Essential Properties Realty Trust Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
October 26, 2023

There are 11 speakers on the call.

Operator

Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust Third Quarter 2023 Earnings Conference Call. 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 Essential Properties Realty Trust website at www.essentialproperties.com, an archive of which will be available for 90 days. On the call this morning are Pete Mavoides, EPRT's President and Chief Executive Officer Mark Patten, EPRT's Executive Vice President and Chief Financial Officer and Rob Saulsberry, EPRT's Senior Vice President and Head of Capital Markets.

Operator

And it is now my pleasure to turn the call over to Rob Saulsberry. Thank you, sir. You may begin.

Speaker 1

Thank you, operator. Good morning, everyone, and thank you for joining us today for the Q3 2023 earnings conference call for Essential Properties Realty Trust. During this 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 The matters discussed in these forward looking statements and we may not release revisions to those forward looking statements to reflect changes after the statements were made. Factors and risks that could cause actual results to differ materially from expectations are disclosed from time to time in greater detail in the company's filings with the SEC and in yesterday's earnings press release.

Speaker 1

With that, I'll turn the call over to Pete.

Speaker 2

Thanks, Rob, and thank you to everyone who is joining us today for your interest in Essential Properties. As our Q3 earnings release indicates, we are pleased to report another quarter of strong results, driven by the strength and stability of our portfolio that continues to perform well and was impacted favorably by our solid investment activity. Despite some areas of the broader consumer sector noting a slowdown in recent months, our growth oriented middle market tenants Continued to perform well as reflected by our unit level rent coverage that remains strong at 4.0x. Our same store rent growth, which remained favorable at 1.2% and just 3 vacant properties. The overall health of our portfolio is a testament to our disciplined underwriting process, which focuses on growing operators in durable service and Based Industries and owning granular and fungible properties that generate strong cash flow for these operators.

Speaker 2

Our tenants provide a strong value proposition to their customers with generally low average tickets that do not rely on consumer financing and therefore do not experience demand headwinds from a rising rate environment. In the Q3, we acquired 65 properties in 30 separate transactions that were 100% sale leaseback transactions with 86% of those opportunities generated from existing relationships. Our 3rd quarter investments reflect an improving pricing environment for our business with initial cash cap rate of 7.6% An average annual rent escalation in those leases of 2% and a weighted average lease term of 17.6 years, which results in an average GAAP yield over the primary lease term of 8.7%. With limited active competitors in the middle market sale leaseback arena today and higher base Driving up the cost of private credit alternatives for these operators, we expect the favorable cap rate environment to persist in the near term. Our balance sheet remains in great shape as Mark will discuss shortly, as we remain committed to maintaining a conservative Leverage profile and strong liquidity position.

Speaker 2

We are establishing our 2024 AFFO per share guidance at $1.71 to 1 $0.75 which implies a 5% growth rate midpoint to midpoint. Our guidance for 2024 reflects continued healthy portfolio performance and an improving pricing on new investments, tempered by an expectation of a higher cost of capital and a generally volatile capital markets backdrop continuing in the near term. Importantly, I am pleased to note that supported by our conservative leverage profile and our low dividend payout ratio, the company's nearly $100,000,000 of forecasted retained free cash can be accretively deployed into our investment pipeline without any additional reliance on the capital markets. Combining the reinvestment of our retained cash flow, our strong capital deployment year to date and our healthy rent escalators, Net of tenant credit assumptions, we estimate our AFFO per share and grow nearly 4% in 2024 without requiring any additional external capital. Notably, favorable developments in the capital markets could provide the opportunity to achieve a higher growth rate than what is implied at our midpoint of guidance.

Speaker 2

Turning to the portfolio. We ended the quarter with 1793 properties in our portfolio that were 99.8% leased to 363 tenants operating in 16 Industries. Our weighted average lease term stood at 13.9 years with only 5% of our ABR expiring through 2027. From a tenant health perspective, Our unit level rent coverage ratio at quarter end was 4.0x and the percentage of our ABR that had a less than 1x rent coverage level remained consistent from the Q2 of 2023, totaling just 3.1% at quarter's end. As I noted, our same store rent growth remained favorable at 1.2%.

Speaker 2

Although that represents a 30 basis points decrease from last quarter, our rent growth in the 3rd quarter was impacted by a 30 basis point headwind from the bankruptcy of a gym operator in Oregon. Like many other businesses in Oregon, this particular operator which was somewhat unique in the context of our broader portfolio of health and fitness properties. Specifically, we did not collect rents on 2 properties operated by this tenant, which totaled only $8,000,000 of net book value. We expect to find a replacement tenant and recruit a meaningful amount of the economics. We view this as a tenant specific event given that our portfolio of health and fitness properties continues to perform well as evidenced by industry unit level rent coverage of 2.1x.

Speaker 2

Regarding our Q3 investments, we invested $213,000,000 in 30 separate transactions and properties representing 12 of our 16 In the quarter, 100 percent of our investments were originated through direct sale leaseback transactions Completed on our lease form with ongoing financial reporting requirements. In addition, 60% of our investments were in a master lease structure. The weighted average unit level rent coverage of the tenants at these properties was 3.3x and our average investment per property was $2,800,000 Looking ahead to the 4th quarter, we remain active and our pipeline should Investment levels relatively consistent with our recent activity with the potential for further improvement for middle market businesses today. Specifically, we expect initial investment cap rates in the high 7% range with strong underlying lease terms. Looking at our portfolio industry breakdown at quarter end, Car washes remained our largest industry at 15.3 percent of ABR, which is down 30 basis points from last quarter.

Speaker 2

Our next largest industries were early childhood education, medical, dental and quick service restaurants. Our largest tenant, equipment share represented 3.3% of ABR at quarter end and our top 10 tenants Continue to demonstrate the diversity in our portfolio accounting for just 17.8% of our ABR. As we've consistently stated, portfolio diversity is an important risk mitigation tool for us and a product Our differentiated investment strategy, a direct benefit of our focus on non credit rated tenants and middle market operators, which offers an expansive opportunity set and in our view, generate superior risk adjusted returns. In terms of dispositions, we sold 10 properties this quarter for $28,500,000 in net proceeds at a weighted average cash yield of 6.5%. The weighted average unit level rent coverage for the properties we sold was 3.6 times.

Speaker 2

Owning fungible and liquid properties and capitalizing on that liquidity is an important aspect of our investment discipline and it allows us to proactively manage our industry, tenant and unit level risks within our portfolio. Heading into the Q4, we expect to selectively take advantage of favorable market pricing To accretively recycle capital away from identifiable risks, reduce our industry concentrations and importantly support our tenant relationships. With that, I'd like to turn the call over to Mark, who will take you through the operating results and balance sheet for the Q3 and discuss our capital markets activities.

Speaker 1

Thanks, Pete. Echoing Pete's remarks, The Q3 of 2023 was certainly a strong quarter for us, evidenced by our reported results last night and represented by an increase in our guidance 2023 AFFO per share to a range of $1.64 to $1.65 The performance of our portfolio and our investment results for quarter continued to reflect the high quality of our tenancy, our favorable capital market transactions, consistent internal rent growth and the benefits of our differentiated investment platform. As I'll cover in a moment, our consistently conservative balance sheet and strong liquidity position continue to support our aspirations for external growth in 2023 and beyond. Among the headlines last night was our AFFO per share for the Q3, which on a fully diluted per share basis was $0.42 an increase of 11% versus Q3 of 2022. On a nominal basis, our AFFO totaled $66,300,000 for the Q3 of $23,000,000 up $12,800,000 over the same period in 2022, that's an increase of 24% and up over 7% compared to the preceding Q2 of 2023.

Speaker 1

We also reported core FFO per share on a fully diluted per share basis of $0.45 for the 3rd quarter, an increase of 18% versus Q3 of 2022. Total G and A was approximately $7,200,000 in Q3 2023, while cash G and A totaled $5,000,000 in the 3rd quarter. Importantly, our cash basis G and A as a percentage of total revenue decreased to 5.5% in the 3rd quarter, which further supports our expectation that our G and A growth rate will be outpaced by the growth in our assets and earnings as our platform generates operating leverage through the benefits of scale. Turning to our balance sheet, I'll first highlight the following. With our $185,000,000 of net investments in the 3rd quarter, our income producing gross assets reached nearly $4,600,000,000 at quarter end.

Speaker 1

From a capital markets perspective, we had an excellent quarter. Firstly, on the personnel front, we're pleased and fortunate to have hired Rob Salisbury As our Head of Capital Markets, Rob brings an extensive real estate finance and investing background, including experience on top ranked equity research teams, large buy side equity and credit securities platforms and most recently as a senior leader at a leading real estate private equity firm. We're excited to have Rob help us continue to build long term value for our shareholders. On the equity side, we 12,000,000 shares at $23 per share and generating approximately $276,000,000 of gross proceeds. Similar to our February 2023 offering, this transaction was completed 100% on a forward sale basis, which affords us the flexibility to draw down the capital on an as needed basis.

Speaker 1

On the ATM program this quarter, We settled approximately 836,000 shares in July for proceeds of $20,000,000 and we sold an additional $11,000,000 during the quarter, which remains unsettled as of quarter end. On the debt side, we closed on the previously announced $450,000,000 delayed draw term loan in August. We are very appreciative of the continued support of our entire bank group, all of whom participated in this execution. We utilized $200,000,000 at closing to retire the 2024 term loan, which was our only near term debt maturity set to expire in April of next year. Assuming we exercise the extension options available to us, the $450,000,000 Term loan would mature in February of 2029.

Speaker 1

At quarter end, we had $375,000,000 drawn on the term loan And we subsequently drew the remaining $75,000,000 in October. Consistent with our interest rate hedging program, we fully swapped 100% of the amounts drawn for the fully extended term of the debt commitment at a weighted average fixed rate of 5.4%. As we noted on our last earnings call, we retained the favorable swap on the $200,000,000 linked to the 2024 term loan that we repaid, which currently has an effective fixed rate of just under 3%. Subsequent to quarter end, we executed new forward starting swaps To extend the $200,000,000 hedge through the remaining term of the 2029 term loan, which will go into effect in April of 2024 at an all in fixed rate of approximately 5.5%. We have incorporated this within our 2024 guidance.

Speaker 1

Regarding our debt maturities, utilizing all the extension options in the new term loan would, as I mentioned, result in a maturity date in 2029, which would result in us having no debt maturities until 2027. From a leverage perspective, our net debt to annualized adjusted EBITDARE was 4.5 times at quarter end. When factoring in the net proceeds that we generate by settling the $273,000,000 Of equity we issued on a forward basis in the quarter, our leverage at quarter end would equal 3.7 times. Our Total liquidity at the end of the 3rd quarter totaled approximately $989,600,000 up $356,000,000 from 634,000,000 last quarter. Again, our conservative leverage, strong balance sheet and significant liquidity position continues to be supportive of our current investment pipeline and sufficient to fund our external growth plans for the remainder of the year.

Speaker 1

With that, I'll turn the call back over to Pete.

Speaker 2

Thanks, Mark. Operator, please open the call for questions.

Operator

Thank you, sir. We will now be conducting a question and answer session. One moment please while we poll for questions. And the first question comes from the line of Haendel St. Juste with Mizuho.

Operator

Please proceed with your question.

Speaker 3

Hi, good morning. This is Ravi Vaidya on the line for Haendel. Hope you guys are doing well. Just wanted to touch a bit on the 2024 guide. What gives you the confidence to provide 24 guide in the current environment?

Speaker 3

I know you guys Strong liquidity position, your balance sheets have been shaped, but how are you thinking about volume and spreads going forward, especially when we're expecting Slower volumes and shifting capital costs.

Speaker 2

Yes. Listen, we run a very predictable business. We have a very stable portfolio of long dated leases that provide us a great operating base. We also generate significant free cash flow to invest And we have a large amount of well priced capital available to us that's on our balance sheet. And Given the factors that our business is so predictable and we have largely baked in our capital needs and The cost of that capital for 2024, we felt it was appropriate and timely to provide guidance.

Speaker 3

Got it. And if we just assume a worst case scenario and transaction markets are completely shut down, How much do you think you can grow AFFO next year?

Speaker 2

Mark, why don't you take that?

Speaker 1

How much we can grow AFFO next You're at a baseline? So I think the way yes, the way I'd answer that is if you take a look at what you might Refer to kind of doing nothing else other than kind of the run rate activity in the Q4, which is really going to have the most significant impact on 2024. So So what we do in the Q4 of 'twenty three is going to be the biggest component. Our embedded rent bumps would be the Secondary element and then obviously redeploying our retained capital, which Pete mentioned is nearing $100,000,000 which is a pretty significant milestone for us. So those three components and really just the other things you build into like the headwinds around our swap That we've got forward starting, you'd probably be just under 4% growth.

Speaker 2

Yes. And listen, I would add, we see a great market to invest and we've been driving cap rates up and we We are actively engaged with our relationships to deploy capital at accretive spreads. And so we are no by By no means sitting on our hands and not taking advantage of the dislocation in the capital markets. On the contrary, we see a great opportunity For us to put capital to work at accretive spreads.

Speaker 3

Got it. Thank you. Appreciate it, guys.

Speaker 2

Thank you. Thanks.

Operator

And the next question comes from the line of Eric Wolf with Citi. Please proceed with your question.

Speaker 4

Thanks. It's actually Mick Joseph here with Eric. Maybe just following up on that in terms of 2024 guidance assumptions. What's the investment spread assumption embedded there? What are you thinking in terms of cap rates to get to the midpoint of 2024 guidance?

Speaker 2

Yes. Listen, we 1, as we generally do, we kind of Pumped on the specifics of that question and that there's a wide range of assumptions supporting guidance. Generally, what we're seeing today is Investment cap rates in the high 7s and we assume that that persists and our You put capital to work at that level persists through at least the first half of twenty twenty four. And as I said earlier, a large Part of the capital that is complete, we're putting to work is already priced in the form of the term loan that we did And that we swapped and we get the rates on that and the forward equity that's already priced in. And so I think you can do the math On those components, but that's kind of how we're thinking about it.

Speaker 4

That's helpful. Thanks. And then just going back, you mentioned kind of the desirability of sale leasebacks Some of these middle market tenants. Can you talk about those conversations that are going on today? How they're thinking about doing those deals versus other capital sources that they may be

Speaker 2

Yes. And this has been an evolving and improving theme for us over the last couple quarters, but the bank market is 1, costly and 2, challenging to access. And so When you think about SOFR plus 4, 5, 6, you're talking about rates that are wide of where we're getting deals on a 20 year basis Today, if you can even get that and then you look at the unsecured sub investment grade market that's even wider. And These middle market operators are struggling with capital alternatives and largely focused on Long term permanent capital against the real estate with equity from the owners to capitalize New investments and growth and grow their businesses.

Speaker 4

Thank you very much.

Speaker 5

Thank you, Nick. Thanks, Nick. Take care.

Operator

And the next question comes from the line of Greg McGinniss with Scotiabank. Please proceed with your

Speaker 5

Hi, good morning. Thanks for the time. This is actually Almerich Chang on with Greg. So You've grown exposure to the car wash industry from 10% of ABR to 15% in the last 5 years, primarily due to, as you've talked about, the cash flow stability and growing credit quality they provide. With having to be more selective on these types of deals in recent quarters, what other types of businesses do you see growing with You're going within the portfolio in the near term that offer similar attributes, but maybe don't require you to have to be as selective?

Speaker 2

Yes. Listen, I would say our investment discipline is designed to be very Selective and source an opportunity set that allows us to be selective amongst the mix of transactions that we're seeing. When you run a business that is focused on prior relationships and relying on those prior relationships Such that 80% to 90% of your business is coming from those relationships, your incremental investment activity is going to look a whole lot like your portfolio. And so generally what we tell people is to expect our portfolio to grow ratably, which means we'll continue to invest in car washes and That will be in that kind of 12% to 15% range. We'll continue to invest in early childhood education.

Speaker 2

That will be in that 12% to 15% range, quick serve restaurants, automotive service, casual dining, all these are industries with inherent real estate Characteristics that we like and as a result we conduct our sourcing activity and have relationships to generate opportunities out of those industries.

Speaker 5

Okay, got it. And maybe if I can touch on your watch list. It seems it improved incrementally during the quarter or at least was stable. As you look ahead to next year, Could you give us a sense of which tenants or industries you believe would be most impacted if there's a weaker consumer?

Speaker 2

Not a lot of our industries are This is consumer discretionary by design. And what we see is and we've seen this through a I would say really the only area and where we usually see it the hardest and fastest is in casual dining, But it's never really that deep, but we would expect the portfolio to perform stable through a period of consumer distress.

Operator

And the next question comes from the line of Sanket Agrawal with Evercore ISI. Please proceed with your question.

Speaker 6

Hi, good morning. Thanks for taking my question. So we just wanted to understand like Let's get some color around early childhood education exposure in the portfolio, like how many different tenants represent that? And then what is the everyday VR exposure there? And then funding trends you're seeing from the BPE side in that particular sector or any and also any particular Credit issues percolating in that sector?

Speaker 2

Yes. Generally, we have We currently own about 186 early childhood education centers. You can see in the quarter that Busy Bees Came into our top 10. Actually Busy Bee's is the local brand. What's the name of the BrightPath Kids is the corporate, which is a large operator that purchased a smaller operator that we had already Generally, we see good trends in that sector with improving coverage and PE continues to roll up a lot of the smaller localized and regional operators Such that we see improving credit trends in our investments.

Speaker 6

Thank you.

Operator

And the next question comes from the line of Ki Bin Kim with Truist Securities. Please proceed with your question.

Speaker 7

Thanks. Good morning. When you talked about higher yields that you expect going into 2024, I was just curious if That's a if you're noticing that in a broad spectrum or is it more concentrated to a couple of key industries?

Speaker 2

No. I think the our ability to drive pricing is more Factor of the dislocation in the broad capital markets that is affecting all our industries equally. And so it's really across the board of our opportunity set.

Speaker 7

And in terms of your 2024 guidance, what are you assuming for credit losses? I think in the past you said 25 to 40 basis points is Normal for the portfolio, just curious how 2024 compares to that?

Speaker 2

Yes. We've said what we have said is that 25 to 40 basis points is a kind of historical loss experience. Generally, when we build a guide, particularly this far in advance and in a market backdrop that we're seeing, we're a little bit more conservative Then that, as we go through and take a real deep dive into our individual exposures and tenants and What may happen there, so you can assume baked in the guide is a range of scenarios that's probably a little wider than that. And but historically, the tailwinds to our guidance throughout the year is the lack of manifestation of those losses.

Operator

Okay. Thank you.

Speaker 2

Thank you,

Operator

The next question comes from the line of Connor Seversky with Wells Fargo. Please proceed with your question.

Speaker 8

Hi. Thanks for taking the question guys. Hey, Sussan for Connor This morning, in the context of weakening consumer metrics, how should we be thinking about tenant credit specifically here? So EPRT's portfolio exhibited resiliency during the COVID environment. How can we feel comfortable to expect the same kind of performance if consumer spending drops off?

Speaker 2

Yes. Listen, I would it's It's hard to imagine the scenario where you see a larger drop off in consumer spending than we saw during COVID. And if you start with the premise that the portfolio Performed well through that period of time. I think you should assume that it should continue to perform well going forward. I would say We are ultimately landlords to these businesses and we are owning the cash flow assets that These that could comprise these businesses and ultimately a weakening consumer is going to have impact On the equity values of these companies, but not the obligations to the landlords.

Speaker 2

And I think we very deliberately invest in a very specific set of Are not really discretionary or subject to a weakening consumer.

Speaker 8

Appreciate the color. Just a A follow-up, if you just if you had to choose one area, where do you think the highest risk to consumer behavior is within your portfolio?

Speaker 2

Yes. As I said, the casual dining tends to get hit the earliest and hardest when you see a recession as Consumers eat out less and will trade down to QSR options. That would probably be The biggest hit. That said, we have great coverage in that space and good assets such that I would not expect to have any material credit losses.

Speaker 8

Appreciate the color. Thanks guys.

Speaker 2

Thank you.

Operator

And the next question comes from the line of Josh Dennerlein with Bank of America. Please proceed with your question.

Speaker 9

Hi. This is Farrell Granath on behalf of Josh. I wanted to touch on again for 2024 Capital Sourcing, Kind of with the assumption if acquisitions are expected to stay largely in line with historic trends, what Is your maybe strategy and plan for capital sourcing and perhaps thought process on prefunding going into 2024?

Speaker 1

Yes. I mean, like capital sourcing, I think what we started with was really the bottom end of our range Utilizing the liquidity that we have available to us now, otherwise, sourcing as you move Through kind of a range, the capital sourcing is number 1, the availability on our revolver, and that's really probably the biggest component of anything that we do relative to the 2024 guide.

Speaker 2

Yes. And I would add given Our unsettled forwards, the term loan and the capacity That we have built into the balance sheet. We have almost $800,000,000 to $1,000,000,000 of investable capital without exceeding our leverage targets.

Speaker 9

Great. Thank you.

Speaker 2

Thank you.

Operator

And the next question comes from the line of Spenser Allaway with Green Street Advisors. Please proceed with your question.

Speaker 10

Thank you. Thank you guys for all the great color on 'twenty four guidance. Maybe just one more as it relates to that. So Can you talk about how far acquisition spreads could compress before you ultimately decided to perhaps pump the brakes or just not grow next year?

Speaker 2

Yes. I'd stop short of putting a hard number on that. Ann, it really we take a forward look. We expect markets to improve. I would more say you're unlikely to see us it would be more come down to managing our balance sheet such that Leverage gets out of whack and we get into a spot where we're uncomfortable relative to the balance sheet and our ability to Access Capital and historically, our behavior around leverage is pretty predictable.

Speaker 2

You've seen us crest 5% or 5 times net debt to RE, I think a couple of times. And I think I would look at it that way, Spencer.

Speaker 1

Yes. And I think, Spencer, the other thing I might mention is just Depending on where you land on a weighted average cost of capital for us, our net spread today is in a pretty good spot and You know, it's incredibly favorable and underpinning compression and cap rates would probably be A market backdrop that would make our weighted average cost of capital get favorable, and I think that means our spreads stay constructive.

Speaker 10

Okay. Yes, fair enough. And then can you just remind us if you currently have a share buyback program in place? And if we did enter an environment where External growth was off the table. Should that be expected to be like a use of capital?

Speaker 2

We do not. We have not put one in place. And Listen, I think if we got to that point and we thought the best thing for shareholders was to for us to invest in our shares then the Board would consider that, but we do not have one in place as we sit today.

Speaker 10

Okay. Thank you, guys.

Speaker 1

All right. Thanks, Spencer.

Operator

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

Speaker 2

Great. Well, I'd like to congratulate the team on a great quarter. As we said, we're pretty optimistic about what we're seeing going forward and we're happy to have our 2024 guidance out there and we look forward to meeting everyone in the coming weeks That's the conference schedules. Thank you and have a great day.

Operator

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.

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