Essential Properties Realty Trust Inc

NYSE:EPRT

Earnings Call Transcript 2019-Q1

[Operator]

Good day, ladies and gentlemen, and welcome to the Essential Properties First Quarter 2019 Quarterly Financial Results Call. [Operator Instructions]

At this time, it's my pleasure to turn the floor over to Pete Mavoides, President and CEO. Sir, the floor is yours.

[Daniel Donlan, executive]

Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties First Quarter 2019 Conference Call. Here with me today to discuss our first quarter results are Pete Mavoides, our President and CEO; Gregg Seibert, our COO; and Hillary Hai, our CFO.

During this conference call, we will make certain statements that may be considered forward-looking statements under federal security laws. The company's actual future results may differ significantly from the matters discussed in these forward-looking statements and we may not release revisions to these forward-looking statements to reflect changes after the statements were made. Factors and risk 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.

Before I turn the call over to Pete, I would note that our 10-Q and first quarter supplemental are available on the Investor Relations section of our website.

Pete, please go ahead.

[Peter Mavoides, executive]

Thank you, Dan, and thank you to everyone who has joined us today for your interest in Essential Properties.

We're excited to report our first quarter results, which, in our opinion, was a quarter where the market began to appreciate the underlying value of the platform that we established 3 years ago and the predictability of our new vintage, highly transparent portfolio of single-tenant net lease properties.

Starting with the portfolio. As of March 31, we own 711 properties that were 99.9% leased to 172 tenants operating in 16 distinct industries, with only 1 vacant property. Our weighted average lease term was 14.5 years, which is 4.5% of our ABR expiring over the next 5 years. Our same-store portfolio, which represents 59% of our portfolio at quarter end, experienced 1.8% growth in contractual cash rent and NOI for the quarter.

As we have mentioned in the past, we expect our same-store portfolio to grow approximately 1.5% per annum. So we're pleased to see that threshold again this quarter through diligent asset management and a lack of credit losses.

With an average investment per property of $2.1 million, our portfolio remains highly liquid from the sales perspective and readily fungible from a leasing standpoint. Combining this, with our 98% unit-level reporting, we can proactively see and mitigate risks as a development of portfolio, which we believe is an important differentiator for Essential Properties. And from a health perspective, our portfolio has weighted average rent coverage ratio of 2.8x and 72.5% of our cash ABR has a rent coverage ratio of 2x or better. With that in mind, less than 1% of our leases that expire over the next 5 years have unit-level rent coverage below 1.5x, which we believe indicates a high likelihood of lease renewal at expiration.

Similarly, only 2.4% of our tenants have both an implied credit rating lower than BB- per Moody's Risk Analytics and unit-level rent coverage below 1.5x. We believe this ongoing disclosure provides unique visibility into the health and profitability of our tenants that operate in our properties, which bolsters the predictability and security of our rental revenue.

Turning to our investment activity. As discussed on our last call, we began the first quarter with a highly conservative investment poster, given the volatility in our cost to capital in the broader markets during the fourth quarter.

That said, we invested $118 million in the first quarter at a weighted average initial cap rate of 7.5%. This level of investment activity was slightly below our trailing quarterly average, but much higher than our first quarter of last year.

Approximately 78% of our first quarter investments came via sale-leaseback transactions, 47% were subject to master-lease provisions and 100% are required to provide us with corporate and unit-level financial reporting on a regular basis.

In addition, 82% of our first quarter investments were transactions with sellers or agents that we have worked with in the past, which speaks to the strength of our industry and tenant relationships and our focus on relationship-driven investing.

As we look out to the second quarter and the balance of the year, we will continue to source attractive investment opportunities and remain focused on delivering capital and to sale-leaseback transactions with quality tenants in service-oriented and experience-based industries.

We anticipate our level of investment activity in the coming quarters to be consistent with our historical averages. That said, with the yield on the 10-year U.S. treasury down 23 basis points since year-end and the general improvement in equity evaluations across the net lease sector, we are seeing greater competition for our investments, which may place downward pressure on our cap rates assuming the current operating environment persists.

On the balance sheet front, we opportunistically accessed the equity markets in mid-March, raising approximately $235 million in net proceeds. This offering was well received by the market, and we would like to thank our new and existing shareholders for supporting the company on this transaction. This accretive capital raise was our first follow-on offering since coming public in June, provided numerous benefits to the company, including increasing our free flow, improving our daily liquidity and further broadening our shareholder base.

In addition, our leverage declined to 3.7x net debt-to-adjusted EBITDA at quarter end, which gives us ample capacity to capitalize on our investment pipeline of high-quality sale-leaseback transactions. We anticipate becoming self-eligible shortly after the 1-year anniversary of our IPO in late June. We should enhance our flexibility and access the capital going forward.

Overall, this was a great quarter for the company and has paved the way for us to scale our portfolio accretively and continue to generate attractive risk-adjusted return for shareholders.

With that, I'd like to turn it over to Hillary Hai, our CFO, who will take you through our financial results for the first quarter. Hillary?

[Hillary Hai, executive]

Thank you, Pete, and good morning, everyone. Starting with the balance sheet, we ended the quarter with $1.6 billion in total assets, $530 million of debt related to our master trust funding program, nothing outstanding on our unsecured revolving credit facility and $114 million in cash and restricted cash.

Our net debt to annualized adjusted EBITDAre was 3.7x at quarter end, which gives us ample capacity to continue to execute on our external growth plans, while managing within our targeted leverage range.

Subsequent to quarter end, we amended and expanded our unsecured credit facility to increase our revolver by $100 million to $400 million, while adding a $200 million 5-year unsecured term loan with a delayed draw feature. We also favorably amended various terms in the facility, lowered our interest rate spread on the revolver by 15 to 30 basis points depending on our leverage level and pushed out the revolvers expiration to April 2023. As of today, our $400 million revolver and $200 million term loan remain undrawn.

Turning to the income statement. Our first quarter net income was $8.7 million or $0.13 per diluted share. NAREIT defined funds from operations, or FFO, was $18.6 million or $0.29 per diluted share and adjusted funds from operation, or AFFO, was $17.9 million or $0.27 per diluted share. Total revenues were $31.1 million in the quarter, which was 54% increase year-over-year.

In terms of G&A, we continue to increase our operating efficiencies, as our G&A for the first quarter was 13.5% of total revenues versus 16.6% for the same quarter last year. We expect to see this to come down as we continue to grow our portfolio.

Our nonreimbursable property expenses as a percentage of revenue, excluding reimbursements, was 1.7% for the quarter, which was higher than last quarter due to an increase in property taxes and nonrecurring property maintenance expenses related to property subject to double net leases.

Subsequent to quarter end, we paid a dividend of $0.21 per share for the first quarter, which equated to a 78% payout of our first quarter AFFO per share.

Turning to guidance, we are reiterating our 2019 AFFO per share guidance to range of $1.11 to $1.15.

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

[Gregg Seibert, executive]

Thanks, Hillary. During the quarter, we invested $118 million in 35 transactions and 51 properties at a weighted average cash cap rate of 7.5%. The weighted average lease term of these properties was 15.1 years, the weighted average annual rent escalation was 1.6%, the weighted average unit-level coverage was 3.2x and our average property size was $2.3 million.

Consistent with our investment strategy, approximately 78% of our first quarter investments were originated through direct sale-leaseback transactions, which are subject to our lease form with ongoing financial reporting requirements and master lease provisions in most cases.

In addition, 82.5% of our first quarter investment activity was relationship based, which we define as transactions completed with operators, sponsors, advisers or brokers that senior management has done business with in the past.

From an industry perspective, quick service restaurants, or QSRs, remain our largest industry at 13.8% of ABR, followed by carwashes at 11% and early childhood education at 10.8%.

Our casual dining and home furnishing concentrations sequentially declined 60 and 40 basis points, respectively, which is a trend that should continue as we see better risk-adjusted returns in other industries like early childhood education, medical and dental, entertainment and convenience stores.

From a concentration perspective, no tenant represented over 5% of our cash ABR at quarter end, as our largest tenant, Captain D's, now represents 4.5% of cash ABR.

Our top 10 tenants represented 30.7% of our cash ABR at quarter end, which was down 240 basis points sequentially and down over 1,100 basis points year-over-year. We expect our top 10 concentration to continue to decrease over the coming quarters as we grow exposures with existing tenants outside of our top 10 and capitalize on relationships with tenants that are new to our portfolio.

Looking at the portfolio more broadly. Approximately 92% of our cash ABR is derived from tenants that operate service-oriented and experience-based businesses, which has been a deliberate focus for Essential since we started investing over 3 years ago. We believe tenants in these industries and more importantly, real estate occupied by these tenants are more recession-resistant and heavily insulated against e-commerce pressures. We would expect to see our exposure to these tenants gravitate higher as we continue to invest in our targeted industries.

Moving on to asset management. Our portfolio remains healthy, with a weighted average rent coverage ratio of 2.8x and approximately 72.5% of our cash ABR having a rent coverage ratio of 2x or better.

In addition, with approximately 98% of our tenants required to report unit-level financials to us, we have near real-time transparency into the health of our tenancy, which is an important component for our active asset management approach.

From a lease expiration standpoint, we had one lease expired during the quarter that was not renewed, and we are actively marketing this property for sale or lease. Looking at more broadly, just 4.5% of our cash ABR is coming due over the next 5 years, which was a big improvement over the last quarter, thanks to the lease extension we executed with Captain D's during the quarter. We extended Captain D's average lease term by 7.8 years to 12 years and thus eliminated a near-term renewal risk.

In the context of a lease extension, we granted Captain D's some minor concessions, which will negatively impact our same-store rent growth by approximately 10 basis points over the next 12 months. We believe this was of highly favorable outcome for the company as we receive fresh long-term leases with our largest tenant without making any onerous concessions.

Turning to dispositions. We sold 7 lease properties during the quarter at a cash cap rate of 6.5% and $10.5 million in net proceeds.

With that, I will turn it back to Pete for his concluding remarks.

[Peter Mavoides, executive]

Thanks, Greg. Our portfolio is in excellent shape, which is one vacancy, healthy coverages, coupled with complete transparency, good property-level liquidity and limited near-term lease expirations.

Our investment pipeline is full. Our balance sheet is positioned to support continuing investments, and we look forward to continuing to execute on the business plan that we articulated at the time of our IPO.

With that, operator, we'll take our questions.

[Operator]

[Operator Instructions] And we do have our first question from Christine McElroy from Citi.

[Christy McElroy, analyst]

Pete, just wanted to follow up on a comment you made in the opening remarks regarding greater competition for assets and potential downward pressure on cap rates. Maybe you could you provide a little bit more color on those statements, where is the competition coming from? And how you're thinking about the cap rates that you expect to transact at relative to your pace that you've been in the last few quarters?

[Peter Mavoides, executive]

Sure, Christine, and thanks for the question. We -- I would start by saying, we try to find deals and transactions through our relationships that have less competition by nature and tend to focus our efforts there, but there is increasing competition from our public competitors. As many of them have seen, their cost to capitals come in much like us. And so we're seeing -- at the margin more competition, I wouldn't expect that to impact our cap rates more than 10 or 20 basis points. We've, historically, been investing in the mid-7s, and we should be in that general vicinity going forward.

[Christy McElroy, analyst]

Okay. And then just with regard to guidance and how you're thinking about acquisitions and understanding your -- not necessarily willing to give a specific range, but now that you sort of raise capital sort of your balance sheet, maybe you could give us some sense for what the pace should be like the next few quarters? How you're thinking about acquisitions differently, given the capital you've raised? And what sort of inherent in your guidance range today for net investment?

[Peter Mavoides, executive]

Yes. I would say we disclose our quarterly average looking back about 8 quarters and that's roughly $130 million, and we staff the organization to kind of transact at that level and our constraints aren't necessarily the opportunities, but it's more our ability to underwrite process and diligence assets. And in my comments, I indicated our ability to kind of get back to that norm. Looking back over the past 8 quarters, clearly, we came into the year with moderated investment appetite, given our year-end cost of capital and this capital raise and the recent movement in our cost of capital has supported a more aggressive stance. And we're staffing our organization to continue to transact, but I look at kind of the last 8 quarters as a pretty good indicator of where we should be.

[Christy McElroy, analyst]

So you wouldn't see -- I mean, just based on those comments, you would think that maybe you would be a little bit more aggressive going forward than you had in the past, given your cost of capital. I mean, is it fair to assume that's not out of the realm of possibility?

[Peter Mavoides, executive]

It's not out of the realm. It really just -- it depends on our ability to source and process and diligence and get deals closed. And so that becomes an organizational constraint. And staffing out the organization and building the infrastructure takes time. And we've transacted just on a more bigger picture. We've transacted approximately $500 million a year for the last 3 years and are staffed and equipped to do that. And I wouldn't anticipate pushing us much higher than that in the near term.

[Operator]

And our next question comes from Ki Bin Kim from SunTrust.

[Alexei Siniakov, analyst]

This is Ki Bin's associate Alexei Siniakov. I'm looking on Page 7 of the supplemental, where you showed the quarterly activity for the last 8 quarters. It looks like this quarter the acquisitions had a rent coverage of 3.2x, which is visibly higher than prior quarters. Could you just give some color around what contributed to that?

[Peter Mavoides, executive]

Yes. I would start by saying, if you look on that page, we've had quarters where we're 4, we've had quarters where we're 2, 3. And so clearly, the coverage varies depending upon most of the industries that we invest in, in any given quarter. And certain industries have different coverage ratios and different targets for us. And so really, in that quarter -- in this quarter, it was just a factor of the deals that we did, in the industries that we were in. And so it's nothing really specific, and I would say that, that 3, 2 is certainly within the range that we've been operating.

[Operator]

Our next question comes from Douglas Harter from Crédit Suisse.

[HyungJun Choe, analyst]

This is Sam Choe filling in for Doug. So just going back to the question about investment activity period. Just based on your comments, it seems like you guys are more focused on prudence about getting the right quality of investments. And such that like even if you build scale that $130 million pacing is kind of what you're thinking about going forward?

[Peter Mavoides, executive]

Yes. I think that's accurate. I think we first and foremost want to buy good smart deals that have good risk characteristics and appropriate returns and are durable, right? We're making 20-year investments here and hope they tend to stay long before that. Secondly, we want to invest at an accretive spread to our cost to capital to generate growth for shareholders, and we want to have an appropriate growth trajectory to -- for a long period of time. And we're not looking at just 1 or 2 years of growth, we're looking at a decade of growth. And we're going to have moderate investment activity with good deals that allow us to grow and hopefully be a -- the most compelling growth alternative in our sector.

[HyungJun Choe, analyst]

Got it. And just going -- just looking at the portfolio, I mean, the rental yields were -- seemed stronger this quarter. Was that a function of the lease escalations kicking in this quarter? And how should we be thinking about that?

[Peter Mavoides, executive]

On the new investments or in the portfolio?

[HyungJun Choe, analyst]

The portfolio itself.

[Peter Mavoides, executive]

Yes. It's rental -- the rental escalations kick in at various times, whether 1 year, 5 years or even in some cases 10 years and it's just the timing of those bumps and those things coming online.

[Operator]

And our next question comes from Sheila McGrath from Evercore.

[Sheila McGrath, analyst]

Construction in progress was up sequentially. If you could just remind us what is underdevelopment? And how do the yields vary from the traditional acquisitions?

[Peter Mavoides, executive]

Sure, Sheila, and I'll take the second part of that question. Generally, our construction in progress are situations where we're working with an existing tenant to help reimburse them as they develop sites that are preleased. And so they develop it. They have the construction obligation and construction risk and we fund those dollars as they're expanded and we receive rent on those dollars as we invest. And generally, we're able to get anywhere from 10 to 50 basis points premium yield above where we would buy an established leased operating asset. Typically, we package those new construction assets with existing master lease to help mitigate some of the pro forma performance risk of those sites. So in mitigating those risks, we're also not able to get a commensurate outsized return, but it is kind of 10 to 50 basis points.

[Sheila McGrath, analyst]

Okay. And then on assets sold, this quarter, you sold 7 assets, one was vacant. Can you remind us more detail on the characteristics of the assets you target for sale?

[Peter Mavoides, executive]

Sure. And I would say, also remind you that we started the year with a strong focus on capital recycling given our cost to capital towards the end of the fourth quarter. And when you have a 60- to 90-day sale cycle, some of that activity was in process through the back end of the year. But generally, we look at our sales in 2 buckets, which one is opportunistic where we see an opportunity to generate attractive gains and an investor may value an asset more than we do. And then, secondly, we sell assets where we see potential long-term credit risk, either as it relates to the probability of renewal in the near term or declining coverage. And we're able to sell a weak-performing site out of the master lease and improve our hold position. And so during the first quarter, our sales were about 50% in each of that bucket, which was opportunistic and credit derisking.

[Sheila McGrath, analyst]

Okay. Great. One last quick one, just dividend policy. Remind us are you targeting a payout ratio an annual review, what are you communicating on the dividend?

[Peter Mavoides, executive]

Yes. I would start by saying our dividend policy is still forming as our Board has only -- was established in the context of the IPO, and we haven't been yet to a full year cycle of dividends. But clearly, we're striving to grow our AFFO at an attractive rate and part of that will be raising our dividend correspondingly. Without speaking for the Board, I would anticipate to us, clearly, review the dividend on a quarterly basis, potentially raise it twice a year. And I would imagine we'd operate somewhere in the 70% payout range. We started at the -- in the context of the IPO a little higher and have seasoned into that.

[Operator]

Our next question comes from Nate Crossett from Berenberg.

[Nathan Crossett, analyst]

I see you guys are now in 16 industries for property types. I was just wondering what the new industry type was in the quarter? And then just comments on, are there other net lease areas you would potentially look at? And maybe where -- what property types are you seeing the most acquisition opportunities?

[Peter Mavoides, executive]

Yes, Nate. Generally, we're not dogmatic in our industries. We're dogmatic as to wanting to be in service-based industries and wanting to own fungible real estate. And to the extent, that any industry has a tenant or a piece of real estate have those characteristics, we're open to investing in that industry. In this quarter, pet services, our veterinary clinics and pet hospitals, kennels and the like popped out of other services at 2.5%. Generally, when you see an industry crest that 2.5%, we think it becomes material. We'll pop it out of that other services bucket. And so that's generally how we'll treat that.

I would say more globally, we're investing in all of our sectors kind of ratably and growing them. Greg had some commentary in his prepared remarks, where we've lightened up on casual dining and furniture and saw good opportunities in C stores, in childcare and medical dental. And so you will see some movement within our current industry mix. But in general, I think that will be at the margin and we're going to endeavor to grow the pie ratably.

[Nathan Crossett, analyst]

Okay. That's helpful. And then, sorry if I missed it, but can you just remind us your comfort zone for leverage? I mean, you're currently the lowest in the space. So I'm just trying to gauge what's the normalized number? What are you comfortable with?

[Peter Mavoides, executive]

We have articulated that, saw ceilings 6x net debt-to-EBITDA. We really don't want to crest that without a plan to get back down. In general, we would like to operate in the 5s and that's probably a preference towards the low to mid-5s. And then, lastly, I would say we want to get out and stay in front of our capital needs, and so as to not to put ourselves in a box. And we finished the year in the low 5s, saw an opportunity to raise some capital to recharge the balance sheet. Clearly, a 3 7, it's a bit lower than we would like and that was an impact of sizing the transaction and then having it upsized and taking the shoe, but we'll operate in the low 5s and stay in front of our capital needs.

[Operator]

Our next question comes from Josh Dennerlein from Bank of America.

[Unknown Analyst]

This is [ Kevin ] here with Josh. We just had a quick question pertaining to your AMC exposure. Do you have any kind of updated thoughts on what you guys are thinking in terms of your exposure there?

[Peter Mavoides, executive]

Yes. I mean, in general, we don't provide specific disclosure around our individual tenants. Clearly, AMC is public company, and there's plenty of information out there. I would say, we've been very selective in the theaters that we purchased. It's been a very targeted and limited amount of theaters and focused on situations where we saw screen profitability relative to rent that was attractive to us and that's where we focused. We've also focused on investing in theaters that have been modernized and upgraded and wanting to own kind of the high-end theaters and that's kind of where we remain focused. Theaters are not a big focus of ours. We will grow that, but probably slower than the overall portfolio.

[Operator]

Our next question comes from John Massocca from Ladenburg.

[John Massocca, analyst]

So can you maybe provide a little more color on the Captain D's extension with the incentive on there and to renew early, just the decline in the ramp ups? Am I reading that correctly?

[Peter Mavoides, executive]

Yes, no. It was -- as you would imagine, we had 77 properties with them, with 3 master leases that were originated close to 15 years ago or so. And there was a lot going on. There was -- they had some assets that they wanted to -- specifically 3 assets that were no longer economic from them that they wanted to get out off. They had percentage rents that we're evaluating, and there was a whole host of kind of put and takes on that transaction that we're in play. And when you balance them all out, we got approximately 8 years of additional rent commitment from them, which equates over $40 million in rent commitment and exchange for small concessions that should drag on our same-store scale, same-store rent NOI growth by about 10 basis points for the next 12 months.

[John Massocca, analyst]

Okay. That makes sense. And I know it's not a huge move, but it looks like your exposure to kind of the percentage of tenants with 2x rent coverage ticked down, and with kind of exposure at 1.5 to 2x kind of ticked up by about a percentage each, even though you had really strong coverage on acquisitions completed in the quarter. So I mean, was there any specific tenant or industry within the existing portfolio that was driving that shift?

[Peter Mavoides, executive]

Yes. I would say, it's certainly is an industry shift and it's specific tenant shift. And you may had a guy that was at 1 5 1 that went down to 1 4 9. And so there's going to be some ebb and flows in those numbers. And we recognize that this is kind of new disclosure and people need to get comfort in the trends in that, but there's nothing in there that's alarming to us. And we've been very aggressive and vocal about selling and getting out of assets where we saw risk and we're managing this portfolio. And there will be ebbs and flows, but I think take comfort that we're in front of it, we see issues and we're getting out of them.

[John Massocca, analyst]

Understood. And then I know it's a little bit unfair because you're young company, but there's no increase in your exposure to any of your top 10 tenants, was that a conscious choice in order to maintain diversity? Or just a product of the last 2 quarters of deal flow?

[Peter Mavoides, executive]

Yes. It's -- there is -- we've had some caps on the guys at the top of our list, where we don't want to take tenants above 5%. There's guys further down the list where they just -- they don't have any more real estate, but they want to do sale leasebacks on and aren't transacting. And there's other guys on the list who mature these companies and have been afforded a cost of capital that -- such that it no longer makes sense for us to transact with them. So it's really across-the-board, John.

[Operator]

[Operator Instructions] And there appears to be no more questions at this time.

[Peter Mavoides, executive]

Great. Well, thank you, operator, and thank you, everyone, for joining us on today's call. As I said in the prepared remarks, we're very excited about where the company sits today. The first quarter was really a transformational quarter for us, largely to the support of investors and shareholders that supported us in the market in this quarter. And so thank you again, and we look forward to engaging with you all in the coming conferences at ICSE and Nareit and have a great day.

[Operator]

Thank you. This does conclude today's teleconference. We thank you for your participation. You may disconnect your lines at this time, and have a great day.