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Essential Properties Realty Trust Inc
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Good morning, ladies and gentlemen, and welcome to Essential Property Realty Trust Third Quarter 2021 Earnings Conference Call. [Operator Instructions].
This conference 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 numbers for the replay can be found on today's press release. Additionally, there will be an audio webcast available on Essential Properties' website at www.essentialproperties.com, an archive of which will be available for 90 days.
It is now my pleasure to turn the call over to Dan Donlan, Senior Vice President and Head of Capital Markets at Essential Properties.
Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties' Third Quarter 2021 Conference Call. Here with me to discuss our operating results are Pete Mavoides, our President and CEO; Gregg Seibert, our COO; and Mark Patten, our CFO.
During this conference call, we 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 those forward-looking statements to reflect changes after the statements were made. Factors and risks that could cause actual results to differ materially from expectations are disclosed from time to time in greater detail in the company's filings with the SEC and in yesterday's earnings release.
With that, Pete, please go ahead.
Thank you, Dan, and thank you to everyone who is joining us today for your interest in Essential Properties. The third quarter was another strong quarter for us on all fronts as we saw a continuation of the trends that have been present throughout the year, including strong portfolio performance, a robust and attractive investment environment and supportive capital markets.
In terms of the portfolio, with collections at 100% and only 1 vacant property today, our portfolio has fully stabilized. In fact, over the trailing 12 months ended September 30, we experienced recovery of 87% on all re-leasing activity, which is a strong indicator of the quality of our real estate and our disciplined underwriting. Two, in terms of investments, similar to past quarters, our industry relationships drove the bulk of our growth as over 80% of our investments in the quarter were prior relationships. During the quarter, we invested $231 million into 85 properties at a weighted average cash yield of 7%, with 84% of investments originated through direct sale-leasebacks and 80% containing master lease provisions.
While we expect this high level of investment activity relative to our historical averages to persist into the fourth quarter, our future investment activity levels are likely to moderate for 3 main reasons: one, activity paused during the pandemic demand has largely been recaptured. Two, product from sellers motivated by potential changes in the tax laws should dissipate next year. And three, pandemic induced M&A activity moderates back to more normalized levels. Lastly, in terms of the capital markets, we remain active on the equity issuance front with approximately $103 million of gross ATM issuance during the quarter, which helped lower our leverage sequentially. As such, we continue to have ample capacity to capitalize on our investment pipeline.
Turning to the portfolio, more specifically. We ended the quarter with investments in 1,397 properties that were 99.9% leased to 297 tenants operating in 17 industries. Our weighted average lease term stood at 13.9 years, with 3.8% of our ABR expiring through 2025. Our weighted average unit level coverage ratio was 3.5x, which improved versus last quarter's coverage of 3.2x. While our traditional credit statistics, which focus on an implied credit ratings and unit level coverage, experienced solid sequential improvement this quarter.
These statistics remain negatively skewed for certain industries like movie theaters, early childhood education and health and fitness, which faced continued state level shutdowns and capacity restrictions well into the spring of 2021 in certain areas of the country. However, with most of our tenants reporting to us on a trailing 12-month financial basis with a 1 quarter lag, we expect these statistics continue to experience solid sequential improvement over the next few quarters.
Looking out to the balance of the year. We expect these positive trends to continue, and we are reaffirming our 2021 AFFO per share guidance range of $1.30 to $1.32. In addition, we are establishing our 2022 AFFO per share guidance at a range of $1.46 to $1.50 per share. We continue to believe our strong AFFO growth potential, combined with our well-covered dividend and our commitment to prudently manage our balance sheet and portfolio risks, offers investors a compelling total return opportunity.
With that, I'd like to turn the call over to Gregg, our COO, who will take you through the portfolio and investment activities in greater detail.
Thanks, Pete. During the third quarter, we invested $231 million through 31 separate transactions at a weighted average cash yield of 7%. These investments were made in 12 different industries, with 70% of our activity coming from grocery, auto service, equipment rental and sales, early childhood education and casual dining. The weighted average lease term of our investments this quarter was 16.4 years. The weighted average annual rent escalation was 1.6%, the weighted average unit level coverage was 2.8x, with the average investment per property being $2.7 million.
Consistent with our investment strategy, 84% of our quarterly investments were originated through direct sale-leasebacks, which are subject to our lease form with ongoing financial reporting requirements and 80% contain master lease provisions. Looking forward, we are seeing increased competition from existing and new market participants due to the growing appreciation for the durability of the asset class. As a result, we continue to see cap rate compression as we seek to service and protect our relationships.
From an industry perspective, early childhood education is our largest industry at 14.5% of ABR, closely followed by quick service at 13.2%, car washes at 12.9% and medical dental at 11.7%. We continue to view these 4 business segments as Tier 1 industries for Essential Properties. And therefore, they are likely to remain our highest concentration industries for the foreseeable future. Of note, we continue to selectively invest in proven operators of profitable locations in both the entertainment and casual dining industries, which continue to experience strong rebounds in revenues and profits.
From a tenant concentration perspective, no tenant represented more than 2.7% of our ABR at quarter end, and our top 10 tenants account for just 19% of ABR, which was down 50 basis points versus last quarter. Increased tenant diversity is an important risk mitigation tool and differentiator for us, and it is a direct benefit of our focus on large unrated credits and middle market businesses, which offers a significantly more expansive opportunity set that is strategy concentrated on publicly traded companies and investment rated credits.
In terms of dispositions, we sold 11 properties this quarter for $10.1 million in net proceeds. When excluding transactions cost and properties sold subject to tenant buyback options, we achieved a 6.5% average cash yield on these dispositions. As we have mentioned in the past, owning liquid properties is an important aspect of our investment discipline as it allows us to proactively manage industries, tenants and unit level risk within the portfolio.
With that, I'd like to turn the call over to Mark Patten, our CFO, who will take you through the financials and balance sheet for the third quarter.
Thanks, Gregg, and good morning, everyone. As Pete noted, the third quarter was another strong quarter for us. The notable elements of our reported operating results for the third quarter of 2021 are as follows: our total revenue was up $16.7 million or almost 40% versus same period in 2020, totaling $59.6 million for Q3 2021, which reflects the benefits of a full quarter of our $223 million of investments in Q2 2021, and more broadly, our net investment activity so far this year, which has totaled nearly $600 million. Total G&A was just under $5.6 million in Q3 2021 versus $5.9 million for the same period in 2020, a decrease of 5.4%, which was largely due to a decrease in noncash stock compensation expense.
More importantly, our G&A continues to scale as our cash basis G&A as a percentage of total revenue was just 7.5% for Q3 2021 versus 10.6% for Q3 2020. Net income was $27.6 million in the quarter. Our FFO totaled $43.6 million for the quarter or $0.36 per fully diluted share, a 38% increase over the same period in 2020. Our nominal AFFO totaled $40.2 million for the quarter, up $13.9 million over the same period in 2020, which on a fully diluted per share basis was $0.33. That's an increase of a bit more than 22% versus Q3 2020.
Turning to our balance sheet. The elements I would like to highlight include the following. With another great quarter of investments by our team, our income producing gross assets reached $3.1 million at the quarter end. From an equity perspective, our ATM program generated approximately $101 million of net proceeds during the third quarter. As Pete noted, our balance sheet remains strong with net debt to annualized adjusted EBITDAre at 4.5x at quarter end and total liquidity of $428 million. As a result, our balance sheet and liquidity position continue to provide a strong foundation to support our investment pipeline and our future growth goals.
Lastly, I'll reiterate Pete's important note that our current investment pipeline, our portfolio outlook and our strong performance this quarter provided us with a basis to reaffirm our 2021 AFFO per share guidance and establish our 2022 AFFO per share guidance at a range of $1.46 to $1.50, which implies a 13% year-over-year growth on a midpoint to midpoint basis.
With that, I'll turn the call back over to Pete.
Thanks, Mark. We are encouraged that the operating environment and capital markets have allowed us to capitalize on our robust pipeline of accretive investment opportunities, which are the predominant driver of our earnings growth. More importantly, we believe our disciplined and differentiated investment strategy has created an incredibly resilient net lease portfolio that should continue to generate attractive risk-adjusted returns as we grow into the future.
And with that, operator, let's please open the call for questions.
[Operator Instructions]. Our first question comes from the line of Greg McGinniss with Scotiabank.
Pete, thank you for the color you provided on the acquisition pipeline in your opening remarks. And I appreciate that you're hesitant to provide strict acquisition guidance. But when you speak about the pace of acquisitions maybe moderating, should we take that to mean pre pandemic level is reasonable going forward, so $160 million to $200 million per quarter? Or do you anticipate even greater headwinds in 2022?
No. Listen, I think when we came public in 2018, we thought we had an organizational infrastructure to kind of support $500 million or $125 million in a quarter. That has grown since that time. And I think when we think of moderating, it's more closer to the 8-quarter average looking backwards, kind of I think you're in the right range there.
Okay. And then if I'm not mistaken, I believe the unit level rent coverage this quarter at 3.5x is the best you've ever had in the portfolio. Could you help me understand the drivers of the improvement over the historical levels, obviously, ignoring the pandemic? And then also which categories generally have higher or lower coverage, especially with the top 4 categories that you mentioned?
Yes. Listen, I think that number is a headline number, and I think not a true indicator of what's going on in the portfolio, which is why we try to provide additional disclosure around that in our supplement. But it's a great number. We're happy about it. Certainly, some of the industries that are going to have higher coverage are going to be things like the equipment rental, things like medical, dental and other services, things that are going to have lower coverage are going to be the industries where the business is solely revolved around the real estate. Clearly, the movie theaters in the current environment, quick-serve restaurants should be kind of in that 2, 2 plus range. So there's a wide dispersion of coverage, but we certainly think that headline number is healthy.
Our next question comes from the line of Sheila McGrath with Evercore.
I was wondering, Pete, if you could give us a little bit more detail on the G&A outlook in 2022. What was in your guidance? And do you expect that you're going to have to add more acquisition personnel or just personnel in general?
Yes. I'll start and then kick it to Mark. Obviously, we don't guide to G&A. But Mark can give you some color on the trend there. But we're staffed, Sheila. We're transacting at a very high level, and I think the team is operating really in a great form, and so we don't see a lot of additions in G&A. And I think the team and the hiring is in a good spot as we sit now. But Mark, from a trend perspective, what should they expect?
Yes, Sheila, thanks for that question. First, I'll just mention that sort of the puts and takes in 2021 that gave us some good efficiencies was paying off the ABS was not just a benefit to being 100% unencumbered, 100% unsecured, but it allowed us to kind of get more efficiencies in some of our outsourced expenses. And we also kind of benefited from the world around our controllable expenses that has to do with sort of conferences and the like still were generally virtual. So -- and our travel just generally was moderated. So we got some benefits from that in 2021. But the way I kind of think about it because stock comp is sometimes a variable that you can't peg. But on a cash basis, as a percentage of revenue, if you ran out Q4 '21, at kind of a similar level of where we've been and use that as your kind of percentage of revenue, I think that's a good metric. In 2022, maybe with just a little bit of inflation.
Okay. Great. And then the same-store NOI profile, it was significant for retail and experience. I was just wondering if you could provide some detail what was driving those changes?
Yes. Listen, I think if you think back to a year ago, we had some significant repositionings in the portfolio where sites were taken offline and related to new tenants. And I think that's the noise you're seeing in the same-store sale number, Sheila.
Okay. One last one. Equipment Chair is now your biggest tenant. I was just wondering if you could provide us a little detail on -- about that business, that company.
Yes. They're a growing equipment rental firm with a very differentiated technology platform. We've been doing business with them for a number of years now and have seen them execute on their growth plan very reliably and efficiently and predictably. And so we were happy to continue to partner with them as they continue to kind of grow. And I think there are well over 100 units at this point in time, 100 site locations and have a national footprint. More specifically, we generally like the real estate underlying the equipment rental space. Large yards with good buildings and industrial zonings tend to have great fungibility and appeal to multiple users. So a great company. We're happy to continue to do business with them and really solid underlying real estate fundamentals. I would say at 2.7% of ABR, there's room to grow there. We certainly ideally wouldn't have a tenant over 5%. But we feel comfortable where they're at.
Our next question comes from the line of Nate Crossett with Berenberg.
Just a question on pricing. I mean you noted increased competition. But if you look historically, you guys have kind of been able to stay above that 7% mark. And I know you don't give specific guidance on this measure, but what are you kind of expecting, I guess, going into next year? Is that 7% going to hold? Or how should we be thinking about that, I guess?
Yes. Listen, I think we're facing increased competition. We fight for every basis point. We get -- we specifically focus on an investment strategy that allows us to compete on the strength of our relationships and our reliability as a capital provider in order to get appropriate risk-adjusted returns. The cap rate is really the blend of the 30 transactions that we did in the quarter across 16 industries, and that can vary greatly from a low of a 6% to a high of an 8% or 7.5%. And so if you look back, it's been 7.1%, 7.1%, 7%. Could it dip to 6.9 or thereabouts? Certainly. It really just depends upon the opportunity set that we get in any given quarter.
Okay. That's helpful. And then just a question on, I guess, the other side of the equation. I saw one of your peers did their first preferred offering this quarter. Just curious to get your thoughts on that type of funding source and how you view it? And if you have priced out anything in that market?
We haven't priced out preferred. We think we have a pretty simple and efficient capital structure today. Certainly, getting our inaugural ABS bonds or inaugural unsecured bonds done earlier this year and paying off the secured bonds that we had in the ABS went a long way to funding up that capital structure. I think we have a little ways to go with the rating agencies before the preferred market is truly efficient for us, but it's certainly a market that will keep our finger on the pulse and evaluate over time.
Our next question comes from the line of Haendel St. Juste with Mizuho.
I guess, first one, I just want to follow-up on the competition you noted. I'm curious, any particular subsectors, asset type deal size. You're seeing that most prominent in. I think most folks would have thought you're focusing on smaller deals that provide you some inflation. So I'm curious on what impact -- what level of competition you're seeing and what impact it's having on pricing and where?
Yes. Listen, I think the competition is most acute for larger deals and larger credits. And I think bigger credits with bigger deals get more people excited and they're better able to move the needle, and they get -- it gets more competition. With us transacting $230 million in the quarter and 31 separate transactions, that's, we believe, a differentiator for us. Our ability to do small deals and deliver capital through a sale-leaseback reliably, allows us to compete and get outsized risk-adjusted returns. But the bigger the deal and the bigger the credit, the more competition I think you're going to see.
Appreciate that. Second question is on, I guess, a follow-up on the 2022 guidance. I'm curious what's embedded in there from a maybe a recovery perspective for sector that hasn't quite recovered to pre COVID levels, like, say, childcare, early childhood centers? And any other sectors that you're still inching back towards pre COVID levels and on the other deferral income or recoveries baked in there?
Yes. Listen, as we said in the prepared remarks, we think the portfolio has recovered, and we're collecting 100 cents on the dollar. And while there is some recovery to go yet with the movie theaters and the child care operators and some of the gym operators, those guys are paying us. They're current, and we expect that to continue into 2022. We bake in a normalized credit loss assumption into our model, which is baked upon very specific views of individual situations. But I would say that's more tenant specific and more normalized and not a recovery of COVID sort of analysis.
In terms of our deferrals, essentially, the vast majority of our deferrals are behind us from a recognition perspective, and we're probably halfway through the collection of those deferrals, and we've been collecting substantially all of that spend due to us.
One clarification I could, normalized credit loss. Is that definition or the level of reserve any different versus, say, last year -- well, maybe pre COVID, and any change in the level of reserve you're taking there?
No. I think that normalized is based upon historical experience in this asset class. And what we're seeing in 2022 would have been very similar to what we were seeing or expecting prior to COVID. And to put some color around that, Haendel, as we've said a number of times, we build in roughly 1.6x growth into our lease and the actual growth that we realize over time is offset by a credit loss of somewhere between 25 and 40 basis points.
Our next question comes from the line of Caitlin Burrows with Goldman Sachs.
It looks like leverage was 4.5x as of 3Q, which seems somewhat low. So I was wondering if you could go through your view on expected leverage going forward? And to what extent you'd be comfortable having an increase?
Yes. Listen, our leverage has largely been an output of our desire to derisk our external growth and keep the dry powder on the balance sheet to ensure that we have the ability to execute reliably on our growth plan. And it is varied somewhere between 4% and a little over 5% since coming public, and you shouldn't expect that to change materially going forward and kind of sitting right in that middle of the range kind of feels appropriate now. But it certainly, we don't think about it as a spot estimate, given the pace at which we're deploying capital and the sometimes chunky niche in which we raise capital, it's going to vary, but generally within that range.
Got it. Okay. And then could you also go through maybe some more of the thought process of completing dispositions in the quarter? Obviously, you have a variety of ways to raise capital, but what made you go that route for those properties?
Yes. Listen, as we said, the disposition activity is really largely driven from a risk management perspective, not a generation of capital perspective. So the $10 million in assets we sold during the quarter were really getting at assets that we didn't feel met our long-term investment criteria and most of it is moving those out of the portfolio and freeing up that capital to invest with -- into other assets. So that's generally our view on selling assets.
Our next question comes from the line of Katy McConnell with Citi.
So just going back to the strong growth you saw in same-store rent for experiential tenants in 3Q. Can you touch on the key drivers of that improvement? And with that, any update on how your experiential tenant has been performing?
Yes. Listen, I would say, in terms of theaters, the vast majority of our theaters are -- the 5 or 6 of our theaters to be specific is AMC. And I think everyone, AMC is a public company with a very clear disclosure. And so I think people can get a good sense of what's going on there. As we said, during the pandemic, we think we have good theaters that work for the tenant. And certainly, I think, coming out, we're seeing that in the numbers. In terms of the improvement in the experiential tenant or the experiential sector, as I told, Sheila, that was specifically related to some asset level repositioning. And if you think back a year ago, when we worked through our town sports bankruptcy, those sites would have been offline for a period of time in that -- in the reported period that would have highly impacted that number.
Got it. Okay. And then for your service-based tenants, I'm curious how much of an impact labor shortages are having there? And are there any categories in particular that you're more concerned about within your portfolio today?
We're not going to see that. We're getting the financials to us on a trailing 12 basis. Anecdotally, we're hearing that. But I just point to the fact that coverage is up across the board. And generally, everyone is doing well and certainly, everyone is paying. So it's only anecdotal at this point. We're hearing about labor challenges in the restaurant spaces and the early childhood education space, but we're not seeing it impact our collections at this point in time.
[Operator Instructions]. Our next question comes from the line of Ki Bin Kim with Truist.
So just to follow-up on that previous question. When you talk to your attendance and what is your kind of real-time sense of what is happening to their kind of overall profit scenario given that you're probably getting good top line growth but facing higher cost structures?
Yes. I think you kind of see that in the numbers and the coverage, right? Our rents aren't growing that fast, but our coverages are improving. So as we said, it's anecdotal, and we haven't really dissected the numbers for that. And generally, I think the recovery that we're seeing and the pickups and benefit from recovering from the pandemic is outweighing the headline pressure to margins that labor and other things would create. All that said, that's not a static analysis. And I think as we think out, there's going to be continued pressure to margins and continued both to cost of goods sold as well as labor, and we'll watch that closely. But with coverage of 3.5x in real estate as rent one of the first line items to be paid, really, that's more of an operator risk and landlord risk.
Got it. And so I guess, thus far, have you seen that impact the willingness for some of your tenants to open new stores?
Yes. Yes. Listen, the vast majority of our incremental investment activity is with tenants opening, buying or merging into new stores. And as we've said, it's a heightened level activity, and there's a lot of capital feeding that, and we have not seen any reluctance for our tenants to continue to grow.
I guess last quick one here, talking about the same thing, the cap rate compression environment and competition. On the flip side, I mean you could probably -- it's probably a good time to sell additional assets that might not meet your criteria. As we look forward, is it reasonable to expect a higher level of disposition activity than what we've seen?
Listen, I think generally, we have tried to transact somewhere around 10% of what we bought, and it's somewhere between $10 million and $20 million a quarter. Certainly, where we're trading, that becomes dilutive for us from an -- and so we're really going to sell to mitigate risks. And I would say, if anything, disposition activity is going to moderate in the coming quarters.
Our next question comes from the line of Joshua Dennerlein with Bank of America.
Curious on your comments on the potential tax law changes driving M&A activity. Was there any specific area within where you would look where you're seeing like a lot of extra activity, where it might flow into 2022? Or just kind of curious if there's any more color you guys could provide there?
Yes. I think it's a couple of things. It's -- there's the threat of repeal of 1031 that leads people with investment properties more inclined to sell. I would say that's less of an impact. The bigger impact is potential increase in capital gains and taxes on wealthy pool, motivating people to sell businesses and business investments. So if you're a 4 unit child care operator on the cusp of retirement, and you're going to sell your business in the next 3 to 5 years, the threat attacks change. We really accelerate that. And really, overall, that would result in the heightened M&A activity that we're seeing.
Interesting. Would any of these potential tax law changes or maybe specifically the 1031 is going away impact cap rates at all?
I don't think so. The business seller, the business seller's scenario, that's not really a cap rate play. That's more of a business valuation play, and that's driven by the overall macro capital markets environment. And so I think there's not going to be a direct impact to cap rates there. And as we've said in the past, when we invest in sale-leasebacks, it's generally not a 1031 motivated scenario. It's helping to capitalize the business, and we're not competing on cap rates. When we sell, we'll sell into the 1031 market, but that's not a driver. And to be clear, this is just the threat of changes in tax laws, so that it's not as actionable as when it becomes apparent that something is going to change.
There are no further questions at this time. I'd like to turn the floor over to Pete for closing comments.
Great. Well, thank you all for your attendance today, and thank you for your questions, and we look forward to engaging with everyone in the upcoming Nareit meetings. Have a great day. Thank you.
This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.