Cash and Cash Equivalents  The Company considers all short-term, highly liquid investments that are readily convertible to cash and have an original maturity of three months or less at the time of purchase to be cash equivalents.

Depreciation and Amortization  Depreciation of buildings and improvements and amortization of goodwill are computed using the straight-line method over an estimated useful life of approximately 25 years.

Leases  All leases are accounted for as operating leases. Under this method, lease payments are recognized as revenue over the term of the lease on a straight-line basis.

Income Taxes  Prior to the Consolidation, the Company’s operations were conducted through private and public real estate limited partnerships. In accordance with partnership taxation, each partner was responsible for reporting its share of taxable income. Accordingly, no federal income tax provision has been made in the accompanying consolidated financial statements prior to August 16, 1994.

After August 15, 1994, the Company elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended. Management believes the Company has qualified and continues to qualify as a REIT and therefore will be permitted to deduct distributions paid to its stockholders, eliminating the federal taxation of income represented by such distributions at the Company’s level. Accordingly, no provision has been made for federal income taxes in the accompanying consolidated financial statements for the period August 16, 1994 through December 31, 1994 and the years ended December 31, 1996 and 1995.

Distributions Paid and Payable – For the year ended December 31, 1996, cash distributions of $2.0925 per share were paid. The 1996 distributions were paid as a special distribution of $0.23 per share, eleven monthly distributions of $0.155 per share and one distribution of $0.1575 per share. As of December 31, 1996, a distribution of $0.1575 per share was declared and payable.

For the year ended December 31, 1995, cash distributions of $1.825 per share were paid. The 1995 distributions were paid as seven monthly distributions of $0.15 per share and five monthly distributions of $0.155 per share. As of December 31, 1995, three distributions totaling $0.54 per share were declared and payable.

For the period August 16, 1994 through December 31, 1994, cash distributions of $0.60 per share were paid. The 1994 distributions were paid as four monthly distributions of $0.15 per share.

Provision for Impairment Losses  The Company reviews long-lived assets, including goodwill, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Generally, a provision is made for impairment loss if estimated future operating cash flows (undiscounted and without interest charges) over a long-term holding period plus estimated disposition proceeds (undiscounted) are less than the current book value. If properties are held for sale, they are carried at the lower of cost or estimated fair value less cost to sell. For the years ended December 31, 1996 and 1994, provisions for impairment losses of $579,000 and $135,000, respectively, were charged to operations to reduce the net carrying value of four properties held for sale in 1996 and one property held for sale in 1994. There was no provision for impairment losses for the year ended December 31, 1995.

Net Income Per Share  Net income per share for 1996 and 1995 was calculated based upon the weighted average number of common shares and common stock equivalents outstanding during the year. Net income per share for 1994 was calculated assuming 19,502,091 shares of the Company’s common stock were outstanding. Prior to the Consolidation, no shares of common stock were outstanding.

Stock Option Plan  The Company accounts for its stock option plan in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On January 1, 1996, the Company adopted Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123") which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS 123 also allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS 123.

Derivative Financial Instrument  The Company uses an interest rate treasury lock agreement to hedge the effect of interest rate fluctuations. This instrument meets the requirement for hedge accounting, including a high correlation to a specific transaction. Accordingly, amounts receivable or payable under the terms of the agreement and changes in market value are recognized in income when the effects of related changes of the hedge item are recognized.

Reclassifications  Certain of the 1995 and 1994 balances have been reclassified to conform to the 1996 presentation. The reclassifications had no effect on stockholders’ equity or net income.

The credit facility is subject to various leverage and interest coverage ratio limitations, all of which the Company is and has been in compliance with.

The following non-cash investing and financing activities are included in the accompanying financial statements:

A. Distributions payable totaled $3.6 million and $12.4 million at December 31, 1996 and 1995, respectively.

B. In 1996, due from affiliates of $183,000 was reclassified to goodwill, related to the resolution of a pre-acquisition contingency.

D. In 1996 and 1995, pursuant to the assumption of the defined benefit pension plan by the Company (Note 11), the Company recorded a due from affiliate and a liability (included in other liabilities) of $73,000 and $493,000, respectively. This represents the amount of the increase in the liability to the plan, of which the Company is indemnified by the former shareholders of the Advisor.

B. Related Party Transactions Prior to the Consolidation

Cash Distributions  The Advisor and William E. and Evelyn J. Clark, the former general partners of the Partnerships, collectively, received distributions of $342,000 for the period from January 1, 1994 through August 15, 1994.

The Company adopted the disclosure-only option under SFAS 123, "Accounting for Stock-Based Compensation," as of January 1, 1996. If the accounting provisions of SFAS 123 had been adopted as of the beginning of 1996, the effect on 1996 net income and net income per share would have been immaterial. Furthermore, based on current and anticipated use of stock options, it is not anticipated that the impact of the provisions of SFAS 123 would be material in any future period.

In December 1996, the Company entered into a treasury interest rate lock agreement to hedge against rising interest rates applicable to its anticipated debt offering. Under the interest rate lock agreement, which is in the notional amount of $90 million, the Company receives or makes a payment based on the differential between a specified interest rate (6.537%) and the actual 10-year treasury interest rate. Based on the December 31, 1996 10-year treasury interest rate, the Company has an unrecognized loss of $80,000.

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Realty Income adheres to a focused strategy of acquiring freestanding, single-tenant, retail properties leased to national and regional retail chains under long-term, net lease agreements. The Company typically acquires, and then leases back, retail store locations from retail chain store operators, providing capital to the operators for continued expansion and other purposes. The Company’s net lease agreements generally are for initial terms of 10 to 20 years, require the tenant to pay a minimum monthly rent and property operating expenses (taxes, insurance and maintenance), and provide for future rent increases based on limited increases in the consumer price index or additional rent calculated as a percentage of the tenant’s gross sales above a specified level.

Since 1970, Realty Income has acquired and leased back to national and regional retail chains over 700 properties (including 25 properties that have been sold) and has collected in excess of 98% of the original contractual rent obligations on those properties. Realty Income believes that the long-term ownership of an actively managed, diversified portfolio of retail properties leased under long-term, net lease agreements will produce consistent, predictable income and the potential for long-term capital appreciation. Management believes that long-term leases, coupled with tenants assuming responsibility for property expenses under the net lease structure, generally produce a more predictable income stream than many other types of real estate portfolios. As of January 1, 1997, the Company’s single-tenant properties were leased pursuant to leases with an average remaining term (excluding extension options) of approximately 8.6 years.

The Company was formed on September 9, 1993 in the State of Delaware. 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 (the "Consolidation"). Each of the partnerships was formed between 1970 and 1989 for the purpose of acquiring and managing long-term, net leased properties.

The Company is a fully integrated real estate company with in-house acquisition, leasing, legal, financial underwriting, portfolio management and capital markets expertise. The seven senior officers of the Company, who have each managed the Company’s properties and operations for between six and 27 years, owned approximately 3.9% of the Company’s outstanding common stock as of February 28, 1997.

The Company’s common stock is listed on the New York Stock Exchange (the "NYSE") under the symbol "O" and commenced trading on October 18, 1994.

Realty Income was organized in the state of Delaware on September 9, 1993 to facilitate the merger, which was effective on August 15, 1994 (the "Consolidation"), of 10 private and 15 public real estate limited partnerships (the "Partnerships") with and into Realty Income.

Investors in the Partnerships who elected to invest in the equity of the Company received a total of 19,503,080 shares of common stock. Certain investors elected to receive Variable Rate Senior Notes due 2001 (the "Notes") totaling $12.6 million.

The Consolidation was accounted for as a reorganization of affiliated entities in a manner similar to a pooling-of-interests. Under this method, the assets and liabilities of the Partnerships were carried over at their historical book values and operations have been recorded on a combined historical cost basis. The pooling-of-interests method of accounting also requires the reporting of the results of operations as though the entities had been combined as of the beginning of the earliest period presented. Accordingly, the results of operations for the year ended December 31, 1994 comprise those of the separate entities combined from the beginning of the period through August 15, 1994 (the date of the Consolidation) and those of the Company from August 16, 1994 through December 31, 1994.

Prior to August 17, 1995, the Company’s day-to-day affairs were managed by R.I.C. Advisor, Inc. (the "Advisor") which provided advice and assistance regarding acquisitions of properties by the Company and performed the day-to-day management of the Company’s properties and business. On August 17, 1995, the Advisor was merged with and into Realty Income (the "Merger") and the advisory agreement between Realty Income and the Advisor was terminated. Realty Income issued 990,704 shares of common stock as consideration for the outstanding common stock of the Advisor.

In July 1996, the Company expanded its board of directors to seven members. The new directors are Richard J. VanDerhoff, President and Chief Operating Officer of the Company, and Willard H. Smith, Jr, formerly a Managing Director, Equity Capital Markets Division, of Merrill Lynch & Co from 1983 until his retirement in August 1995.

Realty Income expects to meet its long-term capital needs for the acquisition of properties through the issuance of public or private debt or equity. In August 1995, the Company filed a universal shelf registration statement with the Securities and Exchange Commission covering up to $200 million in value of common stock, preferred stock or debt securities.

In the fourth quarter of 1995, the Company issued 2,540,000 shares of common stock at a price of $19.625 per share. The net proceeds were primarily used to repay borrowings under the acquisition credit facility. These borrowings were used to acquire properties in 1995.

In December 1996, the Company entered into a treasury interest rate lock agreement to hedge against the possibility of rising interest rates. Under the interest rate lock agreement, the Company receives or makes a payment based on the differential between a specified interest rate, 6.537%, and the actual 10-year treasury interest rate on notional principal of $90 million, at the end of six months. Based on the 10-year treasury interest rate at December 31, 1996, the Company has a deferred loss on the agreement of $79,800. The Company anticipates issuing debt during the second quarter of 1997, subject to market conditions and acquisition levels.

The Company is not currently involved in any negotiations and has not entered into any arrangements relating to any additional securities issuances.

Of the 62 properties acquired in 1996, 57 were occupied as of February 1, 1997 and the remaining five were pre-leased and under construction pursuant to contracts under which the tenants have agreed to develop the properties (with development costs funded by the Company) and to begin paying rent when the premises open for business. All of the New Properties, including the properties under development, are leased with initial terms of 7.75 to 20 years. The allocation of costs between land, and buildings and improvements on the 57 completed and occupied New Properties was approximately 34% and 66%, respectively.

During 1996 the Company purchased a property which was adjacent to an existing tenant for $102,000 and leased the property to that tenant. The Company also invested $37,000 in existing properties, received equipment and other assets valued at $58,000 as settlements for amounts receivable, and purchased the outstanding Class A units in R.I.C. Trade Center, Ltd., Silverton Business Center, Ltd. and Empire Business Center, Ltd. for an aggregate of $150,000. After this purchase, Realty Income owned 100% of these partnerships, which were then dissolved. These partnerships owned three mixed-use light industrial business parks in San Diego, CA.

For the year ended December 31, 1996, the Company paid 11 monthly distributions of $0.155 per share and increased the monthly distributions to $0.1575 per share in December 1996. The regular distributions paid during 1996 totaled $1.8625 per share. In addition, the Company paid a special distribution of $0.23 per share in January 1996. Total distributions paid in 1996 were $2.0925 per share. For tax purposes, a portion of the special distribution, in the amount of approximately $0.144 per share, was taxable as ordinary income in 1995 and the remaining $0.086 per share was included in each stockholders 1996 Form 1099. In December 1996, and January and February 1997, the Company declared distributions of $0.1575 per share which were paid on January 15, 1997, February 17, 1997 and payable on March 18, 1997, respectively.

For the year ended December 31,1995, the Company paid monthly distributions of $0.15 per share from January through July and increased its monthly distributions to $0.155 per share in August. Monthly distributions of $0.155 per share were paid in August through December 1995. The distributions paid for 1995 totaled $1.825 per share.

The 1994 distributions were made up of eight partnership and four corporate monthly distributions in the aggregate amount of $38.9 million and the final partnership distribution of $5.8 million. The 1994 final partnership distributions were substantially comprised of proceeds from the sales of properties sold during 1993.

Management considers FFO to be an appropriate measure of the performance of an equity REIT. FFO is used by financial analysts in evaluating REITs and can be one measure of a REIT’s ability to make cash distribution payments. Presentation of this information provides the reader with an additional measure to compare the performance of different REITs.

FFO is not necessarily indicative of cash flow available to fund cash needs and should not be considered as an alternative to net income as an indication of the Company’s performance or to cash flow from operating, investing, and financing activities as a measure of liquidity or ability to make cash distributions.

At December 31, 1996, 723 or 98.8% of the Company’s leases, on the 732 single-tenant properties, provide for increases in rents through (i) base rent increases tied to a consumer price index with adjustment ceilings or (ii) overage rent based on a percentage of the tenants’ gross sales. Some leases contain both types of clauses. Rental revenue generated on the 619 properties owned for all of both 1995 and 1996 increased by $871,000 or 1.9%, to $48.0 million from $47.1 million. Percentage rent, which is included in rental revenue, was $1.7 million for 1996 as compared to $1.6 million in 1995.

The significant portion of the remaining revenue earned during 1996 and 1995 was attributable to interest earned on cash invested in two funds which hold short-term investments in United States government agency securities and treasury securities. Interest revenue was $109,000 for 1996 as compared to $276,000 during 1995. The decrease in interest revenue was due to lower average cash balances held during 1996, which reflects the Company’s desire to maintain an appropriate amount of cash as working capital reserves and invest excess available cash in properties.

Depreciation and amortization was $16.4 million in 1996 versus $14.8 million in 1995. The $1.6 million increase was primarily due to the depreciation of properties acquired during 1995 and 1996 and amortization of goodwill recorded in connection with the Merger of the Advisor.

Total advisor fees and general and administrative expenses decreased by $1.7 million to $5.2 million in 1996 versus $6.9 million in 1995. General and administrative expenses were $5.2 million in 1996 versus $3.2 million in 1995 and advisor fees of $3.7 million in 1995. The $2.0 million increase in general and administrative expenses was due primarily to the Merger of the Advisor. Subsequent to the Merger, the Company commenced paying for management, accounting systems, office facilities, professional and support personnel expenses (i.e. costs of being self-administered). Prior to August 17, 1995, such costs were the responsibility of the Advisor.

During the third quarter of 1996, the Company initiated a 401(k) plan. Costs of $65,000 associated with the plan are included in general and administrative expenses.

Property expenses were $1.6 million in 1996 and 1995. Property expenses are broken down into costs associated with multi-tenant non-net lease properties, unleased single-tenant properties and general portfolio expenses. Costs related to the multi-tenant and unleased single-tenant properties include, but are not limited to, property taxes, maintenance, insurance, utilities, site checks, bad debt expense and legal fees. General portfolio costs include, but are not limited to, insurance, legal, site checks and title search fees.

Property costs of $1.0 million were incurred on ten multi-tenant properties during 1996, eight of which were owned at the end of 1996. Property costs of $1.0 million were incurred on eleven multi-tenant properties in 1995, ten of which were owned at the end of 1995. During 1996 two multi-tenant properties were sold and in 1995 one multi-tenant property was sold. Costs incurred in 1996 on ten unleased single-tenant properties totaled $250,000 as compared to $161,000 in 1995 on seven unleased single-tenant properties. At December 31, 1996, nine properties were available for lease, one of which was a multi-tenant property. At December 31, 1995, four single-tenant properties were available for lease. The $89,000 increase is due to property taxes, maintenance and utilities on the additional vacant properties. General portfolio costs in 1996 and 1995 totaled $337,000 and $441,000, respectively. The decrease in general portfolio costs is primarily due to a decrease in insurance costs.

Interest expense is made up of four components which include: (i) interest on outstanding loans and notes; (ii) commitment fees on the undrawn portion of the credit facility; (iii) amortization of the credit facility origination costs; which are offset by: (iv) interest capitalized on properties under development. Interest capitalized on properties under development is included in the cost of the completed property and amortized over the estimated useful life of the property.

Interest expense decreased by $275,000 to $2.4 million in 1996 as compared to $2.6 million for 1995. Interest incurred on loans and notes in 1996 and 1995 was $2.1 million and $2.4 million, respectively. Interest incurred was $266,000 lower in 1996 than in 1995 due to a decrease in the average outstanding balance and lower interest rates on the acquisition credit facility and the Notes. During 1996, the average outstanding balance and interest rate were $30.7 million and 6.96% as compared to $31.3 million and 7.68% during the comparable period in 1995. Included in the interest incurred in 1996 and 1995 was capitalized interest totaling $150,000 and $217,000, respectively. Commitment fees in 1996 were $156,000 as compared to $127,000 in 1995. In 1996 and 1995, a commitment fee of 0.15% per annum was incurred on the undrawn portion of the credit facility. Commitment fees increased in 1996 because the borrowing capacity was increased to $130 million from $100 million in December 1995. Amortization of the credit facility origination fees were $224,000 in 1996 as compared to $329,000 in 1995. The amortized credit facility origination fees decreased in 1996 as compared to 1995, because in December 1995 the term of the credit facility was extended one year, which extended the period of time over which unamortized fees are amortized.

The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. In 1996, a $579,000 charge was taken to reduce the net carrying value on four properties because they became held for sale. No charge was recorded for an impairment loss in 1995.

The Company anticipates property sales will occur in the normal course of business. During 1996, the Company recorded a gain of $1.5 million on the sale of two multi-tenant properties, five restaurant properties and the granting of an easement on another property. During 1995, the Company recorded a net gain of $18,000 on the sale of two child care properties and a multi-tenant property. During 1996 and 1995 cash proceeds generated from these sales were $4.4 million and $617,000, respectively.

Rental revenue generated on 623 properties owned during all of both 1994 and 1995 increased by $681,000 or 1.5%, to $47.3 million from $46.6 million. Percentage rent, which is included in rental revenue, was $1.6 million for 1995 as compared to $2.6 million in 1994.

The significant portion of the remaining revenue earned during 1995 and 1994 was attributable to interest earned on cash invested in two funds which hold short-term investments in United States government agency securities or direct purchases of short-term United States government agency securities. Interest revenue was $276,000 for 1995 as compared to $862,000 during 1994. The decrease in interest revenue was due to a reduction of cash held, which was invested in properties.

Depreciation and amortization was $14.8 million in 1995 versus $13.8 million in 1994. The $1.0 million increase was primarily due to the depreciation of 62 properties acquired from December 1994 through December 31,1995 and amortization of goodwill recorded in connection with the Merger of the Advisor.

Total advisor fees and general and administrative expenses decreased by $312,000 to $6.9 million in 1995 versus $7.2 million in 1994. General and administrative expenses were $3.2 million in 1995 versus $1.8 million in 1994. Advisor fees were $3.7 million in 1995 versus $5.4 million in 1994. The $1.4 million increase in general and administrative expenses and $1.7 million decrease in advisor fees was due to the Merger of the Advisor. Subsequent to the Merger, the Company commenced paying for management, accounting systems, office facilities, professional and support personnel expenses (i.e. costs of being self-administered). Such costs were the responsibility of the Advisor through August 17, 1995.

The advisor fees for 1995 were calculated in accordance with the terms of the advisory agreement which became effective August 15,1994 and was terminated on August 17,1995. Prior to August 16,1994, advisor fees were calculated in accordance with the terms of the Partnership agreements of the Partnerships.

Administration expense in 1994 included approximately $500,000 of one-time expenses primarily associated with the distribution of stock certificates, shareholder informational material and final partnership K-1’s to shareholders after the Consolidation had occurred. Other administrative expenses increased in 1995 compared to 1994 due to additional expenses associated with the operation of a publicly traded REIT including, but not limited to, transfer agent fees, NYSE fees, board of directors fees and property acquisition expenses.

Property costs decreased to $1.6 million in 1995 as compared to $2.1 million in 1994. The $488,000 decrease was primarily due to a decrease in property taxes, maintenance and utilities.

Interest expense for 1995 was $2.6 million as compared to $396,000 for 1994. Of the $2.2 million increase, $1.4 million was for interest paid on the acquisition credit facility in 1995 and an increase of $665,000 of interest paid on the Notes. Interest incurred on loans and notes in 1995 and 1994 was $2.4 million and $354,000, respectively. Interest incurred was higher in 1995 due to borrowings on the credit facility, and senior notes issued as part of the Consolidation. During 1995, the average outstanding balances and interest rates on the acquisition credit facility and the Notes were $31.3 million and 7.68%. Included in the interest incurred in 1995 was capitalized interest totaling $217,000. No interest was capitalized in 1994. Commitment fees in 1995 were $127,000 as compared to $13,000 in 1994. In 1995 and 1994, a commitment fee of 0.15% per annum was incurred on the undrawn portion of the credit facility. Amortization of the credit facility origination fees were $329,000 in 1995 as compared to $29,000 in 1994. Commitment fees and amortization of credit facility origination fees were $329,000 in 1995 as compared to $29,000 in 1994. Commitment fees and amortization of credit facility origination fees increased in 1995 because the credit facility was not entered into until November 1994.

During 1995, the Company recorded a net gain of $18,000 on the sale of two child care properties and a multi-tenant property. During 1994, the Company recorded a gain of $1.2 million on the sale of five restaurant properties. During 1995 and 1994, cash proceeds generated from these sales were $617,000 and $3.8 million, respectively.