Broadstone Net Lease Inc

NYSE:BNL

Earnings Call Transcript 2022-Q3

[Operator]

Hello, and welcome to Broadstone Net Lease's Third Quarter 2022 Earnings Conference Call. My name is Drew, and I'll be coordinating your call today. Please note that today's call is also being recorded.

I will now turn the call over to Mike Caruso, Senior Vice President of Corporate Finance and Investor Relations at Broadstone. Please go ahead.

[Michael Caruso, SVP, Corporate Finance & IR]

Thank you, operator, and thank you, everyone, for joining us today for Broadstone Net Lease's Third Quarter 2022 Earnings Call. On today's call, you will hear from our Chief Executive Officer, Chris Czarnecki, our Chief Financial Officer, Ryan Albano, and our Chief Operating Officer, John Moragne, will be available for Q&A.

Before we begin, I would like to remind everyone that the following presentation contains forward-looking statements, which are subject to risks and uncertainties that can cause actual results to differ materially due to a variety of factors. We caution you not to place undue reliance on these forward-looking statements and refer you to our SEC filings, including our Form 10-K for the year ended December 31, 2021, for a more detailed discussion of the risk factors that may cause such differences. Any forward-looking statements provided during this conference call are only made as of the date of this call.

I will now turn the call over to our Chief Executive Officer, Chris Czarnecki.

[Christopher Czarnecki, CEO]

Thank you, Mike, and good morning, everyone. During the third quarter, we continued to carefully navigate the current economic backdrop and dynamic capital markets environment with a keen focus on prudent capital allocation and discipline selectivity. As we announced in our business update following the completion of the quarter, the BNL portfolio continues to perform well with 100% of base rents collected during Q3 and mineral vacancies. In addition, we continue to source opportunities to accretively invest capital during the quarter despite a challenging market backdrop.

Proactive execution in the capital markets during the first 3 quarters of the year has positioned us to close out 2022 on a strong footing, delivering another year of consistent same-store portfolio performance and accretive external growth, both of which have translated into strong earnings growth. Given heightened levels of economic uncertainty as we approach a new calendar year, we remain focused on prudent capital allocation during this period of public and private net lease market dislocation. Conservative balance sheet management, disciplined underwriting and proactive portfolio management, our core B&L competencies, and they will continue to serve as key pillars to our success as we navigate current and future economic uncertainty.

As of September 30, 2022, all but 3 of our 790 properties were subject to a lease, and our properties were occupied by 218 different commercial tenants across 56 industries with no single tenant accounting for more than 2.4% of ABR. As of quarter end, the portfolio's weighted average annual rent escalation sits at 2% and the weighted average remaining lease term was 10.7 years. As I've mentioned many times in the past, diversification serves as a defensive hedge against any singular tenant credit event with some of the lowest levels of tenant concentrations in the net lease space, our highly diversified operating model provides us the flexibility to patiently work through any one-off tenant matters as we look to preserve and protect long-term shareholder value.

For example, following the completion of the third quarter, we successfully released a health care property located in Arizona to an experienced hospital operator under a new 21-year lease with an effective GAAP yield of 7.5% over the course of the term. At only 1.2% of ABR, we were afforded the ability to patiently pursue a positive long-term solution without feeling pressure to backfill the asset as quickly as possible.

We appreciate that net lease investing is not a 0 loss business and when occasionally taking calculated risks, situations can arise that require a carefully crafted solution. Our industry-leading diversification continues to provide risk-mitigating benefits and allows us to presciently pursue the best outcome for our shareholders during these one-off situations. On an external growth front, we invested approximately $205 million in 28 properties at a weighted average initial cash cap rate of 6.5% during the third quarter. The leases for new acquisitions include a strong weighted average lease term of approximately 21 years and solid 2% annual rent escalations, translating into a weighted average GAAP cap rate of 7.9%.

These investments were predominantly weighted towards industrial opportunities at 86% of the quarter's volume with the remaining investment activity spanning restaurants at 6%, health care at 5% and retail at 3%. Proactive capital markets execution year-to-date has allowed us to lock in the cost of capital that supports accretive spread investing in the current environment. We remain focused on selectively deploying our dry powder on accretive investment opportunities in our pipeline.

Since quarter end, we've closed an additional $283 million of transactions and currently have $22 million of acquisitions under control, which we define as having an executed contract or letter of intent. With approximately $902 million of acquisitions either closed or under control year-to-date, we are reaffirming our 2022 full year acquisition guidance range of $900 million to $1 billion, which we previously revised upward in our business update in early October. This revised acquisition guidance range reflects our cautious external growth outlook for the remainder of the fourth quarter, given the volatility in the capital markets and resulting pressure on investment spreads given prevailing market cap rates.

While we recognize that the current capital market environment requires us to be highly selective in the near term, I'm proud of all that we've accomplished thus far in 2022 and where we are tracking to end the year from an external growth perspective. Changes in cost of capital for all public REITs without a commensurate adjustment in private asset values has forced many to take a more measured approach in the near term. We, like many of our peers, will continue to focus on prudent capital allocation during this period of public and private market dislocation. However, we believe our broadly diversified buy box provides us the unique opportunity to allocate capital to property types where cap rates have or will continue to expand at a more accelerated pace due to sector-specific supply and demand characteristics.

I'm encouraged by the cap rate expansion we are currently seeing in our pipeline and expect to see further movement in the near term as seller pricing expectations reset in the wake of changes in buyer cost of capital. Before passing the call to Ryan, I want to take a few moments to provide additional detail on several transactions completed during and subsequent to the third quarter. During Q3, we acquired 19 industrial properties and 3 separate transactions for $175 million. The leases include weighted average annual rent escalations of 2.1% and a weighted average 22-year lease term.

In addition, we invested revenue-generating CapEx in one existing industrial profit during the quarter at an initial yield of 8.1%. Largest acquisition completed during Q3 was an 11 property sales and lease transaction with a well-established tenant in the food production and distribution space. We continue to remain bullish on the space given its resiliency during challenging economic environment, and we're pleased to grow our exposure with the acquisition of this high-quality portfolio.

In addition, following the completion of the quarter, we successfully closed the largest sale and leaseback transaction in BNL's history. We acquired 7 assets as part of a directly sourced transaction with a food manufacturer that has a very strong operating history. We continue to see compelling opportunities in the industrial space as many levered buyers remain on the side-line in light of rising debt costs.

Finally, during the quarter, we continued to acquire granular investments across both nondiscretionary retail and restaurant spaces. These transactions account for approximately $19.4 million with an average asset size of $2.8 million. We continue to view these smaller often one-off investments as an effective complement to our large sourcing efforts. With that, I'll now turn the call over to Ryan.

[Ryan Albano, EVP & CFO]

Thank you, Chris, and good morning, everyone. I am pleased to report another solid quarter of earnings and provide additional details with regard to our capital markets execution during the quarter and balance sheet positioning as we approach year-end. As Chris stated in his opening remarks, inflation, rising interest rates and results in capital markets volatility has placed pressure on cost of capital for all publicly traded REITs. Year-to-date, we have taken an opportunistic approach to raising both debt and equity via many of the capital markets tools available to us. This approach has allowed us to proactively lock in an attractive cost of capital that complements our evolving pipeline of acquisition opportunities.

As we highlighted during our call last quarter, we entered into 2 new unsecured bank term loans in August, including a $200 million 5-year term loan that matures in 2027 and a $300 million 7-year term loan that matures in 2029. We currently have no major debt maturities until 2026. Given the current conditions in the investment-grade bond market, I am pleased with the decision to extend our maturity profile at attractive relative pricing we were able to achieve during the summer. In addition, we entered into interest rate swaps with a total notional value of $260 million to fix the SOFR component of borrowing rate at a weighted average fixed interest rate of 2.59% until August of 2029. With the addition of these interest rate swaps, our unsecured bank term loans remain entirely hedged.

During the third quarter, we opportunistically raised net proceeds of $20.3 million on our ATM at a weighted average sale price of $21.44. There was approximately $145.4 million of capacity remaining on our ATM as of quarter end. In addition, we completed a forward sell public offering of 13 million shares of common stock at a price of $21.35 per share in August. As of September 30, 2022, we anticipate that the forward sale agreement will provide net proceeds of approximately $270.7 million, resulting in a pro forma net debt to annualized adjusted EBITDAre of 4.8x.

We have not settled any part of the forward sale agreement as of quarter end. This opportunistic approach to capital raise has provided the dry powder to fuel accretive acquisitions during the second half of the year and positions us for disciplined growth in the near term. We remain committed to maintaining a conservative leverage profile with ample liquidity, especially given the current macroeconomic uncertainty. As of quarter end, we had approximately $1.1 billion of liquidity, which includes $76 million of cash on hand, $780 million of availability on our revolver and approximately $271 million of outstanding forward equity.

Now turning to our financial results. During the quarter, we generated AFFO of $63.4 million or $0.35 per share, which represents approximately 6.1% growth over per share results from the same period last year. AFFO per share was flat quarter-over-quarter when compared to Q2, which is largely driven by revenue generated from Q2 acquisitions, offset by a full quarter share count waiting for equity raised during late Q2. Although 92.5% of our total debt outstanding is fixed, rising rates have caused pressure in the form of increased interest expense on our revolving line of credit. During the quarter, SOFR increased 136 basis points. We expect late Q3 and early Q4 acquisitions will serve as a tailwind to earnings in the final quarter of the year. We incurred $9.9 million of total general and administrative expenses during Q3, which includes $8.4 million of cash expenses, keeping us on track to fall within our SG&A guidance range.

For fiscal year '22, we are reaffirming our AFFO guidance range of $1.38 to $1.40 per diluted share, which represents an implied growth rate of 6.1% at the midpoint over our 2021 results of $1.31 per share. This guidance range is based on the following key assumptions which remain unchanged since our October 4 press release. Acquisition volume between $900 million and $1 billion, disposition volume between $50 million and $75 million in total cash G&A between $31 million and $33 million.

As a reminder, our per share results for the year are sensitive to both the timing and amount of acquisition, disposition and capital markets activity that occurs throughout the year. Finally, at our Board meeting held on October 27, our directors declared a $0.275 dividend per common share in OP unit. This represents a 1.9% increase over the October dividend. We will continue to evaluate additional future increases to our dividend with our Board on a quarterly basis. With that, I'll turn it back over to Chris for closing remarks.

[Christopher Czarnecki, CEO]

Thank you, Ryan. The team at P&L is immensely proud of all that has been accomplished this year on behalf of our shareholders. We continue to believe that our portfolio is purposely constructed, highly diversified and comprised of tenants that are positioned to perform during difficult economic conditions. We remain thoughtful in capital allocation position during this period of dislocation between private and public market valuations and seek to position ourselves favorably as cap rates continue to evolve in the coming quarters. Operator, we can now open the line for questions.

[Operator]

[Operator Instructions]. Our first question today is from Ki Bin Kim from Truist.

[Ki Bin Kim, Truist Securities]

Can you talk about the new operator for the Santa Cruz Hospital, maybe some color on the economics of the deal versus what it was previously? And is there any type of mechanism where this new operator might need a loan from you guys? I'm not sure what kind of cash reserve they have coming in to operate this hospital?

[Christopher Czarnecki, CEO]

Sure, Ki Bin. Happy to talk about the new operator. The operator is a group and a management team that has had a deep experience in hospital turnarounds and reboots. They've had 40 to 50 years in the space collectively together and is one that we're obviously very excited about and think that they're going to do some really great things at the property. They currently are operating one hospital out of California. We expect they'll have another one in their portfolio by the end of the year and a view towards adding several more in the coming years as well.

They're not private equity backed, they're private capital and private investors who have been through this before, and they were very excited about being able to step in to Santa Cruz and be able to take the property and begin to deliver services to the community again. So that's their general background. They are based in the Arizona area. So that's also another key positive and one that is a positive for us as well.

Ryan, do you want to talk about the economics associated with the lease? And I should be clear, the lease did not have any TI associated with it from us or anything along those lines and that they're actually actively looking at potentially reconfiguring the facility to get more capacity out of it and thinking about that through their own dollars, not through ours.

[Ryan Albano, EVP & CFO]

Sure. Hi Ki Bin, in terms of the new lease and some specifics around it, to your last question, we don't expect to provide any loan to them in terms of ramp-up time. We were very careful and thoughtful in our structuring of the new lease, and you'll see that as I sort of lay out the specifics.

So the new lease is a 21-year lease with an effective GAAP yield of 7.5% over the lease term. From a specifics perspective, we have a period of free rent that's variable in duration that's built into the lease. The timing of that is dependent on the new entities' ability to relicense the hospital and achieve Medicare enrollment. So that period could be up to a year or through August of next year or shorter just depending on that time frame. After that period, there is a period of scaling rent as they begin to scale operations that, assuming that they use that full free rent period, would run from September of 2023 through the end of 2024, and the rent would scale and increase 3x over that period, eventually achieving what we consider to be stabilized rent beginning January 2025, which would represent a 6.7% yield on our initial investments or 90% of the prior rent. From there, it would escalate annually at 2%, and that results in the overall effective yield over the life of the lease of 7.5% that I referenced earlier.

[Ki Bin Kim, Truist Securities]

Okay. Great. And when you look at your tenant list, are there any other operators that might have a similar situation or what's on your watch list in general?

[Christopher Czarnecki, CEO]

Sure. The heightened credit watch list today, Ki Bin, is comprised of a handful of names. I'd say none of them are thematic, they're individual tenant names. Within that, the Santa Cruz facility which we'll obviously keep on the watch list and continue to monitor as they go through their ramp period makes up the bulk of it. So most of the other tenant matters are simply bespoke to things that have been on the watch list for a long time and don't have any specifics tied to your reference in Santa Cruz.

[Ki Bin Kim, Truist Securities]

But those tenants on the watch list, do they rise up to the point of, let's say, being over 1% of rent? Or are you kind of smaller situations?

[Christopher Czarnecki, CEO]

They're all very small situations of 0.2, 0.3 kind of... and again, a handful of tenants, so relatively small and they've continued to pay rent, and we continue to monitor them for the long term.

[Operator]

Our next question comes from Chris Lucas from Capital One Securities.

[Christopher Lucas, Capital One Securities]

Chris, just a couple of follow-ups on the hospital situation. Did it contribute anything to third quarter in terms of cash rent?

[Christopher Czarnecki, CEO]

So when we went and structured this, Chris, we had placed a letter of credit in part of the initial transaction when we thought about the risk profile of this relative to a more traditional hospital system. It was one of the key components that we thought about from a structuring perspective. So we ended up having a 1-year letter of credit that was put in place at the time of the transaction. When the tenant had some stumbles in the first quarter, we switched them to cash-based accounting and ultimately wrote-off the accrued rental income. And then towards the end of the second quarter, we drew on the letter of credit, and then the 3 quarters were covered by the letter of credit and then the remainder is ours to keep and will ultimately come through as other income during the fourth quarter.

The lease remained in place for the entire time, which is a key component, especially because the new operator wanted to acquire the entity to be able to effectuate and obtain the medical records, the FF&E and all of the equipment in the facility. So the lease maintained through that time period. And then ultimately, the new lease kicked in just after the quarter was over.

[Christopher Lucas, Capital One Securities]

Okay. I guess one of follow-up questions is, just as it relates to different lines of business, one of the sort of painful processes that still remains is the inability for many businesses to find workers and wage inflation. How is that impacting your perspective on underwriting various lines of business?

[Christopher Czarnecki, CEO]

Yes. That's a great question, Chris. I think that was obviously a pain point for Santa Cruz to be perfectly honest. That was one of the things that was a struggle for them over the winter months was having the right level of staffing. I think to your question, it probably impacts tenants that operate in lower-margin spaces more than anything. So we haven't done as much over the last 2 quarters in the restaurant retail space, and there's obviously been a little bit of a lower-margin business there. I think that's certainly something that if we were to do future acquisitions in the coming quarters, one that we'd be paying close attention to and trying to think through the cost and impact of labor on an individual tenants margins there.

And then for us on the industrial side, it's a question that comes up during most investment committees as well relative to labor sourcing, labor availability for some of those specific tenants that we're underwriting there, the margins are a little bit lighter and they've been able to absorb more of costs associated with higher labor. But it's fundamental in every component in every transaction we're looking at. And I think it probably shows through most in those lower margin businesses such as the restaurant and retail space.

[Christopher Lucas, Capital One Securities]

Okay. And then just... you mentioned industrial. I think when we met back in June at Nareit, you talked about the fact that industrial cap rates were gapping out as it related to single tenant longer duration leases. You guys executed on that in the second quarter and third quarter. Have you seen the cap rate gap out further? Or has it stalled at sort of the levels that you've been executing on here over the last several months.

[Christopher Czarnecki, CEO]

Sure. I'll let John do it, but I'd continue on your theme that we've executed on in the fourth quarter as well with the food processing facilities we've done as well, so... but John, take that...

[John Moragne, EVP & COO]

Sure. Hey Chris. You're exactly right. That's the place where we've seen the most cap rate expansion. It certainly has installed. I don't know if it's moving at the same momentum as it was when things first started to move, but you certainly are seeing that reflected in the focus of our acquisitions in Q2, Q3, and as Chris indicated in Q4 as well, which I think really goes to highlight the benefit of our strategy where we do have a broader aperture than most, a multi-class diversified acquisition strategy that allows us to pivot very quickly in markets like this, to focus on the place where we see the best opportunity on a risk-adjusted basis, and that's been industrial for us since Q1, and that will continue to be the focus.

[Christopher Lucas, Capital One Securities]

Are you seeing any other lines of business that you have underwritten or invested in show comparable or are starting to show that kind of cap rate adjustment that you saw so quickly with the industrial stock?

[John Moragne, EVP & COO]

Certainly, in sort of non-IG retail and some casual dining restaurants, not really in QSR. Not enough in terms of the overall volume that we would shift away from the focus that we've had on industrial at this point. That being said, they have to move. At this point, as we think about the overall macro environment, when you're phasing down impaired cost of capitals for a whole host of people, we're starting to hear of a slowing in the 1031 market, although not at the level that you would see a full drop-off in that space, continuing rising interest rates, looming fears of recession and everything else, you're just at a point where cap rates have to move.

And so our disciplined prudent approach to allocating capital allows us to focus on those places where we see the best opportunities, which right now is industrial. But as those things begin to move, since they're going to have to, given everything that's happening, we'll evaluate them at pace and on a case-by-case basis and move to allocate to those spaces as they catch up to what's happening elsewhere.

[Operator]

Our next question comes from Ronald Kamdem from Morgan Stanley.

[Ronald Kamdem, Morgan Stanley]

Just on the hospital, just to make sure I understand. So it sounds like the rent is 90% of previous, no capital dollars are going into it from your end and the operator sort of goes into it, which makes sense. And then you said some things coming through in 4Q on the other income line. Can you just clarify what that was?

[Christopher Czarnecki, CEO]

Oh, sure. So we had a year's letter of credit run. And a portion of it during the third quarter and June, I believe, was applied to rents while we were negotiating the transaction and the new operator. And so the residual of that, the rest of it is now treated as other income and will be backed out of AFFO next quarter because it's nonrecurring.

[Ronald Kamdem, Morgan Stanley]

Okay. Got it. Okay. Makes sense. Just moving on, I want to talk a little bit about sort of funding. I think, number one, there's the $500 million of unsecured term loans. I see the $260 million that was swapped. Is the other sort of, I guess, 240 also swapped? Or I guess I'm trying to understand when you said it's entirely hedged, what am I missing there?

[Christopher Czarnecki, CEO]

No, I'll let Ryan jump in there.

[Ryan Albano, EVP & CFO]

Sure. We're entirely swapped out on all of our unsecured term loans at this point. We think about it as a pool of swaps and a pool of unsecured debt. So as we refinance some of that debt, there are already existing swaps in place. So the incremental amount we added was for incremental debt needs that weren't already swapped out. So upon the completion of that, our unsecured term loans were entirely swapped out.

[Ronald Kamdem, Morgan Stanley]

Got it. And where does that put you on a fixed rate just ballpark with those swaps factored in?

[Ryan Albano, EVP & CFO]

Yes. So at quarter end, our fixed rate debt was 92.5% of total debt.

[Ronald Kamdem, Morgan Stanley]

Got it. Okay. That's helpful. And then obviously, the 4 is... I mean, it seems like you guys did a lot of really good transactions and locked in really good rates, which should fund most of '22. But as you're sort of thinking about '23, right, and the stock is below 17%, you did the $4 to 21.3%. Should we just expect you guys to stay on the sidelines in '23 until the stock comes back? Or how are you guys thinking about funding that business just given obviously really good transactions for '22, but the incremental transaction may be a little bit more tricky, right?

[Ryan Albano, EVP & CFO]

Sure. Yes. As we think about '23, we're very pleased with the proactive execution on the capital markets front over the last quarter and, frankly, the year as a whole. It really set us up to be able to continue to invest capital. And as we think about moving through the fourth quarter, we have $20-ish million of under control right now. So we're moderating a bit as we watch this very dynamic market change with our expectation that cap rates expand. But we are sitting with a decent amount of dry powder to be able to work our way into 2023. As I think about it at the quarter end, our pro forma leverage with the forward equity agreement, brings us to a 4.8x. So that certainly gives us some runway at this point to make our way into 2023 and continue to assess the situation.

[Ronald Kamdem, Morgan Stanley]

So would you issue equity here? So for '23 I guess is what I'm trying to figure out.

[Ryan Albano, EVP & CFO]

Well, luckily, I don't have to make that decision today, given the runway that we have. I think where we sit today, that's sort of looking at one variable, right? There are a few variables and John highlighted some of it before with cap rates moving and the expectation that they continue to move. So it's really a matter of looking at our pipeline of opportunities. Do we think that they are priced appropriately in the market and want to execute on them versus where our share price is.

Other levers that we think about is our existing portfolio and positive capital recycling. We have a handful of properties that I think we've certainly given a good look at that make more sense than raising the incremental equity dollar today. However, again, happy we don't need to make that decision right now.

[Operator]

Our next question comes from Michael Gorman from BTIG.

[Michael Gorman, BTIG]

Chris, I was wondering if you could just go back, and I'm sorry if I missed it, but as you talked about the potential for cap rates moving in the market and kind of where you're seeing things trend. I was wondering if you could talk across your different sourcing channels. We've heard some discussions that maybe those cracks are starting to appear first on the merchant builder side of things. But I'm just wondering with the lending market tightening up, are you starting to see current owners start to move their pricing expectations as well? Or are you seeing different movements across where the sellers are coming from?

[Christopher Czarnecki, CEO]

Sure. I'll start, and then John can also jump in too since he's on the ground with this. I'd say where we are seeing cap rate movement first is probably more on the sophisticated owner side, as you sort of alluded to. Folks that recognize that the debt markets for individual transactions are probably not very attractive relative to other options and there might even be negative leverage on certain property types today relative to that. And then also an appreciation that the public markets certainly adjusted much faster than the private markets do. And when I always think about the lag in cap rates, it's funny this quarter as results include a transaction that we talked about on the call that we picked up in March, we closed in July, and here we are talking about it in November, and it's in that 6.5% blended yield for the quarter. So there is a slower recognition that cap rates do take a while to flow through. But we've been pretty pleased by the movement we've seen as of late.

I would say, again, the more sophisticated folks have been the ones who have accepted the new reality and understand it, probably more than more individualized owners on the builder front. I don't know, maybe John has some specific thoughts there that might be helpful.

[John Moragne, EVP & COO]

Well, the only other thing I'd add, I think would be one of the benefits of a market like this is all the effort that we put into proactive tenant relationship strategy leading up to it, where you know as our tenants are thinking about funding sources, they are increasingly coming to us to talk. In a low interest rate environment, that sometimes can be more difficult. But now we're in a situation where our tenants are trying to think more creatively, they're not liking the terms that they're seeing on potential financing opportunities as they are looking to continue to expand.

And so that presents us with something that we get really excited about, and we've seen a real uptick in it. So in terms of where people are taking advantage of sort of the dislocation and some of the rates that we're seeing out there as well as where they're more open to cap rate expansion, those existing relationships with our tenants, those direct deals, that's reflective in the large majority of the deals that we closed at the end of Q3 and the beginning of Q4 as well as the growing pipeline of development opportunities with our existing tenants.

[Michael Gorman, BTIG]

Great. That's helpful. And then maybe just taking one branch off of your discussion about the lease restructure -- or the new lease at Santa Cruz, Chris. You mentioned kind of right at the top that the new tenant isn't private equity backed. And I'm just curious if you could speak to within the existing portfolio, kind of what's the percentage of your tenant base that is private equity backed? And in the market right now, assuming you could get there on pricing, would you be comfortable doing more private equity-backed deals? Or is that more of a concern with a potential economic slowdown in '23?

[Christopher Czarnecki, CEO]

Sure. The answer to your first question is it's about 1/3 that our PE backed in the portfolio, which has been relatively consistent over time, at least in the last couple of years. I think the answer to your question about more or less PE deals, again, as Ryan sort of alluded to, it's a lot of variables go into it. One is certainly and more importantly, is the business line, what business they're in, how does that stack up relative to the other defensive opportunities we have in our portfolio. So some of the food processing transactions we've mentioned today, one of them has a sponsor behind it. But given the defensive nature of what they do, especially in this economic environment, it gives us a lot of comfort that the business is going to be very successful during what is theoretically a more difficult time.

Then if you think about it from there, it's the quality of the management team that's in place, obviously, capitalization structure and where any of the tenants have from a pending debt maturity profile. And then also, I think we talked about it last time, Mike, a heavy focus on where do we see their capitalization structure break from a downside perspective, where does the fixed charge coverage get into trouble? How much of a sales decline would they need to -- or margin compression would they need to see before they really got into financing type issues. And then finally, it's the quality of the real estate we're acquiring here as well. And I know you weren't implying this as binary as PE yes or no. But I think those are all the things that we look at when assessing not only any tenant, but another private equity-backed investment. Thanks, Mike.

[Operator]

Our next question comes from John Kim from BMO Capital Markets.

[John Kim, BMO Capital Markets]

You've already been very active in acquisitions this quarter. But Chris, you've noted the disconnect between transaction market and the capital markets. What's a good pace going forward as far as quarterly investment activity?

[Christopher Czarnecki, CEO]

It's a good question, John. I think it's always one that will be variable. And we're going to take it quarter-by-quarter. And so you can see a lot of the activity we've closed to date in the fourth quarter closed in October and -- or through yesterday even, and so for us, from that perspective, relative to what's under control at just the $20 million is reflective of a little bit of a moderation we're seeing and thinking that through. And so for us, we're going to continue that thoughtful disciplined pace going into next year.

I don't know that it's completely -- to putting a number on is exactly the way I'd go today, but we certainly have capacity, as Ryan outlined, to continue to grow. We're liking the opportunities we're seeing in the market north of a 7% cap today. So that's dynamic, but it's going to be a little bit of a wait and see, and we'll continue to provide more information in February on that front. But would not expect that we're going to be out of the transaction market or anything of that nature.

[John Kim, BMO Capital Markets]

And can you remind us if there's typically seasonality in your acquisition activity? I haven't noticed it this year, but just looking back at...

[Christopher Czarnecki, CEO]

Could you just say -- you say seasonality, John? I just want to make sure I heard you.

[John Kim, BMO Capital Markets]

Yes, that's right.

[Christopher Czarnecki, CEO]

Yes and no. I'd say this year, we've been far more consistent. And as we've continued to grow the team and continue to use our diversified strategy, we've done a much more consistent job of having the similar levels of transaction activity each quarter.

I'd say historically, fourth quarter is a busier time when there was certain tax motivated sellers and year-end transactions to get closed. So I think from our view, we're far more consistent quarter-over-quarter, but there can be certain spikes in Q4 that we see.

[John Kim, BMO Capital Markets]

On the industrial acquisitions this quarter, I think you mentioned the annual escalators at 2.1%, but I was wondering if there were any discussions with the tenants of increasing those annual rent increases just given the inflationary environment.

[Christopher Czarnecki, CEO]

Sure. I'll let John jump in there.

[John Moragne, EVP & COO]

Yes, I mean we certainly talk about that on every one of the deals that we look at. I think one of the places to focus in terms of the 2% sort of weighted average for the portfolio and in the industrial space is, for me, thinking back about 12 months ago, when in the industrial space, we were starting to look at new acquisitions in that 1.5% range. They were getting squeezed really quickly, and they moved very quickly, almost in line with how we've been thinking about the movement in cap rates over the last 12 months in the industrial space. So we feel very comfortable where we are.

Our tenants continue to focus on overall occupancy costs over the course of a 15- or 20-year lease. And so looking at higher than 2% bumps over a 15- or 20-year period on a compounded basis starts to be a little bit difficult from an overall occupancy place. So we feel very comfortable overall in terms of the return that we're receiving on these deals, that 2% is a good number.

[John Kim, BMO Capital Markets]

Okay. And then just one follow-up on Santa Cruz. Thank you for all the detail that you provided. But for next year, what will the ASO impact be? You do have the free rent that you mentioned, but also the letter of credit from the current operator. I'm just wondering if that letter of credit extends until next year as the transition occurs.

[John Moragne, EVP & COO]

I'll let Ryan give you that.

[Ryan Albano, EVP & CFO]

Sure. So the impact on AFFO next year will really come down to how much of the free period rent is exercised versus not, which is you know dependent on the relicensing and Medicare approval of the hospital. That will really drive what it will be. In terms of the second piece of that question, with the letter of credit that will all flush through this year.

[John Moragne, EVP & COO]

The letter of credit and the original lease were tied together and now that there's a new lease in place, the rest just, as Ryan said, flushes through as other income, but won't have an AFFO impact.

[Operator]

There are no further questions at this time. So I'll now hand you back over to Chris Czarnecki for closing remarks.

[Christopher Czarnecki, CEO]

Excellent. Thank you all for your thoughtful questions today. Again, I'd reiterate how proud the team is of all that we've accomplished this year on behalf of our shareholders and look forward to seeing everybody at Nareit in just a week or so. We'll talk to you all soon again. Bye.

[Operator]

This concludes Broadstone Net Lease, Inc. Q3 2022 Earnings Conference Call. You may now disconnect.