Essential Properties Realty Trust Inc (EPRT) 2022 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust Third Quarter 2022 Earnings Conference Call. (Operator Instructions) This conference call is being recorded, and a replay of the call will be available 2 hours after the completion of the call for the next 2 weeks. The dial-in details for the replay can be found in yesterday's press release. Additionally, there will be an audio webcast available on the Central Properties' website at www.essentialproperties.com, an archive of which will be available for 90 days. It is now my pleasure to turn the call over to Dan Donlan, Senior Vice President and Head of Capital Markets at Essential Properties. Thank you, sir. Please go ahead.

Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties Third Quarter 2022 Conference Call. Here with me today to discuss our operating results are Peter Mavoides, our President and CEO; and Mark Patten, our CFO. During this conference call, we will make certain statements that may be considered forward-looking statements under federal securities law. The company's actual future results may differ significantly from the matters discussed in these forward-looking statements, and we may not lease revisions to these forward-looking statements to reflect changes after the statements were made. Broader risk sector actual results to differ materially from expectations exclude from time to time in greater detail in the company's filings with the SEC and in yesterday's earnings press release. With that, Pete, please go ahead.

Thank you, Dan, and thank you to everyone who is joining us today for your interest in Essential Properties. As our third quarter results indicate, our portfolio continues to perform at a high level with record-level unit level coverage of 4.2x, same-store rent growth of 1.7% and just 3 vacant properties. This strong performance is a testament to our disciplined underwriting process, the resiliency of our service-oriented and experience-based tenancy and our consistent recycling of capital out of weak performing properties. On the investment front, we remained active in support of our long-standing tenant relationships, and we continue to adjust cap rates and sellers' expectations throughout the quarter to better reflect the abrupt moves in the capital markets. With quarter-end leverage of 4.4x and liquidity of nearly $900 million, our balance sheet is well capitalized for continued investments. We are committed to maintaining a conservative balance sheet and investors should expect us to remain well within our historical leverage range of 4.5x to 5.5x.

We are establishing 2023 AFFO per share guidance at $1.58 to $1.64, which implies 5% growth midpoint to midpoint. This earnings growth projection relative to the double-digit growth experienced over the last 2 years, mostly results from our measured external growth outlook, current volatility in the capital markets and underlying investment spreads. Turning to the portfolio. We ended the quarter with investments in 1,572 properties that were 99.8% leased to 329 tenants operating in 16 industries. Our weighted average lease term stood at 14 years with only 4.2% of our ABR expiring through 2026. From a tenant health perspective, our weighted average unit-level coverage ratio sequentially improved to 4.2x this quarter with our percentage of ABR under 1x coverage declining to just 3.7% of ABR versus 6.4% last quarter. We expect this positive trend among our lowest coverage cohorts to continue as these statistics still remain negatively skewed by our trailing 12-month reporting convention, which lags our own reporting by 1 or 2 quarters. And the fact that various municipalities were still placing capacity restrictions on certain industries in the back half of 2021.

During the third quarter, we invested $195 million through 27 separate transactions at a weighted average cash yield of 7.1%, which was up 10 basis points versus the prior quarter. These investments were made in 13 different industries, with approximately 60% of our activity coming from the quick service restaurant, equipment rental, medical and casual dining industries. The weighted average lease term on our investments this quarter was 16.5 years. The weighted average annual rent escalation was 1.6%. The weighted average unit level coverage was 4.4x, and the average investment per property was $3.8 million.

Consistent with our investment strategy, 89% of our quarterly investments were originated through direct sale leasebacks, which are subject to our lease form with ongoing financial reporting requirements and 68% contained master lease provisions. Looking ahead to the fourth quarter, we have closed $60 million of investments to date, and our pipeline remains active at increasingly higher cap rates. From an industry perspective, early childhood education remains our largest industry at 13.5% of ABR, followed by quick service restaurants at 12.6%, medical and dental at 11.4% and car washes at 11%. Of note, unit-level coverage for our early childhood education portfolio continues to increase above pre-pandemic levels as our operators have experienced strong pricing power due to favorable supply-demand imbalance. From a tenant concentration perspective, our largest tenant represents 3.7% of ABR at quarter end, and our top 10 tenants account for only 19.4% of ABR. Tenant diversity is an important risk mitigation tool and differentiator for us, and it is a direct benefit of our focus on unrated tenants and middle market operators, which offers an expansive opportunity set.

In terms of dispositions, we sold 12 properties this quarter for $35.5 million in net proceeds at a 6.2% weighted average cash yield with a weighted average unit level coverage of 1.2x. As we have mentioned in the past, owning fungible and liquid properties is an important aspect of our investment discipline as it allows us to proactively manage industries, tenants and unit level risks within the portfolio. We expect our level of dispositions to remain elevated in the fourth quarter as cap rates for individual granular properties remain near historic lows. With that, I'd like to turn it over to Mark Patten, our CFO, who will take you through the financials and the balance sheet for the second quarter. Mark?

Thanks, Pete, and good morning, everyone. As was evident in our release last night, the third quarter was another solid quarter for us, with our portfolio continuing to produce consistent internal rent growth and our balance sheet and liquidity in a highly favorable position. Among the headlines last night was our AFFO per share, which on a fully diluted per share basis was $0.38, it's an increase of 15% versus Q3 2021.

On a nominal basis, our FFO totaled $53.5 million for the quarter, up $13.3 million over the same period in 2021, an increase of nearly 33% and up nearly 6% compared to the preceding second quarter of 2022. We also reported last night that our AFFO per share for the 9 months ended September 30, 2022, totaled $1.15 per share on a fully diluted per share basis , which is a 19% increase over the same period in 2021. On a nominal basis, our year-to-date 2022 AFFO totaled $153 million. That's an increase of $40.4 million over the same period in 2021, an increase of nearly 36%. Total G&A was approximately $7.9 million in Q3 2022 versus $5.6 million for the same period in 2021, with the majority of the increase relating to an increase in noncash stock compensation expense. Our third quarter cash G&A moved higher sequentially by approximately $800,000, of which nearly $300,000 was a onetime item relating to the expensing of costs associated with an amendment that lowered the rates in our 2027 term loan, which we were required to write off. Our cash basis G&A as a percentage of total revenue was up during the quarter, but we continue to expect this percentage to rationalize through the balance of 2022 and into 2023.

Turning to our balance sheet, I'll highlight the following. With our $195 million in 3Q 2022 investments, our income producing gross assets reached $3.8 billion at quarter end. From a capital markets perspective, we had a very strong quarter from both a debt and equity perspective. In August, we completed an overnight offering that was upsized based on strong demand, which generated just over $190 million in net proceeds. We also generated approximately $20 million of net proceeds in the early part of the third quarter from our ATM program. As we reported with our second quarter 2022 earnings call, we closed a $400 million 5.5-year term loan this past July. We completed the 2028 term loan through an amendment of our credit facility.

And at closing, we drew an initial $250 million, which we swapped to fix during the third quarter. In October, we drew the remaining $150 million that was available under the 2028 term loan, $50 million of which we have swapped to fixed, and we expect to swap the remaining $100 million to fix in the near term. Our net debt to annualized adjusted EBITDA was 4.4x at quarter end. At quarter end, our total liquidity stood at nearly $900 million. Our conservative leverage position, strong balance sheet and significant liquidity position continues to be supportive of our current investment pipeline and sufficient to fund our future growth plans in 2023.

Lastly, I'll reiterate that our current investment pipeline outlook for the core portfolio and our continued strong performance this quarter provided us with the basis to maintain our 2022 AFFO per share guidance range of $1.52 to $1.54, which as we've previously noted, implies a 14% year-over-year growth rate at the midpoint. Lastly, as Pete mentioned in our release last night, we issued our AFFO per share guidance for 2023 at a range of $1.58 to $1.64, which implies a 3% to 7% growth at the low and high ends of the range relative to the midpoint of our 2022 AFFO per share guidance. With that, I'll turn the call back over to Pete.

Thanks, Mark. Operator, let's please open the call for questions.

Thank you, sir. At this time, we will be conducting a question-and-answer session. (Operator Instructions) Our first question comes from the line of Nick Joseph with Citi.

It's Nick Per on for Nick Joseph this morning. It's a quick one for me. I was just wondering if you could quantify sort of what being more prudent means on the acquisition market versus the average quarterly acquisition volume, which I think you've all said is around $220 million.

Yes. I mean and we quantify that in our materials. And I'd be reluctant to put a number on that. Certainly, the markets have been volatile, and we're fortunate to be in a position where we have ample capital to invest. And our investment pace will really depend on what's going on in the capital markets and our ability to move cap rates with our relationships. And so we're trying to moderate expectations, but it's obviously a dynamic time, and it will depend on what the markets bring.

Sure. And then a quick follow-up on that is if there's sort of a threshold on cap rates that you think would bring you back into the markets to be a little bit more active on acquisitions going forward?

Yes. I'd stop short of providing a threshold. And we price each individual transaction based upon our view of appropriate risk-adjusted returns for that transaction. And we make investments to create accretion. And so there's no hard number there. But certainly, given our current cost of capital and where cap rates are, we're being a little more judicious than we had in the past because the spread isn't as wide as we've seen. You got it. Thank you, Nick, and congrats to Nick.

And our next question comes from the line of R.J. Milligan with Raymond James.

I guess I'll start with my boilerplate question here. And how do you view your current cost of capital? What is it? And how do you calculate it?

Yes. So as I said to Nick, we're not -- we don't love our current cost of capital. But that said, we were fortunate to raise capital earlier in the year and have capital to deploy that's already been raised. We also have the ability to raise capital through capital recycling kind of in that low 6 range as you see through our accelerated disposition activities, and I'll kick it over to Dan to kind of give you the specifics on how we think about it, but stop short of giving a specific number at this point because obviously, it's been pretty volatile. But Dan, go ahead.

Yes. R.J., in terms of our WACC, we always look at our implied cap rate as kind of a shorthand way to look at that, which is around a 6.6. And then we look at the traditional weighted average cost of capital analysis, which we view as a 50-40-10 mix of equity debt and free cash dividends. And when you do that math and you put everything together and wait it, our weighted average cost of capital is anywhere between 64% and 68%. And that's about a 75 to 100 basis point spread versus where we're seeing our pipeline today on an initial yield basis. And then on a straight-line basis, you can add another 90 to 100 basis points to that.

p id="53428814" name="Richard Milligan" type="A"

Yes. So listen, we tend to think about the cap rates on the overall pipeline. And certainly, based upon the mix of deals that we have in any given quarter. But -- so 7.2% on that 60%, I think, we'd want to be more a wider range kind of in the low to mid-7s for the entire quarter.

Got it. So certainly, accretive deals so far this quarter, just based on your current WACC, but a little bit tighter spread.

I think that's accurate, yes. which is one kind of goes part and parcel with tempering our investment appetite.

And our next question comes from the line of Wendy Ma with Evercore.

So my first question is, would you mind talking about your current acquisition pipeline and how much of acquisitions are like in the pipeline? And also given the 4Q acquisitions to date, how would you compare this to the historical levels?

Yes. So $60 million quarter to date would indicate a pace relatively consistent with historical levels. As I said in the prepared remarks, our pipeline remains robust, but it's certainly -- it's a volatile market and there is a bid-ask spread with buyers and sellers, given the volatility in the capital markets. And typically, the fourth quarter is a little elevated on a historical basis given the tax motivated sellers at year-end. So it's a little early in the quarter to put a fine point on that. But the pipeline is full, we're seeing good opportunities, but we're continuing to try to push cap rates to get sellers' expectations to meet ours.

Okay. And my second question is, does the current economic slowdown or the recession impact any of your tenants? And do you have any expectation for credit loss for the remaining of this year? And how would you think about your occupancy going into next year?

Yes. Listen, first, I would start that we expect continuous kind of as always to have our occupancy high because we have very fungible assets that are subject to very long-dated leases and very little rollover. And so I would not expect our occupancy to dip materially in the fourth quarter or next year. As part of our operating assumptions, we model credit losses, both for situations that we anticipate and situations we don't anticipate and those assumptions would be embedded in the guidance, one that we reiterated for this year; and two, for the guidance that we provided for next year. All that said, the portfolio is in a great spot. Our coverage is at a record level. We continue to see improvements in our lower-performing cohorts, which are operators with our sites with coverage below 1.5 or below 1. We see that pull continuing to migrate smaller. And it doesn't feel like there's a recession with what we're seeing and hearing from our tenants. The portfolio is operating in a really good fashion at this point.

Our next question comes from the line of Haendel St. Juste with Mizuho.

I guess a follow-up on guidance for next year. I'm curious what gave you the confidence, I guess, to put a guidance range out there given the challenging macro shifting capital markets and asset pricing you mentioned. I'm curious, what are the underlying assumptions for new equity, capital recycling and leverage parameters within that guidance?

Yes, Haendel. And one of the factors that gave us confidence in issuing guidance is, I guess, too. One is it's a wide range. of guidance; and two, it has a very wide range of assumptions underlying the guidance, and that relates to raising capital, buying assets and the cap rates at which we're deploying capital. So unfortunately, at this point, we're not in a position to give more clarity on those specific components because as you point out, they're pretty volatile, but we are confident in the range we provided. Looking at a wide range of scenario around all those inputs. And I would say one of the biggest factors is that contributed to that level converts is the fact that we have a lot of capital availability that's already built into our balance sheet as we sit today with our leverage at historic low levels and nearly $900 million of liquidity.

Okay. Fair enough. A separate question, I guess, on the July debt offering. I think you guys had issued $150 million floating on a 5-year. I think you mentioned you've fixed $50 million of that. So I guess I'm curious, first of all, can you walk us through the thinking there and why you did is long-term fixed for all of it back then? And then what's the plan for the remaining $100 million that hasn't been fixed? What are you looking for? When should we expect you to fix that?

Yes, I'll let Mark tackle the specifics on the term loan. In terms of issuing longer-term we opted to go to the term market on a short-term basis because it was just much more efficient than where the long-term 10-year unsecured bond market was. And given our maturity schedule and debt profile, we had ample runway to layer in that very efficient 5-year execution. But I can give you specifics on when we drew it when we fixed it and what we have left.

And we may have mentioned this on the second quarter call, but I'll -- hopefully, maybe reiterating it, so apologies for that. But first and foremost, as Pete mentioned, the unsecured bond market really through the balance of this year has been pretty dislocated, frankly, has gone from dislocated to extremely dislocated and so we opted for the term loan execution, even though we really modeled in the anticipation of doing a fixed unsecured bond deal. As it relates to the actual term loan itself and the execution, our initial draw was really kind of an indication of what we thought our initial capital need was from that borrowing. So we -- once we decided that, we sort of lagged our way into swapping that to fixed. You can see that in our debt schedule. I think the weighted average rate is 4.4%. So once we -- frankly, once the markets continue to be choppy and frankly, looking like they were going to be challenging for quite some time, we decided to draw the remaining $150 in October. Once again, we kind of lagged our way in and started to swap that. That's probably going to not be too far north of where we were swapping the first 250. And I think that's going to be buttoned up actually pretty quickly.

Okay. And then one more one, I guess, tenant categories, watch list. Curious on any categories you're specifically concerned about here in recession. Anything incremental on watch list? And I guess I'm specifically curious about Town Sports, what's your sense of what's going to happen there?

Yes. I guess on a macro basis, the watch list is as low as it's been and in a good spot. And I think our first level of concerns really become more tenant specific, and less industry specific, really looking at tenants that may have weaker balance sheets or maturities or just not be as good operators, and that tends to be who we focus on. But as I said, overall, the portfolio is in a great spot, and we don't have any high-level concerns going into recession. Some people will point to casual dining as one of the first industries to kind of fall off in a recession, and we'll certainly watch those operators very closely as if this recession sets in certainly doesn't feel like it at this point. As it relates to Town Sports, that used to be a top tenant of ours. That company went through a bankruptcy and a restructuring, a new entity went into our sites coming out of that bankruptcy over a year ago. And that entity continues to struggle, and we were fortunate to re-lease those 3 assets away from that entity with a new operator, it represents probably about 50 basis points of ABR. And we think we've put those assets in better hands at this point. So we don't have any specific concerns or specific commentary about how Town Sports is performing.

Great. Forgive me, I had a follow-up. I got a question from an investor. If you were willing to comment on the guide for next year, if you can -- I know it's a wide range you put out there with a wide range of assumptions. But the question is, can you get to the midpoint of the guidance without new equity.

Yes. Listen, we can. And there's a lot of variables, and we can play with all of them, and we could get to the midpoint without issuing additional equity.

Actually without issuing additional debt but just using the credit facility is kind of what I'd add. And staying well within our historical range of 4.5% to 5.5%... That's important. Appreciate for highlighting that. That is important.

(Operator Instructions) Our next question comes from the line of Greg McGinniss with Scotiabank.

I'm just trying to think about kind of the best way to view this moderated approach towards acquisitions and maybe for some context. If you mind had this view or this approach at the beginning of Q3, how might that have impacted the level of acquisitions and cap rate achieved?

Yes. Listen, I think we had a similar level of caution going into Q2, and we had a similar messaging and that quarter ended up around $175 million at probably a $10 million. And the market is really dynamic. We're fortunate to have ample investment capacity and the pace at which we put that that capital to work will really depend upon the market and our ability to bridge the current bid-ask spread that exists between buyers and sellers. If that bid-ask spread narrows and we're able to get the yields we think appropriate, then we could end up doing more. If bid-ask spread persists and sellers continue to hold expectations that are tethered to the earlier market than our acquisition levels could be extremely muted. And that's a wide range, and it's kind of too early to really tell what that might look like.

And I guess in thinking about this the bid-ask spread that you're seeing today, if the acquisitions didn't come in at the 71 that the sellers were looking for, is it your expectation that the deals just wouldn't have happened at all? Or is there just enough buyers right now that you're still kind of maintaining cap rates. And I guess with everyone dealing with the same kind of increase in cost of capital, what forces that to change?

Yes. I think there's certainly been a change in the competitive landscape with the private and the leverage buyers becoming less aggressive. And the public markets also becoming a little less aggressive. We, in doing sale-leaseback transactions with long-standing relationships. Our competition tends to be with alternative capital sources. It could be debt financing, it could be equity, it could be however these companies decide to capitalize themselves away from us. And so we're not necessarily just competing against real estate cost of capital, but capital solutions across the spectrum, all of which are currently repricing. And so it's hard to say whether the transactions just wouldn't have happened or they would have happened away from us at a different rate or would have happened away from us with a different capital source, but I think probably some combination of that.

And our next question comes from the line of Joshua Dennerlein with Bank of America.

Two similar questions. One, just what's the buying competition out there like today? And then the conversations with sellers, do they recognize that buyers' cost of capital have changed? And like what kind of pushback are they giving on pricing at this point?

Yes. The competitive environment, as I kind of just alluded to, is kind of a little bit muted with the private buyer going away. That said, public buyers are increasingly searching for yield, and we're finding some peers come into our space and it's getting a little more competitive from that perspective. And so on balance, it's still pretty competitive, but not as competitive as it was, say, in the first quarter of the year or even the fourth quarter of last year. And listen, we're buying from sophisticated sellers that run operating companies, and they recognize what's going on in the markets, and they live it through their businesses and understand how cost of capital has worked and what's going on in the interest rate environment. And so they certainly see it. It doesn't mean they're necessarily willing to pay it. And there's kind of a price discovery process that we're going through now.

And our next question comes from the line of John Massocca with Ladenburg Thalmann.

As you can look at the cap rate environment today, maybe how wide is the spread in terms of cap rate between what was closed during the quarter or maybe even in the pipeline as of quarter end versus what you're kind of bringing into kind of the under PSA or LOI bucket?

Yes. That's kind of -- that's really hard to look at certainly in the pipeline because that number, as I said kind of earlier in the call, is widely dependent upon the mix of deals, the size of the operators and the industries that we're investing in. Our cap rates have moved up 20, 30 basis points throughout the course of the year. If you look at the 7.2% we just disclosed on the subsequent activity versus kind of 6.9%. And so I think that 30 basis points is a good proxy as any.

I mean, is that level of expansion you've seen this year, something that's maybe your visibility in as you think about acquisitions that are going to enter that PSA LOI bucket in November, December, even January of next year? An additional 30 basis point?

An additional, potentially. And that's one of the reasons why we're trying to moderate investment expectations is we would like to see that another 30 basis points, and we think it's appropriate, but we're not sure we're going to get it. And if we don't get it, we will likely invest less. And so we are pushing cap rates, recognizing that our cost of capital has moved and endeavoring to get as wide investment spread as we can while continuing to service our relationships and protect our relationships. But I do think continuing to move that cap rate is warranted.

And then on the acquisition side, have you seen any tenants that may be kind of priced out of being attractive targets because they become more institutionalized or people enamored with their kind of credit come back into a kind of pricing range that makes sense for you to kind of target from an acquisition perspective.

Yes. I think we've seen a fair amount of that where deals in the first or second quarter, priced away from us or priced away from where we thought the appropriate risk-adjusted return was that went to other buyers, maybe a private buyer or someone else who didn't perform or retreated and come back to us based upon our certainty and reliability at higher cap rates. And so there's a fair amount of that, as you would expect in markets that are as choppy and volatile as these.

And then on the disposition side of things, I mean I know there's language in kind of the prepared remarks about dispositions being elevated in the back half of the year. Should we view what happened in 3Q as kind of an elevated pace of dispositions? Or could that accelerate further?

Yes. We disclosed our 8-quarter average for a reason. We think and I think that's a good indicator of what to expect. The third quarter is elevated. I would stop short of setting expectations beyond that. That said, we have a very liquid portfolio retail buyers. That market remains active, and the cap rates in that market have not moved as much as one would expect. So it remains an attractive source of capital for us. And so I think the third quarter expectation is probably reasonable going forward.

And our next question comes from the line of Chris Lucas with Capital One Securities.

Three questions for me. So one bigger picture question, Pete, you've been at this a long time. And I guess I'm just curious as to what you see or your experience has been as what a normalized spread between acquisition cap rate and cost of capital should be in this business over a long period of time.

Yes. It's kind of ebbed from as high as 300 to as low as $100 or $80. I would say, certainly north of $100 million should be a reasonable threshold as a spot estimate. But I do think that overall, the asset class has evolved and there's greater appreciation for the durability of the asset class and that there was excess spread given the inefficiency in the asset class, and I would expect that excess spread to come out over time as people have a growing appreciation for the durability of these assets through various cycles.

Okay. And then just in terms of the conversations you're having with potential sellers, is there motivations changing at all given the environment? Or is it still essentially what it was, say, a year ago or 3, 4 years ago?

Yes. I would say given we're doing, call it, 90% sale-leasebacks and sale-leaseback motivations tend to be driven by a defined set of catalysts, business M&A growth, acquisition tends to be the largest of that. There could be some equity recaps or debt refinancing that could be part of that as well. And so those factors change slightly. But the vast majority of our sale-leaseback transactions are driven by our relationship tenants that are seeking to grow and buy up competitors and grow in adjacent markets.

Okay. And then last question for me just relates to a prior question, which is you mentioned that the retail buyer cap rate has been a little stickier. Do you think because your typical asset is smaller, more liquid and, therefore, more likely to find an all-cash buyer that, that cap rate will be stickier over time.

Absolutely. That's a key fundamental of why we buy assets and how we look at an asset and the risk of owning that asset is our ability to have liquidity in selling that asset. And to the extent that the end buyer is not tethered to a third-party financing, which you tend to see in, I call it, a $1 million to $4 million asset that you wouldn't see in a $4 million to $20 million asset cap rates are going to be a lot more stickier than less tied to interest rates.

There are no further questions at this time. I would like to turn the floor back over to Pete Mavoides for any closing remarks.

Great. Well, thank you all for your time today. Thank you for your questions. Certainly, a dynamic time that we're navigating through, and we appreciate your diligence in working with us, and we look forward to meeting with you all in the upcoming NAREIT. Take care, and have a great day.