Essential Properties Realty Trust Inc

NYSE:EPRT

Earnings Call Transcript 2024-Q1

[Operator]

Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust First Quarter 2024 Earnings Conference Call. [Operator Instructions] This conference call is being recorded, and a replay of the call will be available 2 hours after the completion of the call for the next 2 weeks. The dial-in details for the replay can be found in yesterday's press release. Additionally, there will be an audio webcast available on the Essential Properties' website at www.essentialproperties.com, an archive of which will be available for 90 days. On the call this morning is Peter Mavoides, President and Chief Executive Officer; Mark Patten, Chief Financial Officer; Rob Salisbury, Head of Capital Markets; Max Jenkins, Head of Investments; and A.J. Peil, Head of Asset Management. It is now my pleasure to turn the call over to Rob Salisbury. Thank you. You may begin.

[Robert Salisbury, executive]

Thank you, operator. Good morning, everyone, and thank you for joining us today for Essential Properties First Quarter 2024 Earnings Conference Call. During this conference call, we will make certain statements that may be considered forward-looking statements under federal securities law. The company's actual future results may differ significantly from the matters discussed in these forward-looking statements, and we may not release revisions to these 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. With that, I'll turn the call over to Pete.

[Peter Mavoides, executive]

Thank you, Rob, and thank you to everyone joining us today for your interest in Essential Properties. On our year-end earnings call in February, we noted an industry backdrop of heightened volatility in the capital markets and wide bid-ask spreads in the transaction markets. That backdrop persists today as markets have again readjusted to contemplating a higher for longer interest rate environment. Our business is well suited to this environment with a well-capitalized balance sheet and a value proposition of providing reliable growth capital to middle market companies in our targeted industries. Against this backdrop, we started 2024 on a positive note with healthy portfolio credit trends and $249 million of investments in the quarter, translating into solid AFFO per share growth of 5%. In the first quarter, 87% of our investments were generated from existing relationships, underscoring the value we provide as a reliable and efficient capital provider funding their growing businesses. Our sale-leaseback capital is particularly attractive as the continued dislocation in the credit and bank markets has contributed to tighter lending conditions. With quarter end pro forma leverage of 3.6x and liquidity of over $850 million, our balance sheet positions thus well to grow our portfolio by deploying into these tailwinds, resulting in attractive risk-adjusted returns for our shareholders. Based upon our first quarter results and the building momentum in our investment pipeline heading into the second quarter, we have refined our 2024 AFFO per share guidance to a range of $1.72 to $1.75, which implies over 5% growth at the midpoint. As our first quarter results indicate, our portfolio continues to operate at a strong level. We ended the quarter with investments in 1,937 properties that were 99.9% leased to 383 tenants operating in 16 industries. The portfolio had just 1 vacant property at quarter end, down from 3 at the end of last year. Our portfolio continues to demonstrate excellent durability and extraordinarily high occupancy. Our weighted average lease term stood at 14.1 years at quarter end, which is up slightly year-over-year, with only 4.5% of annual base rent expiring through 2028. From a tenant health perspective, our weighted average unit level rent coverage ratio was 3.9x this quarter, up slightly from last quarter. Same-store rent growth in the first quarter was 1.5%, which was consistent with last quarter and suggests minimal leakage from credit losses. During the quarter, we invested $249 million through 36 separate transactions at a weighted average cash yield of 8.1%, representing an increase of 20 basis points from last quarter and 50 basis points from 2 quarters ago. Our investment activity in the quarter was broad-based across most of our top industries, with no notable departures from our well-defined investment strategy. Our investments this quarter had a weighted average lease term of 17.2 years and a weighted average annual rent escalation of 1.9%, generating an average GAAP yield of 9.3%, which is the highest GAAP yield in our company's history. Our investments this quarter had a weighted average unit level rent coverage of 2.7x and the average investment per property was $2.8 million, consistent with our focus on owning granular liquid properties. 100% of the investments this quarter were originated through direct sale leasebacks, which are subject to our lease form with ongoing financial reporting requirements. 82% contained master lease provisions and 87% were generated from existing relationships. Looking ahead to the second quarter of 2024, we have closed $61 million of investments quarter-to-date, and our pipeline remains robust as an increasing number of middle market companies are seeking sale-leaseback capital as a financing alternative as other sources of capital have become unavailable or uneconomic. A persistently high interest rate backdrop supports our ability to continue to generate attractive risk-adjusted returns, and our current pipeline suggests that investment cap rates should be stable in the near term. From a tenant concentration perspective, our largest tenant represents 4.3% of ABR at quarter end, and our top 10 tenants now account for only 19.1% of ABR. Tenant diversity is an important risk mitigation tool and differentiator for us, and it is a direct benefit of our focus on middle market operators, which offers an expansive opportunity set. In terms of dispositions, we sold 7 properties this quarter for $11.9 million in net proceeds at a 6.5% weighted average cash yield and a weighted average unit level rent coverage of 2.7x. As we have mentioned in the past, owning tangible and liquid properties is an important aspect of our investment discipline as it allows us to proactively manage industries, tenants and unit level risks within our portfolio. Going forward, we expect our disposition activity over the near term to remain relatively in line with our trailing 8-quarter average, driven by opportunistic asset sales and ongoing portfolio management activity. With that, I'd like to turn the call over to Mark, who will take you through the financials and our balance sheet for the quarter.

[Mark Patten, executive]

Thanks, Pete, and good morning, everyone. As Pete noted, we had a solid first quarter, which was punctuated by a record level of investments at an 8.1% cash cap rate. Among the headlines from the quarter was our AFFO per share of $0.42, which is an increase of 5% versus Q1 2023. On a nominal basis, our AFFO totaled $71.1 million for the quarter. That's up $12.9 million over the same period in 2023, which is an increase of 22%. This AFFO performance was in line with our expectations, underlying the guidance range we provided last quarter. Total G&A was $9.4 million in Q1 2024 versus $8.6 million for the same period in 2023, which with the majority of the increase relating to an increase in compensation expense. Our recurring cash G&A as a percentage of total revenue was 6.2% for the quarter, which compares favorably to the 7% in the same period a year ago. We continue to expect that on an annual basis, our cash G&A as a percentage of total revenue will decline this year as our platform generates operating leverage over a scaling asset base. We declared a $28.5 dividend in the first quarter, which represents an AFFO payout ratio of 68%. Our retained free cash flow after dividends continues to build, reaching $23.9 million in the first quarter. Turning to our balance sheet, I'll highlight the following: with our $249 million in Q1 2024 investments, our income-producing gross assets reached $5.1 billion at quarter end. The scale of our income-producing assets continues to build, and we expect to approach $6 billion by later this year. The diversity, equality and scale of our asset base enhances the reliability and durability of our cash flows and provides an increasing level of risk mitigation. On the Capital Markets side, it was a productive first quarter, highlighted by a successful overnight equity offering in March, generating gross proceeds of $256.2 million. The offering was completed on a forward basis. Through our ATM program, we completed the sale of approximately $53.4 million of stock, also all on a forward basis. Combined during the first quarter, we raised over $300 million of equity capital. During the quarter, we settled $244.7 million of forward equity, including the remaining unsettled shares from our September 2023 offering, all of the shares issued on our ATM and a portion of our March 2024 offering, leaving us with a balance of unsettled forward equity totaling $184.2 million at quarter end. Our pro forma net debt to annualized adjusted EBITDA are, adjusted for unsettled forward equity was 3.6x at quarter end. We remain committed to maintaining a well-capitalized balance sheet with best-in-class leverage and liquidity. At quarter end, our total liquidity stood at over $850 million. Our conservative leverage, strong balance sheet and significant liquidity positions the company well to fund our growth plans for 2024. Combined with the strong performance to start the year, as Pete mentioned, this supports our refined 2024 AFFO per share guidance range of $1.72 to $1.75 implying an over 5% growth rate at the midpoint. It's important to note that with the equity issuance executed this quarter, we do not require any additional equity to achieve our 2024 guidance range. With that, I'll turn the call back over to Pete.

[Peter Mavoides, executive]

Thanks, Mark. We're very pleased with our first quarter results and remain optimistic about the prospects for the business. Operator, please open the call for questions.

[Operator]

[Operator Instructions] Our first question comes from Eric Borden with BMO.

[Eric Borden, analyst]

With the rates now seemingly higher for longer, how should we think about the appropriate funding mix to fund external growth for the remainder of the year? And then I guess the part 2, if you were to issue debt today, what's the most attractive source of debt capital? And at what rate could you raise that at?

[Peter Mavoides, executive]

Mark, why don't you handle that?

[Mark Patten, executive]

You got it. Look, I think I tried to catch that at the tail end of my remarks in terms of the equity side of that equation. So if you think about it, what we really have today is equity that we have available to us from the standpoint of debt financing, our view is that where you could maybe execute a term loan. So if you think about that avenue, it's probably somewhere in the 5.4, 5.5, given the 10 years move swapping that out. We think that the bank debt market is available to us and that would probably be an avenue we pursue an unsecured bond issuance, albeit we'd love to be back in that market even with our spread down to $194, the 10 years been on a tear. So that's still less accretive and certainly not constructive for us right now. But I think what I'd also mention is we could do $1 billion worth of investments sitting with the liquidity we have today and not even crest 5x leverage.

[Eric Borden, analyst]

Okay. That's helpful. And then maybe one for Pete. Just how competitive is the sale-leaseback market today? Are you seeing investors or peers kind of stepping off the sidelines just given how attractive that sale-leaseback capital is for potential tenants?

[Peter Mavoides, executive]

Yes. I think overall, our narrative that has been competition has been muted in the last couple of quarters as back to what Mark was talking about, the financing costs for these assets is a little challenging, but there's certainly competition out there from other investors as well as alternative capital sources. So I wouldn't say the market is devoid of competition, but certainly, it's a lower level than we've seen in past years.

[Operator]

Our next question comes from Smedes Rose with Citi.

[Bennett Rose, analyst]

Acknowledging that your 4-wall coverage actually increased sequentially, but I'm just wondering, there's a lot of concern that consumers, particularly kind of on the lower end of the economic spectrum are kind of increasingly tapped out. And I'm just wondering if that concern is sort of bleeding over into your conversations with tenants around things like escalators or their willingness to transact right now just that especially on a hire for longer environment. I'm just wondering if that's maybe showing up at all.

[Peter Mavoides, executive]

Yes. Listen, we're in industries that aren't really reliant on the low-end consumer. We're an essential service in experience-based industries. And we're not really seeing those concerns come through in our tenant discussions or new operator discussions. I would say, overall, -- the guys that are growing are a little fewer than they've been in the past and a little less reliant on debt capital as they've been in the past, and which means they're using more sale-leaseback capital and equity capital. But overall, the industries that we're investing in have been and continue to be pretty healthy.

[Operator]

Our next question comes from Greg McGinniss with Scotiabank.

[Greg McGinniss, analyst]

I was hoping you could just talk about some of the movement around the tenant risk, like the less than onetime rent coverage population growing, the CCC+, although mostly that's 2x rent coverage increasing, but just about some of the movement on the tenant risk there, what's causing that? And then also, if you could touch on your comfort with Red Robin, which has seen its share price kind of decline over the last few years, just how those assets are doing and what gives you comfort around those acquisitions.

[Peter Mavoides, executive]

Sure thing. Listen, there's always going to be ebbs and flows in credit and coverage. Overall, our less than 1.5 bucket is down sequentially, and our overall coverage is up sequentially despite adding $250 million of assets at a 2.7x rent coverage. So you're always going to have the flows. So really, the focusing on the CCC and even the sub-1 bucket, those are very idiosyncratic events relative to those specific names and operators and rest assured that we're watching and working with those guys closely to figure out if those assets are permanently impaired or temporarily impaired and whether or not what the long-term solution is. But I would say, overall, we feel really good about where the portfolio is. And you see that with one vacant property and our same-store sales coverage, solid 1.5 as well as our increasing guidance. So overall, the ebbs and flows are kind of a natural part of the business. And our job is to manage that and we take the portfolio in a great spot and supporting the business. Getting into Red Robin, we've done a number of deals with them. And we're not equity investors. We're not buying the shares. We're buying their real estate. And ultimately, the restaurants we own that they lease from us are great real estate. And with solid coverage, they've been operating as restaurants for over 20 years, and we have confidence that they'll continue to operate as restaurants. We've had a very positive credit experience in the casual dining space. And so when we do have credit events, we actually end up better relative to our ABR going into it. Red Robin is a good company. We have a lot of confidence in their management, and they'll get that brand turned around and -- but ultimately, as real estate investors, that's equity risk.

[Greg McGinniss, analyst]

And sorry, could you just expand on what you meant in terms of the credit improvement on the casual dining side?

[Peter Mavoides, executive]

As we look at credit losses, when we have credit experience, we look at ABR after the credit events versus ABR before the credit events. And in the casual dining space, specifically when we retenant assets, our ABR is higher.

[Operator]

Our next question is from Haendel St. Juste with Mizuho Securities.

[Haendel St. Juste, analyst]

First, to follow up on Greg's question. I'm curious how much more exposure you'd be comfortable with in casual dining, I think you're up to about 7.5%. And also on the C-store side, you're about 5%.

[Peter Mavoides, executive]

Yes. We're comfortable in all our industries. We're in 16 focused industries and generally have a soft ceiling of 15% for industries. Given my commentary around our credit experience in the casual dining space, we certainly feel comfortable taking that exposure up. I don't know that would go double to 15, but there's certainly room to grow there. And C-stores is a similar sort of narrative where we've had positive credit experience and we like the space. Really, the -- ultimately, it depends on the opportunities that we're able to source and whether or not those opportunities are priced at a rate that is attractive to us. And I guess from an overall perspective, I would expect those industries to grow ratably.

[Haendel St. Juste, analyst]

Okay. And then just, I guess, going back to the first quarter volume, you highlighted in the release that it's your busiest first quarter ever. I guess I'm curious is stepping back. Is this a function of just seeing more assets that fit your buybacks? Is it less competition, a greater desire for tenants to transact given lack of the alternatives you cited or maybe all of the above? And what does that suggest for your opportunity to deploy capital this year? Is the first quarter a good run rate to think about for the rest of the year?

[Peter Mavoides, executive]

Yes. The first quarter is not a great quarter to run rate. Generally, I would think look toward our 8-quarter average more as an indicator of what to expect. The first quarter is a little slower historically as there's a year-end push for deals and in the year starts off pretty slow as January and people get back to focus to doing deals. And you sort of -- if you followed our incremental disclosures throughout the quarter, you'll see that. Generally, our posture has been we're transacting as much as we can. We have a great opportunity set. Our opportunity set is -- was up in '23 over '22 or 20%, and I would expect it to be up again this year. And really that opportunity set is the growth in the opportunity set is driven by an increasing demand for sale-leaseback capital as the pricing of it is more compelling than some of the financing alternatives that these middle market operators have as well as diminished competition. Going back to some of my earlier comments. So we're working hard to buy assets and put the capital that we have raised and have ready to deploy to work, but it takes a lot of work and a lot of negotiation, a lot of underwriting, a lot of diligence and to put the capital out, but we're working hard to do that.

[Haendel St. Juste, analyst]

And one last one, if I could, just on the pipeline. You mentioned that cap rates in the pipeline were fairly stable. I'm curious on what your expectations for cap rates are in the near term. We've seen some of your peers have larger increases in sequential cap rate versus last quarter. I think yours were only up about 20 basis points. So curious on where you think cap rates are today, where they're heading, the opportunity to see a bit more yield in this higher rate environment?

[Peter Mavoides, executive]

Yes. I don't, I would set the expectations for cap rates to be flat. We haven't seen the ability to push them up much higher. And ultimately, we would expect cap rates to be -- to gravitate down as the capital markets normalize and competition returns. That dynamic is not priced into our current pipeline. That current pipeline would suggest a flat trend. But later in the year, if things were to improve on the capital market side, we would expect a bit of downward pressure.

[Operator]

Our next question comes from John Massocca with B. Riley Securities.

[John Massocca, analyst]

So maybe kind of digging in a little more on the Red Robin transaction. I mean, I guess, how did the coverage and cap rate on those deals compared to maybe the average for the quarter, just roughly?

[Peter Mavoides, executive]

It would have been accretive to the coverage dilutive to the cap rate.

[John Massocca, analyst]

Okay. That's helpful. And then kind of bigger picture, particularly as you look at the pipeline today, what's the mix of kind of private equity-sponsored tenants in the pipeline? And I guess how is that compared to historical levels, particularly maybe before we saw interest rates increase here over the last couple of years?

[Peter Mavoides, executive]

John, the vast, vast majority of our tenants and our operators are private equity backed. We have very few publicly traded companies, Red Rob and certainly is one of the exceptions in that regard. And so when I would speculate on a historical basis, it's in the high 90s and that private equity backing takes many different forms from family offices to founder family founders to big private equity shops. And so that really hasn't changed. Private equity and /or some of the people that use their assets to leverage their business. And one of the reasons why sale-leaseback track transactions are compelling to them.

[John Massocca, analyst]

And I guess has that dynamic been the same for maybe bigger regional private equity-backed companies versus maybe some of the more mom-and-pops or MBO type run.

[Peter Mavoides, executive]

Operator? Yes. Listen, capital market behavior is really -- it doesn't matter how big you are, you're going to try to find the most efficient sources of capital to capitalize your business. Inherently, back to the Red Robin, if you're public and you're using your assets to finance your business, it's because your cost of capital in the public market is impaired and not attractive. And inherently, it's -- you're looking for other sources of capital. So capitalism is pretty efficient and people are trying to find the most efficient capital to capitalize their business, whether it's a $3 billion, $6 billion enterprise or a $50 million enterprise.

[John Massocca, analyst]

Okay. That's very helpful. And then maybe, Mark, I know you talked about having kind of enough equity capital to finance deals for the remainder of the year and stays in the leverage targets. But maybe kind of more near term, I mean, is the thought process to use nothing but kind of the in-place equity capital to finance transactions and maybe even be able to kind of stay off the line on a short-term basis? Or just given how low that would take your leverage and the fact that as you kind of think about dilution, you might kind of stretch the existing forwards out a little more over the course of the year.

[Mark Patten, executive]

Yes. I guess what I'd say it's probably a little bit more towards the latter, meaning today, utilizing -- and first of all, I'll start with, and I think you made this point. At our pro forma leverage level, we are pretty significantly equitized. So we have some room to utilize leverage. In addition, utilizing that leverage is frankly accretive to utilizing the remainder of our forward. So most likely, to your latter point, we would probably push out settling the forwards and utilize some of our leverage capacity that then becomes more accretive if you execute a term loan that is going to be well south of revolver.

[Operator]

Our next question comes from Joshua Dennerlein with Bank of America.

[Unknown Analyst]

This is [indiscernible] on behalf of Josh. I was wondering if you could quickly touch on your current watch list.

[Peter Mavoides, executive]

Sure. Our watch list as we define it as a single B credit or low and coverage or below, and that represents about 100 basis points of ABR, which is up slightly from last quarter. And it's kind of what we got on the watch list.

[Unknown Analyst]

And what is driving that increase?

[Peter Mavoides, executive]

Just much to my earlier commentary is very idiosyncratic events around individual tenants in their credit ratings and their coverage at the asset level. There's no real macro trends kind of driving it. And going from 70 to 100 basis points is really not a material move.

[Mark Patten, executive]

And I'd say similar that AMC is really the biggest chunk of.

[Unknown Analyst]

Okay. And also what is driving your confidence for the increase from the low end of your guidance?

[Peter Mavoides, executive]

Yes, it's a lot of factors. I would say, first and foremost, the stability we're seeing in our portfolio. We take a pretty conservative credit loss assumptions into our guidance when we initially put it out for the year. And so we're seeing positive momentum there. visibility into our pipeline. As we sit here, we have good visibility into a strong second quarter. And then having printed the first quarter, good visibility into 1 quarter of the year. So you got half the year pretty well baked and strong performance, and we feel good about what we're seeing and the numbers would suggest the low end need to be raised.

[Operator]

[Operator Instructions]. Our next question comes from Jim Kammert with Evercore.

[James Kammert, analyst]

We've sort of talked about it around on the call, but would it be possible to quantify the delta between, let's say, your representative of 8% sale leaseback cap right now and the alternative funding costs for representative pool of your tenants? Is that delta 100 basis points? And has it widened or narrowed over time? I'm just curious.

[Peter Mavoides, executive]

Yes. It's-- again, it really ebbs and flows, if you think about SOFR plus 400 or you look at any sort of single bond metric, one of the key factors is just having an inverted yield curve. And with SOFR in the short end of the curve being so elevated, you throw any kind of reasonable spread for these credits on it, you're going to be wide of what is our initial cap rate of 8% and the average cap rate over the life of the lease of 9.3% in last quarter. And so it varies. I would say, certainly, the move -- recent move in the 10-year from 4 to 4.6 has helped that. It's material for these guys. But it's a unique period of time, unique to my 20 years of investing in this asset class.

[James Kammert, analyst]

That's interesting. And secondly, if I could, you obviously enjoy all the unit level reporting for your tenants. And I'm just curious, are there any particular trends you can call out that people are spending the consumer spending more to convenience stores or casual dining? Or I'm just wondering how that cash shapes up across your different verticals?

[Peter Mavoides, executive]

I would say we don't enjoy all the reporting. Some of it is negative. But for the most part, we're seeing positive trends. Casual dining has generally been flat. But when our leases are growing at 1.5, 1.6 and you have a period of high CPI, you're seeing rent coverages that increase. And you can really see that quarter-over-quarter, going from 3.8% to 3.9% despite adding $250 million out of $2.7 million. So generally, the trends are positive. But the casual dining would be the one call out as to flat, but car washes continued to do really well and overall health is fine.

[Operator]

Our next question comes from Conor Siversky with Wells Fargo.

[John Kilichowski, analyst]

This is John Kilichowski on for Connor. Last quarter, you mentioned the target range for acquisitions were 75% existing relationships versus 25% new. But over the trailing 8 quarters, you've been running well above that 75% number. And I'm just interested in why you think that is? And wouldn't you expect this rate environment to be pushing new potential tenants to you given your differentiated leasing strategy?

[Peter Mavoides, executive]

Yes. So the 75%, I would say, was an ideal aspirational mix, really recognizing that tenants naturally outgrow our capital as they become larger, more sophisticated operators with access to more capital sources. In the current environment where the capital markets are volatile, capital reliability is getting a higher premium. And we're more focused on servicing our existing relationships through where we're the embedded solution, and they value us as a counterparty than going out and finding new relationships. But on a long-term stabilized basis, we got to continue to find new relationships, and we spend a lot of time and effort and energy to doing that. I would expect that to balance out over time.

[John Kilichowski, analyst]

Got it. And focusing on the disposition side, you mentioned the cadence of this decisions with light, but I'm more interested in the 20% realized loss number. How much is cash flow from dispositions in your guide sort of forcing your hand there? Or are these just noncore assets you're happy to rotate out of.

[Peter Mavoides, executive]

Yes. I wouldn't put too much into the 20%. There tends to be can be a pretty big delta between where we book an asset on our balance sheet to where we ultimately sell it and allocate rents. And so that number is terribly insightful to anything, really, particularly on a $12 million subset. But generally, our disposition activity is focused on getting rid of assets we don't own on a long-term basis and managing industry -- specific industry and tenant concentrations where we may be overexposed and looking to add. So we will sell off those exposures.

[Operator]

Got it. Our next question is from Spenser Allaway with Green Street Advisors.

[Spenser Allaway, analyst]

You mentioned you continue to see a bit of spread in the market. Just curious how big is that spread on average for the deals you've looked at? And are there any tenant industries where you're seeing larger spreads than others?

[Peter Mavoides, executive]

Yes. I think that commentary, Spencer, was more around the broader net lease market, single-tenant net lease, which is down 40% to 60% to off of historical volumes. And where you have an in-place cash flowing single tenant net lease asset, the price of capital today is probably above where you put that asset -- where you bought that asset, creating that bid an that spread, where we're investing in new capital formation sale-leasebacks that has spread is a lot tighter. And so in our market where we're investing and particularly our capital going out is because there isn't a bit as spread.

[Operator]

We have reached the end of the question-and-answer session. I would now like to turn the call back over to Pete Mavoides for closing comments.

[Peter Mavoides, executive]

Great. Thanks, Rob, and thank you all for participating in our call today. We appreciate your interest and your questions, and we look forward to seeing you all in the coming months. Have a great day.

[Operator]

This concludes today's conference. You may disconnect your lines at this time, and we thank you for your participation.