Realty Income
Annual Report 2007

Plain-text annual report

T H E M O N T H LY D I V I D E N D C O M PA N Y® Realty Income 2007 Annual Report AS THE CHARTS ON THE COVER ILLUSTRATE, 2007 WAS AN EXTREMELY POSITIVE YEAR FOR THE OPERATIONS OF YOUR COMPANY. DURING THE YEAR WE MADE SUBSTANTIAL PROGRESS IN INCREASING THE SIZE OF THE REAL ESTATE PORTFOLIO, MAINTAINED HIGH PORTFOLIO OCCUPANCY, AND GENERATED RECORD INCREASES IN OUR FUNDS FROM OPERATIONS, WHICH ALLOWED US TO SUBSTANTIALLY RAISE THE AMOUNT OF THE MONTHLY DIVIDEND. GENERATING ADDITIONAL CASH FLOW TO PAY INCREASING DIVIDENDS HAS BEEN THE GOAL OF “THE MONTHLY DIVIDEND COMPANY®” SINCE ITS FOUNDING BACK IN 1969. WE ARE PLEASED WITH THE PROGRESS WE’VE MADE IN ACHIEVING THAT GOAL OVER THE PAST 38 YEARS. M I S S I O N S TAT E M E N T 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 2,270 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. 2007 Annual Report REALTY INCOME 1 2 0 07 R E V I E W ( T H E S H O R T V E R S I O N ) GENERAL COMMENT: Another terrific year for The Monthly Dividend Company® DIVIDEND UPDATE: Paid 12 monthly dividends Increased the dividend 5 times Paid 449 consecutive monthly dividends since 1970 SHARE PRICE PERFORMANCE: 12/31/06 closing price: $27.70 12/31/07 closing price: $27.02 2.4% decrease RETURNS TO SHAREHOLDERS: Dividend yield of 5.6% Share price decrease of 2.4% Total return of 3.2% for 2007 TOTAL MARKET CAPITALIZATION: $4.55 billion on 12/31/07 BALANCE SHEET: Very strong PROPERTY MORTGAGE DEBT: Zero ($0) REAL ESTATE PORTFOLIO: 2,270 retail properties leased to 115 retailers in 30 retail industries located throughout 49 states PORTFOLIO OCCUPANCY: 97.9% on 12/31/07 PROPERTY ACQUISITIONS: Bought 357 properties for $534 million 2 REALTY INCOME 2007 Annual Report 2 0 0 8 B U S I N E S S P L A N • PAY 12 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 TA I N A C O N S E R VAT I V E B A L A N C E S H E E T • M A I N TA I N H I G H P O R T F O L I O O C C U PA 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 PA N Y ® • R E M A I N C O N S E R VAT I V E 2007 Annual Report REALTY INCOME 3 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 OV E R T I M E For the Years Ended December 31, 2007 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) Cost of properties acquired(4) Properties sold Number of retail industries Number of states Portfolio occupancy rate Remaining weighted average lease term in years $ 297,396,000 $ 240,626,000 $ 197,751,000 $ 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 $ 48,863,000 116,156,000 189,675,000 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 32,223,000 47,139,000 25,600,000 40,414,000 15,224,000 39,050,000 157,659,000 129,667,000 108,575,000 97,420,000 83,842,000 78,042,000 64,871,000 58,262,000 55,925,000 52,301,000 44,367,000 42,794,000 36,710,000 38,816,000 $ $ 3,238,794,000 2,270 18,504,800 357 533,726,000 10 30 49 97.9% $ 2,743,973,000 1,955 16,740,100 378 $ 769,900,000 13 29 48 98.7% $ 2,096,156,000 1,646 13,448,600 156 $ 486,553,000 23 29 48 98.5% $ $ 1,691,283,000 1,533 11,986,100 194 215,314,000 43 30 48 97.9% $ 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 1,197 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 97.7% 98.2% 97.7% 99.5% 99.2% 99.1% 99.3% 1,404 11,350,800 302 35 28 48 98.1% 11.8 1.08 1.45 1.181 1.20 6.7% 21.0% 111 35 26 48 10.9 1.01 1.38 1.151 1 .1 7 117 35 25 48 10.4 0.99 1.30 1.121 1 .1 4 $ $ 22 21 24 46 9.8 0.84 1.26 1.091 1 .1 1 110 3 24 45 98.4% 10.7 0.76 1.23 1.043 1.08 970 149 5 22 45 10.2 0.78 1 .1 8 0.983 1.02 96 10 14 43 9.8 0.74 1 . 1 1 0.946 0.96 5 62 7 8 42 9.5 0.70 1.04 0.931 . 0.95 58 3 7 42 9.2 0.63 1.00 0.913 0.93 11.25 10.7% 42.0% 4 5 5 41 99.4% 9.5 0.39 0.98 0.300 0.90 9.9% 28.5% $ $ $ $ $ $ $ $ $ Common shares outstanding 101,082,717 100,746,226 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 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 stockholders(9)(10) $ 27.02 $ 27.70 $ 21.62 $ 25.29 $ 20.00 $ $ 12.4375 $ 10.3125 $ 12.4375 $ 12.719 $ 11.9375 $ $ 8.5625 5.6% 3.2% 6.7% 34.8% 5.3% -9.2% 6.2% 32.7% 17.50 7.8% 26.9% 14.70 9.0% 27.2% 10.6% 31.2% 8.4% –8.7% 7.7% 5.5% 7.9% 14.5% 8.3% 15.4% (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. 4 REALTY INCOME 2007 Annual Report P E R C O M M O N S H A R E DATA(5) Net income (diluted) Funds from operations (“FFO”)(2) Dividends paid Special dividend Annualized dividend amount(6) $ $ 1 .1 6 1.89 1.560 1.641 $ 1 .1 1 1.73 1.437 1.518 $ 1 .1 2 1.62 1.346 1.395 12.0 1 .1 5 1.50 1.241 1.32 13.0 12.9 12.4 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 32,223,000 47,139,000 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 42,794,000 36,710,000 38,816,000 $ 1,533,182,000 1,404 11,350,800 302 371,642,000 35 28 48 98.1% $ $ $ 1,285,900,000 1,197 9,997,700 111 139,433,000 35 26 48 97.7% $ 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 7,824,100 970 149 6,302,300 826 96 5,226,700 740 62 4,673,700 685 58 630 4,064,800 $ 193,436,000 $ 142,287,000 $ 55,517,000 $ 65,393,000 $ 3,273,000 $ 11.8 1.08 1.45 1.181 1.20 $ 10.9 1.01 1.38 1.151 1 .1 7 75,818,172 69,749,654 $ 20.00 $ 6.7% 21.0% 17.50 7.8% 26.9% $ $ 10.4 0.99 1.30 1.121 1 .1 4 $ 9.8 0.84 1.26 1.091 1 .1 1 $ 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 $ $ 8.5625 10.6% 31.2% 8.4% –8.7% 7.7% 5.5% 7.9% 14.5% 8.3% 15.4% 4 5 41 99.4% 9.5 0.39 0.98 0.300 0.90 9.9% 28.5% 99.3% 7 42 9.2 0.63 1.00 0.913 0.93 11.25 10.7% 42.0% 5 8 42 99.1% 9.5 0.70 1.04 0.931 . 0.95 22 45 99.5% 10.2 0.78 1 .1 8 0.983 1.02 99.2% 14 43 9.8 0.74 1 . 1 1 0.946 0.96 (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. (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. 2007 Annual Report REALTY INCOME 5 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% $ 699,797,000 826 6,302,300 96 $ 142,287,000 10 14 43 99.2% $ 564,540,000 740 5,226,700 62 55,517,000 7 8 42 99.1% $ $ $ 515,426,000 685 4,673,700 58 65,393,000 3 7 42 99.3% $ 450,703,000 630 4,064,800 4 3,273,000 5 5 41 99.4% $ $ 10.2 0.78 1 .1 8 0.983 1.02 $ 9.8 0.74 1 . 1 1 0.946 0.96 $ 9.5 0.70 1.04 0.931 .23 0.95 $ 9.2 0.63 1.00 0.913 0.93 $ 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 $ 7.7% 5.5% 7.9% 14.5% 8.3% 15.4% 11.25 10.7% 42.0% $ 8.5625 9.9% 28.5% (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. 2007 Annual Report REALTY INCOME 6 TA B L E O F C O N T E N T S MISSION STATEMENT 2007 REVIEW (THE SHORT VERSION) 2008 BUSINESS PLAN RELIABLE FINANCIAL PERFORMANCE OVER TIME CEO LETTER TO SHAREHOLDERS HIGHLIGHTS OF 2007 INVESTOR RETURNS IT’S ABOUT FUNDS FROM OPERATIONS AND DIVIDENDS WHAT MORE DO YOU NEED TO KNOW ABOUT YOUR COMPANY? I. WHY WE’RE IN BUSINESS II. WHAT IS OUR STRATEGY AND HOW DOES OUR BUSINESS WORK? PROVEN STRATEGY HOW WE WORK FUNDING ACQUISITIONS HOW WE INCREASE EARNINGS AND FUNDS FROM OPERATIONS STAYING ON TOP OF PORTFOLIO PERFORMANCE III. WERE WE SUCCESSFUL IN DELIVERING ON OUR STRATEGY? ANOTHER VERY GOOD ACQUISITIONS YEAR ACCESS TO CAPITAL CREST PERFORMANCE PORTFOLIO PERFORMANCE IV. CAREFUL UNDERWRITING AND RECORD FINANCIAL PERFORMANCE UNDERWRITING ANALYSIS AND PROCESS WHAT HAPPENS IF A TENANT GETS INTO FINANCIAL TROUBLE? MANAGEMENT EXPERIENCE WITH FINANCIALLY CHALLENGED TENANTS RECORD FINANCIAL PERFORMANCE V. LOOKING AHEAD-OPPORTUNITIES AND CHALLENGES IN 2008 VI. WHAT YOU MIGHT EXPECT FROM US A FEW LAST WORDS FINANCIAL PERFORMANCE AND OPERATING RESULTS 1 2 3 4 8 8 9 10 1 1 1 1 12 12 12 13 13 14 15 15 16 16 16 17 17 18 18 20 21 21 22 23 OPEN HERE 7 2007 Annual Report REALTY INCOME 7 C E O L E T T E R T O S H A R E H O L D E R S Dear Shareholders, I am very pleased to report to you that during 2007 your Company had the best operating performance in its 38-year history. During the year we made excellent progress in all areas of the Company’s business, including strong real estate portfolio performance, access to attractively priced capital, substantial progress in our real estate acquisition program, and solid financial performance that allowed us to raise the dividend five times. We believe our continued success is the result of a business strategy that has proven to be resilient through many years of varying economic conditions. As we begin 2008, we believe we are well positioned to achieve continued operating success and to pursue our mission of providing dependable monthly income that increases over time. H I G H L I G H T S O F 2 0 07 (as compared to 2006) • Revenue rose 23.8% to $296.5 million • Funds from operations (FFO) increased 21.8% to $189.7 million • Common stock dividends paid increased 21.6% to $157.7 million • Portfolio occupancy of 97.9% at year end • Large and diverse portfolio of 2,270 properties located in 49 states occupied by 115 different retailers in 30 different industries • Same store rents increased 1.4% • 357 new properties acquired for $533.7 million • Issued $550 million of senior unsecured notes issued in September of 2007 • Zero balance on our credit facility and $193.1 million in cash to pursue 2008 acquisitions • No mortgages on any of our properties 8 REALTY INCOME 2007 Annual Report I N V E S T O R R E T U R N S During 2007, we paid 12 monthly dividends on our Rising Dividends Over Time” table below). The price of Realty Income’s shares was $27.02 common stock and increased the amount of the at December 31, 2007, a decrease of $0.68, as dividend five times. Dividends paid per share compared to the closing price of $27.70 on increased 8.6% and shareholders who owned our December 31, 2006. As sometimes happens in the stock for the entire year received $1.56 per share financial markets, the closing price of our shares, in dividends during 2007. at year end, did not reflect the record operating Investors who have owned Realty Income for results we achieved in 2007. While this may be many years also benefited from the regular somewhat disappointing, it is important to realize payment of dividends and dividend increases. that neither our fundamental business nor our For example, shareholders who purchased shares operations were the cause of this modest share ten years ago (12/31/97), now enjoy a current yield price decrease during the year. on the original cost of their shares of 12.9% and As for total return in 2007, combining the have received back 95.6% of their original dollars dividends paid of 5.6% with the share price invested because of consistent and increasing decrease of 2.4%, shareholders achieved a total payments of dividends. (See “The Magic of return of 3.2% for 2007. The Magic of Rising Dividends Over Time * Based on 12/31/07 Annualized Dividend Per Share Amount of $1.641. Yield on Cost The Cumulative Dividend Effect 1,000 Shares Purchase Date Original Investment Original Dividends Original Yield Current Yield on Cost* Dividends Received to Date % of Original Investment Paid Back 10/18/94 $ 8,000.00 $ 900.00 11.3% 20.5% $ 15,360.00 12/31/94 $ 8,562.50 $ 900.00 10.5% 12/31/95 $ 11,250.00 $ 930.00 8.3% 12/31/96 $ 1 1 ,9 37.50 $ 945.00 12/31/97 $ 1 2 ,7 1 9.00 $ 960.00 7.9% 7.5% 12/31/98 $ 12,437.50 $ 1,020.00 8.2% 12/31/99 $ 10, 312.50 $ 1,080.00 10.5% 12/31/00 $ 12,437.50 $ 1 , 1 1 0 .00 8.9% 12/31/01 $ 14,700.00 $ 1,140.00 7.8% 12/31/02 $ 17,500.00 $ 1 ,1 70 .00 6.7% 12/31/03 $ 20,000.00 $ 1,200.00 6.0% 12/31/04 $ 25,290.00 $ 1,320.00 5.2% 12/31/05 $ 21,620.00 $ 1,395.00 6.5% 12/31/06 $ 27,700.00 $ 1,518.00 5.5% 12/31/07 $ 27,020.00 $ 1,641.00 6.1% 19.2% 14.6% 13.7% 12.9% 13.2% 15.9% 13.2% 11.2% 9.4% 8.2% 6.5% 7.6% 5.9% 6.1% $ 15,060.00 $ 1 4,1 47.50 $ 1 3,1 0 1 .25 $ 1 2 ,1 55.00 $ 1 1 , 1 7 2 .50 $ 1 0,1 30.00 $ 9,038.75 $ 7,9 1 7.50 $ 6,766.25 $ 5,585.00 $ 4,343.75 $ 2,997.50 $ 1,560.25 192.0% 175.9% 125.8% 109.7% 95.6% 89.8% 98.2% 72.7% 53.9% 38.7% 27.9% 17.2% 13.9% 5.6% 2007 Annual Report REALTY INCOME 9 I T ’ S A B O U T F U N D S F R O M every year has not necessarily correlated to the O P E R AT I O N S A N D D I V I D E N D S movement of our stock price over the short term. Different people look for different things from an Since 1999, Realty Income’s FFO per share growth investment. Some look for earnings growth. Some rate was: 4.2% in 1999, 2.4% in 2000, 3.2% in look for dividend growth (these people generally 2001, 6.2% in 2002, 5.1% in 2003, 3.4% in 2004, need increasing income to replace the salaries 8.0% in 2005, 6.8% in 2006, and 9.2% in 2007. they no longer receive). And some look for stock In comparison, the Company’s stock price price growth (these more risk tolerant people percentage change during the same years has generally look to achieve sizable capital gains). been: -17.1% in 1999, 20.6% in 2000, 18.2% in What we look for as a company is funds from 2001, 19.1% in 2002, 14.3% in 2003, 26.5% in operations and dividend growth. Our view is that if we 2004, -14.5% in 2005, 28.1% in 2006 and -2.4% pay attention to the quality and growth of our funds in 2007. You can see this more clearly in the table from operations, then regular dividend payments and below that compares our dividend per share dividend increases should be a natural outcome. growth, FFO per share growth (our earnings or cash As a company, we have the most in common with flow metric) and share price growth over the past investors who are looking for earnings growth and 9 years. The numbers reveal historical operating dividend growth. In the long run, we believe that our performance and dividend payments that have shareholders are best served when we keep our consistently increased while share price performance eye on what we can control (the operations of the has been somewhat erratic. Annual Per Share Comparisons 2007 2006 2005 2004 2003 2002 2001 2000 1999 Dividend Growth 8.6% 6.8% 8.5% 5.1% 2.6% 2.7% 2.7% 4.7% 6.1% FFO Growth 9.2% 6.8% 8.0% 3.4% 5.1% 6.2% 3.2% 2.4% 4.2% Share Price Growth -2.4% 28.1% -14.5% 26.5% 14.3% 19.1% 18.2% 20.6% -17.1% business and our dividends) rather than on what we The point of this is that if we are income can’t control (the day to day price of our shares). investors, what we care most about is a company’s By this, we mean that we view stock market track record of consistent and increasing funds performance in much the same way as the well- from operations and dividends and not particularly known investor, Warren Buffet, who has sometimes how the shares traded on any given day, week, commented that, in the short run, the market is a month or year. True, we also want to protect our voting machine that reflects people’s current principal, but as most savvy investors know, if we hopes, fears and emotions. However, in the long pay attention to our operations and manage for run, the market is more of a weighing machine, cash flow and dividend growth, then, over the long measuring a company’s growth in revenue, earnings term, the price of our shares should usually reflect and dividends. To illustrate this, it is very interesting our positive long term performance. to note that strong performance in our operations 10 REALTY INCOME 2007 Annual Report W H AT M O R E D O YO U N E E D T O K N O W increasing dividends. Whether it’s a decision to A B O U T YO U R C O M PA N Y ? acquire a single property or a portfolio of properties, There are six things we think you should know a decision as to what type of capital we use to about Realty Income, and I’ll address them in fund property acquisitions, or a decision on how order throughout the rest of this letter. to structure a lease agreement, the quality of the I. We need to reiterate why we are in business lease revenue that will be produced by the and what we’re trying to accomplish for all of investment is front and center in our analysis. us as shareholders. Our goal is to grow your Company and maintain II. We should explain what our strategy is and a real estate portfolio that is a reliable generator how our business works. of income for the long haul. III. We need to let you know what kind of shape Our track record in accomplishing our mission your company is in and how well we executed includes: our business strategy this past year. • 449 consecutive monthly dividends paid IV. We need to provide insight into how we since 1970 underwrite real estate acquisitions and discuss • 47 increases in the amount of the monthly our financial and operating performance in 2007. dividend, of which 41 have been consecutive V. We should give you our take on what might quarterly increases since 1994, and happen in 2008 (our crystal ball is never quite • $1.4 billion in dividends paid. clear, but we have a few ideas). This dividend-paying track record is the VI. Finally we should share our thoughts about result of the following operating performance what you ought to expect from us as an owner from 1994 (when we were listed on the NYSE) of Realty Income. until December 31, 2007: • Increase in the number of properties that we I . W H Y W E ’ R E I N B U S I N E S S own from 630 to 2,270 Realty Income is “The Monthly Dividend Company®”. • Increase in the value of the real estate at The mission of The Monthly Dividend Company® original cost from $451 million to $3.2 billion is to provide dependable monthly income that • Increase in the diversification of lease revenue increases over time. This is both the reason we from approximately 15 retail chains and 5 industries exist and our primary goal year after year. to 115 retail chains and 30 industries today The Company was founded in 1969 to invest in quality commercial properties, leased to regional • • Increase of 608% in our revenue Increase of 486% in our funds from operations and national retail chains, under long-term leases • Maintaining portfolio occupancy in excess of that produce consistent lease revenue. The goal 97.5% since 1970 then and now is to preserve capital, to produce • Increase in the total capitalization of the monthly income by owning these types of properties company from $325 million to $4.55 billion. and to increase that income over time. These results indicate the importance we’ve Because we are dedicated to producing reliable placed on meeting our goal of providing dividend income that rises over time, our activities and income that increases over time and our decisions are guided by the need to generate an commitment to performing in accordance with enduring stream of lease revenue that generates the mission of The Monthly Dividend Company®. the cash flow to support the regular payment of Producing consistent operating results and 2007 Annual Report REALTY INCOME 11 achieving the goals set by a company is not a location, is also a priority because it means our given in any business. It requires a workable lease revenue isn’t overly dependent on any single strategy, good execution of that strategy and retail industry, chain or area of the country. a consistency of commitment to the overriding This strategy, as simple as it is, still requires mission of the company. Fundamental to Realty consistent execution. To acquire $533.7 million Income’s historical success is the simplicity of in properties in 2007, as well as to consistently its operating strategy. achieve a high level of acquisition success year after year is hard work (much harder than it may I I . W H AT I S O U R S T R AT EGY A N D look). It takes a great deal of planning and H O W D O E S O U R B U S I N E S S W O R K? Proven Strategy organization to uncover property acquisition opportunities, decide which ones will pay us over Our strategy is to acquire properties with three the long term, raise attractively priced capital to particular characteristics: purchase the properties and then monitor the First, they are single-tenant, freestanding, properties once we own them. Making all of this retail properties with 15 to 20-year net leases. work year after year is most certainly not a given, Second, we focus on retail chains that provide so let’s take a look at the processes we have in basic human needs goods and services used place that have allowed us to generate real estate by consumers almost every day. And third, the portfolio growth, earnings growth and dividend properties we acquire generally provide for growth in recent years. additional portfolio diversification by retail industry, retail chain and/or geographic location. How We Work We do our best to acquire and own these types We uncover property acquisitions through the of properties because they generate consistent, efforts of a staff of acquisition officers who have long-term lease revenue. relationships with, and call on, individual retail The benefit of owning real estate under net chains, real estate developers, brokers, private lease agreements is that the tenant (retail chain) equity firms, and investment banks. This requires is responsible for the payment of taxes, insurance diligence, experience, consistent contact with these and the maintenance of the property, rather than firms, a good reputation for timely performance, as us. We‘ve also said that consistency of lease well as being in the right place at the right time. revenue is important to our shareholders, so Since there is generally a great deal of competition purchasing properties from retailers selling for net-leased retail real estate, the advantages we “basic human needs goods and services” offers us some degree of protection against the usual ups and downs of retail trends. (Some examples of retailers that provide these types of services are: auto parts and service stores, convenience stores, and child care centers.) A focus on acquiring freestanding retail locations provides us with real estate that is accessible and attractively located. Diversifying the source of our lease revenue by retail industry and chain, as well as by geographic 12 REALTY INCOME 2007 Annual Report Our business strategy is to acquire and own freestanding retail properties under 15 to 20-year leases that generate consistent long-term lease revenue from which we pay dividends. bring to the table are ready access to capital, solid Funding Acquisitions experience in financing a variety of industries, a The Company’s long-term capital structure is an track record of closing transactions on time and a important strategic discussion for our Board of reputation for being reasonably easy to work with. Directors and senior management team. Our goal Once an opportunity has been identified as is to consistently maintain a conservative capital viable for Realty Income to review, the due diligence, structure while employing the lowest cost of capital or underwriting process begins. There are many available. Achieving this optimal capital structure at real estate transactions identified that don’t make any given point in time is a bit challenging and it past an initial analysis, but the ones that do, go requires us to always be aware of the market through a rigorous review process by our in-house environment in which we’re operating so that we research team, which culminates in intense can access attractively priced capital given the discussion and analysis by the four most senior ebb and flow of ever-changing market conditions. level executives who comprise our Investment This often requires a great deal of patience to time Committee. (An in-depth look at our underwriting capital issuances appropriately so that the capital process comes later in this letter.) we access meets our goals. Our bias, generally, is If a potential transaction is approved by to issue common stock so that we minimize debt the Investment Committee, we then have to levels. We believe that this delivers a certain degree determine how to fund the acquisition. It’s of comfort to our shareholders and also provides important to note that the capital funding aspect us with significant balance sheet flexibility so we of our process does not necessarily proceed in a have access to capital when attractive investment linear fashion with the rest of the acquisition opportunities present themselves. process. The majority of the time, when a transaction is approved by the Investment Committee, we have already identified how it will How We Increase Earnings and Funds from Operations be funded. Generally, we use our $300 million Realty Income generates earnings growth in two acquisition credit facility to fund acquisitions for primary ways, by increasing the size of our real the short term. When the credit facility gets to estate portfolio and through regular rent increases a certain level, we typically look to permanently on the real estate that we already own. We generate fund acquisitions by issuing common or preferred increasing cash flow from our new property stock or long-term bonds. We do this because acquisitions based on the spread, or difference, we permanent funding provides us with capital at a achieve between the cost of the capital we use to long-term fixed cost rather than the short-term acquire a property and the return, or lease yield, variable rate funding that is available through our we receive from the property we buy. In short, the acquisition credit facility. lower the cost of our capital and the higher the 2007 Annual Report REALTY INCOME 13 lease yield on the property acquired, the greater high level of occupancy arising from proactive the spread. Sounds simple, however, our ability to portfolio management. achieve this spread is determined by conditions in the capital markets on the one hand and conditions Staying on Top of Portfolio Performance in the real estate market on the other. To the extent that our properties and tenants have For example, from time to time our share price passed a rigorous due diligence process, we enjoy increases to a level where we are able to achieve a certain degree of confidence that our tenants a very attractive spread between the cost of the will meet their 15 to 20-year contractual lease capital we’ve generated for new investments and agreements. Behind the scenes, however, there the return, or lease yield, on the properties we are many aspects to the consistent portfolio acquire. The timing of stock issuance is challenging, performance that supports the payment of monthly however, because share price movement is based dividends. The research that goes into acquiring on a variety of factors over which we have little properties with good tenants in the first place is control as well as stock market conditions that are one aspect, but monitoring the month to month difficult to predict. Thus, constant monitoring of collection of rents and staying on top of the market conditions is required in order to maximize operations of 115 retailers and 2,270 retail stores our returns when we issue additional common stock. is also critical to realizing dependable lease On the other hand, there are times when we can revenue. Realty Income’s retail research group achieve a more attractive spread, and greater follows economic and industry trends on over earnings growth, by issuing long-term bonds or 30 different retail industries and scrutinizes the preferred stock. Our decision to issue additional operations of the retail chains in our portfolio. long-term bonds is not totally dependent on cost We monitor tenant financial health and perform of capital issues, however. Another objective is to tenant financial analysis with a goal to realize the operate with a conservative balance sheet. As such, consistent payment of rent every month. we are constantly monitoring our capital structure Another aspect is the proactive management of so that the ratio between common stock, preferred the portfolio. Instead of waiting for a lease to expire stock and long-term bonds matches our desire for to discover a retailer’s intentions, our portfolio a conservative capital structure and, at the same management team enters into discussions, time, we are still able to generate the earnings considerably in advance of the lease expiration growth that supports regular dividend increases. date, to determine our options. The markets where Earnings growth is also achieved through rent we own properties with leases scheduled to expire increases in our property portfolio that generally are also closely monitored to gauge whether or occur on a regular basis throughout the duration not it would be better to re-lease a property to of our 15 to 20-year leases. Typically we look for the same tenant, to a new tenant, or to sell the annual increases, though there are many properties property when the lease expires. in our portfolio that have contractual rent increases Finally, we must manage our real estate assets every five years. In general, we target annual rent with respect to the property sales that may occur increases of around 1% to 2%, though this depends from time to time. Ascertaining whether or not to on the number of properties scheduled for rent sell a particular property is not just a strategic increases in any given year. The foundation for decision, it can also represent a potential source reliable rent growth, however, is a consistent, of capital for Realty Income. Property sales occur 14 REALTY INCOME 2007 Annual Report when we believe that the sale proceeds can be reinvested at higher returns, or when the sale of the property will enhance portfolio credit quality, or when selling the property will likely increase the average remaining lease term in the portfolio. I I I . W E R E W E S U C C E S S F U L I N D E L I V E R I N G O N O U R S T R AT E GY ? So how well did our strategy, planning and processes work for us this past year? pressure on the lease yield that can be realized. Another Very Good Acquisitions Year In Investment Committee we walk a fine line During 2007, we enjoyed continued success in between pricing and credit quality to acquire uncovering and acquiring the types of properties properties that we believe will be able to provide that are our strategic focus. For the year ended attractive long-term lease revenue. This past year December 31, 2007, Realty Income and its subsidiary proved to be somewhat more challenging with company, Crest Net Lease, Inc. (Crest) invested respect to what we were able to approve based $533.7 million in 357 new properties and properties on credit. The volume of acquisition opportunities under development. Realty Income invested remained strong, but a great many of the $503.8 million in 325 new properties with an initial transactions we reviewed were a bit challenging weighted average lease yield of 8.6%. The 325 from a credit perspective. To summarize how this new properties, acquired by Realty Income, are played out during 2007, the Investment Committee located in 38 states and are 100% leased under reviewed nearly $4 billion of potential transactions net-lease agreements with an initial average lease in order to acquire $533.7 million in new properties, length of 19.2 years. They are leased to 16 different or about 13% of what we reviewed. This completed retail chains in 9 separate industries. Crest invested transaction ratio is generally consistent with the $29.9 million in 32 properties, all of which are results of the past five years where we purchased being marketed for sale. 15%, 14%, 8%, 26% and 12% of what we reviewed. We achieved strong 2007 acquisitions in the While it appears that we spent a great deal of face of an increasingly competitive operating time and effort to uncover the properties we environment. We would note, however, that we could acquired, we believe that the income needs of our have done nearly twice or more of the volume in shareholders are best served by maintaining strict acquisitions if we had relaxed our tenant or industry due diligence and credit underwriting standards. concentration standards and given just a little on We believe shareholders look to us to compete our underwriting standards. But since we are The based on our ability to uncover new markets and Monthly Dividend Company®, we are always mindful industries in which to do transactions, and based of the fact that we are investing dollars that provide on our track record of getting deals done, rather thousands of retired people (and people nearing than solely on pricing. That’s why we spend a retirement) with much needed income. great deal of time investigating new ways to On the other hand, there is a great deal of approach our business. The growth in the number competition for every transaction, which puts of our retail industries from 5 to 30 and in the 2007 Annual Report REALTY INCOME 15 number of our retail chains from 15 to 115 since Fitch Ratings, BBB+ stable outlook, Moody’s 1994 demonstrates our ability to creatively pursue Investors Services, Baa1 stable outlook, and new opportunities and compete in this way. But it’s Standard & Poor’s Ratings Group, BBB positive important to emphasize that our approach to new outlook. Maintaining solid credit ratings is ideas is to start small and then see if there is important as they determine the rate of interest we opportunity for growth. Some of the areas we’ve pay for our preferred stock and notes offerings. investigated don’t work out so we try not to invest a large amount of capital into business areas that Crest Performance have not proven themselves. It is a process of first Crest is Realty Income’s wholly-owned subsidiary crawl, then walk, then run rather than jumping in that was formed in 2000 for the purpose of with both feet. Nevertheless we aim to remain acquiring properties for resale. The properties agile, vigilant and well capitalized in order to are primarily sold in the 1031 tax-deferred pursue new opportunities as they arise. exchange market. Crest has been an important Access to Capital strategic addition for us as it assists us in competing for large portfolio transactions so that In terms of financing 2007 acquisitions, capital we can manage tenant level concentrations in raised at the end of 2006 funded acquisitions Realty Income’s core portfolio by selling off the made early in the year. Then, in September 2007, properties Crest acquires. During 2007, Crest we issued $550 million of 6.75%, senior unsecured acquired 32 properties for $29.9 million. These notes, due in 2019, in an offering that was properties are being marketed for sale in underwritten by: Joint–book running managers, accordance with Crest’s operating strategy. Banc of America Securities LLC and Citigroup During 2007, Crest sold 62 properties for a gain Global Markets Inc., as well as Co-managers, BMO on sales of $12.3 million. Crest’s inventory, at Capital Markets Corp., BNY Capital Markets, Inc., December 31, 2007, was $56.2 million, which Morgan Keegan & Company, Inc., Piper Jaffray & Co. consists of 30 properties that are held for sale. and Wells Fargo Securities LLC. While Crest helps Realty Income complete We were pleased to have been able to access large portfolio transactions and does contribute credit during a capital-constrained environment to Realty Income’s earnings, its earnings for the majority of American businesses. Demand contributions are relatively small and we don’t for the 2019 notes was extremely strong and we rely on this more volatile income stream to pay doubled the size of the offering so that our capital monthly dividends. requirements for 2008 would largely be met in what we believed would be a very difficult financing Portfolio Performance market in 2008. As of December 31, 2007, we had Realty Income’s real estate portfolio is in excellent no borrowings on our $300 million acquisition shape. As of December 31, 2007, we owned 2,270 credit facility and $193 million in cash. Our retail properties located in 49 states leased to 115 $4.55 billion total capitalization consisted of, retail chains doing business in 30 separate retail $2.73 billion in common stock, $348 million in industries. Portfolio occupancy, as of the end of the preferred stock, and $1.47 billion in senior year, was 97.9% with just 48 properties available unsecured notes outstanding. Our corporate credit for lease or sale. The average remaining lease and senior unsecured debt ratings are as follows: term for properties in our portfolio was 13 years. 16 REALTY INCOME 2007 Annual Report Maintaining strong portfolio occupancy year after well as some indication of the challenges and year is largely the result of good initial underwriting opportunities that might impact the industry in the and then proactively managing lease expirations. In future. In addition, we meet with the management 2007 we successfully managed 139 lease expirations team of the individual retail chain, review audited and in 2008 we anticipate that our portfolio financial statements at the corporate level and management group will work with 144 leases that review a variety of internal operating metrics that come up for renewal. Our track record of effectively can give us insight into the retailer’s performance. managing the lease expirations in the portfolio Additionally, a review of available external research is year after year is demonstrated by the consistently completed to augment our internal research expertise. high portfolio occupancy we’ve experienced since A second important analysis is the unit the Company was founded 38 years ago. profitability, or the operating results, for each In terms of properties that were identified for individual store we are considering for purchase. sale in the core portfolio, during 2007, we sold 10 This is particularly important information when we properties for $7.0 million, all of which met the are considering the purchase of properties that are strategic requirements to qualify for sale. part of a large portfolio of properties. In general we Finally, same store rent increases for Realty seek to purchase only the most profitable stores Income’s portfolio were 1.4%, which is consistent of the retail chains, with whom we do business. with the 1% to 2% increase in rental income we Finally, we send out real estate research people hope to achieve every year. to visit every property that we are considering. Each individual property is analyzed along with the I V. C A R E F U L U N D E R W R I T I N G A N D trade area in which it operates. Typically we obtain R E C O R D F I N A N C I A L P E R F O R M A N C E Underwriting Analysis and Process data on property values and we review area demographics, as well as analyze traffic flow, Our ability to rely on a tenant’s property level cash economic data and prepare comparative purchase flow to meet their contractual lease obligations, price and rent studies for each location. for the 15 to 20-year lease term, is another reason Once we’ve obtained all of the data that comprise we’ve achieved historically high levels of occupancy. the three-part analysis, the information is compiled We know that finding good tenants and good prop- into a report for our Investment Committee to erties with profitable operations can potentially review. The Investment Committee consists of the neutralize portfolio performance issues in the future. chief executive officer, chief operating officer, In general, our underwriting process is a three- chief financial officer and general counsel. Most part analysis that examines the: Fridays (and many other days) are spent reviewing 1. Retail chain (tenant) and retail industry research on new opportunities, watching property 2. Unit profitability of the stores we are acquiring videos and research presentations, reviewing 3. Real estate location financial information on properties we are When we underwrite a particular retail chain considering for purchase, and discussing the merits and/or industry, we ascertain the competitive of each opportunity and each individual property. conditions of the industry, how the particular retail A key metric we use in analyzing every chain we are considering fits within the industry, transaction is an individual property’s “cash flow the historical financial performance of the industry, coverage” ratio. To arrive at this number we divide the outlook for future operating performance, as the cash flow from the operations of each retail 2007 Annual Report REALTY INCOME 17 location by the amount of rent that is to be paid (Cash flow or EBITDA 4 rent). Generally speaking, we’re looking for cash flow coverage of 1.75 to down debt, or otherwise work through their financial issues, provides us with an important competitive advantage. We have concentrated our 4 times the required rent. This coverage ratio efforts on less than investment grade tenants, for requirement, however, can vary according to the the past 38 years, because of attractive price and particular retail industry, individual retail chain, lease yield advantages. We believe a historical and the specific property being considered. So this occupancy rate in excess of 97.5% (in every year useful metric tells us what, exactly? since our founding in 1969) has generally indicated In the simplest terms, it helps us to determine the effectiveness of our ability to underwrite such how bad things have to get before the operations transactions and the soundness of our approach. of a particular retail location won’t be able to support the payment of rent. Since the majority of our recent acquisitions have been large portfolio Management Experience with Financially Challenged Tenants transactions, strong cash flow coverage for When we enter into any transaction, an important individual store locations is critical to the part of our analysis is how we would fare if the underlying stability of the overall lease revenue tenant runs into financial difficulty. Generally, we receive and is one of the most important tenants can run into a couple of different problems factors in determining whether we accept or reject that could cause them to file for bankruptcy. The first is an absolute failure of the operations of the business to generate positive cash flow. If a Portfolio Occupancy (as of the end of each year) a transaction. What Happens if a Tenant Gets into Financial Trouble? Despite all of the careful due diligence and time spent reviewing every aspect of a potential transaction, there have been times when certain retail chains in our portfolio have encountered financial difficulty. In fact, we have underwritten transactions where the retail chain was already under financial pressure and we have moved forward with these transactions because both the real estate and the store level operations were strong. Our ability to successfully do business with less than investment grade retail chains and acquire properties 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 business cannot generate cash flow it usually files for Chapter 7 bankruptcy and is liquidated. We believe this is pretty good public policy as a business that cannot generate positive cash flow should 97.9% 98.7% 98.5% 97.9% probably not exist. 98.1% 97.7% 98.2% 97.7% 98.4% 99.5% 99.2% 99.1% 99.3% 99.4% The second is where a business generates a lot of cash flow from its operations, but management has borrowed a great deal of money to capitalize the business. As a result, the company cannot make the required interest payments. In this case, the problem isn’t business operations or cash flow generation, but that the management borrowed too much money. In such a situation, the company would generally file from retail chains that are looking 1969-1993 >99.0% for Chapter 11 reorganization for alternative financing to pay rather than liquidation. This allows 18 REALTY INCOME 2007 Annual Report the company to reduce its borrowings and still Chapter 11. That is bad for all of them, but, continue to operate. We believe this is pretty good generally, not for us, as we are the property public policy too, by the way, as the business owners and not the shareholders. Next, the debt actually works pretty well, generates cash flow and, holders generally have all or part of their debt through the reorganization process, employees can converted to equity. They now become the new keep their jobs and consumers can continue to do owners or shareholders. These former debt holders, business with the company. generally, no longer receive interest payments but When we underwrite a business, our first series they do have the opportunity to recoup their of questions address whether or not we believe the investment as the new equity owners. Through this business could become a candidate for a Chapter 7 process, the company decreases the amount of filing in the future. If we believe the business will interest it has to pay, which was the problem to not generate consistent cash flow over the long begin with. Again, not great for the debt holders, term, and could potentially become a candidate as this was not what they signed up for, but not for Chapter 7 liquidation, we walk away from the necessarily bad for us because we are the property transaction because there is too much risk to us as owners, not the debt holders. a landlord. However, if we believe it is a good business What about our position as property owners? that will consistently generate positive cash flow In the reorganization, the retail chain can either in the future, we usually ASSUME that at some “reject” or “accept” our leases. If they reject a point the company could borrow too much money lease, the chain gets out of its obligation to pay us and perhaps become a candidate for a Chapter 11 rent. We get the keys back to our property and then reorganization. We then structure the transaction seek to re-lease the property to another chain. in a manner that would tend to minimize the risk Our risk in this situation is the difference between to our rent in the event of financial difficulties. the rent we received from the former tenant versus Since our listing on the New York Stock Exchange what we can get from a new tenant. in 1994, we’ve worked with about 15 tenants who If they accept the lease on our property our have faced such financial difficulty and filed for tenant must continue to pay us rent. We’ve had no Chapter 11 reorganization. One tenant filed for credit event and we continue to receive our rent Chapter 7 liquidation. At the same time, our from a chain that now, in general, has a lot less debt. portfolio occupancy never dropped below 97.5%. So how does the retail chain make the decision How can this be? We have already talked about whether to accept or reject a lease? Well, obviously how we underwrite transactions, focusing on the the one thing the retail chain HAS TO HAVE coming ability of each store to generate more cash flow out of the reorganization is the store where they for the retail chain, than the rent it pays, and generate their cash flow. No store, no customers, also focusing on the real estate itself. These are no sales and no cash flow, right? Obviously, they part of our underwriting processes for very cannot operate the stores without accepting our important reasons. Let’s start with the Chapter 11 lease and paying rent to us as the landlord. So, reorganization. Again, the business generates a lot during the Chapter 11, the retailer looks at each of of cash, but not enough to pay the interest on its its stores and asks a very simple question: does borrowings. So what usually happens is, the this store generate cash flow to the chain after shareholders or equity owners lose all or a majority paying the property owner the rent? If the store of their investment in the company during the does generate good cash flow after rent, the retail 2007 Annual Report REALTY INCOME 19 We believe this is why, in the past, we have fared pretty well when one of our tenants ran into problems. However, this method of underwriting is not foolproof (us being the fools here). So, in addition, by diversifying our portfolio by industry, tenant, and geographic location, we seek to minimize the overall impact to the portfolio from a financial problem with any single tenant. We have experienced tenant difficulties many times in our 38-year history, while continuing to generate chain will usually accept the lease and keep consistent performance, and we believe there will operating the store and paying rent since this is be many more such occurrences in the future. We how they generate their cash flow. If not, they also believe that by adhering to these underwriting will reject the lease and stop operating the store. standards and operating principals we should Either way, we are usually in much better shape continue to prosper in the future. than the other creditors, as we either keep getting our rent when the lease is accepted, or we have Record Financial Performance our asset back and can immediately seek to lease We enjoyed record financial performance in 2007. it to another retail chain if the lease is rejected. Revenue increased 23.8% to $296.5 million, as This brings us back to our discussion about how compared to $239.5 million during 2006. This we underwrite transactions: year’s revenue growth is primarily attributable to 1. We undergo substantial research on the the high level of property acquisitions achieved in retail chain’s industry and on its operations 2006 and 2007. and financials. The purpose of this is to assess FFO available to common shareholders also whether it will generate reliable cash flow over increased 21.8% to $189.7 million, as compared to the long term and, if it does run into trouble, $155.8 million in 2006. On a diluted per common it will likely be a Chapter 11 reorganization share basis, FFO increased 9.2% to $1.89 per rather than a Chapter 7 liquidation. share as compared to $1.73 per share in 2006. 2. We look carefully at the profitability of each This increase in FFO and FFO per share is the store after it pays our rent. We seek to own result of higher than average acquisition activity properties that are very profitable to the throughout the year. retailers so that, even after a downturn in Realty Income’s subsidiary company, Crest, also the business, we will own the stores they contributed to Realty Income’s earnings growth would want to accept in the event of a during 2007. Crest generated $10.7 million, or $0.11 Chapter 11 filing. per share, in FFO for Realty Income, in comparison 3. We focus carefully on how much we pay for to $1.4 million, or $0.02 per share, in FFO for a property, its market rents and alternative Realty Income in 2006. uses, so that, if a property were rejected FFO is a common financial operating measure- in a Chapter 11, we would seek to replicate ment for a REIT. It is an alternative, non-GAAP the majority of the rent the property had measure, that is considered to be a good previously been receiving. indicator of a company’s ability to pay dividends. (1) Total revenue includes amounts reclassified to income from discontinued operations, but excludes revenue from Crest. 20 REALTY INCOME 2007 Annual Report Our portfolio of properties is well diversified and provides us with reliable revenue that allows us to pay the consistent monthly dividends we all depend upon. A reconciliation of net income available to other asset classes. At the same time, we have common stockholders to FFO available to common seen historically low default rates on mortgages, stockholders, is included in Management’s bonds, consumer loans, and virtually all other Discussion and Analysis of Financial Condition types of credit. It has been our experience that all and Results of Operations on page 66. “good runs” eventually end, asset values get a bit Net income available to common stockholders, overdone and, at some point, things slow down. as of December 31, 2007, was $116.2 million as We wouldn’t be surprised if 2008 is a year that, at compared to $99.4 million in 2006. On a diluted best, we all move towards a more normal operating per common share basis, net income was $1.16 per environment, and, at worst, we face more share in 2007 as compared to $1.11 per share in challenging conditions throughout the economy. 2006. The calculation to determine net income for We believe we are prepared for such an a real estate company includes gains from property environment and should be able to make progress sales and impairments, which vary from year to in our operations in 2008. Our portfolio of year according to the timing of property sales. properties has long term leases, is well diversified, This variance can significantly impact net income. and provides us with the reliable revenue that Same store rent increases on 1,505 properties allows us to pay the consistent monthly dividends under lease for the entire year ended December 31, we all depend upon. Our balance sheet is extremely 2007, increased 1.4% to $204.2 million from strong and we have limited debt maturities over $201.3 million in 2006. To break down the same the next few years, which should allow us to store rent increases during 2007, we had 24 weather what could be a potentially challenging industries with increases in rents, 5 with flat same financing environment in 2008. At year end, we store rents and one with declining same store have substantial cash on hand and no balance on rents, so a pretty good result in 2007. our $300 million acquisition credit facility, which V. L O O K I N G A H E A D — O P P O R T U N I T I E S A N D C H A L L E N G E S I N 2 0 0 8 that could present themselves in such an environment. Indeed, we believe 2008 will be a We believe that many companies (us included) most interesting year and, once again, a profitable have had a fairly easy operating environment in year for the operations of your Company. should allow us to capitalize on the opportunities recent years. Interest rates have been historically low, which has allowed businesses, consumers and VI. WHAT YOU MIGHT EXPECT FROM US investors to finance their purchases of assets with As always, we will work hard to perform in a manner higher levels of debt. This has led to increased consistent with our mission. That is, we will strive values in the stock market, bond market, residential to, not only pay twelve monthly dividends, but to real estate, commercial real estate and almost all regularly increase the amount of the monthly 2007 Annual Report REALTY INCOME 21 dividend. To do that we will continue to work A F E W L A S T W O R D S prudently to increase the size of your real estate We’ve accomplished a great deal during 2007 and portfolio and strive to manage the properties that believe we’ve operated your Company in a manner you own so that they continue to perform well. We that is consistent with our mission to generate will also report our results to you so that they are increasing monthly dividends. We also have both easy to understand and are communicated attempted to build a company that will endure to you in a timely fashion. over time. There will always be challenges in We also think it’s important to bear in mind accomplishing our mission. The ebb and flow of that share prices go up and down because of a the economy, gyrations in the financial markets, great variety of factors over which we have little and the operations of our tenants can all weigh control. Investor sentiment towards the market on our results. However, we continue to believe in general is a factor, people’s perceptions of the that our proven business strategy, coupled with consumer also weigh on the market, and research a conservative balance sheet, will continue to analysts are typically paid to provide opinions provide a firm foundation for generating increasing about which companies are likely to provide the monthly income over time. highest return over various periods of time. All of As always, we’re grateful to the thousands of this can impact the movement of share prices, loyal shareholders, who, like us, have enjoyed however, not much of it has to do with the fact years of monthly dividend checks. We look forward that we’re looking to receive a dividend check in to reporting the progress of your Monthly Dividend the mail every month. So our responsibility is to Company® throughout 2008. see that we continually build our cash flow so we can keep paying the monthly dividend and increase it on a regular basis. Our general goal is to “dividend” the stock price into submission over the long term. By that we mean that if we increase our cash flow, increase the dividend and perform according to plan, over the long term our share price should tend to reflect that performance. As you know, in all of this there are absolutely no guarantees of success every year and all of us should be sure to diversify so that no one single security represents too much of our investment capital. You’ve seen, hopefully, how important Sincerely, diversification is to Realty Income’s lease revenue stream. It is equally important to an individual investor. We will continue to attempt to stay conservative in our approach and operate within Tom A. Lewis our level of competency. Hopefully, this means Chief Executive Officer that the mistakes we make (and we will make some) will be small and that we learn something in the process that helps us in the future. 22 REALTY INCOME 2007 Annual Report FINANCIAL PERFORMANCE AND OPERATING RESULTS 2007 Annual Report REALTY INCOME 23 R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S C O N S O L I D AT E D B A L A N C E S H E E T S (dollars in thousands, except per share data) As of December 31, 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 2007 2006 $ 1,110,897 2,127,897 3,238,794 (470,695) 2,768,099 56,156 2,824,255 193,101 7,142 17,206 35,648 $ 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 $ 3,077,352 $ 2,546,508 $ 15,844 38,112 15,304 — 1,470,000 1,539,260 $ 15,096 27,004 8,416 — 920,000 970,516 Stockholders’ equity: Preferred stock and paid in capital, par value $1.00 per share, 20,000,000 shares authorized, 13,900,000 shares issued and outstanding in 2007 and 2006 337,790 337,781 Common stock and paid in capital, par value $1.00 per share, 200,000,000 shares authorized, 101,082,717 and 100,746,226 shares issued and outstanding in 2007 and 2006, respectively Distributions in excess of net income Total stockholders’ equity Total liabilities and stockholders’ equity 1,545,037 (344,735) 1,538,092 $ 3,077,352 1,540,365 (302,154) 1,575,992 $ 2,546,508 The accompanying notes to consolidated financial statements are an integral part of these statements. 24 REALTY INCOME 2007 Annual Report R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S C O N S O L I D AT E D S TAT E M E N T S O F I N C O M E (dollars in thousands, except per share data) Years Ended December 31, 2007 2006 2005 Revenue Rental Other Expenses Depreciation and amortization Interest General and administrative Property Income taxes 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 Net income available to common stockholders Amounts available to common stockholders per common share: Income from continuing operations: $ 290,159 6,354 296,513 77,192 64,331 22,694 3,521 1,392 — 169,130 127,383 10,703 2,323 13,026 140,409 (24,253) $ 116,156 Basic Diluted Net income, basic and diluted Weighted average common shares outstanding: Basic Diluted $ $ $ 1.03 1.03 1.16 100,195,031 100,333,966 The accompanying notes to consolidated financial statements are an integral part of these statements. $ 237,487 2,042 239,529 59,288 51,363 17,539 3,319 747 1,555 133,811 105,718 1,402 3,661 5,063 110,781 (11,362) $ 99,419 $ $ $ 1.05 1.05 1.11 89,766,714 89,917,554 $ 195,099 354 195,453 46,002 40,949 15,421 3,865 813 — 107,050 88,403 2,781 7,935 10,716 99,119 (9,403) $ 89,716 $ $ $ 0.99 0.98 1.12 79,950,255 80,208,593 2007 Annual Report REALTY INCOME 25 R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S C O N S O L I D AT E D S TAT E M E N T S O F S T O C K H O L D E R S ’ E Q U I T Y (dollars in thousands) For the Years 2005, 2006 and 2007 Shares of Preferred stock Shares of Common stock Preferred stock and paid in capital Common stock and paid in capital Distributions in excess of net income Total 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) 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 8,800,000 — 213,977 Share-based compensation — 234,579 — — — 402,745 — 3,320 989,214 110,781 110,781 (144,045) (144,045) — — — 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 Net income Distributions paid and payable Preferred stock issuance cost Share-based compensation — — — — — — — 336,491 — — 9 — — — — 4,672 140,409 140,409 (182,990) (182,990) — — 9 4,672 Balance, December 31, 2007 13,900,000 101,082,717 $ 337,790 $ 1,545,037 $ (344,735) $ 1,538,092 The accompanying notes to consolidated financial statements are an integral part of these statements. 26 REALTY INCOME 2007 Annual Report R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S C O N S O L I D AT E D S TAT E M E N T S O F C A S H F L O W S (dollars in thousands) 2007 2006 2005 $ 140,409 $ 110,781 $ 99,119 Years Ended December 31, 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 sales of land and improvements Gain on reinstatement of property carrying value Amortization of share-based compensation Provisions for impairment on real estate held for investment Cash provided by (used in) 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 notes 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 improvements to investment properties Restricted escrow funds acquired in connection with acquisitions of 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 Cash distributions to common stockholders Cash dividends to preferred stockholders Proceeds from other stock issuances Net cash provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year 77,192 (10,703) (2,323) (1,835) — 3,857 138 (1,610) 863 (29,886) — 119,790 651 (49) 21,675 318,169 4,370 7,014 (506,360) (2,648) (997) (498,621) 407,800 (407,800) — 544,397 — 9 (157,659) (24,583) 816 362,980 182,528 10,573 59,288 46,002 (1,402) (3,661) — (716) 2,951 — 371 961 (113,166) — 22,405 1,333 4,418 3,382 86,945 2 9,804 (654,149) (2,781) (7,935) (18) — 2,167 151 (510) 2,059 (54,110) (1,780) 22,195 — (3,292) 8,290 109,557 109 22,191 (417,347) — — (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 (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 Cash and cash equivalents, end of year $ 193,101 $ 10,573 For supplemental disclosures, see note 13. The accompanying notes to consolidated financial statements are an integral part of these statements. 2007 Annual Report REALTY INCOME 27 R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S N O T E S T O C O N S O L I D AT E D F I N A N C I A L S TAT E M E N T S December 31, 2007, 2006 and 2005 1 . O R G A N I Z AT I O N A N D O P E R AT I O N The following reconciles our net income available to common Realty Income Corporation (“Realty Income,” the “Company,” stockholders to taxable income for 2007 (dollars in thousands) “we” or “our”) is organized as a Maryland corporation. We invest (unaudited): in commercial retail real estate and have elected to be taxed as a real estate investment trust (“REIT”). Net income available to common stockholders $ 116,156 At December 31, 2007, we owned 2,270 properties, located Tax loss on the sale of real estate in 49 states, containing over 18.5 million leasable square feet, along with 30 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 who are less than book gains Elimination of net revenue and expenses from Crest Dividends received from Crest involved in tax-deferred exchanges under Section 1031 of the Preferred dividends not deductible for tax Internal Revenue Code of 1986, as amended (the “Tax Code”). Depreciation and amortization timing differences Information with respect to number of properties, square feet, average initial lease term and weighted average contractual lease Adjustment for straight-line rent Adjustment for an increase in prepaid rent (3,839) (6,677) 3,300 24,583 22,668 (1,217) 5,608 (164) rate is unaudited. 2 . S U M M A R Y O F S I G N I F I C A N T A C C O U N T I N G P O L I C I E S A N D P R O C E D U R E S Federal Income Taxes We have elected to be taxed as a REIT under the Tax Code. We believe we have qualified and continue to qualify as a REIT. Under the REIT operating structure, we are permitted to deduct distributions paid to our stockholders and generally will not be required to pay federal corporate income taxes on such income. Accordingly, no provision has been made for federal income taxes in the accompanying consolidated financial statements, except for federal income taxes of Crest, which totaled $2.5 million in 2007, $396,000 in 2006 and $760,000 in 2005 and are included in discontinued operations. Earnings and profits that determine the taxability of distributions to stockholders differ from net income reported for financial reporting purposes due to differences in the estimated useful lives and methods used to compute depreciation and the carrying value (basis) on the investments in properties for tax purposes, among other things. 28 REALTY INCOME 2007 Annual Report Other adjustments Estimated taxable net income, before our dividends paid deduction $ 160,418 In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109. Interpretation No. 48 applies to all tax positions accounted for under Statement No. 109 and clarifies the accounting for uncer- tainty in income taxes by defining criteria that a tax position on an individual matter must meet before that position is recognized in the financial statements. The adoption of Interpretation No. 48 in January 2007 did not impact our financial position or results of operations and we do not have any material unrecog- nized tax benefits or liabilities. Absent an election to the contrary, if a REIT acquires property that is or has been owned by a C corporation in a transaction in which the tax basis of the property in the hands of the REIT is determined by reference to the tax basis of the property in the hands of the C corporation, and the REIT recognizes a gain on the disposition of such property during the 10 year period begin- ning on the date on which it acquired the property, then the REIT will be required to pay tax at the highest regular corporate tax rate on this gain to the extent of the excess of the fair market value of the property over the REIT’s adjusted basis in the prop- erty, in each case determined as of the date the REIT acquired the property. In August 2007, we acquired 100% of the stock of a C corporation that owned real property. At the time of acqui- sition, the C corporation became a Qualified REIT Subsidiary, was deemed to be liquidated for Federal income tax purposes, and the real property was deemed to be transferred to us with a carryover tax basis. As of December 31, 2007, we have built-in gains of $59 million with respect to such property. We do not Discontinued Operations In accordance with FASB Statement expect that we will be required to pay income tax on the built-in No. 144, Accounting for the Impairment or Disposal of Long-Lived gains on these properties during the ten-year period ending Assets (“SFAS 144”), Realty Income’s operations from invest- August 28, 2017. It is our intent, and we have the ability, to ment properties sold in 2007, 2006 and 2005 are reported as defer any dispositions of these properties to periods when the discontinued operations. Their respective results of operations related gains would not be subject to the built-in gain income tax have been reclassified to “income from discontinued operations, or otherwise to defer the recognition of the built-in gain related real estate held for investment” on our consolidated statements to these properties. However, our plans could change and it may of income. We do not depreciate properties that are classified as be necessary to dispose of one or more of these properties in a held for sale. No investment properties were classified as held for taxable transaction before August 28, 2017, in which case we sale at December 31, 2007. would be required to pay corporate level tax with respect to the Crest acquires properties with the intention of reselling them built-in gains on these properties as described above. rather than holding them for investment and operating the prop- erties. Consequently, we classify properties acquired by Crest as Net Income Per Common Share Basic net income per common held for sale at the date of acquisition and do not depreciate share is computed by dividing net income available to common them. In accordance with SFAS 144, the operations of Crest’s stockholders by the weighted average number of common shares properties are classified as “income from discontinued operations, outstanding during each period. Diluted net income per common real estate acquired for resale by Crest” on our consolidated share is computed by dividing net income available to common stockholders for the period by the weighted average number of statements of income. No debt was assumed by buyers of our investment properties common shares that would have been outstanding assuming the or repaid as a result of our investment property sales and we do issuance of common shares for all potentially dilutive common not allocate interest expense to discontinued operations related shares outstanding during the reporting period. to real estate held for investment. We allocate interest expense The following is a reconciliation of the denominator of the related to borrowings specifically attributable to Crest’s basic net income per common share computation to the denom- properties. The interest expense amounts allocated to the inator of the diluted net income per common share computation: Crest properties are included in “income from discontinued 2007 2006 2005 idated statements of income. operations, real estate acquired for resale by Crest” on our consol- Weighted average shares used for the basic net income per share The following is a summary of Crest’s “income from discontinued operations, real estate acquired for resale” on our consolidated statements of income (dollars in thousands): computation 100,195,031 89,766,714 79,950,255 Incremental shares from share-based compensation 138,935 150,840 258,338 Adjusted weighted average shares used for diluted net income per share computation 100,333,966 89,917,554 80,208,593 Nonvested shares from share-based compensation that were anti-dilutive 243,631 235,035 305,476 Provisions for impairment Income taxes No stock options were anti-dilutive in 2007, 2006 or 2005. Income from discontinued Crest’s income from discontinued operations, real estate acquired for resale Gain on sales of real estate acquired 2007 2006 2005 for resale $ 12,319 $ 2,219 $ 3,291 Rental revenue Other revenue Interest expense General and 8,165 190 5,065 2,083 15 2 (6,201) (3,708) (1,139) administrative expense (691) Property expenses (40) — (3,039) (440) (67) (1,188) (494) (453) (60) — (943) operations, real estate acquired for resale by Crest $ 10,703 $ 1,402 $ 2,781 2007 Annual Report REALTY INCOME 29 The following is a summary of Realty Income’s “income from Other revenue includes non operating interest earned from discontinued operations, from real estate held for investment” on investments in money market funds and other notes of $3.6 million our consolidated statements of income (dollars in thousands): in 2007, $1.2 million in 2006 and $171,000 in 2005. Realty Income’s income from discontinued operations, real estate held for investment Gain on sales of 2007 2006 2005 investment properties $ 1,724 $ 3,036 $ 6,573 Rental revenue Other revenue 881 2 Depreciation and amortization (130) Property expenses Provisions for impairment Income from discontinued operations, real estate (20) (134) 1,063 2,296 34 (320) (136) (16) 2 (662) (239) (35) held for investment $ 2,323 $ 3,661 $ 7,935 Principles of Consolidation The accompanying consolidated financial statements include the accounts of Realty Income, Crest and other entities for which we make operating and financial decisions (control), after elimination of all material intercompany balances and transactions. All of Realty Income’s and Crest’s subsidiaries are wholly-owned. We have no unconsolidated or off- balance sheet investments in variable interest entities. 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. Our cash equivalents are primarily investments in United States Treasury or government money market funds. The following is a summary of our total income from discon- tinued operations (dollars in thousands, except per share data): Gain on Sales of Properties We recognize gains on sales of properties in accordance with FASB Statement No. 66, Accounting for Sales 2007 2006 2005 of Real Estate. Real estate acquired for resale by Crest $ 10,703 $ 1,402 $ 2,781 Real estate held for investment 2,323 3,661 7,935 Income from discontinued operations $ 13,026 $ 5,063 $ 10,716 Per common share, Depreciation and Amortization Land, buildings and improvements are recorded and stated at cost. Major replacements and better- ments, which improve or extend the life of the asset, are capitalized and depreciated over their estimated useful lives, while ordinary repairs and maintenance are expensed as incurred. Buildings and improvements that are under redevelopment, or are being developed, are carried at cost and no depreciation is recorded on these basic and diluted $ 0.13 $ 0.06 $ 0.13 assets. Additionally, amounts essential to the development of the The per share amounts for “income from discontinued operations” above and the “income from continuing operations” and “net income” reported on the consolidated statements of income have each been calculated independently. property, such as pre-construction, development, construction, interest and any other costs incurred during the period of development are capitalized. We cease capitalization when the property is available for occupancy upon substantial completion of tenant improvements, but in any event no later than one year from the completion of major construction activity. Revenue Recognition and Accounts Receivable All leases are accounted for as operating leases. Under this method, lease Properties are depreciated using the straight-line method over the estimated useful lives of the assets. The estimated useful payments that have fixed and determinable rent increases are lives are as follows: 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 recog- nized only after the changes in the indexes have occurred and are then applied according to the lease agreements. We recognize an allowance for doubtful accounts relating to accounts receivable for amounts deemed uncollectible. We con- Buildings 25 years Building improvements 4 to 15 years Tenant improvements and The shorter of the term of the lease commissions related lease or useful life Acquired in-place Remaining terms of the operating leases respective leases sider tenant specific issues such as financial stability and ability Provisions for Impairment We review long-lived assets for impairment to pay rent when determining collectibility of accounts receivable whenever events or changes in circumstances indicate that the and appropriate allowances to record. The allowance for doubtful carrying amount of an asset may not be recoverable. Generally, a accounts was $795,000 at December 31, 2007 and $705,000 provision is made for impairment if estimated future operating at December 31, 2006. 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 30 REALTY INCOME 2007 Annual Report by which the current book value of the asset exceeds the fair Capitalized above-market lease values are amortized as a value of the asset. If a property is held for sale, it is carried at the reduction of rental income over the remaining terms of the lower of cost or estimated fair value, less estimated cost to sell. respective leases. Capitalized below-market lease values are In 2007, we recorded a provision for impairment of $134,000 amortized as an increase to rental income over the remaining on one retail investment property in the motor vehicle industry. terms of the respective leases and expected below-market renewal This provision for impairment is included in “income from dis- option periods. continued operations, real estate held for investment” on our The aggregate value of other acquired intangible assets con- consolidated statement of income (“Discontinued Operations”). sists of the value of in-place leases and tenant relationships. In 2007, we also recorded a provision for impairment of $138,000 These are measured by the excess of the purchase price paid for on one retail investment property in the consumer electronics a property, after adjusting for above or below-market lease value, industry. This provision for impairment is included in property less the estimated fair value of the property “as if vacant,” deter- expense on our consolidated statements of income. mined as set forth above. The value of in-place leases, exclusive In 2006, we recorded a provision for impairment of $16,000 of the value of above-market and below-market in-place leases, on one retail investment property in the restaurant industry. In is amortized to expense over the remaining periods of the respec- 2005, we recorded provisions for impairment of $186,000 on tive leases. If a lease were to be terminated prior to its stated four retail properties, of which two have been sold. These prop- expiration, all unamortized amounts relating to that lease would erties were classified in the following industries: one in child be recorded to revenue or expense as appropriate. care and three in restaurant. The provisions for impairment recorded on investment proper- Share-Based Compensation Effective January 1, 2006, we adopted ties in 2006 and 2005 are included in Discontinued Operations, FASB Statement No. 123R, Share-Based Payments. Statement except for $151,000 in 2005 which is included in property No. 123R requires companies to recognize in the income state- expense on our consolidated statements of income. ment the grant-date fair value of stock options and other equity- In 2006, Crest recorded provisions for impairment of based compensation issued to employees. Effective January 1, $1.2 million on three retail properties, which were held for resale 2002, we adopted the fair value recognition provisions of FASB at December 31, 2006. One of the three properties was sold in Statement No. 123, Accounting for Stock-Based Compensation, 2007. No provision for impairment was recorded by Crest in 2007 and starting January 1, 2002 expensed costs for all stock option or 2005. Provisions for impairment recorded by Crest are included awards granted, modified, or settled. in “income from discontinued operations, real estate acquired for resale by Crest” on our consolidated statements of income. Goodwill Goodwill is tested for impairment during the second quarter of each year as well as when events or circumstances Acquired In-place Leases In accordance with FASB Statement occur indicating that our goodwill might be impaired. We did not No. 141, Business Combinations (“SFAS 141”), the fair value of record any new goodwill or impairment on our existing goodwill the real estate acquired with in-place operating leases is allocated during 2007, 2006 or 2005. to the acquired tangible assets, consisting of land, building and improvements, and identified intangible assets and liabilities, Other Assets Other assets consist of the following (in thousands): consisting of the value of above-market and below-market leases, the value of in-place leases and tenant relationships, based in December 31, 2007 2006 each case on their fair values. Deferred bond financing costs, net $ 14,940 $ 10,868 The fair value of the tangible assets of an acquired property Value of in-place and (which includes land and buildings/improvements) is determined above-market leases, net by valuing the property as if it were vacant, and the “as-if-vacant” Prepaid expenses value is then allocated to land and buildings/improvements Corporate assets, net of accumulated based on our determination of the relative fair value of these depreciation and amortization assets. Our determinations are based on a real estate appraisal Settlements on treasury lock agreements for each property, generated by an independent appraisal firm, Unamortized credit line fees, net and consider estimates of carrying costs during the expected Other items 11,211 10,430 3,803 3,271 1,356 759 434 3,145 463 1,629 954 80 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 corre- sponding in-place lease, measured over a period equal to the remaining term of the lease. $ 35,648 $ 27,695 2007 Annual Report REALTY INCOME 31 Accounts Payable and Accrued Expenses Accounts payable and recognize all the assets acquired and liabilities assumed in a accrued expenses consist of the following (in thousands): transaction at the acquisition-date fair value with limited excep- December 31, 2007 2006 and disclosures for certain specific items in a business combina- Bond interest payable $ 24,987 $ 12,888 tion. Statement No. 141R becomes effective for us at the begin- Other items 13,125 14,116 ning of 2009. We are still evaluating the impact of Statement tions. Statement No. 141R will change the accounting treatment $ 38,112 $ 27,004 No. 141R on our financial position or results of operations. In December 2007, the FASB issued Statement No. 160, Noncontrolling Interest in Consolidated Financial Statements. Statement No. 160 clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that Other Liabilities. Other liabilities consist of the following (in thousands): December 31, 2007 2006 should be reported as equity in the consolidated financial state- Rent received in advance $ 10,626 $ 4,878 Security deposits 2,818 2,291 Value of in-place below-market leases, net 1,860 1,247 $ 15,304 $ 8,416 Sales Taxes We collect and remit sales taxes assessed by different governmental authorities that are both imposed on and concurrent with a revenue-producing transaction between us and our tenants. We report the collection of these taxes on a net basis (excluded from revenues). The amounts of these taxes are not significant to our financial position or results of operations. Use of Estimates The consolidated financial statements were prepared in conformity with U.S. generally accepted accounting principles, which requires management to make estimates and assumptions that affect the reported amounts of assets and lia- bilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Impact of Recent Accounting Pronouncements In September 2006, the FASB issued Statement No. 157, Fair Value Measurements. Statement No. 157 sets out a framework for measuring fair value, and requires additional disclosures about fair-value measurements. Statement No. 157 becomes effective for us at the beginning of 2008. The impact of adopting Statement No. 157 is not expected to have a material effect on our financial position or results of operations. In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities— including an Amendment of FASB Statement No. 115. Statement No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. We have elected not to use the fair value measurement provisions of Statement No. 159. In December 2007, the FASB issued Statement No. 141R (revised 2007), Business Combinations. Statement No. 141R will change the accounting for business combinations. Under Statement No. 141R, an acquiring entity will be required to 32 REALTY INCOME 2007 Annual Report ments. This statement also requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest and requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest. In addition, this statement establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that does not result in deconsol- idation and requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Statement No. 160 is effective for us at the beginning of 2009. This statement will be applied prospectively, except for the presentation and disclosure requirements, which will be applied retrospectively for all periods presented. We currently do not have any minority or noncontrolling interest in a subsidiary, and we do not expect Statement No. 160 to have an impact on our consolidated finan- cial statements; however, transactions between now and the adoption date of Statement No. 160 could have an impact on our consolidated financial statements. Reclassifications Certain of the 2006 and 2005 balances have been reclassified to conform to the 2007 presentation. 3 . R E TA I L P R O P E R T I E S A C Q U I R E D We acquire land, buildings and improvements that are used by retail operators. A. During 2007, Realty Income and Crest invested $533.7 million, in aggregate, in 357 new retail properties and properties under development. These 357 properties are located in 38 states, will contain over 1.9 million leasable square feet, and are 100% leased with an average lease term of 19.3 years. In comparison, during 2006, Realty Income and Crest invested $769.9 million, in aggregate, in 378 new retail properties and properties under development. These 378 retail properties are located in 30 states, contain over 3.8 million leasable square feet, and are 100% leased with an average lease term of 17.1 years. B. Of the $533.7 million invested during 2007, Realty Income invested $503.8 million in 325 new retail properties and properties under development with an initial weighted average contractual lease rate of 8.6%. These 325 properties are located in 38 states, will contain over 1.8 million leasable square feet, due to an increase in LIBOR since the beginning of 2005. The and are 100% leased with an average lease term of 19.2 years. effective borrowing rate at December 31, 2007 was 5.2% and at The initial weighted average contractual lease rate is computed December 31, 2006 was 6.0%. Our current credit facility is by dividing the estimated aggregate base rent for the first year of subject to various leverage and interest coverage ratio limita- each lease by the estimated total cost of the properties. tions. We are and have been in compliance with these covenants. In comparison, during 2006, Realty Income invested Our credit facility is unsecured and accordingly, we have not $656.7 million in 322 new retail properties and properties under pledged any assets as collateral for this obligation. We regularly development, with an initial weighted average contractual lease review our credit facility and may seek to extend, renew or rate of 8.6%. These 322 properties are located in 30 states, con- replace our credit facility, to the extent we deem appropriate. tain over 3.3 million leasable square feet and are 100% leased with an average lease term of 16.7 years. 5 . N O T E S PAYA B L E C. During 2007, Crest invested $29.9 million in 32 new December 31, 2007, sorted by maturity date (dollars in millions): retail properties. In comparison, during 2006, Crest invested $113.2 million in 56 retail properties. 8.25% notes, issued in October 1998 Our senior unsecured note obligations consist of the following as of and due in November 2008 $ 100.0 D. Crest’s property inventory at December 31, 2007 consisted of 8% notes, issued in January 1999 30 properties with a total investment of $56.2 million and at December 31, 2006 consisted of 60 properties with a total and due in January 2009 5.375% notes, issued in March 2003 investment of $137.5 million. These amounts are included on our and due in March 2013 consolidated balance sheets in “real estate held for sale, net.” 5.5% notes, issued in November 2003 and due in November 2015 E. Of the $533.7 million invested in 2007, $14.7 million was 5.95% notes, issued in September 2006 used to acquire five properties with existing leases already in- and due in September 2016 place with retail tenants. In accordance with SFAS 141, Realty 5.375% notes, issued in September 2005 Income recorded $1.8 million as the intangible value of the and due in September 2017 in-place leases and $784,000 as the intangible value of below- 6.75% notes, issued in September 2007 market rents. These amounts are recorded to “other assets” and and due in August 2019 “other liabilities,” respectively, on our consolidated balance 5.875% bonds, issued in March 2005 sheet at December 31, 2007 and are amortized over the life of and due in March 2035 20.0 100.0 150.0 275.0 175.0 550.0 100.0 $ 1,470.0 the respective leases. 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 intangible value of the in-place lease and $628,000 as the intangible value of below- market rents. These amounts were recorded to “other assets” and “other liabilities”, respectively, on our consolidated balance sheet and are amortized over the life of the respective lease. 4 . C R E D I T FA C I L I T Y We have a $300 million acquisition credit facility that expires in October 2008, unless extended as provided for in the credit facility agreement. We have the right to extend the credit facility for an additional term of one year (to October 2009). Since May 2007, our investment grade credit ratings provided for financing under the credit facility at LIBOR (London Interbank Offered Rate) plus 60 basis points with a facility commitment fee of 15 basis points, for all-in drawn pricing of 75 basis points over LIBOR. The average borrowing rate on our credit facilities during 2007 was 6.0%, compared to 5.7% in 2006 and 4.3% in 2005 on our previous $250 million credit facility, which expired in October 2005. The increase in the average borrowing rate is Interest incurred on all of the notes for 2007 was $67.1 million, for 2006 was $49.6 million and for 2005 was $39.5 million. In addition, when our 7.75% senior unsecured notes due 2007 were redeemed in September 2006, we paid a $1.6 million make-whole payment, which is classified as “loss on extinguish- ment of debt” on our consolidated statements of income. The interest rate on each of these notes is fixed. Our outstanding notes are unsecured and accordingly, we have not pledged any assets as collateral for these or any other obligations. Interest on all of the senior note obligations is paid semiannually, with the exception of the interest on the 8.25% senior notes issued in October 1998 which is paid monthly. All of these notes contain various covenants, including: (i) a limitation on incurrence of any debt which would cause our debt to total adjusted assets ratio to exceed 60%; (ii) a limitation on incurrence of any secured debt which would cause our secured debt to total adjusted assets ratio to exceed 40%; (iii) a limitation on incurrence of any debt which would cause our debt service coverage ratio to be less than 1.5 times; and (iv) the maintenance at all times of total unencumbered assets not less than 150% of our outstanding unsecured debt. We have been in compliance with these covenants since each of the notes were issued. 2007 Annual Report REALTY INCOME 33 In September 2007, we issued $550 million in aggregate The following table summarizes the maturity of our notes principal amount of 6.75% senior unsecured notes due 2019 payable as of December 31, 2007 (dollars in millions): (the “2019 Notes”). The price to the investor for the 2019 Notes was 99.827% of the principal amount for an effective yield of Year of Maturity(1) 6.772%. The net proceeds of approximately $544.4 million from this offering were used to fund certain property acquisi- 2008 2009 tions, repay borrowings under our acquisition credit facility and After 2012 for general corporate purposes. The remaining net proceeds, Totals Notes $ 100.0 20.0 1,350.0 $ 1,470.0 which are included in “cash and cash equivalents” on our 2007 consolidated balance sheet, will be used for general corporate purposes, which include additional property acquisitions. 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 for general corporate purposes and to redeem the outstanding $110 million 7.75% unsecured notes due May 2007 (the “2007 Notes”), which were issued in May 1997. In September 2006, we redeemed all of our outstanding 2007 Notes 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. In September 2005, we issued $175 million in aggregate principal amount of 5.375% senior unsecured notes due 2017 (the “2017 Notes”). The price to the investor for the 2017 Notes was 99.974% of the principal amount for an effective yield of 5.378%. The net proceeds of approximately $173.2 million from this offering were used to repay borrowings under our unsecured acquisition credit facility, to fund new property acquisitions and for other general corporate purposes. In March 2005, we issued $100 million in aggregate princi- pal amount of 5.875% senior unsecured bonds due 2035 (the “2035 Bonds”). The price to the investor for the 2035 Bonds was 98.296% of the principal amount for an effective yield of 5.998%. The net proceeds of approximately $97 million from this offering were used to repay borrowings under our acquisition credit facility and for other general corporate purposes. In May 1998, we entered into a treasury interest rate lock agreement associated with the 8.25% senior notes issued in October 1998 (the “2008 Notes”). In settlement of the agree- 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 notes) as a yield adjustment to interest expense. After taking into effect the results of the treasury lock settlement, the effective rate to us on the 2008 Notes is 9.12%. (1) There are no maturities in 2010, 2011 and 2012. We anticipate paying off the notes due in 2008 and 2009 by one or more of the following; using cash on hand, utilizing our credit facility or issuing new securities. 6 . C O M M O N S T O C K O F F E R I N G S 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 new property acquisitions and for other general corporate purposes. 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 approximately $109 million from this offering were used to fund new property acquisitions, repay borrowings under our credit facility and for other general corporate purposes. C. In March 2006, we issued 5.2 million shares of common stock at a price of $24.39 per share. The net proceeds of approximately $120.5 million were used to fund new property acquisitions and for other general corporate purposes. D. In September 2005, we issued 4.1 million shares of common stock at a price of $23.79 per share. The net proceeds of $92.7 million were used to fund new property acquisitions and for other general corporate purposes. 7. P R E F E R R E D S T O C K A. In December 2006, we issued 8.8 million shares of 6.75% Monthly Income Class E cumulative redeemable preferred stock. The net proceeds of $214 million from this issuance were used to repay borrowings under our credit facility and for other general corporate purposes. Beginning December 7, 2011, the Class E preferred shares are redeemable, at our option, for $25 per share. During 2007, we paid twelve monthly dividends to holders of our Class E preferred stock totaling $1.725 per share, or $15.2 million, and at December 31, 2007 a monthly dividend of $0.140625 per share was payable and was paid in January 2008. In January 2007, we paid the first Class E preferred dividend of $0.178125, which covered a period of 38 days. 34 REALTY INCOME 2007 Annual Report B. In 2004, we issued 5.1 million shares of 7.375% Monthly December 31, 2006, a distribution of $0.1265 per common Income Class D cumulative redeemable preferred stock. The net share was payable and was paid in January 2007. proceeds of $123.8 million from this issuance were used to redeem a portion of the outstanding Class B and Class C preferred B. Preferred Stock stock, repay borrowings outstanding under our acquisition credit Dividends of $0.1536459 per share are paid monthly in arrears facility and for other general corporate purposes. Beginning May 27, on the Class D preferred stock. We declared dividends to holders 2009, the Class D preferred shares are redeemable, at our of our Class D preferred stock totaling $9.4 million in 2007, option, for $25 per share. During 2007, 2006 and 2005, we paid $9.8 million in 2006, and $9.4 million in 2005. The dividends twelve monthly dividends to holders of our Class D preferred stock paid per share to our Class D preferred stockholders for 2007, totaling $1.8437508, or $9.4 million, and at December 31, 2007 2006 and 2005 of $1.84375 were characterized for federal a monthly dividend of $0.1536459 was payable and was paid in income tax purposes as ordinary income. January 2008. 8 . D I S T R I B U T I O N S PA I D A N D PAYA B L E A. Common 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 $14.9 million in 2007 and $1.6 million in 2006. The first Class E dividend was We pay monthly cash distributions to our common stockholders. paid in January 2007. The dividends paid per share to our Class The following is a summary of monthly distributions paid per E preferred stockholders for 2007 of $1.725 were characterized common share for the years: for federal income tax purposes as ordinary income. Month January February March April May June July August September October November December Total 2007 2006 2005 9. O P E R AT I N G L E A S E S $ 0.126500 $ 0.116250 $ 0.110000 A. At December 31, 2007, we owned 2,270 properties in 0.126500 0.116250 0.110000 49 states, excluding 30 properties owned by Crest. Of these 0.126500 0.116250 0.110000 2,270 properties, 2,259, or 99.5%, are single-tenant, retail 0.127125 0.116875 0.110625 properties and the remaining 11 are multi-tenant, distribution 0.127125 0.116875 0.110625 and office properties. At December 31, 2007, 48 properties 0.127125 0.116875 0.110625 were vacant and available for lease or sale. 0.127750 0.117500 0.111250 Substantially all leases are net leases where the tenant 0.127750 0.117500 0.111250 pays property taxes and assessments, maintains the interior 0.135500 0.125250 0.115000 and exterior of the building and leased premises, and carries 0.136125 0.125875 0.115625 insurance coverage for public liability, property damage, fire and 0.136125 0.125875 0.115625 extended coverage. 0.136125 0.125875 0.115625 Rent based on a percentage of a tenants’ gross sales (percent- $ 1.560250 $ 1.437250 $ 1.346250 The following presents the federal income tax characteriza- tion of distributions paid or deemed to be paid per common share for the years (unaudited): Ordinary income $ 1.3847719 $ 1.2945466 $ 1.210091 2007 2006 2005 Nontaxable distributions 0.1754781 0.1427034 0.136159 Capital gain — — — Totals $ 1.5602500 $ 1.4372500 $ 1.346250 At December 31, 2007, a distribution of $0.13675 per common share was payable and was paid in January 2008. At age rents) for 2007 was $851,000, for 2006 was $1.1 million and for 2005 was $1.2 million, including amounts recorded to discontinued operations. At December 31, 2007, minimum future annual rents to be received on the operating leases for the next five years and there- after are as follows (dollars in thousands): 2008 2009 2010 2011 2012 Thereafter Total $ 307,983 295,745 286,809 279,163 269,310 2,668,430 $ 4,107,440 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, 2007, 2006 or 2005. 2007 Annual Report REALTY INCOME 35 1 0 . G A I N O N S A L E S O F R E A L E S TAT E A C Q U I R E D F O R R E S A L E B Y C R E S T 1 3 . S U P P L E M E N TA L D I S C L O S U R E S O F C A S H F L O W I N F O R M AT I O N In 2007, Crest sold 62 properties for $123.6 million, which Interest paid in 2007 was $56.7 million, in 2006 was $52.4 million resulted in a gain of $12.3 million. For two property sales during and in 2005 was $36.4 million. 2007, Crest provided the buyers partial financing for a total of Interest capitalized to properties under development in 2007 $3.8 million, of which $619,000 was paid in full in November was $993,000, in 2006 was $2.2 million and in 2005 was 2007. In 2006, Crest sold 13 properties for $22.4 million, which $1.9 million. resulted in a gain of $2.2 million. In 2005, Crest sold 12 prop- Income taxes paid by Realty Income and Crest in 2007 erties for $23.5 million, which resulted in a gain of $3.3 million. were $4.3 million, in 2006 were $775,000 and in 2005 were In 2005, Crest provided a buyer partial financing of $1.3 million $1.4 million. for one property, which was paid in full in February 2006. Crest’s The following non-cash investing and financing activities are gains on sales are reported before income taxes and are included included in the accompanying consolidated financial statements: in discontinued operations. 1 1 . G A I N O N S A L E S O F I N V E S T M E N T P R O P E R T I E S , I M P R OV E M E N T S A N D L A N D B Y R E A LT Y I N C O M E A. Share-based compensation expense for 2007 was $3.9 million, for 2006 was $3.0 million and for 2005 was $2.2 million. B. See “Provisions for Impairment” in note 2 for a discussion of In 2007, we sold ten investment properties for $7.0 million, impairments recorded by Realty Income and Crest. which resulted in a gain of $1.7 million. This gain is included in discontinued operations. In addition, we sold excess land and C. In 2007, Crest sold two properties for an aggregate of improvements from five properties for an aggregate of $4.4 million, $5.5 million and received notes totaling $3.8 million from the which resulted in a gain of $1.8 million. This gain from the land buyers, of which $619,000 was paid in full in November 2007. and improvements sales is reported in “other revenue” on our The remaining note is included in “other assets” on our consolidated statements of income because these improvements December 31, 2007 consolidated balance sheet. and excess land were associated with properties that continue to be owned as part of our core operations. D. In connection with the acquisition of seven properties during In 2006, we sold or exchanged 13 investment properties for 2007, we acquired restricted escrow funds totaling $2.6 million. $10.7 million, which resulted in a gain of $3.0 million that is During 2007, all of these funds were invested in improvements included in discontinued operations. to these properties. In 2005, we sold 23 investment properties and sold a portion of the land from two properties for $23.4 million, which resulted E. In accordance with FASB Statement No. 143, Accounting in a gain of $6.6 million. This gain is included in discontinued for Asset Retirement Obligations, we recorded an additional operations, except for $18,000 that is included in “other revenue” $239,000 of estimated legal obligations related to asset retire- on our consolidated statements of income. ment obligations on two land leases in 2007. In 2005, an asset 1 2 . FA I R VA L U E O F F I N A N C I A L I N S T R U M E N T S retirement obligation was originally established for $402,000 to account for the difference between our obligations to the land- lord under the two land leases and our subtenant’s obligations to We believe that the carrying values reflected in the consolidated us under the subleases. balance sheets at December 31, 2007 and 2006 reasonably approximate the fair values for cash and cash equivalents, F. In 2006, we exchanged one of our properties for a different accounts receivable, and all liabilities, due to their short-term property that was leased to the same tenant. As part of this trans- nature, except for notes payable. In making these assessments, action, accumulated depreciation was reduced by $67,000 and we used estimates. The estimated fair value of the notes payable a gain of $67,000 was recorded. The original cost of and the at December 31, 2007 is $1.413 billion and at December 31, value received for the property exchanged was $900,000. This 2006 is $921.9 million, based upon the closing market price transaction had no impact on land or building and improvements. per note or indicative price per each note at December 31, 2007 and 2006, respectively. 36 REALTY INCOME 2007 Annual Report G. In 2006, we received shares of a public company as settle- K. In 2004, we recorded an impairment of $716,000 on one ment of a bankruptcy claim associated with a former tenant. We property to reduce its carrying value to zero. This loss was the recorded a value of $207,000, which is in “other revenue” on result of a dispute with the original owner and tenant in their our consolidated income statement, based on the closing market bankruptcy proceeding. Our title insurance company failed to price of these shares on December 31, 2006 and included timely record the deed on this property upon our original acqui- them in “other assets” on our consolidated balance sheet at sition, which resulted in a claim by the bankruptcy trustee that December 31, 2006. The shares were sold in January 2007. Realty Income did not have legal title to the property. In the H. In 2005, Crest sold a property for $2.8 million and issued title to the property. At that time we reinstated the original a note of $1.3 million, which was paid in full in 2006 and is carrying value adjusted for depreciation on our balance sheet included in “other assets” on our December 31, 2005 consoli- and recorded other revenue of $716,000. We also reversed second quarter of 2006, this issue was resolved and we obtained dated balance sheet. accrued liabilities and property expenses of $133,000 associated with this property. As part of the settlement, these costs became I. Accrued costs on properties under development resulted in an the responsibility of the title insurance company. increase in buildings and improvements and accounts payable of $1.7 million in 2006. In 2005, non-cash additions to properties 1 4 . E M P L OY E E B E N E F I T P L A N resulted in an increase in buildings of $5.4 million and an We have a 401(k) plan covering substantially all of our employees. increase in accounts payable of $5.1 million. Under our 401(k) plan, employees may elect to make contribu- tions to the plan up to a maximum of 60% of their compensation, J. Distributions payable on our balance sheets is comprised of subject to limits under the IRS Code. We match 50% of our the following declared distributions (dollars in thousands): employee’s contributions, up to 3% of the employee’s compensa- 12/31/07 12/31/06 immaterial to our results of operations. tion. Our aggregate matching contributions each year have been Common stock distributions $ 13,823 $ 12,745 Preferred stock dividends 2,021 2,351 2007 Annual Report REALTY INCOME 37 1 5 . C O M M O N S T O C K I N C E N T I V E P L A N In 2003, our Board of Directors adopted, and stockholders approved, the 2003 Incentive Award Plan of Realty Income Corporation (the “Stock Plan”) to enable us to attract and retain the services of directors, employees and consultants, considered essential to our long-term success, by offering them an opportunity to own stock in Realty Income and/or rights that will reflect our growth, develop- ment and financial success. The Stock Plan was amended and restated by our Board of Directors in February 2006 and in May 2007. Under the terms of this plan, the aggregate number of shares of our common stock subject to options, stock purchase rights (SPR), stock 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 2007 were $3.9 million, during 2006 were $3.0 million and during 2005 were $2.2 million. No stock options were granted after January 1, 2002 and all outstanding options were fully vested as of December 31, 2006. 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 vested over service periods of one, three, four or five years. The following table summarizes our stock option activity for the years: 2007 2006 2005 Number of shares Weighted average exercise price Outstanding options, beginning of year 106,368 Options exercised Options forfeited (61,361) — $ 13.06 13.32 — Number of shares 135,348 (28,696) (284) Weighted average exercise price $ 13.02 12.86 14.7 Number of shares 176,130 (40,352) (430) Weighted average exercise price $ 13.01 12.93 14.70 Outstanding options, end of year 45,007 $ 12.71 106,368 $ 13.06 135,348 $ 13.02 Options exercisable, end of year 45,007 $ 12.71 106,368 $ 13.06 119,924 $ 12.87 At December 31, 2007, the options outstanding and exercisable had exercise prices ranging from $10.63 to $14.70, with a weighted average price of $12.71, and expiration dates ranging from May 2008 to December 2011 with a weighted average remaining term of 3.1 years. 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 exercise price of the option. The market value of the Company’s stock was $27.02, $27.70 and $21.62 at December 31, 2007, 2006 and 2005, respectively. The total intrinsic value of options exercised during the years ended December 31, 2007, 2006 and 2005 was $904,000, $268,000 and $377,000, respectively. The total intrinsic value of options vested during the years ended December 31, 2006 and 2005 was $143,000 and $67,000, respectively. The aggregate intrinsic value of options outstanding was $644,000, $1.6 million and $1.2 million at December 31, 2007, 2006 and 2005, respectively. The aggregate intrinsic value of options exercisable at December 31, 2007, 2006 and 2005 was $644,000, $1.6 million and $1.1 million, respectively. The following table summarizes our common stock grant activity under our Stock Plan for the years 2007, 2006 and 2005. Our common stock grants vest over periods ranging from immediately to 10 years. 2007 2006 2005 Number of shares 868,726 276,631 (149,284) (1,501) Weighted average price(1) $ 17.96 27.64 20.94 24.81 Number of shares 788,722 210,332 (125,879) (4,449) Weighted average price(1) $ 17.83 21.72 20.39 21.35 Number of shares 626,868 306,241 (92,811) (51,576) Weighted average price(1) $ 14.98 25.20 16.69 17.31 994,572 $ 19.46 868,726 $ 17.96 788,722 $ 17.83 Outstanding nonvested shares, beginning of year Shares granted Shares vested Shares forfeited Outstanding nonvested shares, end of year (1) Grant date fair value. 38 REALTY INCOME 2007 Annual Report During 2007, we issued 276,631 shares of common stock • For employees age 57 at the grant date, shares vest in under our Stock Plan. These shares vest over the following service 33.33% increments on each of the first three anniver- periods: 20,000 vested upon issuance, 4,000 vest over a service saries of the grant date; period of one year, 12,000 vest over a service period of three • For employees age 58 at the grant date, shares vest in years, 19,000 vest over a service period of five years and 50% increments on each of the first two anniversaries of 221,631 vest over a service period of 10 years. the grant date; Our Stock Plan was amended on May 15, 2007. For grants • For employees age 59 at the grant date, shares are 100% made on or after May 15, 2007 the vesting schedule for vested on the first anniversary of the grant date; and shares granted to non-employee directors was amended to the • For employees age 60 and above at the grant date, shares following schedule: vest immediately on the grant date. • Shares vest in 33.33% increments on each of the first three anniversaries of the date the shares of stock are In addition, after they have been employed for six full months, granted to directors with less than five years of service at all non-executive employees receive 200 shares of nonvested the date of grant; stock which vests over a five-year period. • Shares vest in 50% increments on each of the first two As of December 31, 2007, the remaining unamortized share- anniversaries of the date the shares of stock are granted based compensation expense totaled $19.4 million, which is to directors with six years of service at the date of grant; being amortized on a straight-line basis over the service period of • Shares are 100% vested on the first anniversary of the date the shares of stock are granted to directors with each applicable award. The amount of share-based compensa- tion is based on the fair value of the stock at the grant date. We seven years of service at the date of grant; and define the grant date as the date the recipient and the Company • There is immediate vesting as of the date the shares of have a mutual understanding of the key terms and condition of stock are granted to directors with eight or more years of the award and the recipient of the grant begins to benefit from, service at the date of grant. or be adversely affected by subsequent changes in the price of the shares. On May 15, 2007, our Board of Directors also approved a The effect of pre-vesting forfeitures on our recorded expense new vesting schedule for shares granted to employees on or after has historically been negligible. Any future pre-vesting forfeitures May 15, 2007, which is as follows: are also expected to be negligible and we will record the benefit • For employees age 49 and below at the grant date, shares related to such forfeitures as they occur. Under the terms of our vest in 10% increments on each of the first ten anniver- Stock Plan, we pay non-refundable dividends to the holders of saries of the grant date; our nonvested shares. Under Statement No. 123R, the dividends • For employees age 50 through 55 at the grant date, paid to holders of these nonvested shares should be charged as shares vest in 20% increments on each of the first five compensation expense to the extent that they relate to nonvested anniversaries of the grant date; shares that do not or are not expected to vest. Given the negli- • For employees age 56 at the grant date, shares vest in gible historical and prospective forfeiture rate determined by us, 25% increments on each of the first four anniversaries of we did not record any amount to compensation expense related the grant date; to dividends paid in 2007, 2006 or 2005, nor do we expect to record any amounts in future periods. 2007 Annual Report REALTY INCOME 39 1 6 . S E G M E N T I N F O R M AT I O N Assets, as of December 31: 2007 2006 We evaluate performance and make resource allocation decisions Segment net real estate: on an industry by industry basis. For financial reporting purposes, Automotive parts $ 42,555 $ 36,026 we have grouped our tenants into 31 industry and activity seg- Automotive service ments (including properties owned by Crest that are grouped Automotive tire services together). All of the properties are incorporated into one of the Child care applicable segments. Because almost all of our leases require Convenience stores the tenant to pay operating expenses, revenue is the only com- Drug stores ponent 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 Health and fitness Home furnishings Home improvement respective tenants as of December 31, 2007 (dollars in thousands): Motor vehicle dealerships 101,238 212,746 91,219 408,119 100,154 169,109 54,508 59,497 101,886 776,973 57,135 267,423 56,156 104,089 211,760 96,263 334,839 78,347 102,718 56,286 61,301 104,122 540,093 56,291 272,135 137,506 Restaurants Sporting goods Theaters Crest 17 other non-reportable segments 325,537 293,305 Total segment net real estate 2,824,255 2,485,081 Other intangible assets– Drug stores Other intangible assets–Theaters Other intangible assets– Automotive tire services Other intangible assets– Grocery stores 6,988 2,496 765 962 7,629 2,801 — — Other corporate assets 241,886 50,997 Total assets $ 3,077,352 $ 2,546,508 For the years ended December 31, Segment rental revenue(1): 2007 Revenue 2006 Automotive parts Automotive service Automotive tire services Child care Convenience stores Drug stores $ 6,347 $ 6,066 $ 14,849 16,495 21,235 24,323 40,727 7,830 14,501 24,649 38,283 6,986 Health and fitness 14,874 10,212 Home furnishings Home improvement 7,797 6,116 Motor vehicle dealerships 9,540 7,623 7,127 7,890 2005 6,077 15,083 13,821 24,819 36,711 5,593 7,212 7,552 2,152 4,747 Restaurants Sporting goods Theaters 17 non-reportable segments 60,908 28,191 17,888 7,443 6,829 6,747 26,120 22,906 10,139 42,050 39,729 36,558 Total rental revenue 290,159 237,487 195,099 Other revenue Total revenue 6,354 2,042 354 $ 296,513 $ 239,529 $ 195,453 (1) Crest’s revenue appears in “income from discontinued operations, real estate acquired for resale by Crest” and is not included in this table, which covers revenue but does not include revenue classified as part of income from discontinued operations. 40 REALTY INCOME 2007 Annual Report 1 7. CO M M I T M E N TS A N D CO N T I N G E N C I ES 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 con- solidated financial position or results of operations. At December 31, 2007, we have committed $7.9 million under construction contracts. These costs are expected to be paid in the next 12 months. In addition, we also have contingent payments for tenant improvements and leasing costs of $743,000. We have certain properties that are subject to ground leases which are accounted for as operating leases. At December 31, 2007, minimum future rental payments for the next five years and thereafter are as follows (dollars in thousands): 2008 2009 2010 2011 2012 Thereafter Total Ground leases paid by Realty Income(1) $ 137 92 82 69 69 969 $ 1,418 Ground leases paid by our tenants(2) $ 1,844 1,778 1,701 1,668 1,591 16,485 $ 25,067 Total $ 1,981 1,870 1,783 1,737 1,660 17,454 $ 26,485 (1) Realty Income currently pays the ground lessor directly for the rent under the ground lease. A majority of this rent is reimbursed to Realty Income as additional rent from our tenant. (2) Our tenants, who are generally sub-tenants under the ground leases, are responsible for paying the rent under these ground leases. In the event a tenant fails to pay the ground lease rent, we are primarily responsible. 2007 Annual Report REALTY INCOME 41 R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S C O N S O L I D AT E D Q U A R T E R LY F I N A N C I A L D ATA (dollars in thousands, except per share data) (not covered by Report of Independent Registered Public Accounting Firm) 2007(1) Total revenue Depreciation and amortization expense Interest expense Other expenses Income from continuing operations Income 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) $ 71,198 $ 70,589 $ 74,080 $ 80,646 $ 296,513 18,083 12,420 6,207 34,488 1,835 36,323 18,475 13,029 7,151 31,934 5,002 36,936 19,559 16,163 7,458 30,900 3,073 33,973 21,075 22,719 6,791 30,061 3,115 33,176 77,192 64,331 27,607 127,383 13,026 140,409 30,260 30,873 27,910 27,113 116,156 Basic Diluted 0.30 0.30 0.31 0.31 0.28 0.28 0.27 0.27 1.16 1.16 Dividends paid per common share 0.379500 0.381375 0.391000 0.408375 1.56025 2006(1) Total revenue $ 55,015 $ 56,366 $ 59,154 $ 68,995 $ 239,529 Depreciation and amortization expense Interest expense Other expenses Income from continuing operations 13,461 13,198 5,335 23,021 Income (loss) from discontinued operations 1,867 24,888 14,740 11,930 5,268 24,428 2,212 26,640 14,581 12,530 6,520 25,523 1,035 26,558 16,505 13,706 6,037 32,747 (51) 32,696 59,288 51,363 23,160 105,718 5,063 110,781 Net income Net income available to common stockholders Net income per common share: Basic Diluted 22,537 24,289 24,207 28,386 99,419 0.27 0.27 0.28 0.27 0.27 0.27 0.29 0.29 1.11 1.11 Dividends paid per common share 0.348750 0.350625 0.360250 0.377625 1.437250 (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. 42 REALTY INCOME 2007 Annual Report R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S R E P O R T O F I N D E P E N D E N T R E G I S T E R E D P U B L I C A C C O U N T I N G F I R M The Board of Directors and Stockholders Realty Income Corporation: We have audited the accompanying consolidated balance sheets statements for external purposes in accordance with generally of Realty Income Corporation and subsidiaries as of December 31, accepted accounting principles. A company’s internal control 2007 and 2006, and the related consolidated statements of over financial reporting includes those policies and procedures income, stockholders’ equity, and cash flows for each of the years that (1) pertain to the maintenance of records that, in reason- in the three-year period ended December 31, 2007. We also able detail, accurately and fairly reflect the transactions and dis- have audited Realty Income Corporation’s internal control over positions of the assets of the company; (2) provide reasonable financial reporting as of December 31, 2007, based on criteria assurance that transactions are recorded as necessary to permit established in Internal Control—Integrated Framework issued preparation of financial statements in accordance with generally by the Committee of Sponsoring Organizations of the Treadway accepted accounting principles, and that receipts and expendi- Commission (COSO). Realty Income Corporation’s management tures of the company are being made only in accordance with is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely and for their assessment of the effectiveness of internal control detection of unauthorized acquisition, use, or disposition of the over financial reporting. Our responsibility is to express an opinion company’s assets that could have a material effect on the finan- on these consolidated financial statements and on Realty Income cial statements. Corporation’s internal control over financial reporting based on Because of its inherent limitations, internal control over our audits. financial reporting may not prevent or detect misstatements. We conducted our audits in accordance with the standards of Also, projections of any evaluation of effectiveness to future peri- the Public Company Accounting Oversight Board (United States). ods are subject to the risk that controls may become inadequate Those standards require that we plan and perform the audits to because of changes in conditions, or that the degree of compli- obtain reasonable assurance about whether the financial state- ance with the policies or procedures may deteriorate. ments are free of material misstatement and whether effective In our opinion, the consolidated financial statements referred internal control over financial reporting was maintained in all to above present fairly, in all material respects, the financial material respects. Our audits of the consolidated financial state- position of Realty Income Corporation and subsidiaries as of ments included examining, on a test basis, evidence supporting December 31, 2007 and 2006, and the results of their operations the amounts and disclosures in the financial statements, assessing and their cash flows for each of the years in the three-year period the accounting principles used and significant estimates made ended December 31, 2007, in conformity with U.S. generally by management, and evaluating the overall financial statement accepted accounting principles. Also in our opinion, Realty Income presentation. Our audit of internal control over financial report- Corporation maintained, in all material respects, effective internal ing included obtaining an understanding of internal control over control over financial reporting as of December 31, 2007, based financial reporting, assessing the risk that a material weakness on criteria established in Internal Control—Integrated Framework exists, and testing and evaluating the design and operating issued by the Committee of Sponsoring Organizations of the effectiveness of internal control based on the assessed risk. Our Treadway Commission. audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial San Diego, California February 12, 2008 2007 Annual Report REALTY INCOME 43 R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S 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 In addition, at December 31, 2007, our wholly-owned Realty Income Corporation, The Monthly Dividend Company®, is taxable REIT subsidiary, Crest Net Lease, Inc. (“Crest”), had a Maryland corporation organized to operate as an equity real invested $56.2 million in 30 properties, which are classified as estate investment trust, or REIT. Our primary business objective held for sale. Crest was created to buy and sell properties, primarily is to generate dependable monthly cash distributions from a to individual investors who are involved in tax-deferred exchanges consistent and predictable level of funds from operations, or FFO under Section 1031 of the Internal Revenue Code of 1986, as per share. Our monthly distributions are supported by the cash amended (the “Tax Code”). flow from our portfolio of retail properties leased to regional and We typically acquire retail store properties under long-term national retail chains. We have in-house acquisition, leasing, legal, leases with retail chain store operators. These transactions retail and real estate research, portfolio management and capital generally provide capital to owners of retail real estate and retail markets expertise. Over the past 38 years, Realty Income and its chains for expansion or other corporate purposes. Our acquisition predecessors have been acquiring and owning freestanding retail and investment activities are concentrated in well-defined target properties that generate rental revenue under long-term lease agreements (primarily 15 to 20 years). markets and generally focus on retail chains providing goods and services that satisfy basic consumer needs. In addition, we seek to increase distributions to common Our net-lease agreements generally: stockholders and FFO per share through both active portfolio • Are for initial terms of 15 to 20 years; management and the acquisition of additional properties. Our • Require the tenant to pay minimum monthly rent and property portfolio management focus includes: operating expenses (taxes, insurance and maintenance); • Contractual rent increases on existing leases; and • Rent increases at the termination of existing leases, when • Provide for future rent increases based on increases in the market conditions permit; and consumer price index, fixed increases, or to a lesser • The active management of our property portfolio, including degree, additional rent calculated as a percentage of the re-leasing vacant properties and selectively selling properties. tenants’ gross sales above a specified level. In acquiring additional properties, we adhere to a focused We commenced operations as a REIT on August 15, 1994 strategy of primarily acquiring properties that are: through the merger of 25 public and private real estate limited • Freestanding, single-tenant, retail locations; partnerships with and into us. Each of the partnerships was • Leased to regional and national retail chains; and formed between 1970 and 1989 for the purpose of acquiring • Leased under long-term, net-lease agreements. and managing long-term, net-leased properties. The eight senior officers of Realty Income owned 1.3% of our At December 31, 2007, we owned a diversified portfolio: outstanding common stock with a market value of $33.2 million at • Of 2,270 retail properties; February 1, 2008. The directors and eight senior officers of Realty • With an occupancy rate of 97.9%, or 2,222 properties Income, as a group, owned 2.5% of our outstanding common occupied of the 2,270 properties in the portfolio; stock with a market value of $64.6 million at February 1, 2008. • With only 48 properties available for lease; Our common stock is listed on The New York Stock Exchange • Leased to 115 different retail chains doing business in 30 (“NYSE”) under the ticker symbol “O” with a cusip number of separate retail industries; • Located in 49 states; 756109-104. Our central index key number is 726728. Our Class D cumulative redeemable preferred stock is listed • With over 18.5 million square feet of leasable space; and on the NYSE under the ticker symbol “OprD” with a cusip • With an average leasable retail space per property of number of 756109-609. approximately 8,150 square feet. Our Class E cumulative redeemable preferred stock is listed on the NYSE under the ticker symbol “OprE” with a cusip Of the 2,270 properties in the portfolio, 2,259, or 99.5%, are number of 756109-708. single-tenant, retail properties and the remaining 11 are multi- Realty Income’s 8.25% Monthly Income Senior Notes due tenant, distribution and office properties. At December 31, 2007, 2008 are listed on the NYSE under the ticker symbol “OUI” with 2,212 of the 2,259 single-tenant properties were leased with a cusip number of 756109-203. a weighted average remaining lease term (excluding extension In February 2008, we had 75 permanent employees as options) of approximately 13.0 years. compared to 70 permanent employees in February 2007. 44 REALTY INCOME 2007 Annual Report We maintain an Internet website at www.realtyincome.com. goods. Also included in the $533.7 million is $29.9 million On our website we make available, free of charge, copies of our invested by Crest in 32 new restaurant properties. annual report on Form 10-K, quarterly reports on Form 10-Q, The initial weighted average contractual lease rate is computed current reports on Form 8-K, and amendments to those reports, as estimated contractual net operating income (in a net-leased as soon as reasonably practicable after we electronically file property this is equal to the base rent or, in the case of prop- these reports with the SEC. None of the information on our web- erties under development, the estimated base rent under the site is deemed to be part of this report. lease) for the first year of each lease, divided by the estimated R E C E N T D E V E L O P M E N T S Increases in Monthly Distributions to Common Stockholders We continue our 38-year policy of paying distributions monthly. Monthly distributions per share were increased in April 2007 by total costs. Since it is possible that a tenant could default on the payment of contractual rent, we cannot assure you that the actual return on the funds invested will remain at the percent- ages listed above. $0.000625 to $0.127125, in July 2007 by $0.000625 to $0.12775, in September 2007 by $0.00775 to $0.1355, in Investments in Existing Properties In 2007, we capitalized costs of $1.9 million on existing properties October 2007 by $0.000625 to $0.136125 and in January 2008 in our portfolio, consisting of $614,000 for re-leasing costs and by $0.000625 to $0.13675. The increase in January 2008 was $1.3 million for building improvements. our 41st consecutive quarterly increase and the 47th increase in the amount of our dividend since our listing on the New York Stock Exchange, or NYSE, in 1994. In 2007, we paid the following Issuance of 12-Year Senior Unsecured Notes In September 2007, we issued $550 million in aggregate principal monthly cash distributions per share: three in the amount of amount of 6.75% senior unsecured notes due 2019 (the $0.1265, three in the amount of $0.127125, two in the amount “2019 Notes”). The price to the investor for the 2019 Notes of $0.12775, one in the amount of $0.1355 and three in the was 99.827% of the principal amount for an effective yield of amount of $0.136125, totaling $1.56025. In December 2007 6.772%. The net proceeds of approximately $544.4 million and January 2008, we declared distributions of $0.13675 per from this offering were used to fund certain acquisitions, share, which were paid in January 2008 and will be paid in repay borrowings under our acquisition credit facility and for February 2008, respectively. general corporate purposes. The remaining net proceeds, which The monthly distribution of $0.13675 per share represents are included in “cash and cash equivalents” on our 2007 a current annualized distribution of $1.641 per share, and an consolidated balance sheet, will be used for general corporate annualized distribution yield of approximately 6.5% based on purposes, which include additional property acquisitions. Interest the last reported sale price of our common stock on the NYSE of on the 2019 Notes is paid semiannually. $25.15 on February 1, 2008. Although we expect to continue our policy of paying monthly distributions, we cannot guarantee that we will maintain our current level of distributions, that we Credit Ratings Upgrade In April 2007, Moody’s Investors Service upgraded our senior will continue our pattern of increasing distributions per share, or unsecured debt rating to Baa1 from Baa2 and our preferred what our actual distribution yield will be in any future period. stock rating to Baa2 from Baa3, with a stable outlook. Acquisitions During 2007 During 2007, Realty Income and Crest invested $533.7 million, Standard & Poor’s MidCap 400 Index In November 2007, we were added to the Standard & Poor’s in aggregate, in 357 new retail properties and properties under (“S&P”) MidCap 400 Index. The S&P MidCap 400 stock index development. These 357 new properties are located in 38 states, covers companies with market capitalizations in the range of will contain over 1.9 million leasable square feet, and are 100% $1.5 billion to $5.5 billion and is part of a series of S&P indices. leased with an average lease term of 19.3 years. As described below, Realty Income acquired 325 properties and Crest acquired 32 properties. Net Income Available to Common Stockholders Net income available to common stockholders was $116.2 million Included in the $533.7 million is $503.8 million invested by in 2007 versus $99.4 million in 2006, an increase of $16.8 million. Realty Income in 325 new properties and properties under devel- On a diluted per common share basis, net income was $1.16 per opment, with an initial weighted average contractual lease rate share in 2007 as compared to $1.11 per share in 2006. of 8.6%. These 325 properties are located in 38 states, will The calculation to determine net income available to common contain over 1.8 million leasable square feet and are 100% leased stockholders includes the gain from the sales of properties. The with an average lease term of 19.2 years. The 325 new properties amount of gains varies from period to period and can significantly acquired by Realty Income are net-leased to 16 different retail impact net income available to common stockholders. chains in the following nine industries: automotive service, auto- The gain recognized from the sales of investment properties motive tire service, convenience store, distribution and office, during 2007 was $3.6 million, as compared to $3.0 million drug store, grocery, health and fitness, restaurant, and sporting for 2006. 2007 Annual Report REALTY INCOME 45 Funds from Operations (FFO) In 2007, our FFO increased by $33.9 million, or 21.8%, to Future distributions will be at the discretion of our Board of Directors and will depend on, among other things, our results of $189.7 million versus $155.8 million in 2006. On a diluted per operations, FFO, cash flow from operations, financial condition common share basis, FFO was $1.89 in 2007 compared to and capital requirements, the annual distribution requirements $1.73 for 2006, an increase of $0.16, or 9.2%. under the REIT provisions of the Tax Code, our debt service See our discussion of FFO in the section entitled requirements and any other factors the Board of Directors may “Management’s Discussion and Analysis of Financial Condition deem relevant. In addition, our credit facility contains financial and Results of Operations” in this annual report, which includes covenants that could limit the amount of distributions payable by a reconciliation of net income available to common stockholders us in the event of a deterioration in our results of operations or to FFO. Crest’s Property Sales During 2007, Crest sold 62 properties from its inventory for financial condition, and which prohibit the payment of distribu- tions on the common or preferred stock in the event that we fail to pay when due (subject to any applicable grace period) any principal or interest on borrowings under our credit facility. an aggregate of $123.6 million, which resulted in a gain of Distributions of our current and accumulated earnings and $12.3 million. Crest’s gains are included in “income from profits for federal income tax purposes generally will be taxable discontinued operations, real estate acquired for resale by Crest” to stockholders as ordinary income, except to the extent that we on our consolidated statements of income. Crest’s Property Inventory Crest’s property inventory at December 31, 2007 totaled recognize capital gains and declare a capital gains dividend or that such amounts constitute “qualified dividend income” subject to a reduced tax rate. The maximum tax rate of non-corporate tax- payers for “qualified dividend income” has generally been reduced $56.2 million. These properties are included in “real estate held to 15% (until it “sunsets” or reverts to the provisions of prior for sale, net” on our consolidated balance sheets. law, which under current law will occur with respect to taxable D I S T R I B U T I O N P O L I CY years beginning after December 31, 2010). In general, dividends payable by REITs are not eligible for the reduced tax rate on cor- Distributions are paid monthly to our common, Class D preferred porate dividends, except to the extent the REIT’s dividends are and Class E preferred stockholders if, and when, declared by our attributable to dividends received from taxable corporations Board of Directors. (such as our taxable REIT subsidiary, Crest), to income that was In order to maintain our tax status as a REIT for federal subject to tax at the corporate or REIT level (for example, if we income tax purposes, we generally are required to distribute distribute taxable income that we retained and paid tax on in the dividends to our stockholders aggregating annually at least 90% prior taxable year) or, as discussed above, dividends properly of our REIT taxable income (determined without regard to the designated by us as “capital gain dividends.” Distributions in dividends paid deduction and excluding net capital gains), and excess of earnings and profits generally will be treated as a we are subject to income tax to the extent we distribute less non-taxable reduction in the stockholders’ basis in their stock. than 100% of our REIT taxable income (including net capital Distributions above that basis, generally, will be taxable as a gains). In 2007, our cash distributions totaled $182.2 million, capital gain to stockholders who hold their shares as a capital or approximately 113.6% of our estimated REIT taxable income asset. Approximately 11.2% of the distributions to our common of $160.4 million. Our estimated REIT taxable income reflects stockholders, made or deemed to have been made in 2007, were non-cash deductions for depreciation and amortization. We classified as a return of capital for federal income tax purposes. intend to continue to make distributions to our stockholders We are unable to predict the portion of future distributions that that are sufficient to meet this distribution requirement and may be classified as a return of capital. that will reduce our exposure to income taxes. Our 2007 cash distributions to common stockholders totaled $157.7 million, representing 83.1% of our funds from operations available to common stockholders of $189.7 million. B U S I N ESS P H I LOS O P H Y A N D ST RAT EGY Investment Philosophy We believe that owning an actively managed, diversified portfolio The Class D preferred stockholders receive cumulative distri- of retail properties under long-term, net leases produces butions at a rate of 7.375% per annum on the $25 per share consistent and predictable income. Net leases typically require liquidation preference (equivalent to $1.84375 per annum per the tenant to be responsible for minimum monthly rent and prop- share). The Class E preferred stockholders receive cumulative erty operating expenses including property taxes, insurance and distributions at a rate of 6.75% per annum on the $25 per maintenance. In addition, tenants are typically responsible for share liquidation preference (equivalent to $1.6875 per annum future rent increases based on increases in the consumer price per share). index, fixed increases or, to a lesser degree, additional rent calculated as a percentage of the tenants’ gross sales above a specified level. We believe that a portfolio of properties under long-term leases, coupled with the tenant’s responsibility for 46 REALTY INCOME 2007 Annual Report property expenses, generally produces a more predictable income While our investment strategy focuses primarily on acquiring stream than many other types of real estate portfolios, while properties leased to middle and upper market retail chains, we continuing to offer the potential for growth in rental income. also selectively seek investment opportunities with venture market retail chains. Periodically, venture market opportunities Investment Strategy In identifying new properties for acquisition, our focus is generally arise where we feel that the real estate used by the tenant is high quality and can be purchased at favorable prices. To meet on providing capital to retail chain owners and operators by our stringent investment standards, however, venture retail acquiring, then leasing back, retail store locations. We categorize companies must have a well-defined retailing concept and strong retail tenants as: 1) venture market, 2) middle market, and financial prospects. These opportunities are examined on a case 3) upper market. Venture companies typically offer a new retail by case basis and we are highly selective in making investments concept in one geographic region of the country and operate in this area. between five and 50 retail locations. Middle market retail chains Historically, our investment focus has been on retail indus- typically have 50 to 500 retail locations, operations in more than tries that have a service component because we believe the lease one geographic region, have been successful through one or more revenue from these types of businesses is more stable. Because economic cycles, and have a proven, replicable concept. The of this investment focus, for the quarter ended December 31, upper market retail chains typically consist of companies with 2007, approximately 84.5% of our rental revenue was derived 500 or more locations, operating nationally, in a proven, mature from retailers with a service component in their business. retail concept. Upper market retail chains generally have strong operating histories and access to several sources of capital. Furthermore, we believe these service-oriented businesses would be difficult to duplicate over the Internet and that our properties Realty Income primarily focuses on acquiring properties continue to perform well relative to competition from Internet leased to middle market retail chains that we believe are attrac- businesses. tive for investment because: • They generally have overcome many of the operational and managerial obstacles that can adversely affect venture retailers; Credit Strategy We generally provide sale-leaseback financing to less than investment grade retail chains. We typically acquire and lease • They typically require capital to fund expansion but have back properties to regional and national retail chains and believe more limited financing options than upper market retail that within this market we can achieve an attractive risk-adjusted chains; return on the financing we provide to retailers. Since 1970, our • They generally have provided us with attractive risk-adjusted overall weighted average occupancy rate at the end of each year returns over time since their financial strength has, in many has been 98.5%, and the occupancy rate at the end of each year cases, tended to improve as their businesses have matured; has never been below 97.5%. • Their relatively large size allows them to spread corporate We believe the principal financial obligations of most retail- expenses across a greater number of stores; and ers typically include their bank and other debt, payment obliga- • Middle market retailers typically have the critical mass to tions to suppliers and real estate lease obligations. Because we survive if a number of locations are closed due to under- typically own the land and building in which a tenant conducts performance. its retail business, we believe the risk of default on a retailers’ lease obligations is less than the retailers’ unsecured general We also focus on, and have selectively made investments in, obligations. It has been our experience that since retailers must properties of upper market retail chains. We believe upper market retain their profitable retail locations in order to survive, in the retail chains can be attractive for investment because: event of reorganization they are less likely to reject a lease for a • They typically are of a higher credit quality; profitable location because this would terminate their right to • They usually are larger public and private retailers with use the property. Thus, as the property owner, we believe we will more commonly recognized brand names; fare better than unsecured creditors of the same retailer in the • They utilize a larger building ranging in size from 10,000 event of reorganization. If a property is rejected by the tenant to 50,000 square feet; and during reorganization, we own the property and can either lease • They are able to grow because access to capital facilitates it to a new tenant or sell the property. In addition, we believe that larger transaction sizes. the risk of default on the real estate leases can be further miti- gated by monitoring the performance of the retailers’ individual unit locations and considering whether to sell locations that are weaker performers. 2007 Annual Report REALTY INCOME 47 In order to qualify for inclusion in our portfolio, new property significant portfolio management activities. This monitoring acquisitions must meet stringent investment and credit require- typically includes regular review and analysis of: ments. The properties must generate attractive current yields • The performance of various retail industries; and and the tenant must meet our credit profile. We have established • The operation, management, business planning and a three-part analysis that examines each potential investment financial condition of the tenants. based on: • Industry, company, market conditions and credit profile; We have an active portfolio management program that • Store profitability, if profitability data is available; and incorporates the sale of assets when we believe the reinvestment • Overall real estate characteristics, including property of the sales proceeds will generate higher returns, enhance the value and comparative rental rates. credit quality of our real estate portfolio, or extend our average remaining lease term. At December 31, 2007, we classified real The typical profile of companies whose properties have been estate owned by Crest with a carrying amount of $56.2 million approved for acquisition are those with 50 or more retail locations. as held for sale on our balance sheet. Additionally, we anticipate Generally the properties: selling investment properties in our portfolio that have not yet • Are located in highly visible areas, been specifically identified, from which we anticipate receiving • Have easy access to major thoroughfares; and between $10 million and $35 million in proceeds during the • Have attractive demographics. Acquisition Strategy We seek to invest in industries in which several, well-organized, next 12 months. We intend to invest these proceeds into new property acquisitions. However, we cannot guarantee that we will sell properties during the next 12 months. regional and national retail chains are capturing market share through service, quality control, economies of scale, advertising Universal Shelf Registration In April 2006, we filed a shelf registration statement with the and the selection of prime retail locations. We execute our acqui- SEC, which is effective for a term of three years. In accordance sition strategy by acting as a source of capital to regional and with the SEC rules, the amount of securities to be issued pur- national retail chain store owners and operators, doing business suant to this shelf registration statement was not specified when in a variety of industries, by acquiring and leasing back retail it was filed. The securities covered by this registration statement store locations. We undertake thorough research and analysis to include common stock, preferred stock, debt securities, or any identify appropriate industries, tenants and property locations for combination of such securities. We may periodically offer one or investment. Our research expertise is instrumental to uncovering more of these securities in amounts, prices and on terms to be net-lease opportunities in markets where our real estate financing announced when and if the securities are offered. The specifics program adds value. In selecting real estate for potential investment, of any future offerings, along with the use of proceeds of any we generally seek to acquire properties that have the following securities offered, will be described in detail in a prospectus characteristics: supplement, or other offering materials, at the time of any • Freestanding, commercially-zoned property with a single offering. There is no specific limit to the dollar amount of new tenant; securities that can be issued under this new shelf registration • Properties that are important retail locations for regional before it expires in April 2009, and our common stock, preferred and national retail chains; stock and notes issued after April 2006 were all issued pursuant • Properties that we deem to be profitable for the retailers; to this universal shelf registration statement. • Properties that are located within attractive demographic areas relative to the business of their tenants, with high visibility and easy access to major thoroughfares; and Conservative Capital Structure We believe that our stockholders are best served by a conservative • Properties that can be purchased with the simultaneous capital structure. Therefore, we seek to maintain a conservative execution or assumption of long-term, net-lease agree- debt level on our balance sheet and solid interest and fixed ments, offering both current income and the potential for charge coverage ratios. At February 1, 2008, our total outstanding credit facility borrowings and outstanding notes were $1.47 billion, or approximately 33.7% of our total market capitalization of $4.36 billion. rent increases. Portfolio Management Strategy The active management of the property portfolio is an essential component of our long-term strategy. We continually monitor our portfolio for any changes that could affect the performance of the industries, tenants and locations in which we have invested. We also regularly analyze our portfolio with a view toward optimizing its returns and enhancing its credit quality. Our executives review industry research, tenant research, property due diligence and 48 REALTY INCOME 2007 Annual Report We define our total market capitalization at February 1, 2008 convertible preferred stock, debt securities or convertible debt as the sum of: securities. We cannot assure you, however, that we will be able to • Shares of our common stock outstanding of 101,286,217 obtain any such refinancing or that market conditions prevailing multiplied by the last reported sales price of our common at the time of refinancing will enable us to issue equity or debt stock on the NYSE of $25.15 per share on February 1, securities upon acceptable terms. 2008, or $2.55 billion; • Aggregate liquidation value (par value of $25 per share) of the Class D preferred stock of $127.5 million; Credit Agency Ratings We are currently assigned investment grade corporate credit ratings, • Aggregate liquidation value (par value of $25 per share) on our senior unsecured notes. Fitch Ratings has assigned a of the Class E preferred stock of $220 million; and rating of BBB+, Moody’s Investors Service has assigned a rating • Outstanding notes of $1.47 billion. of Baa1 and Standard & Poor’s Ratings Group has assigned a rating of BBB to our senior notes. The rating by Standard & Poor’s Historically, we have met our long-term capital needs through has a “positive” outlook and the ratings by Fitch and Moody’s the issuance of common stock, preferred stock and long-term have “stable” outlooks. unsecured notes and bonds. Over the long term, we believe that We have also been assigned investment grade credit ratings common stock should be the majority of our capital structure, on our preferred stock. Fitch Ratings has assigned a rating of however, we may issue additional preferred stock or debt securities BBB, Moody’s has assigned a rating of Baa2 and Standard & from time to time. We may issue common stock when we believe that our share price is at a level that allows for the proceeds of Poor’s has assigned a rating of BBB- to our preferred stock. The rating by Standard & Poor’s has a “positive” outlook and the any offering to be accretively invested into additional properties. ratings by Fitch and Moody’s have “stable” outlooks. In addition, we may issue common stock to permanently finance The credit ratings assigned to us could change based upon, properties that were financed by our credit facility or debt securities. among other things, our results of operations and financial con- However, we cannot assure you that we will have access to the dition. These ratings are subject to ongoing evaluation by credit capital markets at terms that are acceptable to us. rating agencies and we cannot assure you that any such rating $300 Million Acquisition Credit Facility We have a $300 million revolving, unsecured credit facility that will not be changed or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. Moreover, a rating is not a recommendation to buy, sell or hold our debt securities, expires in October 2008. In April 2007, Moody’s Investors preferred stock or common stock. Service upgraded our credit ratings. Effective May 2007, our investment grade credit ratings provided for financing under the credit facility at the London Interbank Offered Rate, commonly referred to as LIBOR, plus 60 basis points with a facility commit- ment fee of 15 basis points, for all-in drawn pricing of 75 basis points over LIBOR. At February 1, 2008, we had a borrowing capacity of $300 million available on our credit facility and no outstanding balance. Mortgage Debt We have no mortgage debt on any of our properties. No Off-Balance Sheet Arrangements or Unconsolidated Investments We have no unconsolidated or off-balance sheet investments in “variable interest entities” or off-balance sheet financing, nor do We expect to use the credit facility to acquire additional retail we engage in trading activities involving energy or commodity properties and for other corporate purposes. Any additional contracts or other derivative instruments. borrowings will increase our exposure to interest rate risk. We have As we have no joint ventures, off-balance sheet entities, or the right to request an increase in the borrowing capacity of the mandatory redeemable preferred stock, our current financial credit facility by up to $100 million, to a total borrowing capacity position or results of operations are not affected by Financial of $400 million. Any increase in the borrowing capacity is subject Accounting Standards Board Interpretation No. 46R, Consolidation to approval by the lending banks of our credit facility. of Variable Interest Entities and Statement of Financial Accounting We regularly review our credit facility and may seek to extend, Standards No. 150, Accounting for Certain Financial Instruments renew or replace our credit facility, to the extent we deem appro- with Characteristics of both Liabilities and Equity. priate. We have the right to extend the credit facility for an addi- tional term of one year (to October 2009). We use our credit facility for the short-term financing of new property acquisitions. When outstanding borrowings under the credit facility reach a certain level (generally in the range of $100 million to $200 million) and capital is available on accept- able terms, we generally seek to refinance those borrowings with the net proceeds of long-term or permanent financing, which may include the issuance of common stock, preferred stock, 2007 Annual Report REALTY INCOME 49 Competitive Strategy We believe that to successfully pursue our investment philosophy • TECHNOLOGY: We intend to stay at the forefront of tech- nology in our efforts to efficiently and economically carry and strategy, we must seek to maintain the following competitive out our operations. We maintain sophisticated information advantages: systems that allow us to analyze our portfolio’s perform- • SIZE AND TYPE OF INVESTMENT PROPERTIES: We believe ance and actively manage our investments. We believe smaller ($500,000 to $10,000,000) net-leased retail that technology and information-based systems will play properties represent an attractive investment opportunity an increasingly important role in our competitiveness as in today’s real estate environment. Due to the complexi- an investment manager and source of capital to a variety ties of acquiring and managing a large portfolio of rela- of industries and tenants. tively small assets, we believe these types of properties have not experienced significant institutional ownership P R O P E R T I E S interest or the corresponding yield reduction experienced At December 31, 2007, we owned a diversified portfolio: by larger income-producing properties. We believe the less • Of 2,270 retail properties; intensive day-to-day property management required by net- • With an occupancy rate of 97.9%, or 2,222 properties lease agreements, coupled with the active management occupied of the 2,270 properties in the portfolio; of a large portfolio of smaller properties, is an effective • With only 48 properties available for lease; investment strategy. The tenants of our freestanding retail • Leased to 115 different retail chains doing business in 30 properties generally provide goods and services that satisfy basic consumer needs. In order to grow and expand, they separate retail industries; • Located in 49 states; generally need capital. Since the acquisition of real estate • With over 18.5 million square feet of leasable space; and is typically the single largest capital expenditure of many • With an average leasable retail space per property of of these retailers, our method of purchasing the property approximately 8,150 square feet. and then leasing it back, under a net-lease arrangement, allows the retail chain to free up capital. In addition to our real estate portfolio, our subsidiary, Crest • INVESTMENT IN NEW RETAIL INDUSTRIES: Though we had invested $56.2 million in 30 properties located in 14 states specialize in single-tenant properties, we will seek to fur- at December 31, 2007. These properties are classified as held ther diversify our portfolio among a variety of retail indus- for sale. tries. We believe diversification will allow us to invest in At December 31, 2007, 2,212, or 97.4%, of our 2,270 retail retail industries that currently are growing and have properties were leased under net-lease agreements. Net leases characteristics we find attractive. These characteristics typically require the tenant to be responsible for minimum include, but are not limited to, retail industries that are monthly rent and property operating expenses including property dominated by local store operators where regional and taxes, insurance and maintenance. In addition, tenants are typi- national chain store operators can increase market share cally responsible for future rent increases based on increases in and dominance by consolidating local operators and the consumer price index, fixed increases or, to a lesser degree, streamlining their operations, as well as capitalizing on additional rent calculated as a percentage of the tenants’ gross major demographic shifts in a population base. sales above a specified level. • DIVERSIFICATION: Diversification of the portfolio by retail Our net-leased retail properties primarily are leased to regional industry type, tenant, and geographic location is key to and national retail chain store operators. Most buildings are our objective of providing predictable investment results single-story structures with adequate parking on site to accom- for our stockholders, therefore further diversification of modate peak retail traffic periods. The properties tend to be on our portfolio is a continuing objective. At December 31, major thoroughfares with relatively high traffic counts, adequate 2007, our retail property portfolio consisted of 2,270 access and proximity to a sufficient population base to constitute properties located in 49 states, leased to 115 retail chains a suitable market or trade area for the retailer’s business. doing business in 30 industry segments. Each of the 30 industry segments, represented in our property portfolio, individually accounted for no more than 24.2% of our rental revenue for the quarter ended December 31, 2007. • MANAGEMENT SPECIALIZATION: We believe that our management’s specialization in single-tenant retail prop- erties, operated under net-lease agreements, is important to meeting our objectives. We plan to maintain this specialization and will seek to employ and train high- quality professionals in this specialized area of real estate ownership, finance and management. 50 REALTY INCOME 2007 Annual Report 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: 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 Distribution and office 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 For the Quarter Ended December 31, 2007 Percentage of Rental Revenue(1) For the Years Ended Dec 31, 2007 Dec 31, 2006 Dec 31, 2005 Dec 31, 2004 Dec 31, 2003 Dec 31, 2002 1.1% 1.2% 1.7% 1.6% 1.8% 2.1% 2.3% 1.1 2.0 5.0 6.9 0.2 * 7.7 0.9 14.1 0.3 1.1 2.6 1.3 0.2 0.2 0.7 0.7 5.3 2.4 2.0 3.0 1.0 0.8 0.7 1.1 2.1 5.2 7.3 0.2 0.1 8.4 0.9 14.0 0.3 0.6 2.7 1.4 0.2 0.2 0.7 0.7 5.1 2.6 2.1 3.1 1.1 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 24.2 21.2 11.9 — 2.4 8.4 0.2 1.4 2.1 — 2.6 9.0 0.2 1.7 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 11.8 13.5 0.9 3.8 4.1 0.3 3.3 3.8 0.8 4.1 3.9 — 3.3 4.4 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% * Less than 0.1% (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. 2007 Annual Report REALTY INCOME 51 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, 2007, classified according to the retail business types and the level of services they provide (dollars in thousands): Number of Properties Rental Revenue for the Quarter Ended December 31, 2007 Percentage of Rental Revenue 13 237 265 8 2 8 26 6 31 13 609 30 153 2 489 3 1 19 9 663 1 34 1,404 6 59 2 15 4 39 25 8 42 31 10 2 14 257 2,270 $ 825 1.1% 3,921 5,970 999 150 132 4,105 576 6,578 1,652 24,908 583 5,387 37 11,000 827 57 2,323 607 18,847 170 1,102 40,940 883 1,004 156 683 215 2,007 556 552 1,897 1,451 789 37 1,874 12,104 $ 77,952 5.0 7.7 1.3 0.2 0.2 5.3 0.7 8.4 2.1 32.0 0.7 6.9 * 14.1 1.1 0.1 3.0 0.8 24.2 0.2 1.4 52.5 1.1 1.3 0.2 0.9 0.3 2.6 0.7 0.7 2.4 1.9 1.0 * 2.4 15.5 100.0% 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 Distribution and office 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% 52 REALTY INCOME 2007 Annual Report 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 lease term expirations (excluding extension options) on our 2,212 net leased, single-tenant retail properties as of December 31, 2007 (dollars in thousands): Total Portfolio Rental Revenue for the Quarter Ended 12/31/07(2) % of Total Rental Revenue $ 3,023 4.0% 2,664 1,553 2,377 2,425 3,456 1,968 1,810 1,909 1,956 1,093 4,675 2,980 5,843 3,033 6,760 1,919 6,329 3.5 2.1 3.2 3.2 4.6 2.6 2.4 2.5 2.6 1.5 6.2 4.0 7.8 4.0 9.0 2.5 8.4 11,719 15.6 3,903 1,262 858 714 51 17 357 230 354 13 5.2 1.7 1.1 0.9 0.1 * 0.5 0.3 0.5 * Number of Leases Expiring(1) 144 120 78 80 101 77 47 90 112 50 24 95 82 149 104 240 64 76 217 159 44 35 14 1 1 3 2 2 1 Initial Expirations(3) Subsequent Expirations(4) Rental Revenue for the Quarter Ended 12/31/07 % of Total Rental Revenue $ 1,594 2.1% 880 789 1,368 2,011 3,205 1,714 1,250 1,883 1,870 1,093 4,481 2,916 5,788 2,985 6,735 1,919 6,264 1.1 1.1 1.8 2.7 4.3 2.3 1.7 2.5 2.5 1.5 5.9 3.9 7.7 4.0 9.0 2.5 8.3 11,664 15.5 3,903 1,260 858 714 51 17 357 230 354 — 5.2 1.7 1.1 0.9 0.1 * 0.5 0.3 0.5 — Number of Leases Expiring 70 37 34 36 80 67 34 65 111 45 24 94 79 148 103 239 64 72 215 159 43 35 14 1 1 3 2 2 — Rental Revenue for the Quarter Ended 12/31/07 % of Total Rental Revenue $ 1,429 1.9% 1,784 764 1,009 414 251 254 560 26 86 — 194 64 55 48 25 — 65 55 — 2 — — — — — — — 13 2.4 1.0 1.4 0.5 0.3 0.3 0.7 * 0.1 — 0.3 0.1 0.1 * * — 0.1 0.1 — * — — — — — — — * Number of Leases Expiring 74 83 44 44 21 10 13 25 1 5 — 1 3 1 1 1 — 4 2 — 1 — — — — — — — 1 2,212 $ 75,251 100.0% 1,877 $ 68,153 90.7% 335 $ 7,098 9.3% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2037 2043 Totals * Less than 0.1% (1) Excludes ten multi-tenant properties and 48 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) Excludes revenue of $2,701 from ten multi-tenant properties and from 48 vacant and unleased properties at December 31, 2007. (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. 2007 Annual Report REALTY INCOME 53 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, 2007 (dollars in thousands): State (49) Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming Totals/Average * Less than 0.1% Number of Properties 61 2 79 18 63 54 26 17 168 132 14 74 82 20 33 22 33 3 28 69 51 21 72 62 2 19 15 14 36 8 44 63 6 128 25 18 97 4 59 9 135 215 6 4 103 36 2 17 1 Percent Leased 98% 100 99 100 98 98 100 100 98 98 100 99 98 95 97 100 100 100 100 100 100 100 97 98 100 100 100 100 100 100 95 98 100 97 100 94 100 100 98 100 99 94 83 100 100 89 50 94 100 Approximate Leasable Square Feet 413,700 128,500 394,100 98,500 1,124,700 451,000 282,300 33,300 1,450,800 926,900 91,900 867,600 694,400 140,900 573,500 111,500 190,400 22,500 256,500 587,900 246,200 392,100 359,600 640,100 30,000 196,300 191,000 109,900 266,100 56,400 508,100 454,400 36,600 813,900 145,900 289,100 630,000 14,500 250,700 24,900 635,500 2,282,500 35,100 12,700 622,400 235,100 23,200 157,400 4,200 2,270 98% 18,504,800 Rental Revenue for the Quarter Ended December 31, 2007 Percentage of Rental Revenue $ 1,885 277 2,426 436 4,072 1,943 1,324 372 6,706 3,972 373 4,076 2,971 439 1,109 701 970 54 1,470 2,586 1,235 1,328 1,482 2,121 77 630 847 544 1,905 193 2,544 2,098 71 3,044 609 858 2,940 87 1,569 100 3,018 7,950 91 122 3,085 756 45 409 32 $ 77,952 2.4% 0.4 3.1 0.6 5.2 2.5 1.7 0.5 8.6 5.1 0.5 5.2 3.8 0.6 1.4 0.9 1.2 0.1 1.9 3.3 1.6 1.7 1.9 2.7 0.1 0.8 1.1 0.7 2.4 0.2 3.3 2.7 0.1 3.9 0.8 1.1 3.8 0.1 2.0 0.1 3.9 10.2 0.1 0.1 4.0 1.0 0.1 0.5 * 100.0% 54 REALTY INCOME 2007 Annual Report Description of Leasing Structure At December 31, 2007, 2,212 single tenant and certain other Realty Income owns 116 properties and Crest owns three properties, all leased to subsidiaries of Buffets, Inc. (Buffets) retail properties, or 97.4%, of our 2,270 properties were net and guaranteed by Buffets. Buffets is a subsidiary of Buffets leased. In most cases, the leases: Holding, Inc. (“Buffets Holdings”). On January 22, 2008, Buffets • Are for initial terms of 15 to 20 years; Holdings, together with each of its subsidiaries, filed voluntary • Require the tenant to pay minimum monthly rents and petitions for reorganization under Chapter 11 of the U.S. property operating expenses (taxes, insurance and main- Bankruptcy Code. As of February 12, 2008, Buffets’ lease pay- tenance); and ments to us are current. Based on our analysis of the Buffets’ • Provide for future rent increases based on increases in the locations owned by Realty Income, we believe that the Chapter consumer price index, fixed increases, or to a lesser 11 filing will not have a material adverse affect on our operations degree, additional rent calculated as a percentage of the or financial position. tenants’ gross sales above a specified level. Where leases provide for rent increases based on increases in the con- sumer price index, generally these increases become part Certain Properties Under Development Of the 325 properties Realty Income acquired in 2007, four of the new permanent base rent. Where leases provide for were development properties, all of which were occupied at percentage rent, this additional rent is typically payable December 31, 2007. In the case of development properties, we only if the tenants’ gross sales, for a given period (usually either enter into an agreement with a retail chain where the one year), exceed a specified level and is then typically calculated as a percentage of only the amount of gross retailer retains a contractor to construct the building and we fund the costs of that development, or we fund a developer who con- sales in excess of that level. Matters Pertaining to Certain Properties and Tenants Of the 48 properties available for lease or sale at December 31, structs the building. In either case, there is an executed lease with a retail tenant at the time of the land purchase (with a fixed rent commencement date) and there is a requirement to com- plete the construction in a timely basis and within a specific 2007, all are single-tenant properties except one. As of February 1, budget, typically within eight months after we purchase the land. 2008, transactions to lease or sell 17 of the 48 properties were The tenant or developer generally is required to pay construction underway or completed. At December 31, 2007, 25 of our prop- cost overruns to the extent that they exceed the construction erties under lease were unoccupied and available for sublease by budget by more than a predetermined amount. We also enter into the tenants, all of which were current with their rent and other a lease with the tenant at the time we purchase the land, which obligations. During 2007, each of our tenants accounted for less generally requires the tenant to begin paying base rent when the than 10% of our rental revenue. store opens for business. The base rent is calculated by multiplying For 2007, our tenants in the convenience store and restaurant a predetermined capitalization rate by our total investment in the industries accounted for approximately 14.0% and 21.2%, property including the land cost for the property, construction respectively, of our rental revenue. A downturn in any of these costs and capitalized interest. Crest did not acquire any devel- industries, whether nationwide or limited to specific sectors of opment property in 2007. Both Realty Income and Crest will the United States, could adversely affect tenants in these indus- continue to pursue development opportunities under similar tries, which in turn could have a material adverse affect on our arrangements in the future. financial position, results of operations and our ability to pay the principal of and interest on our debt securities and other indebt- edness and to make distributions on our common stock and preferred stock. Individually, each of the other industries in our property portfolio accounted for less than 10% of our rental revenue for 2007. In addition, a substantial number of our properties are leased to middle-market retail chains that generally have more limited financial and other resources than certain upper-market retail chains, and therefore they are more likely to be adversely affected by a downturn in their respective businesses or in the regional or national economy. Some of our tenants have incurred substantial debt and therefore are more likely to be adversely affected by a downturn in their respective businesses. 2007 Annual Report REALTY INCOME 55 F O R WA R D - L O O K I N G S TAT E M E N T S Additional factors that may cause risks and uncertainties This annual report contains forward-looking statements within include those discussed in the sections entitled “Business”, “Risk the meaning of Section 27A of the Securities Act and Section Factors” and “Management’s Discussion and Analysis of Financial 21E of the Exchange Act. When used in this annual report, the Condition and Results of Operations” in this annual report. words “estimated”, “anticipated”, “expect”, “believe”, “intend” Readers are cautioned not to place undue reliance on forward- and similar expressions are intended to identify forward-looking looking statements, which speak only as of the date our Form 10-K statements. Forward-looking statements are subject to risks, for the fiscal year ended December 31, 2007 filed with the uncertainties, and assumptions about Realty Income Corporation, Securities and Exchange Commission, or SEC. We undertake no including, among other things: • Our anticipated growth strategies; obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or • Our intention to acquire additional properties and the tim- circumstances after the date of this annual report or to reflect ing of these acquisitions; the occurrence of unanticipated events. In light of these risks • Our intention to sell properties and the timing of these and uncertainties, the forward-looking events discussed in this property sales; annual report might not occur. 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, 2007. Unresolved Staff Comments There are no unresolved staff comments. • Our intention to re-lease vacant properties; • Anticipated trends in our business, including trends in the market for long-term net-leases of freestanding, single- tenant retail properties; • Future expenditures for development projects; and • Profitability of our subsidiary, Crest Net Lease, Inc. (“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; • Continued uncertainty in the credit markets; • Other risks inherent in the real estate business including tenant defaults, potential liability relating to environmental matters, illiquidity of real estate investments, and poten- tial 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. 56 REALTY INCOME 2007 Annual Report R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S 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 LYS 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 G E N E R A L Realty Income Corporation, The Monthly Dividend Company®, is a Maryland corporation organized to operate as an equity real L I Q U I D I T Y A N D C A P I TA L R E S O U R C E S Cash Reserves We are organized to operate as an equity REIT that acquires and estate investment trust, or REIT. Our primary business objective leases properties and distributes to stockholders, in the form of is to generate dependable monthly cash distributions from a monthly cash distributions, a substantial portion of our net cash consistent and predictable level of funds from operations, or FFO flow generated from leases on our retail properties. We intend per share. The monthly distributions are supported by the cash to retain an appropriate amount of cash as working capital. At flow from our portfolio of retail properties leased to regional December 31, 2007, we had cash and cash equivalents totaling and national retail chains. We have in-house acquisition, leasing, $193.1 million, which represents a portion of the proceeds from legal, retail research, real estate research, portfolio management the September 2007 issuance of $550 million of 6.75% senior and capital markets expertise. Over the past 38 years, Realty unsecured notes. Income and its predecessors have been acquiring and owning We believe that our cash and cash equivalents on hand, cash freestanding retail properties that generate rental revenue under long-term lease agreements (primarily 15 to 20 years). provided from operating activities and borrowing capacity is sufficient to meet our liquidity needs for the foreseeable future. In addition, we seek to increase distributions to stockholders We intend, however, to use additional sources of capital to fund and FFO per share through both active portfolio management and property acquisitions and to repay future borrowings under our the acquisition of additional properties. At December 31, 2007, credit facility. we owned a diversified portfolio: • Of 2,270 retail properties; • With an occupancy rate of 97.9%, or 2,222 properties $300 Million Acquisition Credit Facility We have a $300 million revolving, unsecured credit facility that occupied of the 2,270 properties in the portfolio; expires in October 2008. In April 2007, Moody’s Investors Service • With only 48 properties available for lease; upgraded our credit ratings. Since May 2007, our investment • Leased to 115 different retail chains doing business in 30 grade credit ratings provided for financing under the credit facility separate retail industries; • Located in 49 states; at the London Interbank Offered Rate, commonly referred to as LIBOR, plus 60 basis points with a facility fee of 15 basis • With over 18.5 million square feet of leasable space; and points, for all-in drawn pricing of 75 basis points over LIBOR. At • With an average leasable retail space per property of February 1, 2008, we had a borrowing capacity of $300 million approximately 8,150 square feet. available on our credit facility and no outstanding balance. We expect to use the credit facility to acquire additional retail Of the 2,270 properties in the portfolio, 2,259, or 99.5%, properties and for other corporate purposes. Any additional are single-tenant, retail properties and the remaining 11 are borrowings will increase our exposure to interest rate risk. We multi-tenant, distribution and office properties. At December 31, have the right to request an increase in the borrowing capacity of 2007, 2,212, or 97.9%, of the 2,259 single-tenant properties the credit facility by up to $100 million, to a total borrowing were leased with a weighted average remaining lease term capacity of $400 million. Any increase in the borrowing capacity (excluding extension options) of approximately 13.0 years. is subject to approval by the lending banks on our credit facility. In addition, at December 31, 2007, our wholly-owned We regularly review our credit facility and may seek to extend, taxable REIT subsidiary, Crest Net Lease, Inc. (“Crest”), had renew or replace our credit facility, to the extent we deem invested $56.2 million in 30 properties, which are classified as appropriate. We have the right to extend the credit facility for held for sale. Crest was created to buy and sell properties, an additional term of one year (to October 2009). primarily to individual investors who are involved in tax-deferred exchanges under Section 1031 of the Internal Revenue Code of 1986, as amended (the “Tax Code”). Mortgage Debt We have no mortgage debt on any of our properties. 2007 Annual Report REALTY INCOME 57 Universal Shelf Registration In April 2006, we filed a shelf registration statement with the Credit Agency Ratings We are currently assigned investment grade corporate credit SEC, which is effective for a term of three years. In accordance ratings, on our senior unsecured notes. Fitch Ratings has assigned with the SEC rules, the amount of securities to be issued pur- a rating of BBB+, Moody’s Investors Service has assigned a rating suant to this shelf registration statement was not specified when of Baa1 and Standard & Poor’s Ratings Group has assigned a it was filed. The securities covered by this registration statement rating of BBB to our senior notes. The rating by Standard & Poor’s include common stock, preferred stock, debt securities, or any has a “positive” outlook and the ratings by Fitch and Moody’s combination of such securities. We may periodically offer one or have “stable” outlooks. more of these securities in amounts, prices and on terms to be We have also been assigned investment grade credit ratings announced when and if the securities are offered. The specifics on our preferred stock. Fitch Ratings has assigned a rating of of any future offerings, along with the use of proceeds of any BBB, Moody’s has assigned a rating of Baa2 and Standard securities offered, will be described in detail in a prospectus sup- & Poor’s has assigned a rating of BBB- to our preferred stock. plement, or other offering materials, at the time of any offering. The rating by Standard & Poor’s has a “positive” outlook and the There is no specific limit to the dollar amount of new securities ratings by Fitch and Moody’s have “stable” outlooks. that can be issued under this new shelf registration before it The credit ratings assigned to us could change based upon, expires in April 2009, and our common stock, preferred stock among other things, our results of operations and financial con- and notes issued after April 2006 were all issued pursuant to dition. These ratings are subject to ongoing evaluation by credit this universal shelf registration statement. Conservative Capital Structure We believe that our stockholders are best served by a rating agencies and we cannot assure you that any such rating will not be changed or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. Moreover, a rating is not a recommendation to buy, sell or hold our debt securities, conservative capital structure. Therefore, we seek to maintain preferred stock or common stock. a conservative debt level on our balance sheet and solid interest and fixed charge coverage ratios. At February 1, 2008, our total outstanding credit facility borrowings and outstanding Notes Outstanding Our senior unsecured note obligations consist of the following as of notes were $1.47 billion or approximately 33.7% of our total December 31, 2007, sorted by maturity date (dollars in millions): market capitalization of $4.36 billion. We define our total market capitalization at February 1, 2008 8.25% notes, issued in October 1998 as the sum of: and due in November 2008 $ 100.0 • Shares of our common stock outstanding of 101,286,217 8% notes, issued in January 1999 multiplied by the last reported sales price of our common and due in January 2009 stock on the NYSE of $25.15 per share on February 1, 5.375% notes, issued in March 2003 2008, or $2.55 billion; and due in March 2013 • Aggregate liquidation value (par value of $25 per share) 5.5% notes, issued in November 2003 of the Class D preferred stock of $127.5 million; and due in November 2015 • Aggregate liquidation value (par value of $25 per share) 5.95% notes, issued in September 2006 of the Class E preferred stock of $220 million; and and due in September 2016 • Outstanding notes of $1.47 billion. 5.375% notes, issued in September 2005 and due in September 2017 Historically, we have met our long-term capital needs through 6.75% notes, issued in September 2007 the issuance of common stock, preferred stock and long-term and due in August 2019 unsecured notes and bonds. Over the long term, we believe that 5.875% bonds, issued in March 2005 common stock may be the majority of our capital structure; how- and due in March 2035 20.0 100.0 150.0 275.0 175.0 550.0 100.0 $ 1,470.0 All of our outstanding notes and bonds have fixed interest rates. ever, we may issue additional preferred stock or debt securities from time to time. We may issue common stock when we believe that our share price is at a level that allows for the proceeds of any offering to be accretively invested into additional properties. In addition, we may issue common stock to permanently finance properties that were financed by our credit facility or debt secu- rities. However, we cannot assure you that we will have access to the capital markets at terms that are acceptable to us. 58 REALTY INCOME 2007 Annual Report Interest on all of the senior note obligations is paid semi- terms of our notes. These calculations, which are not based on annually, with the exception of the interest on the 8.25% senior GAAP measurements, are presented to investors to show our abil- notes issued in October 1998, which is paid monthly. All of ity to incur additional debt under the terms of our notes only and these notes contain various covenants, including: (i) a limitation are not measures of our liquidity or performance. The actual on incurrence of any debt which would cause our debt to total amounts as of December 31, 2007 are: adjusted assets ratio to exceed 60%; (ii) a limitation on incur- rence of any secured debt which would cause our secured debt Note Covenants Required Actual to total adjusted assets ratio to exceed 40%; (iii) a limitation on Limitation on incurrence of incurrence of any debt which would cause our debt service cov- total debt ≤ 60% 41.9% erage ratio to be less than 1.5 times; and (iv) the maintenance Limitation on incurrence of at all times of total unencumbered assets not less than 150% of secured debt our outstanding unsecured debt. We have been in compliance Debt service coverage with these covenants since each of the notes were issued. Maintenance of total The following is a summary of the key financial covenants to unencumbered assets our senior unsecured notes, as defined and calculated per the ≤ 40% ≥ 1.5 x ≥ 150% of unsecured debt 0.0% 4.2 x 239% The following table summarizes the maturity of each of our obligations as of December 31, 2007 (dollars in millions): Table of Obligations Year of Maturity 2008 2009 2010 2011 2012 Thereafter Totals Credit Facility(1) Notes $ — $ 100.0 — — — — — 20.0 — — — 1,350.0 $ — $ 1,470.0 Interest(2) $ 91.2 82.5 82.4 82.4 82.4 505.9 $ 926.8 Ground Leases Paid by Realty Income(3) $ 0.1 0.1 0.1 0.1 0.1 1.0 $ 1.5 Ground Leases Paid by Our Tenants(4) $ 1.8 1.8 1.7 1.7 1.6 16.5 $ 25.1 Other(5) $ 8.6 Totals $ 201.7 — — — — — 104.4 84.2 84.2 84.1 1,873.4 $ 8.6 $ 2,432.0 (1) There was no outstanding credit facility balance on February 1, 2008. (2) Interest on the credit facility and notes has been calculated based on outstanding balances as of December 31, 2007 through their respective maturity dates. (3) Realty Income currently pays the ground lessor directly for the rent under the ground lease. A majority of this rent is reimbursed to Realty Income as additional rent from our tenant. (4) Our tenants, who are generally sub-tenants under the ground leases, are responsible for paying the rent under these ground leases. In the event a tenant fails to pay the ground lease rent, we are primarily responsible. (5) Other consists of $7.9 million of commitments under construction contracts and $743,000 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. We anticipate paying off the notes due in 2008 and 2009 by one or more of the following; using cash on hand, utilizing our credit facility or issuing new securities. 2007 Annual Report REALTY INCOME 59 Preferred Stock Outstanding In 2004, we issued 5.1 million shares of 7.375% Class D payment of contractual rent, we cannot assure you that the actual return on the funds invested will remain at the percent- cumulative redeemable preferred stock. Beginning May 27, 2009, ages listed above. shares of Class D preferred stock are redeemable at our option for $25 per share, plus any accrued and unpaid dividends. Dividends on shares of Class D preferred stock are paid monthly Increases in Monthly Distributions to Common Stockholders We continue our 38-year policy of paying distributions monthly. in arrears. Monthly distributions per share were increased in April 2007 In December 2006, we issued 8.8 million shares of 6.75% by $0.000625 to $0.127125, in July 2007 by $0.000625 Class E cumulative redeemable preferred stock. Beginning to $0.12775, in September 2007 by $0.00775 to $0.1355, in December 7, 2011, shares of Class E preferred stock are October 2007 by $0.000625 to $0.136125 and in January redeemable at our option for $25 per share, plus any accrued 2008 by $0.000625 to $0.13675. The increase in January and unpaid dividends. Dividends on shares of Class E preferred 2008 was our 41st consecutive quarterly increase and the 47th stock are paid monthly in arrears. No Off-Balance Sheet Arrangements or Unconsolidated Investments We have no unconsolidated or off-balance sheet investments in increase in the amount of our dividend since our listing on the New York Stock Exchange, or NYSE, in 1994. In 2007, we paid the following monthly cash distributions per share: three in the amount of $0.1265, three in the amount of $0.127125, two in the amount of $0.12775, one in the amount of $0.1355 and “variable interest entities” or off-balance sheet financing, nor do we engage in trading activities involving energy or commodity three in the amount of $0.136125, totaling $1.56025. In December 2007 and January 2008, we declared distributions of contracts or other derivative instruments. $0.13675 per share, which were paid in January 2008 and will As we have no joint ventures, off-balance sheet entities, or be paid in February 2008, respectively. mandatory redeemable preferred stock, our financial position or The monthly distribution of $0.13675 per share represents results of operations are currently not affected by Financial a current annualized distribution of $1.641 per share, and an Accounting Standard Board Interpretation No. 46R, Consolidation annualized distribution yield of approximately 6.5% based on of Variable Interest Entities and Statement of Financial Accounting the last reported sale price of our common stock on the NYSE of Standard No. 150, Accounting for Certain Financial Instruments $25.15 on February 1, 2008. Although we expect to continue with Characteristics of both Liabilities and Equity. our policy of paying monthly distributions, we cannot guarantee Acquisitions During 2007 During 2007, Realty Income and Crest invested $533.7 million, in aggregate, in 357 new retail properties and properties under development. These 357 new properties are located in 38 states, will contain over 1.9 million leasable square feet, and are 100% leased with an average lease term of 19.3 years. As described that we will maintain our current level of distributions, that we will continue our pattern of increasing distributions per share, or what our actual distribution yield will be in any future period. R E S U LT S O F O P E R AT I O N S Critical Accounting Policies Our consolidated financial statements have been prepared in below, Realty Income acquired 325 properties and Crest accordance with U.S. generally accepted accounting principles acquired 32 properties. (“GAAP”). Our consolidated financial statements are the basis Included in the $533.7 million is $503.8 million invested for our discussion and analysis of financial condition and results by Realty Income in 325 new properties and properties under of operations. Preparing our consolidated financial statements development, with an initial weighted average contractual lease requires us to make a number of estimates and assumptions that rate of 8.6%. These 325 properties are located in 38 states, will affect the reported amounts and disclosures in the consolidated contain over 1.8 million leasable square feet and are 100% financial statements. We believe that we have made these esti- leased with an average lease term of 19.2 years. The 325 new mates and assumptions in an appropriate manner and in a way properties acquired by Realty Income are net-leased to 16 differ- that accurately reflects our financial condition. We continually ent retail chains in the following nine industries: automotive test and evaluate these estimates and assumptions using our service, automotive tire service, convenience store, distribution historical knowledge of the business, as well as other factors, to and office, drug store, grocery, health and fitness, restaurant ensure that they are reasonable for reporting purposes. However, and sporting goods. Also included in the $533.7 million is actual results may differ from these estimates and assumptions. $29.9 million invested by Crest in 32 new restaurant properties. In order to prepare our consolidated financial statements The initial weighted average contractual lease rate is com- according to the rules and guidelines set forth by GAAP, many puted as estimated contractual net operating income (in a net- subjective judgments must be made with regard to critical leased property that is equal to the base rent or, in the case of accounting policies. One of these judgments is our estimate for properties under development, the estimated base rent under the useful lives in determining depreciation expense for our proper- lease) for the first year of each lease, divided by the estimated ties. Depreciation of buildings and improvements is generally total costs. Since it is possible that a tenant could default on the computed using the straight–line method over an estimated useful 60 REALTY INCOME 2007 Annual Report life of 25 years. If we use a shorter or longer estimated useful life Of the 2,270 properties in the portfolio at December 31, it could have a material impact on our results of operations. We 2007, 2,259, or 99.5%, are single-tenant properties and the believe that 25 years is an appropriate estimate of useful life. No remaining 11 are multi-tenant properties. Of the 2,259 single- depreciation has been recorded on Crest’s properties because tenant properties, 2,212, or 97.9%, were net leased with a they are held for sale. weighted average remaining lease term (excluding rights to Another significant judgment must be made as to if, and extend a lease at the option of the tenant) of approximately when, impairment losses should be taken on our properties when 13.0 years at December 31, 2007. Of our 2,212 leased single- events or a change in circumstances indicate that the carrying tenant properties, 1,999 or 90.4%, were under leases that pro- amount of the asset may not be recoverable. Generally, a provi- vide for increases in rents through: sion is made for impairment loss if estimated future operating • Primarily base rent increases tied to a consumer price index; cash flows (undiscounted and without interest charges) plus • Fixed increases; estimated disposition proceeds (undiscounted) are less than • To a lesser degree, overage rent based on a percentage of the current book value. Impairment losses are measured as the the tenants’ gross sales; or amount by which the current book value of the asset exceeds the • A combination of two or more of the above rent provisions. fair value of the asset. If a property is held for sale, it is carried at the lower of carrying cost or estimated fair value, less cost to Percentage rent, which is included in rental revenue, was sell. The carrying value of our real estate is the largest component $836,000 in 2007, $1.1 million in 2006 and $1.1 million in of our consolidated balance sheet. If events should occur that require us to reduce the carrying value of our real estate by 2005. Percentage rent in 2007 was less than 1% of rental rev- enue and we anticipate percentage rent to be less than 1% of recording provisions for impairment losses, it could have a rental revenue in 2008. material impact on our results of operations. Our portfolio of retail real estate, leased primarily to regional The following is a comparison of our results of operations for the years ended December 31, 2007, 2006 and 2005. Rental Revenue Rental revenue was $290.2 million for 2007 versus $237.5 million and national chains under net leases, continues to perform well and provide dependable lease revenue supporting the payment of monthly dividends to our stockholders. At December 31, 2007, our portfolio of 2,270 retail properties was 97.9% leased with 48 prop- erties available for lease, one of which is a multi-tenant property. As of February 1, 2008, transactions to lease or sell 17 of the for 2006, an increase of $52.7 million, or 22.2%. Rental revenue 48 properties available for lease at December 31, 2007 were was $195.1 million in 2005. The increase in rental revenue in underway or completed. We anticipate these transactions will be 2007 compared to 2006 is primarily attributable to: completed during the next several months, although we cannot • The 325 retail properties acquired by Realty Income in guarantee that all of these properties can be leased or sold 2007, which generated $13.6 million of rent in 2007; within this period. It has been our experience that approximately • The 322 retail properties acquired by Realty Income in 1% to 3% of our property portfolio will be unleased at any given 2006, which generated $53.4 million of rent in 2007 time; however, we cannot assure you that the number of proper- compared to $15.7 million in 2006, an increase of ties available for lease will not exceed these levels. $37.7 million; • Same store rents generated on 1,505 properties during the entire years of 2007 and 2006 increased by $2.9 million, Depreciation and Amortization Depreciation and amortization was $77.2 million in 2007 versus or 1.4%, to $204.2 million from $201.3 million; net of $59.3 million in 2006 and $46.0 million in 2005. The increases • A decrease of $1.2 million relating to the aggregate of in depreciation and amortization in 2007 and 2006 were due to (i) development properties acquired before 2006 that the acquisition of properties in 2007, 2006 and 2005, which started paying rent in 2006, (ii) properties that were were partially offset by property sales in these years. As dis- vacant during part of 2007 or 2006 and (iii) lease termi- cussed in the section entitled “Funds from Operations Available nation settlements. These items totaled $17.74 million to Common Stockholders,” depreciation and amortization is a in aggregate in 2007 compared to $18.96 million in non-cash item that is excluded from our calculation of FFO. 2006; and • A decrease in straight-line rent and other non-cash adjust- ments to rent of $274,000 in 2007 as compared to 2006. Interest Expense Interest expense was $13.0 million higher in 2007 than in 2006. Interest expense increased in 2007 primarily due to higher average outstanding balances, which were partially offset by slightly lower interest rates related to our average outstanding borrowings, and Crest’s larger investment in real estate, which contributed to the increase in interest expense included in discontinued operations. We issued $550 million of 12-year 2007 Annual Report REALTY INCOME 61 notes in September 2007 and $275 million of 10-year notes in The following is a reconciliation of net cash provided by September 2006, which contributed to the increase in average operating activities on our consolidated statements of cash flow outstanding balances and slightly lower average interest rates on to our interest coverage amount (dollars in thousands): our debt. The following is a summary of the components of our interest 2007 2006 2005 expense (dollars in thousands): Net cash provided by 2007 2006 2005 Interest expense 64,331 51,363 40,949 operating activities $ 318,169 $ 86,945 $ 109,557 Interest on our credit facility and notes $ 67,964 $ 54,068 $ 40,968 Interest included in discontinued operations from real estate acquired Interest expense included in discontinued operations(1) Income taxes Income taxes included in discontinued 6,201 1,392 3,708 747 1,139 813 for resale by Crest (6,201) (3,708) (1,139) operations(1) 3,039 494 943 Amortization of settlements on treasury lock agreement Credit facility commitment fees Amortization of credit facility origination costs and deferred Investment in real estate acquired for resale(1)(2) 756 Proceeds from sales of real estate acquired 29,886 113,166 55,890 498 for resale(1) (119,790) (22,405) (22,195) 870 456 717 456 Collection of a note receivable by Crest(1) (651) (1,333) Crest provisions for impairment(1) Gain on sales of real estate — (1,188) — — bond financing costs 2,235 Interest capitalized (993) 2,014 (2,184) 1,752 (1,886) Interest expense $ 64,331 $ 51,363 $ 40,949 acquired for resale(1) 12,319 2,219 3,291 Credit facility and notes outstanding Average outstanding balances (dollars 2007 2006 2005 Changes in assets and liabilities: Amortization of share- based compensation (3,857) (2,951) (2,167) Accounts receivable and other assets 49 (4,418) 3,292 in thousands) $ 1,111,914 $ 881,669 $ 647,301 Accounts payable, Average interest rates 6.11% 6.13% 6.33% accrued expenses and other liabilities (21,675) (3,208) (8,290) At February 1, 2008, the weighted average interest rate on Interest coverage our notes payable of $1.47 billion was 6.28% and the average amount $ 289,413 $ 223,139 $ 183,222 interest rate on our credit line was 3.78%. There was no out- Divided by interest standing balance on our credit line at February 1, 2008. expense(3) $ 70,532 $ 55,071 $ 42,088 Interest Coverage Ratio Our interest coverage ratio for 2007 was 4.1 times, for 2006 was (1) Crest activities. (2) The 2005 amount includes intangibles recorded in connection with 4.1 times and for 2005 was 4.4 times. Interest coverage ratio is acquisitions of real estate acquired for resale. Interest coverage ratio 4.1 4.1 4.4 (3) Includes interest expense recorded to “income from discontinued operations, real estate acquired for resale by Crest” on our consolidated statements of income. calculated as: the interest coverage amount (as calculated in the following table) divided by interest expense, including interest recorded to discontinued operations. We consider interest coverage ratio to be an appropriate supplemental measure of a company’s ability to meet its interest expense obligations. Our calculation of interest coverage ratio may be different from the calculation used by other companies and, therefore, comparability may be limited. This information should not be considered as an alternative to any GAAP liquidity measures. 62 REALTY INCOME 2007 Annual Report Fixed Charge Coverage Ratio Our fixed charge coverage ratio for 2007 was 3.1 times, for Property Expenses Property expenses are broken down into costs associated with 2006 was 3.4 times and for 2005 was 3.6 times. Fixed charge non-net leased multi-tenant properties, unleased single-tenant coverage ratio is calculated in exactly the same manner as inter- properties and general portfolio expenses. Expenses related to est coverage ratio, except that preferred stock dividends are also the multi-tenant and unleased single-tenant properties include, added to the denominator. We consider fixed charge coverage but are not limited to, property taxes, maintenance, insurance, ratio to be an appropriate supplemental measure of a company’s utilities, property inspections, bad debt expense and legal fees. ability to make its interest and preferred stock dividend pay- General portfolio costs include, but are not limited to, insurance, ments. Our calculation of the fixed charge coverage ratio may be legal, bad debt expense, property inspections and title search different from the calculation used by other companies and, fees. At December 31, 2007, 48 properties were available for therefore, comparability may be limited. This information should lease, as compared to 26 at December 31, 2006 and 25 at not be considered as an alternative to any GAAP liquidity meas- December 31, 2005. ures or information presented in Exhibit 12.1 to our Form 10-K. Property expenses were $3.5 million in 2007, $3.3 million Interest coverage amount divided by interest expense plus in 2006 and $3.9 million in 2005. Property expenses include preferred stock dividends (dollars in thousands): provisions for impairment of $138,000 recorded for one property 2007 2006 2005 Interest coverage amount $ 289,413 $ 223,139 $ 183,222 Divided by interest expense plus preferred stock in 2007 and $151,000 recorded for two properties in 2005. Income Taxes Income taxes were $1.4 million in 2007 as compared to $747,000 in 2006 and $813,000 in 2005. These amounts are for city and state income taxes paid by Realty Income. The increase in 2007 is due primarily to an increase in rental revenue dividends(1) $ 94,785 $ 66,433 $ 51,491 resulting in higher city and state income tax expense and higher Fixed charge state tax rates. coverage ratio 3.1 3.4 3.6 (1) Includes interest expense recorded to “income from discontinued operations, real estate acquired for resale by Crest” on our consolidated statements of income. General and Administrative Expenses General and administrative expenses increased by $5.2 million to $22.7 million in 2007 versus $17.5 million in 2006. General In addition, Crest incurred state and federal income taxes of $3.0 million in 2007 as compared to $494,000 in 2006 and $943,000 in 2005. The increase in Crest’s 2007 income taxes over the 2006 and 2005 income taxes is due to higher taxable income, primarily attributable to higher rental revenue and higher gain on sales of real estate acquired for resale. These amounts are included in “income from discontinued operations, real estate acquired for resale by Crest” on our consolidated and administrative expenses were $15.4 million in 2005. In statements of income. 2007, general and administrative expenses as a percentage of total revenue were 7.7% as compared to 7.3% in 2006 and 7.9% in 2005. General and administrative expenses increased in 2007 primarily due to increases in employee and director com- pensation costs. During 2007, we added two new directors to our board of directors. We anticipate that in 2008, general and administrative expenses as a percentage of total revenue will be flat or decrease. In February 2008, we had 75 permanent employees as compared to 70 permanent employees in February 2007. As our property portfolio has grown and continues to grow, we have increased, and anticipate that we will continue to gradually increase the level of our staffing. Loss on Extinguishment of Debt In September 2006, we redeemed all of our outstanding $110 million, 7.75%, unsecured notes due May 2007 (the “2007 Notes”). The 2007 Notes were redeemed at a redemption price equal to 100% of the principal amount of the 2007 Notes, plus accrued and unpaid interest of $3.2 million, as well as a make-whole payment of $1.6 million. We recorded a loss on extin- guishment 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. Discontinued Operations Crest acquires properties with the intention of reselling them rather than holding them as investments and operating the prop- erties. Consequently, we classify properties acquired by Crest as held for sale at the date of acquisition and do not depreciate them. The operation of Crest’s properties is classified as “income from discontinued operations, real estate acquired for resale by Crest” on our consolidated statements of income. 2007 Annual Report REALTY INCOME 63 The following is a summary of Crest’s “income from The following is a summary of our total income from discontinued discontinued operations, real estate acquired for resale” on our operations (dollars in thousands, except per share data): consolidated statements of income (dollars in thousands, except per share data): Crest’s income from discontinued operations, real estate acquired for resale Gain on sales of real estate 2007 2006 2005 Real estate acquired for resale by Crest $ 10,703 $ 1,402 $ 2,781 2007 2006 2005 Real estate held for investment 2,323 3,661 7,935 acquired for resale $ 12,319 $ 2,219 $ 3,291 Income from discontinued Rental revenue Other revenue Interest expense General and 8,165 190 5,065 2,083 operations $ 13,026 $ 5,063 $ 10,716 15 2 Per common share, (6,201) (3,708) (1,139) basic and diluted $ 0.13 $ 0.06 $ 0.13 administrative expense (691) Property expenses Provisions for impairment Income taxes (40) — (3,039) (440) (67) (1,188) (494) (453) (60) — (943) Income from discontinued operations, real estate acquired for resale Crest’s Property Sales In 2007, Crest sold 62 properties for $123.6 million, which resulted in a gain of $12.3 million. For two property sales during 2007, Crest provided the buyers partial financing for a total of $3.8 million, of which $619,000 was paid in full in November 2007. In 2006, Crest sold 13 properties for $22.4 million, which resulted in a gain of $2.2 million. In 2005, Crest sold 12 prop- by Crest $ 10,703 $ 1,402 $ 2,781 erties for $23.5 million, which resulted in a gain of $3.3 million. Per common share, basic and diluted $ 0.11 $ 0.02 $ 0.03 Realty Income’s operations from properties sold in 2007, 2006 and 2005 have been classified as discontinued opera- tions. No investment properties were classified as held for sale at December 31, 2007. The following is a summary of Realty Income’s “income from discontinued operations, real estate held for investment” on our consolidated statements of income (dollars in thousands, except per share data): Realty Income’s income from discontinued operations, real estate held for investment Gain on sales of 2007 2006 2005 In 2005, Crest provided a buyer partial financing of $1.3 million for one property sale, which was paid in full in February 2006. Crest’s gains on sales are reported before income taxes and are included in discontinued operations. Crest’s Property Inventory At December 31, 2007, Crest had $56.2 million invested in 30 properties, which are held for sale. At December 31, 2006, Crest’s property inventory totaled $137.5 million in 60 proper- ties. Crest generally carries real estate inventory in excess of $20 million. Crest generates an earnings spread on the differ- ence between the lease payments it receives on the properties held in inventory and the cost of capital used to acquire proper- ties. It is our belief that at this level of inventory, rental revenue will exceed the ongoing operating expenses of Crest without any investment properties $ 1,724 $ 3,036 $ 6,573 property sales. Rental revenue Other revenue Depreciation and amortization Property expenses Provisions for impairment Income from discontinued operations, real estate 881 2 (130) (20) (134) 1,063 2,296 34 2 (320) (136) (16) (662) (239) (35) held for investment $ 2,323 $ 3,661 $ 7,935 Per common share, basic and diluted $ 0.02 $ 0.04 $ 0.10 64 REALTY INCOME 2007 Annual Report Gain on Sales of Investment Properties, Improvements and Land by Realty Income In 2007, we sold ten investment properties for $7.0 million, Provisions for Impairment on Realty Income Investment Properties In 2007, we recorded a provision for impairment of $134,000 which resulted in a gain of $1.7 million. This gain is included in on one property, which is included in “income from discontinued discontinued operations. In addition, we sold excess land and operations, real estate held for investment” on our consolidated improvements from five properties for an aggregate of $4.4 million, statement of income, as the property was subsequently sold. which resulted in a gain of $1.8 million. This gain from the land Additionally, we recorded a provision for impairment of and improvements sales is reported in “other revenue” on our $138,000 on one property in 2007, which is included in property consolidated statements of income because these improvements expense on our consolidated statement of income. In 2006, we and excess land were associated with properties that continue to recorded a provision for impairment of $16,000 on one property. be owned as part of our core operations. In 2006, we sold or In 2005, we recorded provisions for impairment totaling exchanged 13 investment properties for $10.7 million, which $186,000 on four properties. The 2006 and 2005 provisions are resulted in a gain of $3.0 million, which is included in discon- included in “income from discontinued operations, real estate held tinued operations. In 2005, we sold 23 investment properties and for investment” except for $151,000 in 2005, which is included sold a portion of the land from two properties for $23.4 million in property expense on our consolidated statement of income. 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” on our consolidated statements of income. We have an active portfolio management program that incor- porates the sale of assets when we believe the reinvestment of the sale proceeds will generate higher returns, enhance the credit quality of our real estate portfolio or extend our average Preferred Stock Dividends Preferred stock cash dividends totaled $24.3 million in 2007 as compared to $11.4 million in 2006 and $9.4 million in 2005. Net Income Available to Common Stockholders Net income available to common stockholders was $116.2 million remaining lease term. At December 31, 2007, we classified real in 2007, an increase of $16.8 million as compared to $99.4 million estate owned by Crest with a carrying amount of $56.2 million in 2006. Net income available to common stockholders in 2005 as held for sale on our balance sheet. Additionally, we anticipate was $89.7 million. selling investment properties from our portfolio that have not yet The calculation to determine net income available to common been specifically identified, from which we anticipate receiving stockholders includes gains from the sales of properties. The between $10 million and $35 million in proceeds during the amount of gains varies from period to period based on the timing next 12 months. We intend to invest these proceeds into new of property sales and can significantly impact net income available property acquisitions. However, we cannot guarantee that we will to common stockholders. sell properties during the next 12 months. During 2007, the gain recognized from the sales of investment properties was $3.6 million as compared to $3.0 million during 2006 and $6.6 million in 2005. Crest’s gain recognized from the sale of properties during 2007 was $12.3 million as compared to $2.2 million during 2006 and $3.3 million during 2005. Provisions for Impairment on Real Estate Acquired for Resale by Crest In 2007 and 2005, no provisions for impairment were recorded by Crest. In 2006, provisions for impairment of $1.2 million were recorded by Crest on three properties. One of the three properties was sold in 2007. Crest’s properties are held for sale and the provisions for impairment recorded in 2006 reduced the carrying costs to the estimated fair-market value of those proper- ties, net of estimated selling costs. 2007 Annual Report REALTY INCOME 65 F U N D S F R O M O P E R AT I O N S AVA I L A B L E T O C O M M O N S T O C K H O L D E R S ( F F O ) FFO for 2007 increased by $33.9 million, or 21.8%, to $189.7 million as compared to $155.8 million in 2006 and $129.6 million in 2005. The following is a reconciliation of net income available to common stockholders (which we believe is the most comparable GAAP measure) to FFO. Also presented is information regarding distributions paid to common stockholders and the weighted average number of shares used for the basic and diluted computation per share (dollars in thousands, except per share amounts): Net income available to common stockholders $ 116,156 $ 99,419 $ 89,716 2007 2006 2005 Depreciation and amortization: Continuing operations Discontinued operations Depreciation of furniture, fixtures and equipment Gain on sales of land and investment properties: Continuing operations Discontinued operations 77,192 130 (244) (1,835) (1,724) 59,288 320 (192) — (3,036) 46,002 662 (142) (18) (6,573) FFO available to common stockholders $ 189,675 $ 155,799 $ 129,647 FFO per common share: Basic Diluted Distributions paid to common stockholders FFO in excess of distributions paid to common stockholders Weighted average number of common shares used for computation per share: Basic Diluted $ $ 1.89 1.89 $ 157,659 $ 32,016 $ $ 1.74 1.73 $ 129,667 $ 26,132 $ $ 1.62 1.62 $ 108,575 $ 21,072 100,195,031 100,333,966 89,766,714 89,917,554 79,950,255 80,208,593 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 invest- ment properties and extraordinary items. We consider FFO to be an appropriate supplemental measure of a REIT’s operating performance as it is based on a net income analysis of property portfolio performance that excludes noncash items such as depreciation. The historical accounting convention used for real estate assets requires straight-line depreciation of buildings and improvements, which implies that the value of real estate assets diminishes predictably over time. Since real estate values historically rise and fall with market conditions, presentations of oper- ating 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 finan- cial 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 alterna- tive to net income as an indication of our 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. 66 REALTY INCOME 2007 Annual Report Other Non-Cash Items and Capitalized Expenditures The following information includes non-cash items and capitalized I M PA C T O F I N F L AT I O N Tenant leases generally provide for limited increases in rent as expenditures on existing properties in our portfolio. These items a result of increases in the tenants’ sales volumes, increases in are not included in the adjustments to net income available to the consumer price index, and/or fixed increases. We expect common stockholders to arrive at FFO. Analysts and investors that inflation will cause these lease provisions to result in rent often request this supplemental information. increases over time. During times when inflation is greater than increases in rent, as provided for in the leases, rent increases (dollars in thousands) 2007 2006 2005 may not keep up with the rate of inflation. Amortization of settlements on treasury lock agreements(1) Amortization of deferred Approximately 97.4%, or 2,212, of the 2,270 properties in the portfolio are leased to tenants under net leases where the $ 870 $ 717 $ 756 tenant is responsible for property expenses. Net leases tend to reduce our exposure to rising property expenses due to inflation. note financing costs(2) 1,494 1,287 1,034 Inflation and increased costs may have an adverse impact on our Amortization of share-based tenants if increases in their operating expenses exceed increases compensation 3,857 2,951 2,167 in revenue. Capitalized leasing costs and commissions (614) (761) (570) Capitalized building improvements Straight-line rent(3) Provisions for impairment Crest provisions for impairment Crest gain on sale, previously reported as impairment Gain on reinstatement of property carrying value (1,258) (1,217) 272 (203) (1,515) 16 (1,017) (1,360) 186 I M PA C T O F R E C E N T A C C O U N T I N G P R O N O U N C E M E N T S For information on the impact of recent accounting pronounce- ments on our business, see note 2 of the Notes to Consolidated Financial Statements. — 1,188 (271) — — (716) — — — Item 7A: Quantitative and Qualitative Disclosures about Market Risk We are exposed to interest rate changes primarily as a result of our credit facility and long-term notes used to maintain liquidity and expand our real estate investment portfolio and operations. Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flow and to lower (1) The settlements on the treasury lock agreements resulted from an interest our overall borrowing costs. To achieve these objectives we issue rate risk prevention strategy that we used in 1997 and 1998, which correlated to pending issuances of senior note securities. We have not employed this strategy since 1998. (2) Amortization of deferred note financing costs includes the amortization of costs incurred and capitalized when our notes were issued in May 1997, October 1998, January 1999, March 2003, November 2003, March 2005, September 2005, September 2006 and September 2007. 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. long-term notes, primarily at fixed rates, and may selectively enter into derivative financial instruments, such as interest rate lock agreements, interest rate swaps and caps in order to miti- gate our interest rate risk on a related financial instrument. We were not a party to any derivative financial instruments at December 31, 2007. We do not enter into any derivative trans- actions for speculative or trading purposes. 2007 Annual Report REALTY INCOME 67 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, 2007. This information is presented to evaluate the expected cash flows and sensitivity to interest rate changes (dollars in millions): Expected Maturity Data Year of maturity 2008(1)(2) 2009(3) 2010 2011 2012 Thereafter(4) Totals Fair Value(5) Average interest rate on fixed rate debt 8.25% 8.00 — — — 6.10 6.28% Fixed rate debt $ 100.0 20.0 — — — 1,350.0 $ 1,470.0 $ 1,412.5 Average interest rate on variable rate debt —% — — — — — —% Variable rate debt $ — — — — — — $ — $ — (1) $100 million matures in November 2008. (2) The credit facility expires in October 2008. There was no outstanding credit facility balance as of February 1, 2008. (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, $550 million matures in August 2019 and $100 million matures in March 2035. (5) We base the fair value of the fixed rate debt at December 31, 2007 on the closing market price or indicative price per each note. The table incorporates only those exposures that exist as of December 31, 2007. 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, 2007, 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. 68 REALTY INCOME 2007 Annual Report R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S S E L E C T E D F I N A N C I A L D ATA (not covered by Report of Independent Registered Public Accounting Firm) As of or for the years ended December 31, (dollars in thousands, except for per share data) 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 2007 2006 2005 2004 2003 $ 3,077,352 $ 2,546,508 $ 1,920,988 $ 1,442,315 $ 1,360,257 193,101 1,470,000 1,539,260 1,538,092 318,169 182,528 296,513 127,383 13,026 140,409 (24,253) 10,573 920,000 970,516 1,575,992 86,945 (55,131) 239,529 105,718 5,063 110,781 (11,362) 65,704 891,700 931,774 989,214 109,557 63,563 195,453 88,403 10,716 99,119 (9,403) 2,141 503,600 528,580 913,735 178,337 (2,696) 172,711 81,400 21,997 103,397 (9,455) 4,837 506,400 532,491 827,766 73,957 (4,084) 142,296 70,685 15,750 86,435 (9,713) value of preferred shares redeemed — — — (3,774) — Net income available to common stockholders Cash distributions paid to common stockholders Ratio of earnings to fixed charges(1) Ratio of earnings to combined fixed charges and preferred stock cash dividends(1) Basic and diluted net income per common share Cash distributions paid per common share Cash distributions declared per 116,156 99,419 89,716 90,168 76,722 157,659 2.9 times 129,667 2.9 times 108,575 3.2 times 97,420 3.9 times 83,842 4.1 times 2.2 times 2.4 times 2.6 times 3.1 times 3.0 times 1.16 1.11 1.12 1.15 1.08 1.56025 1.43725 1.34625 1.24125 1.18125 common share 1.57050 1.44750 1.35250 1.25125 1.18375 Basic weighted average number of common shares outstanding 100,195,031 89,766,714 79,950,255 78,518,296 71,128,282 Diluted weighted average number of common shares outstanding 100,333,966 89,917,554 80,208,593 78,598,788 71,222,628 (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 7.375% Class D preferred stock in May 2004, 1,100,000 shares of our 7.375% Class D preferred stock in October 2004, and 8,800,000 shares of our 6.75% Class E preferred stock in December 2006. 2007 Annual Report REALTY INCOME 69 R E A L T Y I N C O M E C O R P O R A T I O N A N D S U B S I D I A R I E S C O N T R O L S A N D P R O C E D U R E S C H A N G E S I N A N D D I S A G R E E M E N T S W I T H A C C O U N TA N T S O N A C C O U N T I N G A N D F I N A N C I A L D I S C L O S U R E M A N A G E M E N T ’ S R E P O R T O N I N T E R N A L C O N T R O L OV E R F I N A N C I A L R E P O R T I N G We have had no disagreements with our independent registered Internal control over financial reporting refers to the process public accounting firm on accountancy or financial disclosure, nor designed by, or under the supervision of, our Chief Executive have we changed accountants in the two most recent fiscal years. Officer and Chief Financial Officer, and effected by our board of C O N T R O L S A N D P R O C E D U R E S directors, management and other personnel, to provide reason- able assurance regarding the reliability of financial reporting and Evaluation of Disclosure Controls and Procedures We maintain the preparation of financial statements for external purposes in disclosure controls and procedures (as defined in Securities accordance with generally accepted accounting principles, and Exchange Act 1934 Rules 13a-14(c) and 15d-14(c)) that are includes those policies and procedures that: designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities (1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and disposi- and Exchange Commission’s rules and forms, and that such tions of the assets of the Company; information is accumulated and communicated to our manage- ment, including our Chief Executive Officer and Chief Financial (2) Provide reasonable assurance that transactions are recorded Officer, as appropriate, to allow timely decisions regarding required as necessary to permit preparation of financial statements in disclosure. In designing and evaluating the disclosure controls accordance with generally accepted accounting principles, and and procedures, management recognized that any controls and that receipts and expenditures of the Company are being made procedures, no matter how well designed and operated, can pro- only in accordance with authorizations of management and vide only reasonable assurance of achieving the desired control directors of the Company; and objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possi- (3) Provide reasonable assurance regarding prevention or timely ble controls and procedures. detection of unauthorized acquisition, use or disposition of the As of and for the year ended December 31, 2007, we carried Company’s assets that could have a material effect on the finan- out an evaluation of the effectiveness of the design and operation cial statements. of our disclosure controls and procedures, under the supervision and with the participation of management, including our Chief Management is responsible for establishing and maintaining Executive Officer and Chief Financial Officer. Based on the fore- adequate internal control over financial reporting for the Company. going, our Chief Executive Officer and Chief Financial Officer Management has used the framework set forth in the report concluded that our disclosure controls and procedures were entitled “Internal Control—Integrated Framework” published by the effective and were operating at a reasonable assurance level. Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission to evaluate the effectiveness of the Company’s inter- nal 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 the effectiveness of the Company’s internal control over financial reporting. Submitted on February 12, 2008 by, Thomas A Lewis, Chief Executive Officer and Vice Chairman Paul M. Meurer, Chief Financial Officer, Executive Vice President and Treasurer 70 REALTY INCOME 2007 Annual Report Changes in Internal Controls There have not been any significant Certifications Tom Lewis, Realty Income’s Chief Executive Officer, changes in our internal controls or in other factors that could certified to the NYSE in 2007, pursuant to Section 303A. 12(a) significantly affect these controls subsequent to the date of their of the NYSE’s Listing Standards, that he was not aware of any evaluation. There were no material weaknesses in our internal violation of the NYSE corporate governance listing standards controls, and therefore no corrective actions were taken. by Realty Income. Furthermore, Realty Income filed with the Limitations on the Effectiveness of Controls Internal control over ended December 31, 2007, the certifications by Tom Lewis and financial reporting cannot provide absolute assurance of achieving Paul Meurer, Realty Income’s Chief Executive Officer and Chief financial reporting objectives because of its inherent limitations. Financial Officer, respectively, required under Section 302 of the Internal control over financial reporting is a process that involves Sarbanes-Oxley Act. SEC, as exhibits to its Annual Report on Form 10-K for the year human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. 2007 Annual Report REALTY INCOME 71 M A R K E T F O R T H E R E G I S T R A N T ’ S C O M M O N E Q U I T Y, R E L AT E D S T O C K H O L D E R M AT T E R S A N D I S S U E R P U R C H A S E S O F E Q U I T Y S E C U R I T I E S 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. Price Per Share of Common Stock 2007 First quarter Second quarter Third quarter Fourth quarter Total 2006 First quarter Second quarter Third quarter Fourth quarter Total High $ 30.36 29.13 28.79 30.70 $ 24.93 24.06 25.10 28.43 Low Distributions Declared(1) $ 26.02 24.53 22.87 26.31 $ 21.57 21.25 21.65 24.40 $ 0.380125 0.382000 0.399375 0.409000 $ 1.570500 $ 0.349375 0.351250 0.368625 0.378250 $ 1.447500 (1) Common stock cash distributions currently are declared monthly by us based on financial results for the prior months. At December 31, 2007, a distribution of $0.13675 per common share had been declared and was paid in January 2008. There were 9,356 registered holders of record of our common stock as of December 31, 2007. We estimate that our total number of shareholders is approximately 80,000 when we include both registered and beneficial holders of our common stock. T O TA L R E T U R N P E R F O R M A N C E (cid:3) (cid:1) (cid:2) (cid:4) (cid:1) (cid:2) (cid:4) (cid:3) (cid:4) (cid:2) (cid:3) (cid:1) Realty Income Corporation Russell 2000 Realty Income Peer Group* SNL Triple Net REITS Index e u l a V x e d n I 300 250 200 150 (cid:2) 100 50 (cid:3) (cid:1) (cid:2) (cid:4) (cid:3) (cid:1) (cid:2) (cid:4) (cid:2) (cid:1) (cid:3) (cid:4) 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 12/31/07 Index Realty Income Corporation Russell 2000 Realty Income Peer Group* SNL Triple Net REITS Index 12/31/02 100.00 100.00 100.00 100.00 12/31/03 121.61 147.25 135.71 142.22 Period Ending 12/31/04 162.83 174.24 182.56 178.65 12/31/05 147.43 182.18 201.78 185.99 12/31/06 200.52 215.64 253.28 246.69 12/31/07 207.11 212.26 206.46 228.87 * Realty Income Peer Group consists of thirty-five companies (excluding Realty Income) with an implied market capitalization between $1.5 billion to $3 billion as of September 30, 2007. 72 REALTY INCOME 2007 Annual Report C O M PA N Y I N F O R M AT I O N 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 BOARD OF DIRECTORS Front row: Donald R. Cameron, Dr. Kathleen R. Allen, Thomas A. Lewis, Priya Cherian Huskins, Roger P. Kuppinger, William E. Clark, Jr. Back row: Gregory T. McLaughlin, Ronald L. Merriman, Michael D. McKee, Willard H. Smith, Jr. MANAGEMENT TEAM EXECUTIVE OFFICERS 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 OTHER OFFICERS Robert J. Israel Senior Vice President, Research Kim S. Kundrak Senior Vice President, Portfolio Acquisitions Laura S. King Vice President, Assistant General Counsel and Assistant Secretary Tere H. Miller Vice President, Corporate Communications Dawn Nguyen Vice President, Portfolio Management MDG (Monthly Dividend Girl) Vice President, Corporate Cheerleader Steve D. Burchett Associate Vice President, Senior Legal Counsel Elizabeth Cate Associate Vice President, Portfolio Management Jill M. Cossaboom Associate Vice President, Assistant Controller Kristin K. Ferrell Associate Vice President, Portfolio Management Michael K. Press Senior Vice President, Financial Sponsors & Banking Teresa M. Glenn Associate Vice President, Human Resources & Operations Theresa M. Casey Vice President, Information Technologies Mark Manheimer Associate Vice President, Research Gregory J. Fahey Vice President, Controller Jenette S. O’Brien Associate Vice President, Senior Legal Counsel DIRECTORS William E. Clark, Jr. Chairman of the Board of Directors INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM KPMG LLP San Diego, California Thomas A. Lewis Vice Chairman of the Board of Directors and Chief Executive Officer, Realty Income Corporation Kathleen R. Allen, Ph.D. Director, Center of Technology Commercialization, Marshall School of Business University of Southern California Donald R. Cameron Lead Independent Director President, Cameron, Murphy & Spangler, Inc. Priya Cherian Huskins Partner, Woodruff-Sawyer & Co. Roger P. Kuppinger Private Investment Banker and Financial Advisor Michael D. McKee Vice Chairman, Chief Executive Officer, The Irvine Company Gregory T. McLaughlin President, Tiger Woods Foundation Ronald L. Merriman Consultant, Merriman Partners Willard H. Smith, Jr Retired Managing Director, Merrill Lynch & Co. TRANSFER AGENT BNY Mellon Shareholder Services For shareholder administration and account information please visit BNY Mellon’s website to manage your account online at: www.bnymellon.com/shareowner/isd or call this toll-free number: 1-877-218-2434 or email your question to: shrrelations@bnymellon.com or write to: Shareholder Relations Department P.O. Box 358015 Pittsburgh, PA 15252-8015 FOR ADDITIONAL CORPORATE INFORMATION 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 Realty Income at: telephone: 760-741-2111 email: ir@realtyincome.com Copies of Realty Income’s Annual Report on Form 10-K are available upon written request to: Realty Income Corporation Attention: Investor Relations 600 La Terraza Boulevard Escondido, CA 92025 SUBSIDIARY COMPANY Crest Net Lease, Inc. Cary J. Wenthur President and Chief Operating Officer 600 La Terraza Boulevard Escondido, CA 92025 Printed on recycled paper 

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