, however, to use additional retail properties that generate rental revenue under long-term sources of capital to fund property acquisitions and to repay lease agreements (primarily 15 to 20 years). our credit facility. In addition, we seek to increase distributions to stock- holders and FFO per share through both active portfolio $300 Million Acquisition Credit Facility management and the acquisition of additional properties. At We have a $300 million revolving, unsecured credit facility December 31, 2006, we owned a diversified portfolio: that expires in October 2008. Realty Income’s current invest- • Of 1,955 retail properties; ment grade credit ratings provide for financing under the • With an occupancy rate of 98.7%, or 1,929 properties credit facility at the London Interbank Offered Rate, com- occupied of the 1,955 properties in the portfolio; monly referred to as LIBOR, plus 65 basis points with a • Leased to 103 different retail chains doing business in facility fee of 15 basis points, for all-in drawn pricing of 29 separate retail industries; • Located in 48 states; 80 basis points over LIBOR. At February 13, 2007, we had borrowing capacity of $300 million available on our credit • With over 16.7 million square feet of leasable space; facility and no outstanding balance. and The credit facility is expected to be used to acquire addi- • With an average leasable retail space per property of tional retail properties and for other corporate purposes. Any approximately 8,600 square feet. additional borrowings will increase our exposure to interest rate risk. We have the right to request an increase in the Of the 1,955 properties in the portfolio, 1,948, or 99.6%, borrowing capacity of the credit facility by up to $100 million, are single-tenant, retail properties and the remaining seven to a total borrowing capacity of $400 million. Any increase in are multi-tenant, distribution and office properties. At the borrowing capacity is subject to approval by the lending December 31, 2006, 1,923, or 98.7%, of the 1,948 single- banks of our credit facility. tenant properties were leased with a weighted average remaining lease term (excluding extension options) of approximately 12.9 years. In addition, at December 31, 2006, our wholly-owned taxable REIT subsidiary, Crest Net Lease, Inc. (“Crest”), had invested $137.5 million in 60 properties, which are classified Mortgage Debt We have no mortgage debt on any of our properties. Universal Shelf Registration In April 2006, we filed a shelf registration statement with the as held for sale. Crest was created to buy and sell properties, SEC, which is effective for a term of three years. In accor- primarily to individual investors, many of whom are involved dance with the SEC rules, the amount of securities to be in tax-deferred exchanges under Section 1031 of the Internal issued pursuant to this shelf registration statement was not Revenue Code of 1986, as amended (the “Tax Code”). specified when it was filed. The securities covered by this registration statement include common stock, preferred stock, debt securities, or any combination of such securities. Realty Income may periodically offer one or more of these securities in amounts, prices and on terms to be announced when and if the securities are offered. The specifics of any 5 1 R E A LTY I N C O M E future offerings, along with the use of proceeds of any 2007 Notes and for other general corporate purposes. securities offered, will be described in detail in a prospectus Interest on the 2016 Notes is paid semiannually. supplement, or other offering materials, at the time of any offering. As such, there is no specific limit to the dollar Conservative Capital Structure amount of new securities that can be issued under this new We believe that our stockholders are best served by a con- shelf registration before it expires in April 2009. servative capital structure. Therefore, we seek to maintain a The common stock issued in September 2006, October conservative debt level on our balance sheet and solid interest 2006 and November 2006, the 2016 Notes issued in and fixed charge coverage ratios. At February 13, 2007, our September 2006 and the Class E preferred stock issued in total outstanding credit facility borrowings and outstanding December 2006 were issued pursuant to our universal shelf notes were $920 million, or approximately 21.9%, of our total registration statement. Issuances of Common Stock market capitalization of $4.21 billion. We define our total market capitalization at February 13, 2007 as the sum of: • Shares of our common stock outstanding of In October and November 2006, we issued an aggregate of 101,000,536 multiplied by the last reported sales price 6.9 million shares of common stock at a price of $26.40 per of our common stock on the NYSE of $29.09 per share. The net proceeds of approximately $173.2 million share, or $2.94 billion; were used to fund a portion of the purchase price of the • Aggregate liquidation value of the Class D preferred Buffets/Ryan’s properties and for other general corporate stock of $127.5 million; purposes. • Aggregate liquidation value of the Class E preferred In September 2006, we issued 4.715 million shares of stock of $220 million; and common stock at a price of $24.32 per share. The net proceeds • Outstanding notes of $920 million. of approximately $109 million from this offering were used to fund new property acquisitions, repay borrowings under our Historically, we have met our long-term capital needs credit facility and for other general corporate purposes. through the issuance of common stock, preferred stock and In March 2006, we issued 5.2 million shares of common long-term unsecured notes and bonds. Over the long term, stock at a price of $24.39 per share. The net proceeds of we believe that the majority of our future securities issuances approximately $120.5 million were used to fund new property should be in the form of common stock; however, we may acquisitions and for other general corporate purposes. issue additional preferred stock or debt securities from time Issuance of Preferred Stock to time. We may issue common stock when we believe that our share price is at a level that allows for the proceeds of any In December 2006, we issued 8.8 million shares of 6 3⁄4% offering to be accretively invested into additional properties. Class E cumulative redeemable preferred stock, with a liquida- In addition, we may issue common stock to permanently tion value of $25 per share. The net proceeds of $214 million finance properties that were financed by our credit facility from this issuance were used to repay borrowings under our or debt securities. However, we cannot assure you that we credit facility and for other general corporate purposes. will have access to the capital markets at terms that are Redemption of 2007 Notes In September 2006, we redeemed all of our outstanding Credit Agency Ratings acceptable to us. $110 million, 7 3⁄4%, unsecured notes due May 2007 (the “2007 Notes”). The 2007 Notes were redeemed at a redemption price equal to 100% of the principal amount, plus accrued and unpaid interest of $3.2 million and a make- whole payment of $1.6 million. We recorded a loss on extinguishment of debt totaling $1.6 million related to the make-whole payment associated with the 2007 Notes. For 2006, the make-whole payment represented approximately $0.017 per share. Issuance of 10-Year Senior Unsecured Notes In September 2006, we issued $275 million in aggregate principal amount of 5.95% senior unsecured notes due 2016 (the “2016 Notes”). The price to the investor for the 2016 Notes was 99.74% of the principal amount for an effective yield of 5.985%. The net proceeds of approximately $271.9 million from this offering were used to redeem the We are currently assigned investment grade corporate credit ratings on our senior unsecured notes from Fitch Ratings, Moody’s Investors Service, Inc. and Standard & Poor’s Ratings Group. Currently, Fitch Ratings has assigned a rating of BBB+, Moody’s has assigned a rating of Baa2 and Standard & Poor’s has assigned a rating of BBB to our senior notes. Moody’s and Standard & Poor’s ratings have “positive” outlooks and Fitch has a “stable” outlook. We have also been assigned investment grade credit ratings from the same rating agencies on our preferred stock. Fitch Ratings has assigned a rating of BBB, Moody’s has assigned a rating of Baa3 and Standard & Poor’s has assigned a rating of BBB- to our preferred stock. Moody’s and Standard & Poor’s ratings have “positive” outlooks and Fitch has a “stable” outlook. The credit ratings assigned to us could change based upon, among other things, our results of operations and R E A LTY I N C O M E 5 2 financial condition. These ratings are subject to ongoing Interest on all of the senior note obligations is paid evaluation by credit rating agencies, and we cannot assure semiannually, with the exception of the interest on the 81⁄4% you that any such rating will not be changed or withdrawn senior notes issued in October 1998, which is paid monthly. by a rating agency in the future if, in its judgment, circum- All of these notes contain various covenants, including: stances warrant. Moreover, a rating is not a recommendation (i) a limitation on incurrence of any debt which would cause to buy, sell or hold our debt securities, preferred stock or our debt to total adjusted assets ratio to exceed 60%; (ii) a common stock. Notes Outstanding limitation on incurrence of any secured debt which would cause our secured debt to total adjusted assets ratio to exceed 40%; (iii) a limitation on incurrence of any debt which Senior note obligations consist of the following (dollars in would cause our debt service coverage ratio to be less than thousands), sorted by maturity date: At December 31, 2006 8 1⁄4% senior notes, issued in 1.5 times; and (iv) the maintenance at all times of total unencumbered assets not less than 150% of our outstanding unsecured debt. We have been in compliance with these covenants since each of the notes were issued. October 1998 and due in 2008 $ 100,000 The following is a summary of the key financial covenants 8% senior unsecured notes, issued in January 1999 and due in 2009 5 3⁄8% senior unsecured notes, issued in March 2003 and due in 2013 5 1⁄2% senior unsecured notes, issued to our senior unsecured notes. The actual amounts are as of 20,000 December 31, 2006. 100,000 Note Covenants Required Actual Limitation on Incurrence in November 2003 and due in 2015 150,000 of Total Debt ≤ 60% 5.95% senior unsecured notes, issued Limitation on Incurrence in September 2006 and due in 2016 275,000 of Secured Debt 5 3⁄8% senior unsecured notes, issued Debt Service Coverage in September 2005 and due in 2017 175,000 Maintenance of Total Unencumbered Assets 5 7⁄8% senior unsecured bonds, issued in March 2005 and due in 2035 100,000 $ 920,000 31.6% 0.0% 4.0 x 316% ≤ 40% ≥ 1.5 x ≥ 150% of Unsecured Debt All of our outstanding notes and bonds have fixed interest rates. Our credit facility interest rate is variable. The following table summarizes the maturity of each of our obligations as of December 31, 2006 (dollars in millions): Table of Obligations Year of Maturity Credit Facility(1) 2007 2008 2009 2010 2011 Thereafter Totals $ — — — — — — Notes $ — 100.0 20.0 — — 800.0 Interest(2) $ 55.1 54.1 45.3 45.3 45.3 305.5 Other(3) $ 17.2 — — — — — Totals $ 72.3 154.1 65.3 45.3 45.3 1,105.5 $ — $ 920.0 $ 550.6 $ 17.2 $ 1,487.8 (1)There was no outstanding credit facility balance on December 31, 2006 or February 13, 2007. (2)Interest on credit facility and notes has been calculated based on outstanding balances as of December 31, 2006 through their respective maturity dates. (3)Other consists of $16.4 million of estimated unfunded costs on properties under development and $806,000 of contingent payments for tenant improvements and leasing costs. Our credit facility and note obligations are unsecured. Accordingly, we have not pledged any assets as collateral for these obligations. 5 3 R E A LTY I N C O M E Preferred Stock Outstanding is scheduled to begin at various times during 2007. At In May and October 2004, we issued an aggregate of December 31, 2006, we had outstanding commitments 5.1 million shares of 7 3⁄8% Class D cumulative redeemable to pay estimated unfunded development costs totaling preferred stock. Beginning May 27, 2009, shares of Class D $16.4 million. preferred stock are redeemable at our option for $25.00 per The initial weighted average contractual lease rate is share, plus any accrued and unpaid dividends. Dividends on computed as estimated contractual net operating income (in shares of Class D preferred stock are paid monthly in arrears. a net-leased property this is equal to the base rent or, in the In December 2006, we issued 8.8 million shares of 63⁄4% case of properties under development, the estimated base Class E cumulative redeemable preferred stock. Beginning rent under the lease) for the first year of each lease, divided December 7, 2011, shares of Class E preferred stock are by the estimated total costs. Since it is possible that a tenant redeemable at our option for $25 per share, plus any accrued could default on the payment of contractual rent, we cannot and unpaid dividends. Dividends on shares of Class E preferred assure you that the actual return on the funds invested will stock are paid monthly in arrears. remain at the percentages listed above. No Off-Balance Sheet Arrangements or Acquisition of $349 million of Buffets/Ryan’s Unconsolidated Investments Restaurants on November 1, 2006 Realty Income and its subsidiaries have no unconsolidated The 2006 acquisition amounts include Realty Income and or off-balance sheet investments in “variable interest entities” Crest’s aggregate investment of $349 million to acquire 144 or off-balance sheet financing, nor do we engage in trading Buffets/Ryan’s restaurant properties. The properties are activities involving energy or commodity contracts or other leased under 20-year, triple-net lease agreements. These derivative instruments. properties were acquired subsequent to a merger between As we have no joint ventures, off-balance sheet entities, Buffets, Inc. and Ryan’s Restaurant Group. or mandatory redeemable preferred stock, our financial posi- Of the 144 restaurant properties, 116 were acquired by tion or results of operations are currently not affected by Realty Income and 28 were acquired by Crest. The restaurants Financial Accounting Standard Board Interpretation No. 46R, Consolidation of Variable Interest Entities and Statement of have, on average, approximately 10,300 leasable square feet and are situated on an average lot size of approximately Financial Accounting Standard No. 150, Accounting for 2.86 acres. In general, the properties are existing locations Certain Financial Instruments with Characteristics of both Liabilities and Equity. that, on average, have been operating for 11 years. Investments in Existing Properties Acquisitions During 2006 In 2006, we capitalized costs of $964,000 on existing properties During 2006, Realty Income and Crest invested $769.9 million, in our portfolio, consisting of $761,000 for re-leasing costs in aggregate, in 378 new properties and properties under and $203,000 for building improvements. development. These 378 properties are located in 30 states and are 100% leased with an initial average lease term of Sales of Investment Properties 17.1 years. As described below, Realty Income acquired 322 During 2006, we sold or exchanged 13 properties for properties and Crest acquired 56 properties. $10.7 million, which resulted in a gain of $3.0 million. This gain Included in the $769.9 million is $656.7 million invested is included in discontinued operations. The 13 properties by Realty Income in 322 new properties and properties under development, with an initial weighted average contractual lease rate of 8.6%. These 322 properties are located in 30 states, are 100% leased with an initial average lease term of 16.7 years and will contain over 3.3 million leasable square feet. The 322 new properties acquired by Realty Income are net-leased to 16 different retail chains in the following 11 industries: automotive collision services, automotive tire services, convenience store, drug store, general merchan- dise, health and fitness, home improvement, motor vehicle dealership, private education, restaurant and theater. Also included in the $769.9 million is $113.2 million invested by Crest in 56 new retail properties. At December 31, 2006, Realty Income had invested $15.9 million in four properties that were leased and under contract for development by the tenant (with development costs funded by Realty Income). Rent on these properties sold or exchanged consisted of one automotive parts store, one automotive service facility, one child care facility, two convenience stores, and eight restaurants. The net proceeds from the sale of these properties were used to repay outstanding indebtedness on our credit facility and to invest in new properties. Crest Property Sales During 2006, Crest, our wholly-owned subsidiary, sold 13 properties from its inventory for an aggregate of $22.4 million, which resulted in a gain of $2.2 million. Crest’s gains are included in “income from discontinued operations, real estate acquired for resale by Crest.” R E A LTY I N C O M E 5 4 Crest Property Inventory are reasonable for reporting purposes. However, actual Crest’s property inventory at December 31, 2006 and 2005 results may differ from these estimates and assumptions. totaled $137.5 million and $45.7 million, respectively, and is In order to prepare our consolidated financial statements included in “real estate held for sale, net”, on our consolidated according to the rules and guidelines set forth by GAAP, balance sheets. many subjective judgments must be made with regard to The financial statements of Crest are consolidated into critical accounting policies. One of these judgments is our Realty Income’s financial statements. All material intercom- estimate for useful lives in determining depreciation expense pany transactions have been eliminated in consolidation. for our properties. Depreciation of buildings and improve- ments is generally computed using the straight-line method Increases in Monthly Cash Distributions over an estimated useful life of 25 years. If we use a shorter to Common Stockholders or longer estimated useful life it could have a material impact We continue our 37-year policy of paying distributions on our results of operations. We believe that 25 years is an monthly to our common stockholders. Monthly distributions appropriate estimate of useful life. No depreciation has been per share were increased in April 2006 by $0.000625 recorded on Crest’s properties because they are held for sale. to $0.116875, in July 2006 by $0.000625 to $0.1175, in Another significant judgment must be made as to if, and September 2006 by $0.00775 to $0.12525, in October 2006 when, impairment losses should be taken on our properties by $0.000625 to $0.125875 and in January 2007 by when events or a change in circumstances indicate that the $0.000625 to $0.1265. The increase in January 2007 was our carrying amount of the asset may not be recoverable. 37th consecutive quarterly increase and the 42nd increase in Generally, a provision is made for impairment loss if estimated the amount of our dividend since our listing on the NYSE in future operating cash flows (undiscounted and without 1994. In 2006, we paid the following monthly cash distribu- interest charges) plus estimated disposition proceeds tions per share: three in the amount of $0.11625, three in (undiscounted) are less than the current book value. the amount of $0.116875, two in the amount of $0.1175, one Impairment losses are measured as the amount by which the in the amount of $0.12525, and three in the amount of current book value of the asset exceeds the fair value of the $0.125875 totaling $1.43725. In December 2006, January asset. If a property is held for sale, it is carried at the lower 2007 and February 2007, we declared distributions of of carrying cost or estimated fair value, less cost to sell. The $0.1265 per share, which were paid on January 16, 2007 and carrying value of our real estate is the largest component of February 15, 2007 and will be paid on March 15, 2007, our consolidated balance sheet. If events should occur that respectively. require us to reduce the carrying value of our real estate by The monthly distribution of $0.1265 per share represents recording provisions for impairment losses, it could have a a current annualized distribution of $1.518 per share, and an material impact on our results of operations. annualized distribution yield of approximately 5.2% based on the last reported sale price of our common stock on the The following is a comparison of our results NYSE of $29.09 on February 13, 2007. Although we expect of operations for the years ended December 31, to continue our policy of paying monthly distributions, we 2006, 2005 and 2004. cannot guarantee that we will maintain the current level of distributions, that we will continue our pattern of increasing Rental Revenue distributions per share, or what the actual distribution yield Rental revenue was $238.1 million for 2006 versus $195.7 million will be in any future period. RESULTS OF OPERATIONS Critical Accounting Policies Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). Our consolidated financial statements are the basis for our discussion and analysis of financial condition and results of operations. Preparing our consolidated financial statements requires us to make a number of estimates and assumptions that affect the reported amounts and disclo- sures in the consolidated financial statements. We believe that we have made these estimates and assumptions in an appropriate manner and in a way that accurately reflects our financial condition. We continually test and evaluate these for 2005, an increase of $42.4 million, or 21.7%. Rental revenue was $172 million in 2004. The increase in rental revenue in 2006 compared to 2005 is primarily attributable to: • The 322 retail properties acquired by Realty Income in 2006, which generated $15.7 million of rent in 2006; • The 135 retail properties acquired by Realty Income in 2005, which generated $33.5 million of rent in 2006 compared to $12.1 million in 2005, an increase of $21.4 million; • Same store rents generated on 1,421 properties leased during the entire years of 2006 and 2005 increased by $1.3 million, or 0.7%, to $175.3 million from $174.0 million. • An increase in straight-line rent and other non-cash adjustments to rent of $155,000 in 2006 as compared estimates and assumptions using our historical knowledge to 2005; and of the business, as well as other factors, to ensure that they 5 5 R E A LTY I N C O M E • An increase of $4.0 million relating to the aggregate of Interest Expense (i) development properties acquired before 2005 that Interest expense was $10.4 million higher in 2006 than in started paying rent in 2005, (ii) properties that were 2005. Interest expense increased in 2006 primarily due to vacant during part of 2006 or 2005 and (iii) lease termi- higher average outstanding balances, which was partially nation settlements. These items totaled $9.7 million in offset by slightly lower interest rates related to our average aggregate in 2006 compared to $5.7 million in 2005. outstanding borrowings. We issued $275 million of 10-year notes in September 2006, $175 million of 12-year notes in Of the 1,955 properties in the portfolio at December 31, September 2005 and $100 million of 30-year bonds in March 2006, 1,948, or 99.6%, are single-tenant properties and the 2005, which contributed to the increase in average out- remaining seven are multi-tenant properties. Of the 1,948 standing balances and slightly lower average interest rates single-tenant properties, 1,923, or 98.7%, were net leased on our debt. with a weighted average remaining lease term (excluding The following is a summary of the components of our rights to extend a lease at the option of the tenant) of interest expense (dollars in thousands): approximately 12.9 years at December 31, 2006. Of our 1,923 leased single-tenant properties, 1,713, or 89.1%, were under leases that provide for increases in rents through: • Primarily base rent increases tied to a consumer price index; • Fixed increases; • To a lesser degree, overage rent based on a percentage of the tenants’ gross sales; or Interest on our credit facility and notes Interest included in discontinued operations from real estate acquired 2006 2005 2004 $ 54,068 $ 40,968 $ 32,442 • A combination of two or more of the above rent for resale by Crest (3,708) (1,139) (674) provisions. Percentage rent, which is included in rental revenue, was $1.1 million in 2006, $1.2 million in 2005 and $1.3 million Amortization of settlements on treasury lock agreements 717 in 2004. Percentage rent in 2006 was less than 1% of rental Credit facility revenue and we anticipate percentage rent to be less than commitment fees 456 756 498 756 508 1% of rental revenue in 2007. Our portfolio of retail real estate, leased primarily to regional and national chains under net leases, continues to perform well and provide dependable lease revenue supporting the payment of monthly dividends to our stock- holders. At December 31, 2006, our portfolio of 1,955 retail properties was 98.7% leased with 26 properties available for lease, one of which is a multi-tenant property. Amortization of credit facility origination costs and deferred bond financing costs Interest capitalized 2,014 (2,184) 1,752 (1,886) 1,631 (531) Interest expense $ 51,363 $ 40,949 $ 34,132 As of February 13, 2007, transactions to lease or sell four of the 26 properties available for lease at December 31, 2006 Credit facilities and notes outstanding were underway or completed. We anticipate these transac- Average outstanding 2006 2005 2004 tions will be completed during the next several months, although we cannot guarantee that all of these properties can be leased or sold within this period. It has been our experience that approximately 1% to 3% of our property portfolio will be unleased at any given time; however, we cannot assure you that the number of properties available for lease will not exceed these levels. balances (dollars in thousands) Average interest rates $ 881,669 6.13% $ 647,301 6.33% $ 498,220 6.51% At February 13, 2007, the weighted average interest rate on our notes payable of $920 million was 5.99% and the average interest rate on our credit line was 5.97%. There was no balance on our credit line at February 13, 2007. R E A LTY I N C O M E 5 6 Interest Coverage Ratio Our interest coverage ratio for 2006 was 4.1 times, for 2005 was 4.4 times and for 2004 was 5.0 times. Interest coverage ratio is calcu- lated as: the interest coverage amount (as calculated in the following table) divided by interest expense, including interest recorded to discontinued operations. We consider interest coverage ratio to be an appropriate supplemental measure of a company’s ability to meet its interest expense obligations. Our calculation of interest coverage ratio may be different from the calculation used by other companies and, therefore, comparability may be limited. This information should not be considered as an alternative to any GAAP liquidity measures. The following is a reconciliation of net cash provided by operating activities to our interest coverage amount (dollars in thousands): Net cash provided by operating activities Interest expense Interest expense included in discontinued operations (1) Income taxes Income taxes included in discontinued operations (1) Investment in real estate acquired for resale(1)(2) Proceeds from sales of real estate acquired for resale (1) Collection of a mortgage note receivable by Crest(1) Crest provisions for impairment losses(1) Gain on sales of real estate acquired for resale(1) Amortization of deferred stock compensation Amortization of stock option costs Changes in assets and liabilities: Accounts receivable and other assets Accounts payable, accrued expenses and other liabilities Interest coverage amount Divided by interest expense(3) Interest coverage ratio (1)Crest activities. 2006 $ 86,945 51,363 3,708 747 494 113,166 (22,405) (1,333) (1,188) 2,219 (2,928) (23) (4,418) (3,208) $ 223,139 $ 55,071 4.1 2005 $ 109,557 40,949 1,139 813 943 55,890 (22,195) — — 3,291 (2,155) (12) 3,292 (8,290) $ 183,222 $ 42,088 4.4 2004 $ 178,337 34,132 674 699 3,480 21,787 (74,995) — — 10,254 (1,426) (14) (1,094) 1,051 $ 172,885 $ 34,806 5.0 (2)The 2005 amount includes intangibles recorded in connection with acquisitions of real estate acquired for resale. (3)Includes interest expense recorded to “income from discontinued operations, real estate acquired for resale by Crest.” Fixed Charge Coverage Ratio Our fixed charge coverage ratio for 2006 was 3.4 times, for 2005 was 3.6 times and for 2004 was 3.9 times. Fixed charge coverage ratio is calculated in exactly the same manner as interest coverage ratio, except that preferred stock dividends are also added to the denominator. We consider fixed charge coverage ratio to be an appropriate supplemental measure of a company’s ability to make its interest and preferred stock dividend payments. Our calculation of the fixed charge coverage ratio may be different from the calculation used by other companies and, therefore, comparability may be limited. This information should not be considered as an alternative to any GAAP liquidity measures. Interest coverage amount divided by interest expense plus preferred stock dividends (dollars in thousands): 2006 2005 2004 Interest coverage amount $ 223,139 $ 183,222 $ 172,885 Divided by interest expense plus preferred stock dividends(1)(2) $ 66,433 $ 51,491 $ 44,261 Fixed charge coverage ratio 3.4 3.6 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.” 5 7 R E A LTY I N C O M E Depreciation and Amortization In addition, Crest incurred state and federal income taxes Depreciation and amortization was $59.5 million in 2006 of $494,000 in 2006 as compared to $943,000 in 2005 and versus $46.2 million in 2005 and $39.7 million in 2004. The $3.5 million in 2004. The decrease in Crest’s 2006 income increases in depreciation and amortization in 2006 and 2005 taxes over the 2005 and 2004 income taxes are due to lower were due to the acquisition of properties in 2006, 2005 and taxable income, primarily attributable to lower gain on sales 2004, which were partially offset by property sales during of real estate acquired for re-sale. These amounts are these years. General and Administrative Expenses included in “income from discontinued operations, from real estate acquired for resale by Crest.” General and administrative expenses increased by $2.1 million Loss on Extinguishment of Debt to $17.5 million in 2006 versus $15.4 million in 2005. General In September 2006, we redeemed all of our outstanding and administrative expenses were $13.1 million in 2004. In $110 million, 7 3⁄4%, unsecured notes due May 2007. The 2007 2006, general and administrative expenses as a percentage Notes were redeemed at a redemption price equal to 100% of total revenue decreased to 7.3% as compared to 7.9% in of the principal amount, plus accrued and unpaid interest of 2005 and 7.6% in 2004. General and administrative expenses $3.2 million and a make-whole payment of $1.6 million. We increased in total dollars primarily due to increases in payroll recorded a loss on extinguishment of debt totaling and employee benefit costs. $1.6 million related to the make-whole payment associated As our property portfolio has grown and continues to with the 2007 Notes. For 2006, the make-whole payment grow, we have increased, and anticipate that we will continue represented approximately $0.017 per share. to gradually increase, the level of our staffing. We expect general and administrative expenses to moderately increase Discontinued Operations due to costs attributable to payroll, staffing costs and Crest acquires properties with the intention of reselling them corporate governance. rather than holding them as investments and operating the In February 2007, we had 70 permanent employees as properties. Consequently, we classify properties acquired compared to February 2006 when we had 69 permanent by Crest as held for sale at the date of acquisition and do employees and four temporary employees. not depreciate them. The operation of Crest’s properties is classified as “income from discontinued operations, real Property Expenses estate acquired for resale by Crest.” Property expenses are broken down into costs associated The following is a summary of Crest’s “income from with non-net leased multi-tenant properties, unleased single- discontinued operations, real estate acquired for resale” for tenant properties and general portfolio expenses. Expenses the years 2006, 2005 and 2004 (dollars in thousands, except related to the multi-tenant and unleased single-tenant per share data): properties include, but are not limited to, property taxes, maintenance, insurance, utilities, property inspections, bad debt expense and legal fees. General portfolio costs include, but are not limited to, insurance, legal, bad debt expense, Crest’s income from discontinued operations, real estate acquired for resale property inspections and title search fees. At December 31, Gain on sales of 2006, 26 properties were available for lease, as compared to real estate acquired 2006 2005 2004 25 at December 31, 2005 and 32 at December 31, 2004. for resale $ 2,219 $ 3,291 $ 10,254 Property expenses were $3.3 million in 2006, $3.7 million in 2005 and $3.1 million in 2004. The $392,000 decrease in property expenses in 2006 is primarily attributable to a decrease in costs associated with bad debt expense, legal fees, and property taxes. Income Taxes Income taxes were $747,000 in 2006 as compared to $813,000 in 2005 and $699,000 in 2004. These amounts are for city and state income taxes paid by Realty Income. Rental revenue Interest expense General and 5,080 (3,708) 2,085 (1,139) 2,304 (674) administrative expense Property expenses (440) (67) Provisions for impairment (1,188) (453) (60) — (464) (93) — Income taxes (494) (943) (3,480) Income from discontinued operations, real estate acquired for resale by Crest $ 1,402 $ 2,781 $ 7,847 Per common share, basic and diluted $ 0.02 $ 0.03 $ 0.10 R E A LTY I N C O M E 5 8 Realty Income’s operations from one property listed as held At December 31, 2006, Crest had $137.5 million invested for sale at December 31, 2006, plus properties sold in 2006, in 60 properties, which are held for sale. Crest generally 2005 and 2004 have been classified as discontinued operations. carries a real estate inventory in excess of $20 million. Crest The following is a summary of our discontinued operations generates an earnings spread on the difference between the from real estate held for investment for the years 2006, 2005 lease payments it receives on the properties held in inventory and 2004 (dollars in thousands, except per share data): and the cost of capital used to acquire properties. It is our Realty Income’s income from discontinued operations from real estate held for investment Gain on sales of belief that at this level of inventory, rental revenue will exceed the ongoing operating expenses of Crest without any 2006 2005 2004 property sales. Gain on Sales of Investment Properties investment properties $ 3,036 $ 6,573 $ 12,543 by Realty Income 2006 2005 2004 classified real estate with a carrying amount of $138 million Rental revenue Other revenue Depreciation and amortization Property expenses Provisions for impairment Income from discontinued operations, real estate 492 34 (116) (116) (16) 1,729 2 4,608 121 (458) (222) (35) (1,162) (545) (1,657) held for investment $ 3,314 $ 7,589 $ 13,908 Per common share, basic and diluted $ 0.04 $ 0.09 $ 0.18 The following is a summary of our total discontinued operations for the years 2006, 2005 and 2004 (dollars in thousands, except per share data): Total income from discontinued operations Real estate acquired for resale by Crest $ 1,402 $ 2,781 $ 7,847 Real estate held for investment Income from discontinued 3,314 7,589 13,908 operations $ 4,716 $ 10,370 $ 21,755 In 2006, we sold or exchanged 13 investment properties for $10.7 million, which resulted in a gain of $3.0 million, which is included in discontinued operations. In 2005, we sold 23 investment properties and sold a portion of the land from two properties for $23.4 million and recognized a gain on sales of $6.6 million, which is included in discontinued operations, except for $18,000 that is included in other revenue. In 2004, we sold or exchanged 43 investment properties and sold a portion of the land from four properties for a total of $35.4 million and recognized a gain of $12.7 million, which is included in discontinued operations, except for $185,000 that is included in other revenue. We have an active portfolio management program that incorporates the sale of assets when we believe the reinvest- ment of the sale proceeds will generate higher returns, enhance the credit quality of our real estate portfolio or extend our average remaining lease term. At December 31, 2006, we as held for sale on our balance sheet, which includes proper- ties owned by Crest. Additionally, we anticipate selling investment properties from our portfolio that have not yet been specifically identified, from which we anticipate receiving between $10 million and $35 million in proceeds during the next 12 months. We intend to invest these proceeds into new property acquisitions. However, we cannot guarantee that we will sell properties during the next Per common share, basic and diluted $ 0.05 $ 0.13 $ 0.28 12 months. The above per share amounts have each been calculated Provisions for Impairment on Real Estate independently. Gain on Sales of Real Estate Acquired for Resale by Crest In 2006, Crest sold 13 properties for $22.4 million, which resulted in a gain of $2.2 million. In 2005, Crest sold 12 properties for $23.5 million, which resulted in a gain of $3.3 million. In 2004, Crest sold 51 properties for $75 million, which resulted in a gain of $10.3 million. Crest’s gains on sales are reported before income taxes and are included in “income from discontinued operations, real estate acquired for resale by Crest.” Acquired for Resale by Crest Provisions for impairment of $1.2 million were recorded by Crest on three properties in 2006. No provisions for impair- ment were recorded by Crest in 2005 and 2004. Crest’s properties are held for sale and the provisions for impair- ment recorded in 2006 reduced the carrying costs to the estimated fair-market value of those properties, net of estimated selling costs. 5 9 R E A LTY I N C O M E Provisions for Impairment on Realty Income were paid in 1999 and recorded as a reduction to net income Investment Properties available to common stockholders when the shares were In 2006, a provision for impairment of $16,000 was recorded redeemed. These non-cash charges equated to $0.05 per on one property. In 2005, we recorded provisions for impair- common share in 2004. ment totaling $186,000 on four properties. In 2004, we recorded provisions for impairment totaling $2.4 million on Net Income Available to Common Stockholders six properties. These provisions are included in “income from Net income available to common stockholders was discontinued operations, real estate held for investment” $99.4 million in 2006, an increase of $9.7 million as compared except for $151,000 in 2005 and $716,000 in 2004 which are to $89.7 million in 2005. Net income available to common included in “provisions for impairment.” stockholders in 2004 was $90.2 million. The calculation to determine net income available to Preferred Stock Cash Dividends and Redemption Charge common stockholders includes gains from the sale of Preferred stock cash dividends totaled $11.4 million in 2006 properties. The amount of gains varies from period to period as compared to $9.4 million in 2005 and $9.5 million in 2004. based on the timing of property sales and can significantly When we redeemed our Class B preferred stock in June impact net income available to common stockholders. 2004 and our Class C preferred stock in July 2004, we During 2006, the gain recognized from the sales of invest- incurred non-cash charges of $2.4 million and $1.4 million, ment properties was $3.0 million as compared to $6.6 million respectively, for the excess of redemption value over the during 2005 and $12.7 million in 2004. Crest’s gain recognized carrying value. These non-cash charges represent the Class from the sale of properties during 2006 was $2.2 million as com- B and Class C preferred stock original issuance costs that pared to $3.3 million during 2005 and $10.3 million during 2004. FUNDS FROM OPERATIONS AVAILABLE TO COMMON STOCKHOLDERS (FFO) FFO for 2006 increased by $26.2 million, or 20.2%, to $155.8 million as compared to $129.6 million in 2005 and $118.2 million in 2004. The following is a reconciliation of net income available to common stockholders (which we believe is the most comparable Generally Accepted Accounting Principles (“GAAP”) measure) to FFO. Also presented is information regarding distributions paid to common stockholders and the weighted average number of shares outstanding for the years ended December 31 (dollars in thousands, except per share amounts): Net income available to common stockholders Depreciation and amortization: Continuing operations Discontinued operations Depreciation of furniture, fixtures and equipment Gain on sales of investment properties: Continuing operations Discontinued operations 2006 $ 99,419 2005 $ 89,716 59,492 116 (192) — (3,036) 46,206 458 (142) (18) (6,573) FFO available to common stockholders $ 155,799 $ 129,647 FFO per common share: Basic Diluted Distributions paid to common stockholders FFO in excess of distributions to common stockholders Weighted average number of common shares: Basic Diluted 1.74 1.73 $ $ $ 129,667 $ 26,132 89,766,714 89,917,554 1.62 $ $ 1.62 $ 108,575 $ 21,072 79,950,255 80,208,593 2004 $ 90,168 39,696 1,162 (117) (185) (12,543) $ 118,181 1.51 $ $ 1.50 $ 97,420 $ 20,761 78,518,296 78,598,788 We define FFO, a non-GAAP measure, consistent with the National Association of Real Estate Investment Trust’s definition, as net income available to common stockholders, plus depreciation and amortization of real estate assets, reduced by gains on sales of investment property and extraordinary items. R E A LTY I N C O M E 6 0 We consider FFO to be an appropriate supplemental Other Non-cash Items and Capitalized Expenditures measure of a REIT’s operating performance as it is based on The following information includes non-cash items and a net income analysis of property portfolio performance that capitalized expenditures on existing properties in our excludes noncash items such as depreciation. The historical portfolio. These items are not included in the adjustments to accounting convention used for real estate assets requires net income available to common stockholders to arrive at straight-line depreciation of buildings and improvements, FFO. Analysts and investors often request this supplemental which implies that the value of real estate assets diminishes information. predictably over time. Since real estate values historically rise and fall with market conditions, presentations of operating results for a REIT, using historical accounting for depreciation, could be less informative. The use of FFO is recommended by the REIT industry as a supplemental performance measure. In addition, FFO is used as a measure of our compliance with the financial covenants of our credit facility. Presentation of this information is intended to assist the reader in comparing the operating performance of different REITs, although it should be noted that not all REITs calculate FFO the same way, so comparisons with other REITs may not be meaningful. Furthermore, FFO is not necessarily indicative of cash flow available to fund cash needs and should not be considered as an alternative to net income as an indication of Realty Income’s performance. In addition, FFO should not be considered as an alternative to reviewing our cash flows from operating, investing and financing activities as a measure of liquidity, of our ability to make cash distributions or of our ability to pay interest payments. For the years ended December 31 (dollars in thousands) Provisions for 2006 2005 2004 impairment losses $ 16 $ 186 $ 2,373 Gain on reinstatement of property carrying value (716) Crest provisions for impairment losses 1,188 Amortization of settlements — — on treasury lock agreements(1) Amortization of deferred note financing costs(2) Amortization of deferred stock compensation 717 756 1,287 1,034 — — 756 913 and stock option costs 2,951 2,167 1,440 Capitalized leasing costs and commissions (761) (570) (323) Capitalized building improvements Straight line rent(3) Preferred stock origination (203) (1,515) (1,017) (1,360) (789) 99 costs write-off(4) — — 3,774 (1)The settlements on the treasury lock agreements resulted from an interest rate risk prevention strategy that was used by the Company in 1997 and 1998, which correlated to pending issuances of senior note securities. We have not employed this strategy since 1998. (2)Amortization of deferred note financing costs includes the amorti- zation of costs incurred and capitalized when our notes were issued in May 1997, October 1998, January 1999, March 2003, November 2003, March 2005, September 2005 and September 2006. These costs are being amortized over the lives of these notes. No costs associated with our credit facility agreements or annual fees paid to credit rating agencies have been included. (3)A negative amount indicates that our straight-line rent was greater than our actual cash rent collected. A positive amount indicates that our straight-line rent was less than our actual cash rent collected. (4)Represents the Class B and Class C preferred stock non-cash charges for the excess of redemption value over the carrying value. IMPACT OF INFLATION Tenant leases generally provide for limited increases in rent as a result of increases in the tenants’ sales volumes, increases in the consumer price index, and/or fixed increases. We expect that inflation will cause these lease provisions to result in rent increases over time. During times when inflation is greater than increases in rent, as provided for in the leases, rent increases may not keep up with the rate of inflation. 6 1 R E A LTY I N C O M E Approximately 98.4%, or 1,923, of the 1,955 properties in Interpretation 48 is effective for us at the beginning of 2007. the portfolio are leased to tenants under net leases where The impact of adopting Interpretation No. 48 is not expected the tenant is responsible for property costs and expenses. to have a material effect on our financial position or results Net leases tend to reduce our exposure to rising property of operations. expenses due to inflation. Inflation and increased costs may have an adverse impact on our tenants if increases in their operating expenses exceed increases in revenue. IMPACT OF ACCOUNTING PRONOUNCEMENTS In September 2006, the FASB issued Statement No. 157, Fair QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to interest rate changes primarily as a result of our credit facility and long-term notes used to maintain liq- uidity and expand our real estate investment portfolio and Value Measurements. Statement No. 157 sets out a framework operations. Our interest rate risk management objective is to for measuring fair value, and requires additional disclosures limit the impact of interest rate changes on earnings and cash about fair-value measurements. Statement No. 157 becomes flow and to lower our overall borrowing costs. To achieve effective for us at the beginning of 2008. The impact of adopt- these objectives we issue long-term notes, primarily at fixed ing Statement No. 157 is not expected to have a material rates, and may selectively enter into derivative financial effect on our financial position or results of operations. In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109. Interpretation No. 48 applies 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, 2006. to all tax positions accounted for under Statement No. 109, We do not enter into any derivative transactions for specula- including tax positions acquired in a business combination. tive or trading purposes. Our interest rate risk is monitored using a variety of techniques. The following table presents by year of expected maturity, the principal amounts, average interest rates and fair values as of December 31, 2006. This information is presented to evaluate the expected cash flows and sensitivity to interest rate changes (dollars in millions): Expected Maturity Data as of December 31, 2006 Year of maturity Fixed rate debt Average interest rate on fixed rate debt 2007 2008(1)(2) 2009(3) 2010 2011 Thereafter(4) Totals Fair Value(5) $ — 100.0 20.0 — — 800.0 $ 920.0 $ 921.9 — 8.25% 8.00 — — 5.66 5.99% Average interest rate on variable rate debt 5.98% — — — — — 5.98% Variable rate debt $ — — — — — — $ — $ — (1)$100 million matures in November 2008. (2)The credit facility expires in October 2008. The credit facility balance as of December 31, 2006 and February 13, 2007 was zero. (3)$20 million matures in January 2009. (4)$100 million matures in March 2013, $150 million matures in November 2015, $275 million matures in September 2016, $175 million matures in September 2017 and $100 million matures in March 2035. (5)We base the fair value of the fixed rate debt at December 31, 2006 on the closing market price or indicative price per each note. The table incorporates only those exposures that exist as of December 31, 2006; 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. At December 31, 2006, our credit facility balance was zero; however, we intend to borrow funds on our credit facility in the future. Based on a hypothetical credit facility borrowing of $50 million, a 1% change in interest rates would change our interest costs by $500,000 per year. R E A LTY I N C O M E 6 2 REALTY INCOME CORPORATION AND SUBSIDIARIES SELECTED FINANCIAL DATA (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, 2006 2005 2004 2003 2002 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 $ 2,546,508 $ 1,920,988 $ 1,442,315 $ 1,360,257 $ 1,080,230 10,573 920,000 970,516 1,575,992 86,945 (55,131) 240,100 106,065 4,716 110,781 (11,362) — 99,419 129,667 2.9 times 65,704 891,700 931,774 989,214 109,557 63,563 196,020 88,749 10,370 99,119 (9,403) — 89,716 108,575 3.2 times 2,141 503,600 528,580 913,735 178,337 (2,696) 173,062 81,642 21,755 103,397 (9,455) (3,774) 90,168 97,420 3.9 times 4,837 506,400 532,491 827,766 73,957 (4,084) 142,656 70,947 15,488 86,435 (9,713) — 76,722 83,842 4.1 times 8,921 339,700 357,775 722,455 124,807 6,454 127,337 63,800 14,867 78,667 (9,713) — 68,954 78,042 4.3 times and preferred stock cash dividends(1) 2.4 times 2.6 times 3.1 times 3.0 times 3.0 times Basic net income per common share Diluted net income per common share Cash distributions paid per common share Cash distributions declared per common share Basic weighted average number of 1.11 1.11 1.43725 1.44750 1.12 1.12 1.34625 1.35250 1.15 1.15 1.24125 1.25125 1.08 1.08 1.18125 1.18375 1.02 1.01 1.15125 1.15375 common shares outstanding 89,766,714 79,950,255 78,518,296 71,128,282 67,867,498 Diluted weighted average number of common shares outstanding 89,917,554 80,208,593 78,598,788 71,222,628 67,976,314 (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, including the amortization of debt issuance costs and interest classified to discontinued operations. Fixed charges are comprised of interest costs (including capitalized interest), the amortization of debt issuance costs and interest classified to discontinued operations. 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 and Class E 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 73⁄8% Class D preferred stock in May 2004, 1,100,000 shares of our 73⁄8% Class D preferred stock in October 2004, and 8,800,000 shares of our 6.75% Class E preferred stock in December 2006. 6 3 R E A LTY I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES CONTROLS AND PROCEDURES CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE We have had no disagreements with our independent Management’s Report on Internal Control Over Financial Reporting. Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive registered public accounting firm on accountancy or financial Officer and Chief Financial Officer, and effected by our board disclosure, nor have we changed accountants in the two most of directors, management and other personnel, to provide recent fiscal years. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures. We reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and maintain disclosure controls and procedures (as defined in procedures that: Securities Exchange Act 1934 Rules 13a-14(c) and 15d-14(c)) that are designed to ensure that information required to be (1) Pertain to the maintenance of records that, in reasonable disclosed in our Exchange Act reports is recorded, detail, accurately and fairly reflect the transactions and processed, summarized and reported within the time periods dispositions of the assets of the Company; specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and (2) Provide reasonable assurance that transactions are communicated to our management, including our Chief recorded as necessary to permit preparation of financial Executive Officer and Chief Financial Officer, as appropriate, statements in accordance with generally accepted accounting to allow timely decisions regarding required disclosure. principles, and that receipts and expenditures of the Company In designing and evaluating the disclosure controls and are being made only in accordance with authorizations of procedures, management recognized that any controls management and directors of the Company; and and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the (3) Provide reasonable assurance regarding prevention or desired control objectives, and management necessarily was timely detection of unauthorized acquisition, use or disposi- required to apply its judgment in evaluating the cost-benefit tion of the Company’s assets that could have a material effect relationship of possible controls and procedures. on the financial statements. As of and for the year ended December 31, 2006, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Management is responsible for establishing and main- taining adequate internal control over financial reporting Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective and were operating at a reasonable assurance level. for the Company. Management has used the framework set forth in the report entitled “Internal Control—Integrated Framework” published by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission to evaluate the effectiveness of the Company’s internal control over financial reporting. Management has concluded that the Company’s internal control over financial reporting was effective as of the end of the most recent fiscal year. KPMG LLP has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting. Submitted on February 20, 2007 by, Thomas A Lewis, Chief Executive Officer and Vice Chairman Paul M. Meurer, Chief Financial Officer, Executive Vice President and Treasurer R E A LTY I N C O M E 6 4 Changes in Internal Controls. There have not been any significant changes in our internal controls or in other factors Certifications. Tom Lewis, Realty Income’s Chief Executive Officer, certified to the NYSE in 2006, pursuant to Section that could significantly affect these controls subsequent to 303A. 12(a) of the NYSE’s Listing Standards, that he was not the date of their evaluation. There were no material weak- aware of any violation of the NYSE corporate governance list- nesses, and therefore no corrective actions were taken. Limitations on the Effectiveness of Controls. Internal ing standards by Realty Income. Furthermore, Realty Income filed with the SEC, as exhibits to its Annual Report on Form 10-K for the year ended December 31, 2006, the certifications by control over financial reporting cannot provide absolute Tom Lewis and Paul Meurer, Realty Income’s Chief Executive assurance of achieving financial reporting objectives because Officer and Chief Financial Officer, respectively, required under of its inherent limitations. Internal control over financial Section 302 of the Sarbanes-Oxley Act. reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and break- downs resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. 6 5 R E A LTY I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES CONSOLIDATED QUARTERLY FINANCIAL DATA (dollars in thousands, except per share data) (not covered by Report of Independent Registered Public Accounting Firm) 2006(1) Total revenue Interest expense Depreciation and amortization expense Other expenses Income from continuing operations Income (loss) from discontinued operations Net income Net income available to common stockholders Net income per common share: First Quarter Second Quarter Third Quarter Fourth Quarter Year(2) $ 55,156 $ 56,509 $ 59,297 $ 69,139 $ 240,100 13,198 13,512 5,336 23,110 1,778 24,888 22,537 11,930 14,791 5,270 24,518 2,122 26,640 24,289 12,530 14,632 6,521 25,614 944 26,558 24,207 13,706 16,557 6,052 32,824 (128) 32,696 28,386 51,363 59,492 23,180 106,065 4,716 110,781 99,419 Basic Diluted Dividends paid per common share 0.27 0.27 0.348750 0.28 0.27 0.350625 0.27 0.27 0.360250 0.29 0.29 0.377625 1.11 1.11 1.437250 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 Dividends paid per common share $ 46,431 $ 47,219 $ 48,877 $ 53,492 $ 196,020 9,058 10,709 5,120 21,544 1,959 23,503 21,152 9,793 11,146 4,917 21,363 3,303 24,666 22,315 10,228 11,218 5,370 22,061 1,061 23,122 20,771 11,869 13,133 4,709 23,781 4,047 27,828 25,477 40,949 46,206 20,116 88,749 10,370 99,119 89,716 0.27 0.330000 0.28 0.331875 0.26 0.337500 0.31 0.346875 1.12 1.346250 (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 LTY I N C O M E 6 6 MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS A. Our common stock is traded on the NYSE under the ticker symbol “O.” The following table shows the high and low sales prices per share for our common stock as reported by the NYSE, and distributions declared per share of common stock for the periods indicated. 2006 First quarter Second quarter Third quarter Fourth quarter Total 2005 First quarter Second quarter Third quarter Fourth quarter Total Price Per Share of Common Stock High $ 24.93 24.06 25.10 28.43 $ 25.61 25.69 25.65 23.97 Low $ 21.57 21.25 21.65 24.40 $ 22.00 22.50 22.00 21.08 Distributions Declared(1) $ 0.349375 0.351250 0.368625 0.378250 $ 1.447500 $ 0.330625 0.332500 0.341875 0.347500 $ 1.352500 (1)Common stock cash distributions currently are declared monthly by us based on financial results for the prior months. At December 31, 2006, a distribution of $0.1265 per common share had been declared and was paid in January 2007. There were 9,737 registered holders of record of our common stock as of January 31, 2007. We estimate that our total number of shareholders is approximately 78,000 when we include both registered and beneficial holders of our common stock. TOTAL RETURN PERFORMANCE s l n s l n s l n s l n l e u a V x e d n I 300 250 200 150 n 100 50 n l s Realty Income Corporation Russell 2000 Realty Income Peer Group* SNL Triple Net REITS Index s l n 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 Period Ending Index 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 Realty Income Corporation Russell 2000 Realty Income Peer Group* SNL Triple Net REITS Index 100.00 100.00 100.00 100.00 127.47 79.52 99.70 109.49 155.01 117.09 138.63 155.72 207.56 138.55 179.85 195.60 187.93 144.86 195.10 203.64 255.60 171.47 250.33 270.09 *Realty Income Peer Group consists of 33 companies (excluding Realty Income) with an implied market capitalization between $1.5 billion to $3.0 billion as of September 30, 2006. 6 7 R E A LTY I N C O M E REALTY INCOME CORPORATION AND SUBSIDIARIES FORWARD-LOOKING STATEMENTS 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, and “Management’s Discussion and Analysis of Financial the words “estimated”, “anticipated”, “expect”, “believe”, Condition and Results of Operations” in this annual report. “intend” and similar expressions are intended to identify Readers are cautioned not to place undue reliance on forward-looking statements. Forward-looking statements are forward-looking statements, which speak only as of the date subject to risks, uncertainties, and assumptions about Realty Income Corporation, including, among other things: that this annual report was filed with the Securities and Exchange Commission, or SEC. We undertake no obligation • Our anticipated growth strategies; to publicly release the results of any revisions to these • Our intention to acquire additional properties and the forward-looking statements that may be made to reflect timing of these acquisitions; • Our intention to sell properties and the timing of these property sales; events or circumstances after the date of this annual report or to reflect the occurrence of unanticipated events. In light of these risks and uncertainties, the forward-looking events • Our intention to re-lease vacant properties; discussed in this annual report might not occur. • 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. (“Crest”). Future events and actual results, financial and otherwise, may differ materially from the results discussed in the forward- looking 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 environmental matters, illiquidity of real estate invest- ments 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 proceedings to which we are a party; and • Acts of terrorism and war. R E A LTY I N C O M E 6 8 COMPANY INFORMATION S E N I O R 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 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. O T H E R E X E C U T I V E O F F I C E R S Robert J. Israel Senior Vice President, Research Donald R. Cameron Lead Independent Director President, Cameron, Murphy & Spangler, Inc. a i n r o f i l 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 Kim S. Kundrak Senior Vice President, Portfolio Acquisitions Michael K. Press Senior Vice President, Financial Sponsors & Banking Theresa M. Casey Vice President, Information Technologies Gregory J. Fahey Vice President, Controller Laura S. King Vice President, Assistant General Counsel and Assistant Secretary Tere H. Miller Vice President, Corporate Communications Mitchell N. White Vice President, Business Development Steve D. Burchett Associate Vice President, Senior Legal Counsel Jill M. Cossaboom Associate Vice President, Assistant Controller Kristin K. Ferrell Associate Vice President, Portfolio Management Jenette O’Brien Associate Vice President, Senior Legal Counsel S U B S I D I A R Y C O M PA N Y Crest Net Lease, Inc. Cary J. Wenthur President 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 AG 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 AT E I N F O R M AT 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 D I R E C T O R S William E. Clark, Jr. Chairman of the Board of Directors Copies of Realty Income’s 10-K report are available upon written request to: R E A LT Y I N C O M E C O R P O R AT I O N Attention: Investor Relations 220 West Crest Street Escondido, CA 92025-1707 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 2 2 R E A LT Y I N C O M E 

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