STORE Capital Corp (STOR) 2017 Q4 法說會逐字稿

Good afternoon, and welcome to the STORE Capital Fourth Quarter and Full Year 2017 Earnings Conference Call. (Operator Instructions) Please note that today's event is being recorded.

I would now like to turn the conference over to Moira Conlon, IR for STORE Capital. Please go ahead.

Thank you, Andrea, and thank you all for joining us today to discuss STORE Capital's Fourth Quarter and Full Year 2017 Financial Results. This morning, we issued our earnings release and quarterly investor presentation, which include supplemental information for today's call. These documents are available in the Investor Relations section of our website at ir.storecapital.com, under News & Results, Quarterly Results.

I am here today with Chris Volk, President and Chief Executive Officer of STORE; Mary Fedewa, Chief Operating Officer; and Cathy Long, Chief Financial Officer.

On today's call, management will provide prepared remarks, and then we will open the call up to your questions. (Operator Instructions)

Before we begin, I would like to remind you that comments on today's call will include forward-looking statements under the federal securities laws. Forward-looking statements are identified by words such as will be, intend, believe, expect, anticipate or other comparable words or phrases. Statements that are not historical facts such as statements about our expected acquisitions or our AFFO and AFFO per share guidance are also forward-looking statements.

Our actual financial condition and results of operations may vary materially from those contemplated by such forward-looking statements. Discussion of the factors that could cause the actual results to differ materially from these forward-looking statements are contained in our SEC filings, including our reports on Form 10-K and 10-Q.

With that, I would now like to turn the call over to Chris Volk. Chris, please go ahead.

Thanks so much, Moira, and good morning, everyone, and welcome to STORE Capital's Fourth Quarter 2017 Earnings Call. With me today are Mary Fedewa, our Chief Operating Officer; and Cathy Long, our Chief Financial Officer.

During 2017, we invested nearly $1.4 billion in acquisitions, including more than $360 million in the fourth quarter alone. At the same time, we profitably divested approximately $250 million in real estate investments, with more than half of that happening actually in the second quarter. Combined, our net investment activity for the year exceeded our net investment guidance of $900 million by over 25%. Our year-to-date investments and property sales reflect our ability to consistently invest in and divest of assets in ways that are accretive to our shareholders. At the same time, our portfolio remains healthy with nearly 75% of the net-lease contracts rated investment-grade in quality based upon our STORE score methodology and just 8 vacant properties at the end of the year. You will hear more about our property investment and sales activity and portfolio health from Mary.

Our dividend payout ratio for the quarter approximated 72% of our adjusted funds from operations, serving to provide our shareholders with a well-protected dividend in a company that's well positioned for long-term internal growth based upon anticipated tenant rent increases in the reinvestment of our surplus cash flows. Our payout ratio was down from 76% in the third quarter where we raised the dividend almost 7%, and so it's on track to more closely approximate 70% over a full year based upon our guidance.

Now as I do each quarter, here are some statistics that are relevant to the fourth quarter acquisition activity that we did. Our weighted average lease rate this quarter was approximately 7.89%, up slightly compared to 7.85% last quarter. The average annual contractual lease escalation for investments made during the quarter approximated 2%, providing us with a gross rate of return, which you get by adding the lease escalations to the initial lease rate that was slightly increased from last quarter. Adding the initial lease rates, the contractual lease escalations resulted in an unleveraged gross rate of return of almost 9.9%.

The weighted average primary lease term of our new investments continues to be long at approximately 18 years. The median new tenant Moody's RiskCalc credit rating profile was Ba1. The median post-overhead unit level fixed charged coverage ratio for assets purchased during the quarter was 2.1:1. The median new investment contract rating or STORE score for investments made during the quarter was favorable at Baa1.

Our average new investment was made at approximately 82% of replacement costs. 75% of the net-lease investments made during the quarter were subject to master leases. And all 110 of the new assets we acquired during the quarter are required to deliver us with unit-level financial statements, giving us required unit-level financial reporting from 97% of the properties within our portfolio, which is truly unprecedented.

Our investment activity continued to be highly granular with 47 separate transactions completed at an average transaction size of just $7 million. At the end of the year, the proportion of revenues realized from our top 10 customers was 18.5% of annualized rents and interests, and that was up slightly from 16.7% at the end of 2016. Further, our top 10 customers continued to be highly diverse, and the largest single customer represented just 3.4% of our annualized rents and interest.

And finally, during the quarter, we sold 15 properties, which represented an original acquisition cost of about $44 million, which, in combination with property sales earlier in the year, netted a gain over our original cost of $13 million.

Mary will dive deeper into this number for you, but our ability to generate profits from asset sales owes itself to our direct of origination strategy. And as I've long stated, portfolio management activities like this, which produce real economic gains, serve to offset sporadic vacancies or asset underperformance, which is a customary part of the net-lease business.

And with that, I will turn the call over to Mary.

Thank you, Chris. Good morning, everyone. 2017 was another solid year for acquisitions, with originations up over 12% versus 2016 and continued strong portfolio performance. In the fourth quarter, we funded over $360 million of acquisitions at a cap rate of 7.9%. For the year, we funded nearly $1.4 billion of acquisitions at a cap rate of 7.8%. We sold $254 million, bringing our net acquisition volume to $1.1 billion, ahead of our 2017 target of $900 million net of dispositions.

Active portfolio management has enabled us to minimize portfolio investment risk, and throughout 2017, we continued to sell certain properties. We sold 55 properties in 2017 at an aggregate gain over cost of around $13 million or about 5%. 25% of the properties sold were opportunistic sales and delivered the bulk of the gains, averaging a 21% profit over cost.

We were also able to make money on the 18 properties we sold for strategic reasons to reposition the portfolio. That gain was 8% over cost. These gains were slightly offset by the remaining 23 properties that were sold as part of our ongoing property management activities, which resulted in an impressive 91% recovery.

Now turning to some portfolio performance highlights. As of year-end 2017, the service sector accounted for about 67% of our portfolio, less than 18% within experiential retail and about 15% within manufacturing. Customer ranking within our top 10 remains unchanged from last quarter, with our largest customer representing just 3.4% of annualized base rent and interest. Our portfolio continues to be highly granular and well diversified.

Delinquencies and vacancies remained very low due to our active portfolio management and strong tenant partnerships. As we ended the year, only 8 properties of nearly 2,000 property locations in our portfolio are vacant.

And now turning to our target market and our pipeline. Our target market is the U.S. middle market, which is generally defined as company's having between $10 million and $1 billion in annual revenues. This market consists of approximately 200,000 companies. The average middle-market company has annual revenue slightly exceeding $50 million. Our average customer has approximately $800 million in annual revenue. Between 2011 and 2017, middle-market companies represented more than half of the job creation in the U.S., and currently account for about 48 million employees, representing over 1 in 4 workers in the U.S. We estimate that our tenants employ 1.8 million workers and have added approximately 180,000 employees to their workforces as they grew their revenues in 2017 approximately 10%.

So that new growth is nearly 30% more than the middle market as a whole, about 40% more than the growth rate realized at the S&P 500 for the past 12 months. As we prosper in the large segmented target market, our acquisition pipeline has grown by approximately 40% compared to year-end 2016.

Finally, I wanted to mention that we recently hosted our second annual customer conference, The Inside Track Forum in Scottsdale at the end of January. At this conference, our customers enjoyed a full day of presentations from a leading economist, a futurist, a capital markets panel, ASU business professor and a keynote addressed from Shark Tank star, Daymond John. Our goal is to continue to provide resources to our customers that can help them grow their businesses. STORE universities presented a series of business lessons posted on our website is another example of how we add value to our customers.

With that, I'll turn the call to Cathy to talk about financial results.

Thank you, Mary. I'll start by discussing our capital markets activity and balance sheet, followed by our financial performance for the fourth quarter and year ended December 31, 2017. Then I'll review our guidance for 2018. Please note that all comparisons are year-over-year unless otherwise noted.

From a capital markets perspective, 2017 was an active year for STORE. Over the course of the year, we raised net equity proceeds aggregating $743 million from the sale of approximately 34 million shares of our common stock. This included the $377 million investment by Berkshire Hathaway in June, our follow-on stock offering in the first quarter and the sale of 5.75 million shares under our ATM program at an average price of $25.63 per share. Our ATM program has been a very efficient and effective way to raise equity and makes a lot of sense for us given the flow of our business and the size of our transactions.

During the first quarter, we added $235 million of new secured and unsecured long-term debt. This included a $100 million unsecured bank term loan at an effective rate of 2.57%, with a 2-year term and 3 1-year extension options. We also sold $135 million of A+ rated 10-year net-lease mortgage notes under our STORE Master Funding's secured debt programs at an interest rate of 4.32%.

Then during the third quarter, we prepaid without penalty our Series 2012-1 Class A Master Funding notes, which had a critical balance of just under $200 million and a scheduled maturity of August 2019. These notes carried an interest rate of 5.77%. And by paying them off early, we reduced the weighted average interest rate of our long-term debt by about 11 basis points.

As a result of these capital markets activities, at December 31, our long-term debt stood at $2.3 billion, with a weighted average interest rate of just under 4.4% and a weighted average maturity of 6 years.

In an environment of rising interest rates, it's important to note that all of our long-term borrowings are fixed rate and our debt maturities are intentionally well laddered. Our median annual debt maturity is approximately $250 million, and we have no meaningful near-term debt maturities until the year 2020.

Subsequent to year-end, on February 9, we expanded our unsecured revolving credit facility from $500 million to $600 million and expanded the accordion feature from $300 million to $800 million. This allows us to increase the maximum borrowing capacity under the facility up to $1.4 billion. The amended facility matures in February 2022 and includes 2 6-month extension options.

At year-end, growth investments in our real estate portfolio totaled $6.2 billion, of which, approximately $2.9 billion had been pledged as collateral for our secured debt, and the remaining $3.3 billion was unencumbered. Our unencumbered assets increased to 53% of our portfolio in 2017, up from 43% in 2016. Longer term, we're targeting an unencumbered asset ratio of approximately 65%.

Our leverage ratio at the end of 2017 was 5.7x net debt-to-EBITDA on a run rate basis. This equates to around 42% on a net debt-to-cost basis.

Heading into the new year, with the closing of our expanded credit facility earlier this month, we had borrowing capacity of $310 million in addition to the $43 million of cash on our balance sheet. As I indicated earlier, the accordion feature of our expanded credit facility provides access to even more liquidity.

In summary, we're well positioned with substantial financing flexibility, conservative leverage and access to a variety of attractive equity and debt options to fund a large pipeline of investment opportunities.

Now turning to our financial performance. Acquisition activity during the fourth quarter was funded by cash on hand, net borrowings of $208 million on our credit facility and cash proceeds of approximately $44 million from fourth quarter asset disposition. As of December 31, our real estate portfolio stood at over $6.2 billion, representing 1,921 properties. This compares to $5.1 billion, representing 1,660 properties at the end of December 2016. The annualized base rent and interest generated by our portfolio in place at December 31 increased 20% to $501 million as compared to $419 million a year ago.

Acquisition activity drives revenue growth, and in the fourth quarter, revenues increased 18% year-over-year to $120 million. Total revenues for the year were $453 million, an increase of 20% over 2016 revenues. Our 2017 acquisition volume which spread throughout the year, therefore, the full year revenue impact of that volume will be realized in 2018. Our consistently strong revenue growth reflects the broad-based demand for our real estate capital solutions.

For the fourth quarter, total expenses increased 12% to $83 million compared to $74 million a year ago. Nearly 80% of this increase is due to higher depreciation and amortization, reflecting the growth of the portfolio.

For the full year 2017, total expenses increased to $330 million compared to $266 million last year. Again, this was due to the growth of the portfolio and much of this increase was related to higher depreciation and amortization expense.

For the fourth quarter, interest expense was relatively flat compared to a year ago. Interest expense for the full year 2017 included a $2 million noncash charge related to accelerated amortization of deferred financing costs associated with the STORE Master Funding notes we prepaid in August. Excluding this charge, our interest expense increased about 13% over the prior year as we continued to finance a portion of our acquisition activity with attractively priced long-term fixed-rate debt. This increase was partially offset by a decrease in the weighted average interest rate on our long-term debt.

Property costs were $1.5 million for the fourth quarter and $5 million for the year. The year-over-year increase is primarily related to property taxes, insurance and maintenance costs on properties that were vacant during a portion of 2017 as well as properties where we determined that our tenant was unlikely to pay those obligations. Property costs can vary quarter-to-quarter. But since 98% of our real estate investments are subject to triple-net leases, property level costs are the responsibility of our tenants and therefore, are not a significant portion of our annual expenses.

G&A expenses in the fourth quarter were $11.2 million compared to $8.7 million a year ago. For the year, G&A expenses increased to $41 million from $34 million, primarily due to the growth of our portfolio and related staff additions.

For 2017, G&A expenses expressed as a percentage of average portfolio assets, decreased to approximately 72 basis points from approximately 75 basis points during 2016, reflecting the scale efficiencies that come with portfolio growth.

Net income increased to $41 million for the quarter or $0.21 per basic and diluted share compared to $32 million or $0.20 per share a year ago. Net income for the fourth quarter of 2017 includes an aggregate net gain of $3.8 million from property sales. This is consistent with an aggregate net gain of $3.7 million from property sales in the fourth quarter of 2016.

For the year, net income was $162 million or $0.90 per basic and diluted share compared to $123 million or $0.82 per basic and diluted share for 2016. We had an aggregate net gain of $39.6 million from the sale of 55 properties in 2017. This compares to a net gain of $13.2 million from the sale of 31 properties in 2016. Net income for 2017 includes an impairment charge of $13.4 million, primarily related to 2 properties that became vacant during the year.

For the quarter, AFFO increased 22% to $82 million or $0.43 per basic and diluted share from $67 million or $0.43 per basic and diluted share last year. For the year, AFFO increased 24% to $306 million or $1.71 per basic and diluted share compared to AFFO of $246 million or $1.65 per basic and $1.64 per diluted share in 2016.

Our dividend is an important component of our overall stockholder return. And for the fourth quarter, we declared a quarterly cash dividend of $0.31 per common share. For the year, we declared dividends totaling $1.20 per common share, which included a 6.9% dividend increase in the third quarter. Since our IPO in 2014, we've increased our dividends per share by 24% while maintaining our low dividend payout ratio and at the same time, reducing our leverage.

Now turning to our guidance. We are affirming our 2018 guidance first announced last November. Based on projected net acquisition volume for 2018 of approximately $900 million, we expect AFFO per share to be in the range of $1.78 to $1.84. AFFO per share in any period is always sensitive to the timing of acquisitions during that period as well as the amount and timing of dispositions and capital markets activities.

In 2018, we expect acquisitions to be spread throughout the year, though they're often weighted towards the end of each quarter. The midpoint of our AFFO guidance is based on the weighted average cap rate on new acquisitions of 7.75% and target leverage in the range of 5.5 to 6x run-rate net debt-to-EBITDA.

Our AFFO per share guidance for 2018 equates to anticipated net income, excluding gains or losses on property sales of $0.82 to $0.86 per share plus $0.88 to $0.90 per share of expected real estate depreciation and amortization, plus approximately $0.08 per share related to items such as straight-line rents, equity compensation and deferred financing cost amortization.

And now I'll turn the call back to Chris.

Thanks so much, Cathy. As is usual for me to do, and before I turn the call over to the operator for questions, I'd like to make a few added comments. First of all, we are really proud of our performance. Evaluating a company like STORE, which has so little performance volatility and is highly predictable in the near term, is best done over a much longer timeframe.

So since we took STORE public with AFFO of $1.39 per share in 2014, we've increased this amount by 23%. At the same time, we also raised annual dividends per share that we paid out to shareholders by a sector leading 20%. That means we maintained a low dividend payout ratio to AFFO of roughly 70%. While the multiple we trade at has had some volatility over the last 3 years, it's tended to center on the multiple we went public at in 2014, meaning that our dividend yield at the conclusion of each year has not been far from the approximately 5% at which we introduced STORE to the public market and shareholders in 2014. This overall annual stability has meant that our shareholder returns have deviated little on an annual basis at 12.6% in 2015, 11% in 2016 and 10.7% last year in 2017. In fact, our compound annual rate of return over these 3 years is -- of 11.4% is right on top of the performance for the S&P 500 and more than double the 5.4% compound annual rate of return of the MSCI REIT Index. Over this same period, we've more than doubled the size of our balance sheet, more than tripled our unencumbered assets, meaningfully lowered our financial leverage, maintained our sector-leading investment and portfolio diversity and added to our A+ capital access through our Master Funding conduit by having now a BBB and Baa2 ratings with stable outlooks from all 3 major credit rating agencies.

As a result of our efforts, STORE today is bigger, more diverse and financially amongst the strongest in the net-lease sector. Moreover, with sector leading growth rates of return and investments spreads to our cost of borrowings, we have continued to grow our shareholder value in excess of its actual cost, creating material and sector-leading compound growth in market value added.

Now I mentioned all of this to take some stock in our accomplishments, but also because we have accomplished all of this without trading at the highest multiples in the net-lease space, and we're generally trading at below the aggregate multiples of the MSCI REIT Index.

I believe that our track record over the past 3 years, like our leadership of prior successful net-lease real estate investment trusts over the past 20 years, illustrates that this value -- this valuation gap was and is unwarranted. But more than this, the net-lease sector on its own ranks near the bottom of real estate sectors today, with few sector companies trading at multiples that even equate to the broader R&D average. I believe that the net-lease sector deserves better.

Interest rate sensitivity today is a primary concern of investors with the frequent notion that net-lease REITs have to be more interest-rate-sensitive than other sectors as a result of our comparably long lease terms. And of course, STOREs are amongst the longest in our sector, averaging 14 years. But we are not elongated bond, we are a dynamic operating business, having sector-leading rental increases, together with amongst the sectors most protected dividends to arrive at a high level of embedded internal growth that today approximates 2/3 or more of our expected AFFO growth for 2018. But addressing growth issues is just part of interest rate sensitivity. We are also over 40% leveraged as a percentage of investment cost with no material debt maturities until 2020 and with latter debt maturities on an annual basis that are not projected to be much more than our free cash flows in those years. That means that our liability sensitivity or interest rate sensitivity on the maturation of our liabilities will likely range from a near 1% to less than 2% of our total assets on an annual basis. And there was the 10-year Treasury rate that rise at 4% and have little impact on our future cash flows from our investment portfolio. And more importantly, we've intentionally built STORE with leases having gross rates of return that are not far from those we had more than a decade ago in a prior company we led and in a materially different interest rate environment. With base lease rates close to 8% and lease escalators averaging about 1.8%, the gross unleveraged returns have been in the area of 9.6%.

From 2003 to 2007 with average 10-year Treasury in the area of 4.4%, our leased rates averaged 8.6% with escalators of about 1.6% for a gross unleveraged rate of return just 40 basis points higher than we are -- where we are today. And I should mention that this prior net-lease platform delivered a compound annual shareholder return between 2003 and 2007 of nearly 20% in an environment with a 10-year Treasury list 4.4%.

By the way, our very first net-lease investment platform was public from 1994 to 2001, where 10-year Treasuries were averaging 6.2%. That company produced an investor rate of return of 12.2% compounded or almost double that of government securities, and that works in just about any investment market model.

We also were able to pass the S&P 500 with regularity. I'm mentioning all of this to attempt to dispel the notion that longer lease terms equate to elevated levels of interest rate risk. This is a prevalent cognitive bias, and it's mathematically not so.

As to what changing interest rates might do to impact our external growth, we can expect elevated rates to accompany higher invested lease rates. Based upon our history of more than 30 years, while this relationship does exist and correlation is positive, it is nowhere near perfect. And I believe the word imperfection could also apply to other real estate sectors.

So my conclusion is simply that interest rates adversely impact all corporate valuation. As I remember Warren Buffet once saying, "elevated interest rates are like gravity for the stock market." The discounted cash flow potential from all businesses just becomes worthless. Here, a well-constructed net-lease company should not be impacted any more than any other well-constructed corporation, which gets me back to the thought that based upon our performance and based upon our construct, there's no reason why we should not trade, at the very least, at the multiple equivalent to the overall REIT index that we have shown a long-term ability to exceed.

Now the net-lease business itself is truly amazing, and I'm saying this from the perspective of a former commercial banker. The profit-center lease contracts that we create are highly senior and allow us to have contracts that exceed the implied credit quality of our tenants. Whereas banks are happy just to be paid, we're happy to be paid more next year. Where to think loan portfolios are less liquid and seldom worth more than par, we have shown an ability of regularly solid assets and material gains over our costs. And whereas nonperforming loans for banks can result in material losses, our investments are backed by hard assets and our average recovery is based upon resolved credit events that's averaged 70%, inclusive of their demonstrative costs.

So with this thought in mind, we're starting to at least annually produce some integrated lifecycle analysis in our appendix of our presentation. There, you're going to see the average annual credit loss unresolved tenant issues has been 20 basis points since we started STORE. We have offset this 20 basis point annual loss by about half through the profitable sale of real estate. At any given time, we also have, what I would call, work in process, which is underperforming real estate that's in the process of being administered. Over many years in this business, we've generally tended to an average 6 months or so, to administer to underperforming assets. And I mentioned this because this amount is not illustrated on the chart in the appendix but could add another 40-or-so basis points to our average AFFO drag since we started STORE. So then you take the total drag and compare it to our unleveraged internal growth, which we expect to approximate 3.6% annually, and we still have a number that's more than 3% a year. The reason for the long view when looking at our business cycle is that tenant performance is volatile. One of the reasons that we chop out larger exposures at just around 3% of rent is to construct a portfolio that's always capable of internal growth, even if we have an issue with a larger tenant, as we did with Gander Mountain in 2017. STORE is, by design, a defensive company, and would take a lot for us not to have revenue growth in any one year.

And so with these comments, I'm joined by -- our group here is joined by Chris Burbach and Michael Bennett as well. And I'm going to turn the operator -- call over to the operator for questions.

(Operator Instructions) Our first question comes from Vikram Malhotra of Morgan Stanley.

Just wanted to follow up sort of on your comments regarding some of the schematics and the ability to grow. Wanted to sort of get your view or thoughts on what would make you deviate dramatically downward from the acquisition phase that you've been doing recently? And vice versa, are there -- is there something that you would say would make you go the other way where maybe there are large portfolios, maybe there's other factors? Can you just sort of talk about the tails?

Sure. I'll start and Mary or Catherine can make a brief comment (inaudible). I would say that, first of all, we tend to stay away from large portfolio transactions, so historically, we've stayed away from that. Today, we're trading roughly at 13x AFFO multiple, which is sort of silly, because that means that we're trading at a discount in that asset value. So at 13x AFFO multiple, by the way, placed our cap rate around 7.2%. And so the good news for us is we're able to buy assets at a discount to NAV. So we're buying assets at 7.75%, 7.80%, 7.90%. So that's the good news. But in terms of where we could sell the assets and where they would be worth, they would be worth better than 7.2%. So where we're trading today is almost like a bank that's trading less than book, which makes absolutely 0 sense to us. My guess is over the long term that we will be more in the range that's been in the median. If you look at the REITs as a whole from an FFO yield perspective, the spread today is a record 6-year spread between REIT -- FFO yields and government securities. So that implies that perhaps there's a decoupling of where REITs trade and where our government securities trade. And so if you assume all of that and you look at like the long-term running AFFO or FFO multiple of the REITs over the last -- net-lease REITs over the last, I don't know, 10 to 15 years, you get to sort of around a 15x kind of median multiple in lots of different interest rate environments, by the way. So I think that long term, that's what it'll be. Long term -- I mean, in the near term, it's -- we're trading at, I mean, 12 or 11x AFFO. I guess, we'll slow down on acquisitions. I mean, our ability to make accretive acquisitions is probably better than anybody in the space just due to how we originate. We may have to start managing money for other people. I mean, the private market just might be more efficient than you guys. And if that's the signal that gets sent to us, there are other ways that we can deploy capital. And I mean, we started this company with Oaktree Capital and Howard Marks and Bruce Karsh and we can find other people to give us capital on a private basis if that's where we have to go. I'm expecting that won't happen. I think it makes no sense that a private market that is not liquid and not diverse could somehow trade at a better valuation than the marketplace where it is liquid and is diverse and is BBB-rated, and does have access to different and more efficient cost of capital. But that's not for me to say. I mean, that's going to be driven by the marketplace. What I know is that we have options. We've created a huge platform here with the best acquisitions group in the business and it is -- choose to devalue as an operating platform and sometimes people think of these companies as a conglomeration of assets, but you really have to think about companies as ongoing operating businesses. I mean, it is basically a financial services company by any other means, because we're providing real help to people who need it on their capital stock. I mean, today, if you're in middle market America, there is virtually no good long-term financing for real estate. I mean, you can't get it. It just doesn't exist. And there's no assignable debt, there is no prepayable debt, there's -- debt's very difficult to modify. So the solutions we're giving people are such that they would much rather have a landlord than a banker, and we're giving them -- basically we're replacing both their debt and equity needs. And so we're fulfilling a very huge need in the business for these companies. And as Mary said, our companies have 1.8 million employees. So from a stakeholder perspective, we're gratified and fill a need for these customers and we're going to find a way to do that no matter what.

Okay. That's helpful, Chris. And then just quick question related to Gander. I mean, just sort of give us the final update there in terms of dealing with the Ganders, sort of what the outcomes were? And given your comments, if I remember last -- maybe it was the prior call, where you sort of said, if there's 1 thing you'd go back and redo, you saw the Gander coverages turning down and you'd want to get -- you would like to have gotten ahead of them. Are there any other subsectors, maybe specific tenants, where there are no red flags right now but you've seen sort of deterioration, and you might start considering potentially disposing some?

There are always some assets like that, Vikram, and we've done that over the years. I mean, we just didn't kind of -- we had, I think, a little bit more optimism on Gander than we should have had. And so in retrospect, we know we should have done differently, and so it's a lesson for us. In terms of their recovery, I think on the last earnings call that we had, we estimated the recovery would be between 50% and 70%, and it's really a function of whether we hold it or don't hold it. So we don't hold the assets, which we may not do that, then the recovery goes up, because we're looking for some other profit and redeploy the capital. So we'll see exactly what we do with Gander today. At the end of the year, there were technically 4 vacant of the 8 properties that were on our sheet as vacant. 4 of them were Ganders. But 2 of those were in CMBS, and we noted on our 10-Q that those were assets where we weren't paying any debt service and whatnot. And the recoveries on those CMBS transactions are not expected to be much different from the actual balances on those transactions. So the bank is -- you can expect that the lender there will take our advice on what kind of recoveries to have and take their leads that we've given them in terms of how to maximize the recoveries. So that would take you down the 6 vacant properties at the end of the year, and we think that those are being administered by someone else. And the other 2 Ganders are properties where they're a little harder to move. They're nice locations and -- one is right next to Walmart that's brand-new and so on. And what we may have to do is subdivide them and that's fine. So we'll look at doing that. And we have interest in the properties, so it's not like we don't have interest in properties. So we expect that we'll resolve them before too long.

Our next question comes from Craig Mailman of KeyBanc Capital Markets.

Chris, I just want to follow up on the commentary in response to Vikram. You guys in the past have sold companies. You sound a little bit frustrated about where valuation is. I mean, have you or the board kind of pursued a potential privatization with outside money?

No, we haven't.

I mean, do you think that there is a bid at a significantly higher valuation than the private market versus the public market at this point?

I couldn't begin to tell you that. I mean, I think that when you're running a company, you should evaluate your cost of capital and your alternatives, not just from day to day, but over the long term, right? So it's -- so on certain days, there may be people that might value a company more in their market. But over like 1 year, over the whole course of 2018, that may not be true. So I think that you have to be really careful about that kind of stuff.

Okay. That's helpful. And then just 1 quick follow-up. I mean, post the cash flow getting past through, are you guys seeing an increase in potential sale-leaseback opportunities?

Cathy, you want to talk about the pipeline or something?

No, Craig, I wouldn't say that the tax bill passage has been driving any of that. But I would say that the deal flow is strong and the pipeline is strong, but not particularly related to that.

Our next question comes from Todd Stender of Wells Fargo.

You've got the highest annual rent escalators in the net lease space. Can you go over the escalators you were able to get on the properties acquired in Q4? And then just with that theme, just speak about how the conversations with sellers go? With the backdrop of a pretty robust economy we're in right now, can you push that higher? Or no matter what, it's going to be in that 1% to 2% range?

So we raised them 2% in the last quarter, which was 10 basis points more than the prior quarter. Our cap rate was, let's just say, another 4 basis points higher. So together, the growth return is 15 basis points higher than the previous quarter. Does 15 basis points make a trend? No, I wouldn't think so.

Not just 1 quarter.

Not just 1 quarter. But we are seeing -- the cap rates are certainly remaining the same. And we're -- and (inaudible) tends to get sticky, and it tends to be sort of sector-specific, so we're seeing, for example, in that -- when we survey brokers, and we don't do a lot of business in the brokered market, but when we survey brokers, we're seeing that assets are being listed for longer periods of time. We're seeing that certain sectors are becoming a little bit less desired, like drug stores and dollar stores potentially. We're seeing other sectors like restaurants being highly sought after, industrial assets being highly sought after. So people have a tendency to sector rotate just like REIT investors do, and so you see some of that happening in the marketplace. Overall, I would say that cap rates in the private marketplace are still very low and are reflective of individual investors having a bias towards names that they know and trust and towards -- they have no ability to really underwrite portfolios and they have no -- they're doing 1 property at a time, right? So they're -- and they have no access to deal flows. So they're -- for all that reason, they're willing to accept a much lower yield than we will be willing to accept. So -- but that's about it. I mean, we're not seeing any sort of huge movement in relation to interest rates today.

Our next question comes from David Corak of B. Riley FBR.

Sort of start on projected sales. Obviously, you haven't given an exact number yet, but -- or at all. But how do you think about the breakout of that between the 3 buckets that you guys talk about? And then within that, what industries do you expect to fall into the more strategic bucket?

We're not seeing anything that's broad-based or sector-specific. So we're seeing -- so we could see clients in certain sectors having performance issues or the potential for future performance issues, and we might -- may decide to get in front of that by selling some assets. But that's not to speak of the whole sector. So basically, you can look across our portfolio, and you know that restaurants is our #1 sector, so then restaurants tends to be the #1 thing that we sell in terms of numeric -- just numerically in terms of property count. Last year, the biggest property we sold was an industrial asset and it was actually opportunistic. So that was not by size, that was the biggest asset we sold. Last year, 25% of the assets numerically made up the bulk of the gains, so it made like the 80% of the gains. It was probably bigger than 25% of the dollars because that included the industrial assets that was expensive. But that made up the vast majority of it. We can -- we're booking all the stuff with embedded gains from day 1. I mean, that's very important to us. I mean, we want to be able to have a better gain, because if you have a better gain, then you have just much better liquidity options and you have much better chance to create market value added, you have much better chance to have margins of safety. So for example, if you have -- we've been able to periodically actually lower tenant rents and sell the properties and get our money back for properties that we are concerned about. So we're basically helping those tenants work better so that a subsequent owner of the property feels better about where the rent sales are -- is or what not. And then we're able to get all of our money back out, and then we can redeploy it. And in some cases, we actually make profit on that stuff. So I think that's just very important to us, and so if we wanted to sort of be opportunistic and sell off more assets we could. It's just a trigger we can pull. And that's important because if you can take on average of 20 basis points of loss over the last 6.5 years a year and offset it with 10 basis points in gain, then basically you have a portfolio that has very little frictional loss against AFFO per share, and the internal growth becomes better. And I think that's important to us.

Okay. That's helpful. And then going back to your -- some of the prepared remarks, you talked about the various iterations that you've had of this strategy and the success in various different economic environments. But is there an environment that, I guess, would be reasonably conceivable where a single tenant, kind of freestanding real estate, underperforms a broader CRE? Or do you feel kind of confident that the strategy that you have, given kind of the potential economic scenarios going forward, stands to outperform?

Well, I would say that there are -- the single-tenant real estate market is not monolithic. It is comprised of different companies having different strategies, different approaches to the market for different views on that marketplace. And some companies have higher payout ratios, some companies have lower rent increases. So when you're making a -- I mean you're taking a view on STORE versus other companies, you have to sort of weigh those differences, and you have to decide for yourself whether you like our approach or their approach or whatever. I'm extremely comfortable with our approach. I mean, we have the highest lease escalators in our portfolio that we've ever had. I mean, this goes back to 1980. I mean, that may not seem like a lot for this quarter, but it is a lot. I mean, 2% on a levered basis is more than 3% from an AFFO perspective. Now there's some friction against that. So you'll have some vacancies and some friction against it. But you have to start off with a big number that's meaningful, and it costs us nothing whereas other companies might post bigger same-store rent numbers than 2%. They've got to put out money for a TI to do that. I mean, so on a net basis, 2% flowing right through was a big number, and so we feel good about the rent increases. Our AFFO payout ratio is the lowest we've ever had, period. I mean, and so that basically gives us the ability to wall cash and get basically another 2.5% or so growth. So you're starting off with basically 5% plus embedded growth in AFFO per share before you turn the lights on and -- on January 1, and I think that's just really critical. So if you lose some of that to vacancies, it's fine. At a 13 AFFO multiple, our external growth is not as exciting, right? So basically what happens is, external growth adds another 1 point to 1.5 points of growth of AFFO growth per share. If you guys would be nice and let us trade at 15 or 16 AFFO growth, then it gets like a lot more exciting, right? But the irony of it is, actually, if you're really worried about interest rates and you want higher rates of return, you should trade us at a better AFFO multiple because we'll put up much better growth numbers. But as it is, if you take our AFFO growth and you add our internal growth and you add some external growth, it's going to still beat the 9% or 10% number that the S&P has posted for the last 40 to 50 years. And I think that's a heck of a thing to say. So I don't know who else could say that. And I think that -- I would say that for this company anyway, we're happy with where we are in this marketplace.

(Operator Instructions) Our next question comes from John Massocca of Ladenburg Thalmann.

I know you kind of mentioned some potential leverage you could pull for proceeds if you felt that Green market's got even more challenged. Would you ever consider maybe bringing up your leverage targets if that was the case and you felt there was still some attractive acquisition opportunities out there?

I think the answer is that we -- if we're going to bring up leverage numbers, we might do it in the short term, but just as a blip, right? I think being a BBB company is important. We want to make sure that we sort of maintain ratios that are consistent with that. Personally, I think that having a BBB rating in concert with having a structured finance A+ rating is just better than having a BBB rating by itself. Or -- by the way, an A+ rating on our Master Funding kind of by itself. I just think that they're very complementary. And long term, I think that they're going to cause us to lower our cost of capital relative to people who don't have those multiple choices. And the logic for that is that if you look at our unsecured debt ratios, okay, so basically unencumbered assets, unsecured debt ratio or unencumbered asset that sort of is covered ratio, and there are slides on our presentation that goes through this, it's -- they're better than basically anybody else in the space no matter what their rating is. They're better than most -- any REIT no matter what the rating is. And the reason for that is because the Master Funding assets are leveraged 70%, but we're basically leveraged on a consolidated basis, 45%, so you end up being sort of 33% levered on your unsecured debt on an unencumbered asset ratio. So I think that that kind of synergy is going to help us maintain competitive leverage ratios in the aggregate, which lower our cost to capital and make us more efficient than anybody that would be having one or the other.

That makes sense. And then kind of shifting gears maybe to -- on portfolio mix, your exposure to, what you guys classify as service tenants, has been kind of ticking down over the last 2 years I guess by about 450 basis points since 4Q '15, what's driving that? Is that just a more attractive acquisition opportunity somewhere else? Or is that a conscious decision to shift portfolio exposures?

So this is Mary. No, it's not a conscious decision. We're still very focused on service. It's our primary asset spend, near 70% right along. So it's just the timing of acquisitions and timing of asset classes, but absolutely it's our main focus, the service industry for sure.

This concludes our question-and-answer session. I would like to turn the conference back over to Chris Volk for any closing remarks.

Thanks, operator, and thank you all for attending our year-end earnings call. I'm going to remind you that we have a biannual Investor Day coming up on the afternoon of April 11 at the New York Stock Exchange, and we're also going to ring the closing bell that day. And at that event, we plan to offer a high-level look at what the future holds in STORE of market and portfolio discussion and customer case studies with STORE relationship managers. And we're also going to deliver an analysis of evidence-based real estate investing and cognitive biases, which you're going to find fun. It's kind of like a money ball for real estate. I'd also like to draw your attention to our modified investor presentation entitled Values Added by Design, which follows on last year's presentation by illustrating foundational elements that we design from the outset and combine to make STORE the exceptional company that it is. The presentation also expands on the values that we add to our stakeholders and our important corporate values of strong governments and investor disclosure. And by the way, STORE University is part of an effort to add value to our customers, as Mary pointed out. And Part 1 of 9 has been posted, if you're holding your breath and you couldn't wait to see it. If you want to binge watch now, you can watch episodes, we know, Lessons 1 through 9, and just have a blast and -- or you can wait until Lesson 10 gets posted sometime soon. STORE University is designed to have 10 modules from the start. So finally, we're able to follow this earnings call up with our CEO letter, which should be announced and posted on the website shortly. And thank you so much for listening, and have a great day. We'll be around for questions if you need us.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.