Realty Income - 10-K annual report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC  20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2003

Commission File Number 1-13374

REALTY INCOME CORPORATION

(Exact name of registrant as specified in its charter)

220 West Crest Street, Escondido, California  92025

(Address of principal executive offices)

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

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

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

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes  ý  No  o

At June 30, 2003, the aggregate market value of the Registrant’s shares of common stock, $1.00 par value, held by non-affiliates of the Registrant was $1.2 billion, at the New York Stock Exchange (“NYSE”) closing price of $38.08.

At February 16, 2004, the number of shares of common stock outstanding was 38,006,034, the number of Class B preferred shares outstanding was 2,745,700, the number of Class C preferred shares outstanding was 1,380,000 and the number of Monthly Income Senior Notes, due 2008, outstanding was 4,000,000.

Documents incorporated by reference: Part III, Item 10, 11 and 12 incorporate by reference certain specific portions of the definitive proxy statement for Realty Income Corporation’s Annual Meeting to be held on May 11, 2004, to be filed pursuant to Regulation 14A.  Only those portions of the proxy statement which are specifically incorporated by reference herein shall constitute a part of this Annual Report.

Forward-Looking Statements

This annual report on Form 10-K, including documents incorporated by reference, contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act.  When used in this annual report, the words “estimated”, “anticipated” and similar expressions are intended to identify forward-looking statements.  Forward-looking statements are subject to risks, uncertainties, and assumptions about Realty Income Corporation, including, among other things:

•                  Our anticipated growth strategies;

•                  Our intention to acquire additional properties and the timing of these acquisitions;

•                  Our intention to sell properties and the timing of these property sales;

•                  Our intention to re-lease vacant properties;

•                  Anticipated trends in our business, including trends in the market for long-term net-leases of freestanding, single-tenant retail properties;

•                  Future expenditures for development projects; and

•                  Profitability of our subsidiary, Crest Net Lease, Inc.

Future events and actual results, financial and otherwise, may differ materially from the results discussed in the forward-looking statements.  In particular, some of the factors that could cause actual results to differ materially are:

•                  Our continued qualification as a real estate investment trust;

•                  General business and economic conditions;

•                  Competition;

•                  Fluctuating interest rates;

•                  Access to debt and equity capital markets;

•                  Other risks inherent in the real estate business including tenant defaults, potential liability relating to environmental matters and illiquidity of real estate investments;

•                  Changes in the tax laws of the United States of America; and

•                  Acts of terrorism and war.

Additional factors that may cause risks and uncertainties include those discussed in the sections entitled “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this annual report.

Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date that this annual report was filed with the Securities and Exchange Commission.  We undertake no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date of this annual report or to reflect the occurrence of unanticipated events.  In light of these risks and uncertainties, the forward-looking events discussed in this annual report might not occur.

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REALTY INCOME CORPORATION

Index to Form 10-K

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PART I

Item 1:                                      Business

THE COMPANY

Realty Income Corporation, The Monthly Dividend Company ^®, is a Maryland corporation organized to operate as an equity real estate investment trust, commonly referred to as a REIT.  Our primary business objective is to generate dependable monthly cash distributions from a consistent and predictable level of funds from operations, or FFO, per share.  Over the past 35 years, Realty Income and its predecessors have been acquiring and owning freestanding retail properties that generate rental revenue under long-term (primarily 15- to 20-year) lease agreements.  The monthly distributions are supported by the cash flow from our portfolio of retail properties leased to regional and national retail chains.

We are a fully integrated, self-administered, real estate company with in-house acquisition, leasing, legal, retail and real estate research, portfolio management and capital markets expertise. We seek to increase distributions to stockholders and FFO per share through both active portfolio management and the acquisition of additional properties.  Our portfolio management focus includes:

•                  Contractual rent increases on existing leases;

•                  Rent increases at the termination of existing leases when market conditions permit; and

•                  The active management of our property portfolio, including re-leasing of vacant properties and selective sales of properties.

Our acquisition of additional properties adheres to a focused strategy of primarily acquiring properties that are:

•                  Freestanding, single-tenant, retail locations;

•                  Leased to regional and national retail chains; and

•                  Leased under long-term, net-lease agreements.

At December 31, 2003, we owned a diversified portfolio:

•                  Of 1,404 retail properties;

•                  With an occupancy rate of 98.1%, or 1,378 properties occupied of the 1,404 properties in the portfolio;

•                  Leased to 85 different retail chains doing business in 28 separate retail industries;

•                  Located in 48 states;

•                  With over 11.3 million square feet of leasable space; and

•                  With an average leasable retail space of 8,100 square feet.

Of the 1,404 properties in the portfolio, 1,399, or 99.6%, are single-tenant, retail properties and the remaining five are multi-tenant properties.  At December 31, 2003, 1,374, or 98.2%, of the 1,399 single-tenant properties were leased with a weighted average remaining lease term (excluding extension options) of approximately 11.8 years.

In addition to our real estate portfolio, at December 31, 2003, our wholly-owned subsidiary Crest Net Lease, Inc. owned 37 properties totaling $53.3 million.  These properties are held for sale.

We typically acquire retail store properties under long-term leases with retail chain store operators. These transactions provide capital to the operators for continued expansion and other corporate purposes.  Our acquisition and investment activities are concentrated in well-defined target markets and generally focus on middle-market retailers providing goods and services that satisfy basic consumer needs.

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Our net-lease agreements generally:

•                  Are for initial terms of 15 to 20 years;

•                  Require the tenant to pay minimum monthly rents and property operating expenses (taxes, insurance and maintenance); and

•                  Provide for future rent increases (typically subject to ceilings) based on increases in the consumer price index, fixed increases, or additional rent calculated as a percentage of the tenants’ gross sales above a specified level.

Realty Income commenced operations as a REIT on August 15, 1994 through the merger of 25 public and private real estate limited partnerships with and into the Company.  Each of the partnerships was formed between 1970 and 1989 for the purpose of acquiring and managing long-term, net-leased properties.

The six senior officers of Realty Income owned 1.1% of our outstanding common stock with a market value of $18.2 million at February 16, 2004.  The directors and six senior officers of Realty Income, as a group, owned 2.7% of our outstanding common stock with a market value of $44.1 million at February 16, 2004.

Realty Income’s common stock is listed on The New York Stock Exchange (“NYSE”) under the ticker symbol “O.”  Our central index key number is 726728 and cusip number is 756109-104.

Realty Income’s Class B cumulative redeemable preferred stock is listed on the NYSE under the ticker symbol “OprB” and its cusip number is 756109-302.

Realty Income’s Class C cumulative redeemable preferred stock is listed on the NYSE under the ticker symbol “OprC” and its cusip number is 756109-500.

Realty Income’s 8.25% Monthly Income Senior Notes, due 2008 are listed on the NYSE under the ticker symbol “OUI.”  The cusip number of these notes is 756109-203.

Realty Income had 58 employees as of February 16, 2004.

We maintain an Internet website at www.realtyincome.com. On our website we make available, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, as soon as reasonably practicable after we electronically file these reports with the Securities and Exchange Commission.

RECENT DEVELOPMENTS

The Acquisition of 86 National Tire and Battery Properties.

In November 2003, Realty Income and Crest Net provided an aggregate of $135.7 million in sale leaseback financing to TBC Corporation by acquiring 86 National Tire and Battery (“NTB”) retail tire store locations.  Of the $135.7 million, $109.3 million in properties was acquired by Realty Income and $26.4 million in properties was acquired by Crest Net.  These locations were acquired under 20-year, net lease agreements.  Each store has an average of 10,500 leasable square feet on an average lot size of 1.2 acres and was purchased for an average cost of $1.6 million.  The properties are generally in desirable retail locations near major retail centers, located on high traffic thoroughfares. In addition, the properties acquired are primarily existing, seasoned, retail tire store locations with profitable operating histories.

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Credit Ratings Upgrades.

In November 2003, our credit ratings were upgraded by Standard and Poor’s Ratings Group.  Our senior unsecured debt rating was raised to BBB from BBB- and our preferred stock rating was raised to BBB- from BB+, with a stable outlook.

In February 2003, our credit ratings were upgraded by Moody’s Investors Service.  Our senior unsecured debt rating was raised to Baa2 from Baa3- and our preferred stock rating was raised to Baa3- from Ba1, with a stable outlook.

Issuance of 12-Year, 5-1/2% Senior Unsecured Notes.

In November 2003, we issued $150 million of 12-year, 5-1/2% senior unsecured notes due in 2015.  The price to the investor for the notes was 99.508% of the principal amount for an effective yield of 5.56%. These securities have been rated BBB by Fitch Ratings, Baa2 by Moody’s Investors Service and BBB by Standard & Poor’s Ratings Group.  The net proceeds from the sale of the notes were used to fund the NTB portfolio acquisition for $135.7 million and to repay borrowings under our $250 million unsecured acquisition credit facility.

The Acquisition of 114 Pantry Convenience Store Properties.

In October 2003, Realty Income and Crest Net acquired a portfolio of 114 convenience store properties from The Pantry, Inc. for $94.5 million. Of the $94.5 million, $69.5 million in properties was acquired by Realty Income and $25 million was acquired by Crest Net.  The properties were purchased subject to 20-year, net-lease agreements. The stores are, on average, approximately 2,700 leasable square feet and have an average 14-year operating history.

Issuance of Common Stock.

In October 2003, we issued 2,875,000 shares of common stock at a price to the public of $40.59 per share.  The net proceeds from this offering were approximately $110.8 million and were used to repay borrowings under our $250 million unsecured acquisition credit facility.

Issuance of 10-Year, 5-3/8% Senior Unsecured Notes.

In March 2003, we issued $100 million of 10-year, 5-3/8% senior unsecured notes due in 2013.  The price to the investor for the notes was 99.509% of the principal amount for an effective yield of 5.439%. These securities are rated BBB by Fitch Ratings, Baa2 by Moody’s Investors Service and BBB by Standard & Poor’s Ratings Group.  The net proceeds from the sale of the notes were used to repay borrowings under our $250 million unsecured acquisition credit facility.

Acquisitions during 2003.

Realty Income and Crest Net Aggregate Acquisitions.

Realty Income and Crest Net invested $371.6 million in aggregate in 302 new properties and properties under development in 2003.  These 302 properties are located in 25 states and are 100% leased with an initial average lease term of 19.9 years.

Realty Income.

Realty Income invested $284.0 million during 2003 in 242 new properties and properties under development with an initial weighted average contractual lease rate of 9.8%.  These 242 properties are located in 20 states and are 100% leased with an initial average lease term of 19.9 years and will contain approximately 1.5 million leasable square feet.

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Of the $284.0 million Realty Income invested in real estate during 2003, $13.1 million was invested in properties under development during 2003 that were acquired before 2003.  Estimated unfunded development costs on Realty Income and Crest Net properties under development at December 31, 2003 totaled $8.3 million.  At December 31, 2003, eight new properties acquired during 2003 were leased and under development, pursuant to contracts under which the tenants agreed to develop the properties (with development costs funded by Realty Income or Crest Net) with rent scheduled to begin at various times during first nine months of 2004.

The initial weighted average contractual lease rate is computed as estimated contractual net operating income (in a net-leased property this is equal to the base rent or, in the case of propertiesunder development, the estimated base rent under the lease) for the first year of each lease, divided by the estimated total costs.  Since it is possible that a tenant could default on the payment of contractual rent, we cannot assure you that the actual return on the funds invested will remain at the percentages listed above.

The 242 new properties acquired by Realty Income are net-leased to 15 different retail chains in 10 industries: automotive collision service, automotive service, automotive tire service, convenience store, equipment rental service, grocery store, home improvement, restaurant, sporting goods and travel plaza.  During 2003, we added two new industries to our portfolio, they are equipment rental service and travel plaza.  We also segregated the automotive tire service industry from the automotive parts industry.  This segregation was made because the two industries have different economic characteristics.

Crest Net.

Crest Net invested $87.6 million during 2003 in 60 new retail properties and properties under development.

Investments in Existing Properties.

In 2003, we capitalized costs of $656,000 on existing properties in our portfolio, consisting of $392,000 for re-leasing costs and $264,000 for building improvements.

Net Income Available to Common Stockholders.

Net income available to common stockholders was $76.7 million in 2003 versus $69.0 million in 2002, an increase of $7.7 million.  On a diluted per common share basis, net income was $2.15 per share in 2003 as compared to $2.03 per share in 2002.

The calculation to determine net income available to common stockholders includes gains and losses from the sale of investment properties.  The amount of gains and losses varies from period to period based on the timing of property sales and can significantly impact net income available to common stockholders.

The gain recognized from the sales of investment properties during 2003 was $6.5 million as compared to $6.3 million during 2002.

Funds from Operations (FFO).

In 2003, our FFO increased by $10.3 million, or 11.0%, to $104.0 million versus $93.7 million in 2002.  See our discussion of FFO in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this annual report, which includes a reconciliation of net income available to common stockholders to FFO.

In 2003, Crest Net generated $4.6 million in FFO for Realty Income.  The future contribution, if any, to our FFO by Crest Net will depend on the timing and the number of property acquisitions and sales it achieves, if any, in a given year.

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Crest Net Property Sales.

During 2003 Crest Net sold 27 properties from its inventory for $45.2 million, which resulted in a gain of $6.2 million.

Crest Net’s Property Inventory.

Crest Net’s property inventory at December 31, 2003 and December 31, 2002 totaled $53.3 million and $4.6 million, respectively, and is included in real estate held for sale, net, on our consolidated balance sheets.

The financial statements of Crest Net are consolidated into Realty Income’s financial statements.  All material intercompany transactions have been eliminated in consolidation.

Sales of Investment Properties by Realty Income.

During 2003, we sold 35 properties and exchanged excess land parcels from three properties for an aggregate of $23.1 million, which resulted in a gain of $6.5 million. The 35 properties sold consisted of 19 child care facilities, nine restaurants, three home improvement stores, two auto service location, one consumer electronics store and one other property.  The land exchanges were on three convenience store locations.  These gains are included in discontinued operations.  The net proceeds from the sale of these properties were used to repay outstanding indebtedness on our credit facility and to invest in new properties.

Increases in Monthly Distributions to Common Stockholders.

We continue our 34-year policy of paying distributions monthly.  Monthly distributions per share were increased by $0.00125 on four separate occasions.  In April 2003 the monthly distribution increase per share was to $0.19625, in July 2003 to $0.1975, in October 2003 to $0.19875 and in January 2004 to $0.20.  The increase in January 2004 was our 25^thconsecutive quarterly increase and the 27^th increase in the amount of our dividend since our listing on the NYSE in 1994.  In 2003, we paid 12 monthly cash distributions per share; three in the amount of $0.195, three in the amount of $0.19625, three in the amount of $0.1975, and three in the amount of $0.19875, totaling $2.3625 per share.  In December 2003, January 2004 and February 2004, we declared distributions of $0.20 per share, which were paid on January 15, 2004, February 17, 2004 and will be paid on March 15, 2004, respectively.

The monthly distribution of $0.20 per share represents a current annualized distribution of $2.40 per share, and an annualized distribution yield of approximately 5.6% based on the last reported sale price of our common stock on the NYSE of $42.85 on February 13, 2004.  Although we expect to continue our policy of paying monthly distributions, we cannot guarantee that we will maintain the current level of distributions, that we will continue our pattern of increasing distributions per share, or what the actual distribution yield will be in any future period.

DISTRIBUTION POLICY

Distributions are paid to our common stockholders and Class C preferred stockholders on a monthly basis and are paid to our Class B preferred stockholders on a quarterly basis if, as and when declared by our Board of Directors.  The Class B preferred stockholders receive cumulative distributions at a rate of 9.375% per annum on the $25 per share liquidation preference (equivalent to $2.34375 per annum per share).  The Class C preferred stockholders receive cumulative distributions at a rate of 9.5% per annum on the $25 per share liquidation preference (equivalent to $2.375 per annum per share).

In order to maintain our tax status as a REIT for federal income tax purposes, we generally are required to distribute dividends to our stockholders aggregating annually at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction and by excluding net capital gains) and we are subject to income tax to the extent we distribute less than 100% of our REIT taxable income (including net capital gains).  In 2003, our distributions totaled approximately 108.1% of our estimated REIT taxable income.

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Our estimated REIT taxable income reflects non-cash deductions for depreciation and amortization.  We intend to continue to make distributions to our stockholders that are sufficient to meet this distribution requirement and that will reduce our exposure to income taxes.  Our 2003 distributions to common stockholders were 80.6% of our funds from operations available to common stockholders.

Future distributions will be at the discretion of our Board of Directors and will depend on, among other things, our results of operations, FFO, cash flow from operations, financial condition and capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code of 1986, as amended, our debt service requirements and any other factors the Board of Directors may deem relevant.  In addition, our credit facility contains financial covenants that could limit the amount of distributions payable by us in the event of a deterioration in our results of operations or financial condition, and which prohibit the payment of distributions on the common or preferred stock in the event that we fail to pay when due (subject to any applicable grace period) any principal or interest on borrowings under our credit facility.

Distributions of our current and accumulated earnings and profits for federal income tax purposes, generally will be taxable to stockholders as ordinary income, except to the extent that we recognize capital gains and declare a capital gains dividend or such amounts constitute “qualified dividend income” subject to a reduced rate of tax.  The maximum tax rate of non-corporate taxpayers for “qualified dividend income” has generally been reduced from 38.6% to 15% (for taxable years beginning after December 31, 2002).  In general, dividends payable by REITs are not eligible for the reduced tax rate on corporate dividends, except to the extent the REIT’s dividends are attributable to dividends received from taxable corporations (such as our taxable REIT subsidiary, Crest Net), to income that was subject to tax at the corporate/REIT level (for example, if we distribute taxable income that we retained and paid tax on in the prior taxable year) or, as discussed above, dividends properly designated by us as “capital gain dividends.”  Distributions in excess of earnings and profits generally will be treated as a non-taxable reduction in the stockholders’ basis in the stock.  Distributions above that basis, generally will be taxable as a capital gain.  Approximately 6.4% of the distributions, made or deemed to have been made in 2003, to our common stockholders were classified as a return of capital for federal income tax purposes.  We are unable to predict the portion of future distributions that may be classified as a return of capital.

BUSINESS PHILOSOPHY AND STRATEGY

Investment Philosophy.

We believe that the long-term ownership of an actively managed, diversified portfolio of retail properties, under long-term, net-lease agreements, produces consistent, predictable income.  Under a net-lease agreement, the tenant agrees to pay monthly rent and property operating expenses (taxes, maintenance and insurance) plus, typically, future rent increases (generally subject to ceilings) based on increases in the consumer price index, fixed increases or additional rent calculated as a percentage of the tenants’ gross sales above a specified level.  We believe that long-term leases, coupled with the tenant’s responsibility for property expenses, generally produce a more predictable income stream than many other types of real estate portfolios, while continuing to offer the potential for growth in rental income.

Investment Strategy.

In identifying new properties for acquisition, our focus is on providing expansion capital to retail chains by acquiring, then leasing back, their retail store locations.  We categorize retail tenants as: 1) venture market, 2) middle market, and 3) upper market.  Venture companies typically offer a new retail concept in one geographic region of the country and operate between five and 50 retail outlets.  Middle market retail chains typically have 50 to 500 retail outlets, operations in more than one geographic region, have been successful through one or more economic cycles, and have a proven, replicable concept.  The upper market retail chains typically consist of companies with 500 or more stores, operating nationally, in a proven, mature retail concept.  Upper market retail chains generally have strong operating histories and access to several sources of capital.

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Realty Income primarily focuses on acquiring properties leased to middle market retail chains that we believe are attractive for investment because:

•                  They generally have overcome many of the operational and managerial obstacles that can adversely affect venture retailers;

•                  They typically require capital to fund expansion but have more limited financing options;

•                  They generally have provided us with attractive risk-adjusted returns over time since their financial strength has, in many cases, tended to improve as their businesses have matured;

•                  Their relatively large size allows them to spread corporate expenses across a greater number of stores; and

•                  Middle market retailers typically have the critical mass to survive if a number of locations are closed due to underperformance.

We also focus on and have selectively made investments in properties of upper market retail chains.  We believe upper market retail chains can be attractive for investment because:

•                  They typically are of a higher credit quality;

•                  They usually are larger brand name, public and private retailers;

•                  They utilize a larger building ranging in size from 10,000 to 50,000 square feet; and

•                  They are able to grow because access to capital facilitates larger transaction sizes.

While our investment strategy focuses primarily on acquiring properties leased to middle and upper market retail chains, we also selectively seek investment opportunities with venture market retail chains.  Periodically, venture market opportunities arise where we feel that the real estate used by the tenant is high quality and can be purchased at favorable prices.  To meet our stringent investment standards, however, venture retail companies must have a well-defined retailing concept and strong financial prospects.  These opportunities are examined on a case by case basis and we are highly selective in making investments in this area.

Historically, our investment focus has been on retail industries that have a service component because we believe the lease revenue from these types of businesses is more stable.  Because of this investment focus, for the quarter ended December 31, 2003, approximately 77% of our rental revenue rent was derived from retailers with a service component in their business.  Furthermore, we believe these service-oriented businesses would be difficult to duplicate over the Internet and that our properties continue to perform well relative to competition from Internet businesses.

Credit Strategy.

We generally provide sale-leaseback financing to less than investment grade retail chains.  From 1970 through December 31, 2003, we have acquired and leased back to regional and national retail chains 1,508 properties (including 151 properties that have been sold) and have collected approximately 98% of the original contractual rent obligations on those properties.  We believe that within this market we can achieve an attractive risk-adjusted return on the financing we provide to retailers.

We believe the principal financial obligations of most retailers typically include their bank and other debt, payment obligations to suppliers and real estate lease obligations.  Because we own the land and building in which a tenant conducts its retail business, we believe the risk of default on a retailers’ lease obligations is less than the retailers’ unsecured general obligations.  It has been our experience that since retailers must retain their profitable retail locations in order to survive, in the event of reorganization; they are less likely to reject a lease for a profitable location, because this would terminate their right to use the property.  Thus, as the property owner, we believe we will fare better than unsecured creditors of the same retailer in the event of reorganization.  If a property is rejected by the tenant during reorganization, we own the property and can either lease it to a new tenant or sell the property.  In addition, we believe that the risk of default on the real estate leases can be further mitigated by monitoring the performance of the retailers’ individual unit locations and considering whether to sell locations that are weaker performers.

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In order to qualify for inclusion in our portfolio, new property acquisitions must meet stringent investment and credit requirements.  The properties must generate attractive current yields and the tenant must meet our credit profile.  We have established a three-part analysis that examines each potential investment based on:

•                  Industry, company, market conditions and credit profile;

•                  Location profitability, if profitability data is available; and

•                  Overall real estate characteristics, including value and comparative rental rates.

The standard profile of companies whose properties have been approved for acquisition, generally are those with 50 or more retail stores that are located in highly visible areas, with easy access to major thoroughfares and attractive demographics.

Acquisition Strategy.

We seek to invest in industries in which several, well-organized, regional and national chains are capturing market share through service, quality control, economies of scale, mass media advertising and the selection of prime retail locations.  We execute our acquisition strategy by acting as a source of capital to regional and national retail chain stores in a variety of industries by acquiring then leasing back their retail store locations.  We undertake thorough research and analysis to identify appropriate industries, tenants and property locations for investment.  Our research expertise is instrumental to uncovering net-lease opportunities in markets where our real estate financing program adds value.  In selecting real estate for potential investment, we generally seek to acquire properties that have the following characteristics:

•                  Freestanding, commercially-zoned property with a single tenant;

•                  Properties that are important retail locations for regional and national retail chains;

•                  Properties that are located within attractive demographic areas relative to the business of their tenants, with high visibility and easy access to major thoroughfares; and

•                  Properties that can be purchased with the simultaneous execution or assumption of long-term, net-lease agreements, offering both current income and the potential for rent increases.

Portfolio Management Strategy.

The active management of the property portfolio is an essential component of our long-term strategy.  We continually monitor our portfolio for changes that could affect the performance of the industries, tenants and locations in which we have invested.  The portfolio is regularly analyzed with a view toward optimizing its returns and enhancing its credit quality.  Our executives review industry research, tenant research, property due diligence and significant portfolio management activities.  This monitoring typically includes regular review and analysis of:

•                  The performance of various retail industries;

•                  The operation, management, business planning and financial condition of the tenants; and

•                  The health of the individual markets in which we own properties, from both an economic and real estate viewpoint.

We have an active portfolio management program that incorporates the sale of assets when we believe the reinvestment of the sales proceeds will generate higher returns, enhance the credit quality of our real estate portfolio, or extend our average remaining lease term.  At December 31, 2003, we classified real estate with a carrying amount of $60.1 million as held for sale, which includes $53.3 million in properties owned by Crest Net.  Additionally, we anticipate selling properties from our portfolio that have not yet been specifically identified.  We anticipate we will receive between $15 million and $35 million in proceeds from the sale of investment properties during the next 12 months and we intend to invest these proceeds into new property acquisitions.  However, we cannot guarantee that we will sell properties during the next 12 months.

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Conservative Capital Structure.

We believe our stockholders are best served by a conservative capital structure.  Therefore, we seek to maintain a conservative debt level on our balance sheet and solid interest and fixed charge coverage ratios.  At February 13, 2004, our total outstanding credit facility borrowings and outstanding notes were $493.0 million or approximately 22.2% of our total market capitalization of $2.22 billion.  We define our total market capitalization at February 13, 2004 as the sum of:

•                  Shares of our common stock outstanding of 38,006,034 multiplied by the last reported sales price of our common stock on the NYSE of $42.85 per share, or $1.63 billion;

•                  Liquidation value of the Class B preferred stock of $68.6 million;

•                  Liquidation value of the Class C preferred stock of $34.5 million;

•                  Outstanding borrowings of $13.0 million on our credit facility; and

•                  Outstanding notes of $480.0 million.

We have a $250 million revolving, unsecured credit facility that expires in October 2005.  At February 16, 2004, the outstanding balance on the acquisition credit facility was $13.0 million, with an effective interest rate of approximately 2.0%.  A commitment fee of 0.2% per annum accrues on the total $250 million credit commitment of the credit facility.  The credit facility has been and is expected to be used to acquire additional retail properties leased to regional and national retail chains under long-term net-lease agreements.  The credit facility has also been used to provide capital to subsidiaries for the purpose of funding the acquisition of properties.

We 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 $150 million) and capital is available on acceptable terms, we generally seek to refinance those borrowings with the net proceeds of long-term or permanent financing, which may include the issuance of common stock, preferred stock, convertible preferred stock, debt securities or convertible debt securities.  We cannot assure you, however, that we will be able to obtain any such refinancing or that market conditions prevailing at the time of refinancing will enable us to issue equity or debt securities upon acceptable terms.

Historically, we have met our long-term capital needs through the issuance of common stock, preferred stock and long-term unsecured notes.  Over the long-term, we believe that the majority of our future securities issuances should be in the form of common stock.  However, we may issue additional preferred stock or debt securities from time to time.  We may issue common stock when we believe that our share price is at a level that allows for the proceeds of any offering to be accretively invested into additional properties.  In addition, we may issue common stock to permanently finance properties that were financed by our credit facility or debt securities.  However, we cannot assure you that we will have access to the capital markets at terms that are acceptable to us.

We currently are assigned investment grade corporate credit ratings on our senior unsecured notes from Fitch Ratings, Moody’s Investors Service and Standard & Poor’s Ratings Group.  Currently, Fitch has assigned a rating of BBB, Moody’s has assigned a rating of Baa2 and Standard & Poor’s has assigned a rating of BBB to our senior notes.  These ratings could change based upon, among other things, our results of operations and financial condition.

We also have received credit ratings from the same rating agencies on our preferred stock.  Fitch Ratings has assigned a rating of BBB-, Moody’s Investors Service has assigned a rating of Baa3 and Standard & Poor’s Ratings Group has assigned a rating of BBB-.  These ratings could change based upon, among other things, our results of operations and financial condition.

We have no mortgage debt on any of our properties.

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No Off-Balance Sheet Arrangements or Unconsolidated Investments.

Realty Income and its subsidiaries have no unconsolidated or off-balance sheet investments in “variable interest entities” or off-balance sheet financing, nor do we engage in trading activities involving energy or commodity contracts or other derivative instruments.

As we have no joint ventures, off-balance sheet entities, or mandatorily redeemable preferred stock, our financial position or results of operations are currently not affected by Financial Accounting Standard Board Interpretation No. 46, Consolidation of Variable Interest Entities and Statement of Financial Accounting Standard No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.

Competitive Strategy.

We believe that to successfully pursue our investment philosophy and strategy, we must seek to maintain the following competitive advantages:

•                  Size and Type of Investment Properties:  We believe smaller ($500,000 to $10,000,000) net-leased retail properties represent an attractive investment opportunity in today’s real estate environment.  Due to the complexities of acquiring and managing a large portfolio of relatively small assets, we believe these types of properties have not experienced significant institutional ownership interest or the corresponding yield reduction experienced by larger income-producing properties.  We believe the less intensive day-to-day property management required by net-lease agreements, coupled with the active management of a large portfolio of smaller properties, is an effective investment strategy.  The tenants of our freestanding retail properties generally provide goods and services that satisfy basic consumer needs.  In order to grow and expand, they generally need capital.  Since the acquisition of real estate is typically the single largest capital expenditure of many of these retailers, our method of purchasing the property and then leasing it back, under a net-lease arrangement, allows the retail chain to free up capital.

•                  Investment in New Retail Industries:  Though we specialize in single-tenant properties, we will seek to further diversify our portfolio among a variety of retail industries.  We believe diversification will allow us to invest in retail industries that currently are growing and have characteristics we find attractive.  These characteristics include, but are not limited to, retail industries that are dominated by local store operators where regional and national chain store operators can increase market share and dominance by consolidating local operators and streamlining their operations, as well as capitalizing on major demographic shifts in a population base.

•                  Diversification:  Diversification of the portfolio by retail industry type, tenant and geographic location is key to our objective of providing predictable investment results for our stockholders. Further diversification of our portfolio is an objective of ours.  At December 31, 2003, our retail property portfolio consisted of 1,404 properties located in 48 states, leased to 85 retail chains doing business in 28 industry segments.  Each of the 28 industry segments represented in our property portfolio individually accounted for less than 16.5% of our rental revenue for the quarter ended December 31, 2003.

•                  Management Specialization:  We believe that our management’s specialization in single-tenant retail properties, operated under net-lease agreements, is important to meeting our objectives.  We plan to maintain this specialization and will seek to employ and train high-quality professionals in this specialized area of real estate ownership, finance and management.

•                  Technology:  We intend to stay at the forefront of technology in our efforts to efficiently and economically carry out our operations.  We maintain sophisticated information systems that allow us to analyze our portfolio’s performance and actively manage our investments.  We believe that technology and information-based systems will play an increasingly important role in our competitiveness as an investment manager and source of capital to a variety of industries and tenants.

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PROPERTIES

At December 31, 2003, we owned a diversified portfolio:

•                  Of 1,404 retail properties;

•                  With an occupancy rate of 98.1%, or 1,378 properties occupied of the 1,404 properties in the portfolio;

•                  Leased to 85 different retail chains doing business in 28 separate retail industries;

•                  Located in 48 states;

•                  With over 11.3 million square feet of leasable space; and

•                  With an average leasable retail space of 8,100 square feet.

In addition to our real estate portfolio at December 31, 2003, our subsidiary, Crest Net had invested $53.3 million in a portfolio of 37 retail properties located in 13 states.  These properties are held for sale.

At December 31, 2003, 1,374, or 97.9%, of our 1,404 retail properties were owned under net-lease agreements.  Net leases typically require the tenant to be responsible for minimum monthly rent and property operating expenses including property taxes, insurance and maintenance.  In addition, tenants are typically responsible for future rent increases (generally subject to ceilings) based on increases in the consumer price index, fixed increases or additional rent calculated as a percentage of the tenants’ gross sales above a specified level.

Our net-leased retail properties primarily are leased to regional and national retail chain store operators.  Most buildings are single-story structures with adequate parking on site to accommodate peak retail traffic periods.  The properties tend to be on major thoroughfares with relatively high traffic counts and adequate access and proximity to a sufficient population base to constitute a suitable market or trade area for the retailer’s business.

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The following table sets forth certain information regarding our properties classified according to the business of the respective tenants, expressed as a percentage of our total rental revenue:

* 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) and excludes properties owned by our subsidiary, Crest Net.

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The following table sets forth certain information regarding the properties owned by Realty Income at December 31, 2003, classified according to the retail business types and the level of services they provide (dollars in thousands):

(1)                        Excludes properties owned by our subsidiary, Crest Net.

(2)                        Includes rental revenue for all properties owned by Realty Income at December 31, 2003 (including revenue from properties reclassified to discontinued operations of $74) and excludes revenue of $1,266 from properties owned by our subsidiary, CrestNet.

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Of the 1,404 properties in the portfolio at December 31, 2003, 1,399 were single-tenant properties with the remaining properties being multi-tenant properties.  At December 31, 2003, 1,374 of the 1,399 single-tenant properties, or 98.2%, were net leased with a weighted average remaining lease term (excluding extension options) of approximately 11.8 years.

The following table sets forth certain information regarding the timing of the lease term expirations (excluding extension options) on our 1,374 net-leased, single-tenant retail properties at December 31, 2003 (dollars in thousands):

(1)  Excludes properties owned by our subsidiary, Crest Net.  The lease expirations for properties under construction are based on the estimated date of completion of those properties.

(2)  Includes rental revenue of $74 from properties reclassified to discontinued operations and excludes revenue of $1,306 from four multi-tenant properties and from 26 vacant and unleased properties at December 31, 2003 and revenue of $1,266 from properties owned by our subsidiary, Crest Net.

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The following table sets forth certain state-by-state information regarding Realty Income’s property portfolio owned as of December 31, 2003 (dollars in thousands):

* Less than 0.1%

(1)                        Excludes properties owned by our subsidiary, Crest Net.

(2)                        Includes rental revenue for all properties owned by Realty Income at December 31, 2003 (including revenue from properties reclassified to discontinued operations of $74) and excludes revenue of $1,266 from properties owned by Crest Net.

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Description of Leasing Structure.

At December 31, 2003, 1,374 or 97.9% of our 1,404 properties were net leased.  In most cases, the leases:

•                  Are for initial terms of 15 to 20 years;

•                  Require the tenants to pay minimum monthly rents and property operating expenses (taxes, insurance and maintenance); and

•                  Provide for future rent increases (typically subject to ceilings) based on increases in the consumer price index, fixed increases, or additional rent based upon the tenants’ gross sales above a specified level.  Where leases provide for rent increases based on increases in the consumer price index, generally these increases become part of the new permanent base rent.  Where leases provide for percentage rent, this additional rent is typically payable only if the tenants’ gross sales, for a given period (usually one year), exceed a specified level and is then typically calculated as a percentage of only the amount of gross sales in excess of that level.

Matters Pertaining to Certain Properties and Tenants.

Of the 26 properties available for lease or sale at December 31, 2003; all but one are single-tenant properties.  Seventeen of the properties had been previously leased to child care operators, five to restaurant operators, one to a home improvement operator, one to an automotive service operator, one to a grocery store operator and one to a shoe store operator.  At December 31, 2003, 19 of our properties under lease were unoccupied and available for sublease by the tenants, all of which were current with their rent and other obligations.

For 2003, our largest tenant was Children’s World Learning Centers operates child care facilities and it accounted for 8.2% of our rental revenue and operates child care facilities.  However, as a result of acquisitions during 2003, The Pantry, Inc., an operator of convenience stores, was our largest tenant at December 31, 2003 based on annualized rental revenue.  At December 31, 2003, The Pantry, Inc. accounted for 7.8% of our annualized rental revenue and Children’s World accounted for 7.3% of our annualized rental revenue.  Annualized rental revenue is calculated by multiplying the monthly contractual base rent for each of the properties by 12 and adding the previous 12 month’s historic percentage rent, excluding properties owned by Crest Net.

In general, a downturn in the industries represented by these tenants, whether nationwide or limited to specific sectors of the United States, could adversely affect tenants in these industries, which in turn could have a material adverse affect on our financial position, results of operations, ability to make distributions to stockholders and our ability to make debt service payments.  In addition, a substantial number of our properties are leased to middle-market retail chains that generally have more limited financial and other resources than certain upper-market retail chains, and therefore they are more likely to be adversely affected by a downturn in their respective business or in the regional or national economy in general.

Our tenants in the child care, convenience store and restaurant industries accounted for approximately 17.8%, 13.3% and 11.8%, respectively, of our rental revenue for the year 2003.  Based on annualized rental revenue at December 31, 2003, tenants in the child care, convenience store and restaurant industries accounted for approximately 15.3%, 15.9% and 10.5%, respectively.  Individually, each of the other industries in our property portfolio accounted for less than 10% of our rental revenue or annualized rental revenue.

A downturn in any of these industries, whether nationwide or limited to specific sectors of the United States, could adversely affect tenants in these industries, which in turn could have a material adverse affect on our financial position, results of operations, ability to make distributions to stockholders and our ability to make debt service payments.

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Certain Properties Under Development.

Of the 242 properties Realty Income acquired in 2003 and the 60 properties acquired by Crest Net in 2003, all but four were occupied at February 16, 2004.  The four properties were leased and under construction, pursuant to a contract under which the tenant has agreed to develop the properties (with development costs funded by us or Crest Net), with rent commencing when the premises open for business.  In the case of development properties, we either enter into an agreement with a retail chain where the retailer retains a contractor to construct the improvements and we fund the costs of that development, or we fund a developer who constructs the improvements.  In either case, there is an executed lease at the time of the land purchase and there is a requirement to complete the construction in a timely basis, generally within eight months after we purchase the land.  The tenant or developer generally is required to pay construction cost overruns to the extent that they exceed the construction budget by more than a predetermined amount.  We also enter into a lease with the tenant at the time we purchase the land, which generally requires the tenant to begin paying base rent when the store opens for business.  The base rent is calculated as a percentage of our acquisition cost for the property, including construction costs and capitalized interest.  In 2003, Realty Income acquired eight development properties and Crest Net acquired two development properties, six of which have been completed, were operating and generating rent as of February 16, 2004.  Both Realty Income and Crest Net will continue to pursue development opportunities under similar arrangements.

OTHER ITEMS

Competition for Acquisition of Real Estate.

We face competition in the acquisition, operation and sale of property.  We expect competition from:

•                  Businesses;

•                  Individuals;

•                  Fiduciary accounts and plans; and

•                  Other entities engaged in real estate investment and financing.

Some of these competitors are larger than we are and have greater financial resources.  This competition may result in a higher cost for properties we wish to purchase.

The tenants leasing our properties can face significant competition from other operators.  This competition may adversely impact:

•                  That portion, if any, of the rental stream to be paid to us based on a tenant’s revenues; and

•                  The tenants’ results of operations or financial condition.

Environmental Liabilities.

Investments in real property can create a potential for environmental liability.  An owner of property can face liability for environmental contamination created by the presence or discharge of hazardous substances on the property.  We can face such liability regardless of:

•                  Our knowledge of the contamination;

•                  The timing of the contamination;

•                  The cause of the contamination; or

•                  The party responsible for the contamination of the property.

There may be environmental problems associated with our properties, of which we are unaware.  In that regard, a number of our properties are leased to operators of convenience stores that sell petroleum-based fuels, as well as oil change and tune-up facilities.  These facilities, or other of our properties, use, or may have used in the past, underground lifts or underground tanks for the storage of petroleum-based or waste products, which could create a potential for release of hazardous substances.

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The presence of hazardous substances on a property may adversely affect our ability to sell that property and we may incur substantial remediation costs.  Although our leases generally require our tenants to operate in compliance with all applicable federal, state and local laws, ordinances and regulations and to indemnify us against any environmental liabilities arising from the tenants’ activities on the property, we could nevertheless be subject to strict liability by virtue of our ownership interest.  There also can be no assurance that our tenants would satisfy their indemnification obligations under the leases.  The discovery of environmental liabilities attached to our properties could have a material adverse effect on our results of operations, financial condition or our ability to make distributions to stockholders.

We have not been notified by any governmental authority, and are not otherwise aware, of any material noncompliance, liability or claim relating to hazardous substances, toxic substances or petroleum products in connection with any of our present properties.  Nevertheless, if environmental contamination should exist, we could be subject to strict liability by virtue of our ownership interest.

Since December 1996, we have maintained an environmental insurance policy on our property portfolio. The limit on our current policy is $10 million per occurrence and $50 million in the aggregate, subject to a $25,000 self insurance retention per occurrence for properties with underground storage tanks and a $100,000 self insurance retention per occurrence for all other properties.  It is possible that our insurance will be insufficient to address any particular environmental situation and that we could be unable to continue to obtain insurance for environmental matters, at a reasonable cost or at all, in the future.

Taxation of the Company.

Commencing with our taxable year ended December 31, 1994, we believe that we are organized and have operated, and we intend to continue to operate, so as to qualify as a “REIT” under Sections 856 through 860 of the Code.  However, we cannot assure you that we have been organized or have operated in a manner that has satisfied the requirements for qualification as a REIT, or that we will continue to be organized or operate in a manner that will allow us to continue to qualify as a REIT.

Qualification as a REIT involves the satisfaction of numerous requirements under highly technical and complex Code provisions, for which there are only limited judicial and administrative interpretations, and the determination of various factual matters and circumstances not entirely within our control.

For example, in order to qualify as a REIT, at least 95% of our gross income in each year must be derived from qualifying sources, and we must pay distributions to stockholders aggregating annually at least 90% of our REIT taxable income (as defined in the Code and determined without regard to the dividends paid deduction and by excluding net capital gains).

In the future, it is possible that legislation, new regulations, administrative interpretations or court decisions will change the tax laws with respect to qualification as a REIT, or the federal income tax consequences of such qualification.

If we were to fail to qualify as a REIT in any taxable year:

•                  We would be required to pay federal income tax (including any applicable alternative minimum tax) on our taxable income at regular corporate rates;

•                  We would not be allowed a deduction in computing our taxable income for amounts distributed to our stockholders;

•                  We could be disqualified from treatment as a REIT for the four taxable years following the year during which qualification is lost;

•                  We would no longer be required to make distributions to stockholders; and

•                  This treatment would substantially reduce amounts available for investment or distribution to stockholders because of the additional tax liability for the years involved.

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Even if we qualify for and maintain our REIT status, we are subject to certain federal, state and local taxes on our income and property.  For example, if we have net income from a prohibited transaction, that income will be subject to a 100% tax.  Our subsidiary Crest Net is subject to federal and state taxes at the applicable tax rates on its income and property.

Effect of Distribution Requirements.

To maintain our status as a REIT for federal income tax purposes, we generally are required to distribute to our stockholders at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and by excluding net capital gains each year.  We also are subject to tax at regular corporate rates to the extent that we distribute less than 100% of our REIT taxable income (including net capital gains) each year.

In addition, we are subject to a 4% nondeductible excise tax to the extent that we fail to distribute during any calendar year at least the sum of 85% of our ordinary income for that calendar year, 95% of our capital gain net income for the calendar year, and any amount of that income that was not distributed in prior years.

We intend to continue to make distributions to our stockholders to comply with the distribution requirements of the Code and to reduce exposure to federal income taxes and the nondeductible excise tax.  Differences in timing between the receipt of income and the payment of expenses to arrive at taxable income, along with the effect of required debt amortization payments, could require us to borrow funds on a short-term basis to meet the distribution requirements that are necessary to achieve the tax benefits associated with qualifying as a REIT.

Dilution of Common Stock.

Our future growth will depend in large part upon our ability to raise additional capital.  If we were to raise additional capital through the issuance of equity securities, we could dilute the interests of holders of our common stock. Likewise, our Board of Directors is authorized to cause us to issue preferred stock of any class or series (with dividend, voting and other rights as determined by the Board of Directors).  Accordingly, the Board of Directors may authorize the issuance of preferred stock with voting, dividend and other similar rights that could dilute, or otherwise adversely affect, the interests of holders of our common stock.

Real Estate Ownership Risks.

We are subject to all of the general risks associated with the ownership of real estate.  In particular, we face the risk that rental revenue from the properties may be insufficient to cover all corporate operating expenses, debt service payments on indebtedness we incur and distributions on our stock.  Additional real estate ownership risks include:

•                  Adverse changes in general or local economic conditions;

•                  Changes in supply of, or demand for, similar or competing properties;

•                  Changes in interest rates and operating expenses;

•                  Competition for tenants;

•                  Changes in market rental rates;

•                  Inability to lease properties upon termination of existing leases;

•                  Renewal of leases at lower rental rates;

•                  Inability to collect rents from tenants due to financial hardship, including bankruptcy;

•                  Changes in tax, real estate, zoning and environmental laws that may have an adverse impact upon the value of real estate;

•                  Uninsured property liability;

•                  Property damage or casualty losses;

•                  Unexpected expenditures for capital improvements or to bring properties into compliance with applicable federal, state and local laws;

•                  Acts of terrorism and war; and

•                  Acts of God and other factors beyond the control of our management.

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Dependence on Key Personnel.

We depend on the efforts of our executive officers and key employees.  The loss of the services of our executive officers and key employees could have a material adverse effect on our operations.

Item 2:                                      Properties

Information pertaining to our properties can be found under Item 1.

Item 3:                                      Legal Proceedings

We are subject to certain claims and lawsuits in the ordinary course of business, the outcome of which cannot be determined at this time.  In the opinion of management, any liability we might incur upon the resolution of these claims and lawsuits will not, in the aggregate, have a material adverse effect on our consolidated financial statements taken as a whole.

Item 4:                                      Submission of Matters to a Vote of Security Holders

No matters were submitted to stockholders during the fourth quarter of the fiscal year.

PART II

Item 5:                                      Market For Registrant’s Common Equity And Related Stockholder Matters

A.  Our common stock is traded on the NYSE under the ticker symbol “O.”  The following table shows the high and low sales prices per share for our common stock as reported by the NYSE composite tape, and distributions declared per share of common stock by us for the periods indicated.

(1) Common stock distributions currently are declared monthly by us based on financial results for the prior months.  At December 31, 2003 a distribution of $0.20 per common share had been declared and was paid in January 2004.

B.  There were approximately 11,300 registered holders of record of our common stock as of February 1, 2004.  We estimate that our total number of shareholders is approximately 58,000 when we include both registered and beneficial holders of our common stock.

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Item 6:                                      Selected Financial Data

(not covered by Independent Auditors’ Report)

(1)  Ratio of Earnings to Fixed Charges is calculated by dividing earnings by fixed charges.  For this purpose, earnings consist of net income before interest expense.  Fixed charges are comprised of interest costs (including capitalized interest) and the amortization of debt issuance costs.

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Item 7:                                       Management’s Discussion and Analysis of Financial Condition and Results of Operations

GENERAL

Realty Income Corporation, The Monthly Dividend Company ®, is a Maryland corporation organized to operate as an equity real estate investment trust, commonly referred to as a REIT.  Our primary business objective is to generate dependable monthly distributions from a consistent and predictable level of funds from operations, or FFO per share.  Over the past 35 years, Realty Income and its predecessors have been acquiring and owning freestanding retail properties that generate rental revenue under long-term (primarily 15 to 20 year) lease agreements.  The monthly distributions are supported by the cash flow from 1,404 retail properties leased to regional and national retail chains.

We also seek to increase distributions to stockholders and FFO per share through both active portfolio management and the acquisition of additional properties.  At December 31, 2003, we owned a diversified portfolio:

•                  Of 1,404 retail properties;

•                  With an occupancy rate of 98.1%, or 1,378, properties occupied of the 1,404 properties in the portfolio;

•                  Leased to 85 different retail chains doing business in 28 separate retail industries;

•                  Located in 48 states;

•                  With over 11.3 million square feet of leasable space; and

•                  With an average leasable retail space of 8,100 square feet.

Of the 1,404 properties in the portfolio, 1,399, or 99.6%, are single-tenant retail properties and the remaining five are multi-tenant properties.  As of December 31, 2003, 1,374, or 98.2%, of the 1,399 single-tenant properties were leased with a weighted average remaining lease term (excluding extension options) of approximately 11.8 years.

In addition to our real estate portfolio, at December 31, 2003, our wholly-owned subsidiary, Crest Net Lease, Inc. had invested $53.3 million in a portfolio of 37 retail properties located in 13 states.  These properties are held for sale.

LIQUIDITY AND CAPITAL RESOURCES

Cash Reserves.

Realty Income is organized to operate as an equity REIT that acquires and leases properties and distributes to stockholders, in the form of monthly cash distributions, a substantial portion of its net cash flow generated from leases on its retail properties.  We intend to retain an appropriate amount of cash as working capital.  At December 31, 2003, we had cash and cash equivalents totaling $4.8 million.

We believe that our cash and cash equivalents on hand, cash provided from operating activities and borrowing capacity is sufficient to meet our liquidity needs for the foreseeable future. We intend, however, to use additional sources of capital to fund property acquisitions and to repay our credit facility.

$250 Million Bank Credit Facility.

We have a $250 million revolving, unsecured credit facility that expires in October 2005.  Realty Income’s current investment grade credit ratings provide for financing under the $250 million credit facility at the London Interbank Offered Rate, commonly referred to as LIBOR, plus 90 basis points with a facility fee of 20 basis points, for all-in drawn pricing of 110 basis points over LIBOR.  At February 16, 2004, we had a

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borrowing capacity of $237.0 million available on our credit facility and an outstanding balance of $13.0 million at an effective interest rate of 2.0%.

The credit facility is expected to be used to acquire additional retail properties and for other corporate purposes.  Any additional borrowings will increase our exposure to interest rate risk.

We have no mortgage debt on any of our properties.

Universal Shelf Registration of $500 million.

In December 2002, we filed a universal shelf registration statement with the SEC registering the issuance of up to $500 million in aggregate value of common stock, preferred stock and debt securities.  This registration statement was declared effective by the SEC in January 2003.  At February 16, 2004, $133.3 million remained available for issuance under our universal shelf registration statement.

Issuances of Common Stock in 2003.

In October 2003, we issued 2,875,000 shares of common stock at a price of $40.59 per share.  The net proceeds of $110.8 million were used to repay borrowings under our $250 million acquisition credit facility.

Conservative Capital Structure.

We believe that our stockholders are best served by a conservative capital structure.  Therefore, we seek to maintain a conservative debt level on our balance sheet and solid interest and fixed charge coverage ratios. At February 13, 2004, our total outstanding credit facility borrowings and outstanding notes were $493.0 million or approximately 22.2% of our total market capitalization of $2.22 billion.  We define our total market capitalization at February 13, 2004 as the sum of:

•                  Shares of our common stock outstanding of 38,006,034 multiplied by the last reported sales price of our common stock on the NYSE of $42.85 per share, or $1.63 billion;

•                  Liquidation value of the Class B preferred stock of $68.6 million;

•                  Liquidation value of the Class C preferred stock of $34.5 million;

•                  Outstanding borrowings of $13.0 million on our credit facility; and

•                  Outstanding notes of $480.0 million.

Historically, we have met our long-term capital needs through the issuance of common stock, preferred stock and long-term unsecured notes.  Over the long term, we believe that the majority of our future securities issuances should be in the form of common stock, however, we may issue additional preferred stock or debt securities from time to time.  We may issue common stock when we believe that our share price is at a level that allows for the proceeds of any offering to be accretively invested into additional properties.  In addition, we may issue common stock to permanently finance properties that were financed by our credit facility or debt securities.  However, we cannot assure you that we will have access to the capital markets at terms that are acceptable to us.

Credit Agency Ratings.

We are currently assigned investment grade corporate credit ratings, on our senior unsecured notes, from Fitch Ratings, Moody’s Investor Service, Inc. and Standard & Poor’s Rating Group.  Currently, Fitch Ratings has assigned a rating of BBB, Moody’s has assigned a rating of Baa2 and Standard & Poor’s has assigned a rating of BBB to our senior notes.  All of these ratings have been assigned a “stable” outlook.

We also have received credit ratings from the same rating agencies on our preferred stock.  Fitch Ratings has assigned a rating of BBB-, Moody’s Investor Service, Inc. has assigned a rating of Baa3 and Standard & Poor’s Rating Group has assigned a rating of BBB-.  All of these ratings have been assigned a “stable” outlook.

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During 2003, our credit ratings were upgraded by both Moody’s and Standard & Poor’s for our unsecured notes and our preferred stock.

The credit ratings assigned to us could change based upon, among other things, our results of operations and financial condition.

Notes Outstanding.

In November 2003, we issued $150 million of 5-1/2%, 12-year, senior unsecured notes due 2015 (the “2015 Notes”).  The 2015 Notes were sold at 99.508% of par.  The proceeds from this offering were used to repay borrowings under our unsecured acquisition credit facility.  Interest on the 2015 Notes is paid semiannually.

In March 2003, we issued $100 million of 5-3/8%, 10-year, senior unsecured notes due 2013 (the “2013 Notes”).  The 2013 Notes were sold at 99.509% of par.  The proceeds from this offering were used to repay borrowings under our unsecured acquisition credit facility.  Interest on the 2013 Notes is paid semiannually.

In January 1999, we issued $20 million of 8% senior notes due 2009 (the “2009 Notes”).  Interest on the 2009 Notes is payable semiannually.

In October 1998, we issued $100 million of 8-1/4% Monthly Income Senior Notes due 2008 (the “2008 Notes”).  Interest on the 2008 Notes is payable monthly.

In May 1997, we issued $110 million of 7-3/4% senior notes due 2007 (the “2007 Notes”).  Interest on the 2007 Notes is payable semiannually.

All of these notes contain various covenants, including: (i) a limitation on incurrence of any debt which would cause the our debt to total assets ratio to exceed 60%; (ii) a limitation on incurrence of any secured debt which would cause our secured debt to total 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.  As of February 16, 2004, our credit facility balance was $13.0 million and our notes outstanding totaled $480 million.

The following table summaries the maturity of each of our debt obligations as of December 31, 2003.

Table of Obligations

(as of December 31, 2003, in millions)

(1) Other consists of estimated unfunded development costs on properties under development at December 31, 2003.

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Preferred Stock Outstanding.

In May 1999, we issued 2,760,000 shares of 9-3/8% Class B cumulative redeemable preferred stock (the “Class B Preferred”), of which 2,745,700 shares were outstanding during 2003 and 2002.  Beginning May 25, 2004, the Class B Preferred shares are redeemable at our option for $25.00 per share.  Dividends on the Class B Preferred are paid quarterly in arrears.

In July 1999, we issued 1,380,000 shares of 9-1/2% Class C cumulative redeemable preferred stock (the “Class C Preferred”), all of which were outstanding during 2003 and 2002.  Beginning July 30, 2004, the Class C Preferred shares are redeemable at our option for $25.00 per share.  Dividends on the Class C Preferred are paid monthly in arrears.

No Off-Balance Sheet Arrangements or Unconsolidated Investment.

Realty Income and its subsidiaries have no unconsolidated or off-balance sheet investments in “variable interest entities” or off-balance sheet financing, nor do we engage in trading activities involving energy or commodity contracts or other derivative instruments.

As we have no joint ventures, off-balance sheet entities, or mandatorily redeemable preferred stock, our financial position or results of operations are currently not effected by Financial Accounting Standard Board Interpretation No. 46, Consolidation of Variable Interest Entities and Statement of Financial Accounting Standard No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.

Acquisitions During 2003.

Realty Income and Crest Net.

Realty Income and Crest Net invested $371.6 million in aggregate in 302 new properties and properties under development in 2003.  These 302 properties are located in 25 states and are 100% leased with an initial average lease length of 19.9 years.

Realty Income.

Realty Income invested $284.0 million in 242 new properties and properties under development with an initial weighted average contractual lease rate of 9.8% in 2003.  These 242 properties are located in 20 states and are 100% leased with an initial average lease length of 19.9 years and will contain approximately 1.5 million leasable square feet.

Included in the investments of real estate by Realty Income in 2003 is $13.1 million invested in properties acquired before 2003 that were under development.  Estimated unfunded development costs on Realty Income and Crest Net properties under development at December 31, 2003 totaled $8.3 million.  At December 31, 2003, eight new properties acquired during 2003 were leased and under development, pursuant to contracts under which the tenants agreed to develop the properties (with development costs funded by Realty Income or Crest Net), with rent scheduled to begin at various times during the first nine months of 2004.

The initial weighted average contractual lease rate on our investments is computed as estimated contractual net operating income (in a net-leased property this is equal to the base rent or, in the case of propertiesunder development, the estimated base rent under the lease) for the first year of each lease, divided by the estimated total costs.  Since it is possible that a tenant could default on the payment of contractual rent, we cannot assure you that the actual return on the funds invested will remain at the percentages listed above.

The 242 new properties acquired by Realty Income are net-leased to 15 different retail chains in ten industries: automotive collision service, automotive service, automotive tire service, convenience store, equipment rental service, grocery store, home improvement, restaurant, sporting goods and travel plaza.  During 2003, we added two new industries (equipment rental service and travel plaza) to our portfolio.  We also segregated the

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automotive tire service industry from the automotive parts industry.  This segregation was made to reflect the different economic characteristics of the two industries.

Crest Net.

Crest Net invested $87.6 million during 2003 in 60 new retail properties and properties under development.

Investments in Existing Properties.

In 2003, we capitalized costs of $656,000 on existing properties in our portfolio, consisting of $392,000 for re-leasing costs and $264,000 for building improvements

Sales of Investment Properties.

During 2003, we sold 35 properties and exchanged excess land parcels from three properties for an aggregate of $23.1 million, which resulted in a gain of $6.5 million. The 35 properties sold consisted of 19 child care facilities, nine restaurants, three home improvement stores, two auto services location, one consumer electronics store and one other property.  The land exchanges were on three convenience store locations.  These gains are included in discontinued operations.  The net proceeds from the sale of these properties were or will be used to repay outstanding indebtedness on our credit facility and to invest in new properties.

Crest Net Property Sales.

During 2003, Crest Net our wholly-owned subsidiary sold 27 properties from its inventory for $45.2 million, which resulted in a gain of $6.2 million.

Crest Net’s Property Inventory.

Crest Net’s property inventory at December 31, 2003 and December 31, 2002 totaled $53.3 million and $4.6 million, respectively, and is included in real estate held for sale, net, on our consolidated balance sheets.

The financial statements of Crest Net are consolidated into Realty Income’s financial statements.  All material intercompany transactions have been eliminated in consolidation.

Increase in Monthly Distributions to Common Stockholders.

We continue our 34-year policy of paying distributions monthly.  Monthly distributions per share were increased by $0.00125 in April 2003 to $0.19625, in July 2003 to $0.1975; in October 2003 to $0.19875 and in January 2004 to $0.20.  The increase in January 2004 was our 25^th consecutive quarterly increase and 27^thincrease since our listing in 1994 on the New York Stock Exchange.  In December 2003, January 2004 and February 2004, we declared distributions of $0.20 per share, which were paid on January 15, 2004, February 17, 2004 and payable on March 15, 2004, respectively.

The monthly distribution of $0.20 per common share represents a current annualized distribution of $2.40 per share and an annualized distribution yield of approximately 5.9%, based on a closing price on February 13, 2004 of $42.85.  Although we expect to continue our policy of paying monthly distributions, we cannot guarantee that we will maintain the current level of distributions, that we will continue our pattern of increasing distributions per share, or what the actual distribution yield will be for any future period.

Credit Ratings Upgrades.

In November 2003, our credit ratings were upgraded by Standard & Poor’s Ratings Group.  Our senior unsecured debt rating was raised to BBB from BBB- and our preferred stock rating was raised to BBB- from BB+, with a stable outlook.

In February 2003, our credit ratings were upgraded by Moody’s Investors Service.  Our senior unsecured debt rating was raised to Baa2 from Baa3 and our preferred stock rating was raised to Baa3 from Ba1, with a stable

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outlook.

Stock and Senior Debt Purchase Program.

In January 2000, our Board of Directors authorized the purchase of up to $10 million of our outstanding common and preferred shares and senior debt securities.  From time to time since January 2000, we concluded that our share price justified purchasing shares since this provided an attractive return on our investment capital.  We have purchased an aggregate of $6.7 million of our securities in 2000 and 2001.  We did not purchase any of our securities in 2002 or 2003, but may do so from time to time in the future.

RESULTS OF OPERATIONS

Critical Accounting Policies.

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.  Our consolidated financial statements are the basis for our discussion and analysis of financial condition and results of operations.  Completing our consolidated financial statements requires us to make a number of estimates and assumptions that affect the reported values and disclosures in the consolidated financial statements.  We believe that we have made these estimates and assumptions in an appropriate manner in a way that accurately reflects our financial condition.  We continually test and evaluate these estimates and assumptions using our historical knowledge of the business, as well as other factors to ensure that they are reasonable for reporting purposes.  However, actual results may differ from these estimates and assumptions.

In order to prepare our consolidated financial statements according to the rules and guidelines set forth by generally accepted accounting principles, many subjective judgments must be made with regard to critical accounting polices.  One of these judgments is our estimate for useful lives in determining depreciation expense for our properties.  Depreciation of buildings and improvements is computed using the straight—line method over an estimated useful life of 25 years.  If we use a shorter or longer estimated useful life it could have a material impact on our results of operations.  We believe that 25 years is an appropriate estimate of useful life.  No depreciation has been recorded on Crest Net’s properties because they are held for sale.

Another significant judgment that must be made is the impairment losses taken on our properties when events or change in circumstances indicate that the carrying amount of the asset may not be recoverable.  Generally, a provision is made for impairment loss if estimated future operating cash flows (undiscounted and without interest charges) plus estimated disposition proceeds (undiscounted) are less than the current book value.  Impairment losses are measured as the amount by which the current book value of the asset exceeds the fair value of the asset.  If a property is held for sale, it is carried at the lower of carrying cost or estimated fair value, less cost to sell.  The carrying value of our real estate is the largest component of our consolidated balance sheet.  If events should occur that required us to reduce the carrying value of our real estate by recording provisions for impairment losses, it could have a material impact on our results of operations.

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The following is a comparison of our results of operations for the years ended December 31, 2003, 2002 and 2001.

Rental Revenue.

Rental revenue was $149.3 million for 2003 versus $133.9 million for 2002, an increase of $15.4 million, or 11.5%.  Rental revenue was $115.9 million in 2001.  The increase in rental revenue in 2003 compared to 2002 is attributable to:

•                  The 242 retail properties acquired in 2003 by Realty Income, which generated revenue of $7.6 million;

•                  The 108 retail properties acquired in 2002 by Realty Income, which generated revenue of $13.5 million in 2003 compared to $6.4 million in 2002, an increase of $7.1 million;

•                  Same store rents generated on 1,003 leased properties owned in all of both 2003 and 2002 increased by $1.1 million, or 0.9%, to $122.2 million from $121.1 million.

•                  Properties owned by Crest Net, which generated revenue of $1.7 million in 2003 compared to $1.4 million in 2002, an increase of $0.3 million;

•                  Development properties acquired before 2002 that started paying rent in 2002, properties that were vacant during part of 2003 or 2002 and lease termination settlements generated revenue of $4.5 million in 2003 as compared to $4.6 million in 2002, a decrease of $0.1 million; and

•                  A decrease in straight-line rent of $421,000 in 2003 as compared to 2002.

We anticipate that our rental revenue from the 242 properties acquired in 2003 will increase significantly in 2004 since the majority of these properties were acquired in the fourth quarter.

Of the 1,404 properties in the portfolio at December 31, 2003, 1,399, or 99.6%, are single-tenant properties and the remaining properties are multi-tenant properties.  Of the 1,399 single-tenant properties, 1,374, or 98.2%, were net leased with a weighted average remaining lease term (excluding extension options) of approximately 11.8 years at December 31, 2003.  Of our 1,374 leased single-tenant properties, 1,301, or 94.7%, were under leases that provide for increases in rents through:

•                  Base rent increases tied to a consumer price index with adjustment ceilings;

•                  Overage rent based on a percentage of the tenants’ gross sales;

•                  Fixed increases; or

•                  A combination of two or more of the above rent provisions.

Percentage rent, which is included in rental revenue, was $1.2 million in 2003, $1.5 million in 2002 and $1.6 million in 2001.  Percentage rent in 2003 was less than 1% of rental revenue and we anticipate percentage rent to be less than 1% of rental revenue in 2004.

Our portfolio of retail real estate leased primarily under net leases to regional and national chains continues to perform well and provides dependable lease revenue supporting the payment of monthly dividends to our stockholders. At December 31, 2003, our portfolio of 1,404 retail properties was 98.1% leased with 26 properties available for lease.  Transactions to lease or sell 12 of the 26 properties available for lease or sale at December 31, 2003 were underway or completed as of February 10, 2004.  We anticipate these transactions to be completed during the next six months, although we cannot guarantee that all of these properties can be sold or leased within this period.  It has been our experience that approximately 1% to 3% of our property portfolio will be unleased at any given time, however, we cannot assure you that the number of properties available for lease will not exceed these levels.

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

In 2003, Crest Net sold 27 properties for $45.2 million, which resulted in a gain of $6.2 million.  In 2002, Crest Net sold 23 properties for $27.3 million, which resulted in a gain of $3.5 million.  In 2001, Crest Net sold nine properties for $28.9 million, which resulted in a gain of $3.4 million.  All gains on sales of real estate acquired for resale are reported before income taxes.

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At December 31, 2003, Crest Net had invested $53.3 million in 37 properties, which are held for sale.  Our goal is for Crest Net to carry an average inventory of $20 to $25 million in real estate.  Crest Net’s level of inventory increased substantially during the second half of 2003.  Crest Net generates an earnings spread on the difference between the lease payments it receives on the properties held in inventory and the cost of capital used to acquire properties.  It is our belief that at this level of inventory, earnings will more than cover the ongoing expenses of Crest Net.

Interest Expense.

Interest expense was $3.4 million higher in 2003 than in 2002 primarily due to higher average outstanding balances.  The following is a summary of the five components of our interest expense (dollars in thousands):

Interest on outstanding credit facilities and notes increased by $3.7 million in 2003 as compared to 2002 primarily due to higher average outstanding balances.  In 2002, unamortized fees of $406,000 relating to our previous credit facilities, which were canceled in October 2002, were charged to interest expense.

At February 16, 2004, the weighted average interest rate on our:

•                  Credit facility borrowings of $13.0 million was 2.0%;

•                  Notes payable of $480 million was 6.7%; and

•                  Combined outstanding credit facility and notes of $493.0 million was 6.5%.

Interest Coverage Ratio.

Our interest coverage ratio for 2003 was 5.3 times, for 2002 it was 5.5 times and for 2001 it was 4.4 times.  Interest coverage ratio is calculated as: the interest coverage amount (as calculated below) divided by interest expense.  We consider interest coverage ratio to be an appropriate supplemental measure of a company’s ability to meet its interest expense.  Our calculation of interest coverage ratio may be different from the calculation used by other companies and, therefore, comparability may be limited.  This information should not be considered as an alternative to any GAAP liquidity measures. 

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The following is a reconciliation of net cash provided by operating activities to our interest coverage amount (dollars in thousands):

Fixed Charge Coverage Ratio.

Our fixed charge coverage ratio for 2003 and 2002 was 3.9 times and for 2001 was 3.2 times.  Fixed charge coverage ratio is calculated in exactly the same manner as interest coverage ratio, except that preferred stock dividends are also added to the denominator.  We consider fixed charge coverage ratio to be an appropriate supplemental measure of a company’s ability to make its interest and preferred stock dividend payments.  Our calculation of the fixed charge coverage ratio may be different from the calculation used by other companies and, therefore, comparability may be limited.  This information should not be considered as an alternative to any GAAP liquidity measures.

Interest coverage amount divided by interest expense plus preferred stock dividends (dollars in thousands):

Depreciation and Amortization.

Depreciation and amortization was $33.5 million in 2003 versus $30.1 million in 2002 and $27.7 million in 2001.  The increase in depreciation and amortization was due to the acquisition of properties in 2003, 2002 and 2001, which was partially offset by property sales in these years.  Included in 2001, is $924,000 of amortization expense related to goodwill.

General and Administrative Expenses.

General and administrative expenses increased by $1.7 million to $11.2 million in 2003 versus $9.5 million in 2002. General and administrative expenses in 2001 were $7.8 million.  In 2003, general and administrative expenses as a percentage of total revenue increased to 7.2% as compared to 6.9% in 2002 and 6.5% in 2001.  Included in general and administrative expenses are $566,000, $410,000 and $496,000 of expenses attributable to Crest Net in 2003, 2002 and 2001, respectively.  General and administrative expenses, excluding expenses attributable to Crest Net, increased primarily due to increases in corporate insurance, payroll and staffing costs.

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As our property portfolio has grown and continues to grow, we have and anticipate that we will continue to increase the level of our staffing.  We expect general and administrative expenses to continue to increase due to costs attributable to payroll, staffing costs and corporate governance.  We anticipate that our rental revenue will increase at a faster rate in 2004 than our general and administrative expenses.

We had 58 employees at February 16, 2004 compared to 56 at March 1, 2003, 53 at March 1, 2002 and 49 at March 1, 2001.