Essential Properties Realty Trust Inc
NYSE:EPRT
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Essential Properties Realty Trust Inc
Earnings Call Analysis
Q3-2023 Analysis
Essential Properties Realty Trust Inc
Essential Properties Realty Trust (EPRT) showed resilience in the face of market instability, undeterred by broader consumer sector slowdowns. The third quarter of 2023 revealed EPRT's strength with a solid investment activity leading to strong results. The company's disciplined underwriting process allows it to focus on growing operators in stable service and experience-based industries. With 65 new properties acquired through sale-leaseback transactions in the third quarter and an initial cash cap rate of 7.6%, EPRT's capital efficiency outshone the competition. There was a same-store rent growth of 1.2% and a unit level rent coverage that remained a solid 4.0 times, suggesting efficient asset utilization and financial health. Moving forward, EPRT is reinforcing its financial prudence by setting the 2024 AFFO per share guidance at $1.71 to $1.75, targeting a 5% growth from the midpoint of the previous year's projections.
EPRT maintains a robust portfolio, finishing the quarter with 1,793 properties at a startling 99.8% lease rate across 16 diverse industries. Focusing on long-term stability, the weighted average lease term stands at 13.9 years, with only a minor 5% of annual base rent (ABR) expiring up to 2027. The health of EPRT's tenants is steady, as indicated by the unchanged 3.1% of ABR that had a rent coverage ratio below one times from Q2. However, an adverse event involving a gym operator's bankruptcy in Oregon impacted rent growth, albeit marginally, with an industry-wide strong rent coverage of 2.1 times providing reassurance. Investments in Q3 amounted to $213 million over 30 transactions, and the company's proactive management strategy led to the strategic and accretive sale of 10 properties for $28.5 million. This prudent property churn capitalizes on market conditions to optimize industry and tenant mix, underscoring EPRT's commitment to dynamic risk management and continued capital reinvestment.
EPRT's industry composition continues to evolve, with car washes being the largest industry at 15.3% of ABR, slightly reduced from the previous quarter. The forward-looking strategy encompasses expectations of further improvement in investment cap rates, potentially in the high 7% range, demonstrating EPRT's attractive offerings against the limited capital available for middle market businesses. Equipped with substantial retained cash flow, EPRT is poised to grow its AFFO per share by nearly 4% in 2024 without additional external capital, a testament to the company's disciplined financial management. Notably, should the capital market's dynamics prove to be more benign, EPRT might surpass the projected mid-point growth rate forecast.
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Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust Third Quarter 2023 Earnings Conference Call. [Operator Instructions] This conference call is being recorded, and a replay of the call will be available two hours after the completion of the call for the next 2 weeks.[Operator Instructions] Additionally, there will be an audio webcast available on Essential Properties Realty Trust website at www.essentialproperties.com, an archive of which will be available for 90 days.On the call this morning are Pete Mavoides, EPRT's President and Chief Executive Officer; Mark Patten, EPRT's Executive Vice President and Chief Financial Officer; and Rob Salisbury, EPRT's Senior Vice President and Head of Capital Markets.It is now my pleasure to turn the call over to Rob Salisbury. Thank you, sir. You may begin.
Thank you, operator. Good morning, everyone, and thank you for joining us today for the third quarter 2023 earnings conference call for Essential Properties Realty Trust. During this call, we will make certain statements that may be considered forward-looking statements under federal securities law.The company's actual future results may differ significantly 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 press release.With that, I'll turn the call over to Pete.
Thanks, Rob, and thank you to everyone who is joining us today for your interest in Essential Properties. As our third quarter earnings release indicates, we are pleased to report another quarter of strong results, driven by the strength and stability of our portfolio that continues to perform well and was impacted favorably by our solid investment activity. Despite some areas of the broader consumer sector, noting a slowdown in recent months, our growth-oriented middle-market tenants continued to perform well as reflected by our unit level rent coverage that remained strong at 4.0x. Our same-store rent growth, which remained favorable at 1.2% and just three vacant properties.The overall health of our portfolio is a testament to our disciplined underwriting process, which focuses on growing operators and durable service and experience-based industries and owning granular and fungible properties that generate strong cash flow for these operators. Our tenants provide a strong value proposition to their customers with generally low average tickets that do not rely on consumer financing and therefore, do not experience demand headwinds from a rising rate environment.In the third quarter, we acquired 65 properties in 30 separate transactions that were 100% sale-leaseback transactions with 86% of those opportunities generated from existing relationships. Our third quarter investments reflect an improving pricing environment for our business with initial cash cap rate of 7.6% and an average annual rent escalation in those leases of 2% and a weighted average lease term of 17.6 years, which results in an average GAAP yield over the primary lease term of 8.7%.With limited active competitors in the middle-market sale-leaseback arena today and higher base rates driving up the cost of private credit alternatives for these operators, we expect the favorable cap rate environment to persist in the near term.Our balance sheet remains in great shape, as Mark will discuss shortly as we remain committed to maintaining a conservative leverage profile and strong liquidity position.We are establishing our 2024 AFFO per share guidance at $1.71 to $1.75, which implies a 5% growth rate, midpoint to midpoint. Our guidance for 2024 reflects continued healthy portfolio performance and an improving pricing on new investments, tempered by an expectation of a higher cost of capital and a generally volatile capital markets backdrop continuing in the near term. Importantly, I am pleased to note that supported by our conservative leverage profile and our low dividend payout ratio, the company is nearly $100 million of forecasted retained free cash flow can be accretively deployed into our investment pipeline without any additional reliance on the capital markets.Combining the reinvestment of our retained cash flow, our strong capital deployment year-to-date and our healthy rent escalators, net of tenant credit assumptions, we estimate our AFFO per share can grow nearly 4% in 2024 without requiring any additional external capital. Notably, favorable developments in the capital markets could provide the opportunity to achieve a higher growth rate than what is implied at our midpoint of guidance.Turning to the portfolio. We ended the quarter with 1,793 properties in our portfolio that were 99.8% leased to 363 tenants operating in 16 industries. Our weighted average lease term stood at 13.9 years, with only 5% of our ABR expiring through 2027. From a tenant health perspective, our unit-level rent coverage ratio at quarter end was 4.0x, and the percentage of our ABR that had a less than 1x rent coverage level remained consistent from the second quarter of 2023, totaling just 3.1% at quarter's end.As I noted, our same-store rent growth remained favorable at 1.2%, although that represents a 30 basis point decrease from last quarter.Our rent growth in the third quarter was impacted by a 30 basis point headwind from the bankruptcy of a gym operator in Oregon. Like many other businesses in Oregon, this particular operator experienced significant operating challenges due to the longer imposition of pandemic operating restrictions in Oregon, which was somewhat unique in the context of our broader portfolio of health and fitness properties.Specifically, we did not collect rents on two properties operated by this tenant, which totaled only $8 million of net book value. We expect to find a replacement tenant and recoup a meaningful amount of the economics. We view this as a tenant-specific event given that our portfolio of health and fitness properties continues to perform well as evidenced by industry unit level rent coverage of 2.1x.Regarding our third quarter investments, we invested $213 million in 30 separate transactions and properties representing 12 of our 16 targeted industries. In the quarter, 100% of our investments were originated through direct sale-leaseback transactions completed on our lease form with ongoing financial reporting requirements.In addition, 60% of our investments were in a master lease structure. The weighted average unit level rent coverage of the tenants at these properties was 3.3x, and our average investment per property was $2.8 million. Looking ahead to the fourth quarter, we remain active and our pipeline should support investment levels relatively consistent with our recent activity with the potential for further improvement in initial cash cap rates as our capital is becoming increasingly attractive against the capital-constrained backdrop for middle market businesses today.Specifically, we expect initial investment cap rates in the high 7% range with strong underlying lease terms. Looking at our portfolio industry breakdown at quarter end, carwashes remained our largest industry at 15.3% of ABR, which is down 30 basis points from last quarter.Our next largest industries were early childhood education, medical/dental and quick service restaurants. Our largest tenant, equipment share, represented 3.3% of ABR at quarter end. And our top-10 tenants continue to demonstrate the diversity in our portfolio, accounting for just 17.8% of our ABR. As we've consistently stated, portfolio diversity is an important risk mitigation tool for us and a product of our differentiated investment strategy, a direct benefit of our focus on noncredit rated tenants and middle market operators, which offers an expansive opportunity set and, in our view, generate superior risk-adjusted returns.In terms of dispositions, we sold 10 properties this quarter for $28.5 million in net proceeds at a weighted average cash yield of 6.5%. The weighted average unit level rent coverage for the properties we sold were 3.6x. Owning fungible and liquid properties and capitalizing on that liquidity is an important aspect of our investment discipline, and it allows us to proactively manage our industry, tenant and unit level risks within our portfolio.Heading into the fourth quarter, we expect to selectively take advantage of favorable market pricing to accretively recycle capital away from identifiable risks, reduce our industry concentrations and importantly, support our tenant relationships.With that, I'd like to turn the call over to Mark, who will take you through the operating results and balance sheet for the third quarter and discuss our capital markets activities.
Thanks, Pete. Echoing Pete's remarks, the third quarter of 2023 was certainly a strong quarter for us, evidenced by our reported results last night and represented by an increase in our guidance for 2023 AFFO per share to a range of $1.64 to $1.65. The performance of our portfolio and our investment results for the quarter continue to reflect the high quality of our tenancy, our favorable capital market transactions, consistent internal rent growth and the benefits of our differentiated investment platform.As I'll cover in a moment, our consistently conservative balance sheet and strong liquidity position continue to support our aspirations for external growth in 2023 and beyond. Among the headlines last night was our AFFO per share for the third quarter, which on a fully diluted per share basis was $0.42, an increase of 11% versus Q3 of 2022.On a nominal basis, our AFFO totaled $66.3 million for the third quarter of 2023, up $12.8 million over the same period in 2022. That's an increase of 24% and up over 7% compared to the preceding second quarter of 2023. We also reported core FFO per share on a fully diluted per share basis of $0.45 for the third quarter, an increase of 18% versus Q3 of 2022.Total G&A was approximately $7.2 million in Q3 2023, while cash G&A totaled $5 million in the third quarter. Importantly, our cash basis G&A as a percentage of total revenue decreased to 5.5% in the third quarter, which further supports our expectation that our G&A growth rate will be outpaced by the growth in our assets and earnings as our platform generates operating leverage through the benefits of scale.Turning to our balance sheet. I'll first highlight the following. With our $185 million of net investments in the third quarter, our income-producing gross assets reached nearly $4.6 billion at quarter end. From a capital markets perspective, we had an excellent quarter. Firstly, on the personnel front, we're pleased and fortunate to have hired Rob Salisbury as our Head of Capital Markets.Rob brings an extensive real estate finance and investing background, including experience on top-ranked equity research teams, large buy-side equity and credit securities platforms and most recently as a senior leader at a leading real estate private equity firm. We're excited to have Rob help us continue to build long-term value for our shareholders.On the equity side, we successfully executed an overnight follow-on offering in September that we were able to upsize by 20%, pricing approximately 12 million shares at $23 per share and generating approximately $276 million of gross proceeds.Similar to our February 2023 offering, this transaction was completed 100% on a forward sale basis, which affords us the flexibility to draw down the capital on an as-needed basis. On the ATM program this quarter, we settled approximately 836,000 shares in July for proceeds of $20 million, and we sold an additional $11 million during the quarter, which remains unsettled as of quarter end.On the debt side, we closed on the previously announced $450 million delayed draw term loan in August. We are very appreciative of the continued support of our entire bank group, all of whom participated in this execution. We utilized $200 million at closing to retire the 2024 term loan, which was our only near-term debt maturity set to expire in April of next year. Assuming we exercise the extension options available to us, the $450 million term loan would mature in February of 2029.At quarter end, we had $375 million drawn on the term loan, and we subsequently drew the remaining $75 million in October. Consistent with our interest rate hedging program, we fully swapped 100% of the amounts drawn for the fully extended term of the debt commitment at a weighted average fixed rate of 5.4%. As we noted on our last earnings call, we retained the favorable swap on the $200 million linked to the 2024 term loan that we repay, which currently has an effective fixed rate of just under 3%.Subsequent to quarter end, we executed new forward starting swaps to extend the $200 million hedge through the remaining term of the 2029 term loan, which will go into effect in April of 2024 at an all-in fixed rate of approximately 5.5%. We have incorporated this within our 2024 guidance.Regarding our debt maturities, utilizing all the extension options in the new term loan, would, as I mentioned, result in a maturity date in 2029, which would result in us having no debt maturities until 2027.From a leverage perspective, our net debt to annualized adjusted EBITDAre was 4.5x at quarter end. When factoring in the net proceeds that we generate by settling the $273 million of equity we issued on a forward basis in the quarter, our leverage at quarter end would equal 3.7x. Our total liquidity at the end of the third quarter totaled approximately $989.6 million, up $356 million from $634 million last quarter. Again, our conservative leverage, strong balance sheet and significant liquidity position continues to be supportive of our current investment pipeline and sufficient to fund our external growth plans for the remainder of the year.With that, I'll turn the call back over to Pete.
Thanks, Mark. Operator, please open the call for questions.
[Operator Instructions] The first question comes from the line of Haendel St. Juste with Mizuho.
This is Ravi Vaidya on the line for Haendel. I hope you guys are doing well. I just wanted to touch a bit on the '24 guide. What gives you the confidence to provide '24 guide in the current environment? I know you guys have a strong liquidity position, your balance sheet is in good shape. But how are you thinking about volume and spreads going forward, especially when we're expecting slower volumes and shifting capital costs?
Listen, we run a very predictable business. We have a very stable portfolio of long-dated leases that provide us a great operating base. We also generate significant free cash flow to invest. And we have a large amount of well-priced capital available to us. It's on our balance sheet. And so given the factors that our business is so predictable, and we have largely baked in our capital needs and the cost of those that capital for 2024, we felt it was appropriate and timely broad guidance.
And if you just assume a worst-case scenario and transaction markets are completely shut down, how much do you think you can grow FFO next year?
Mark, why don't you take that?
How much we can grow AFFO next year at a baseline? Yes, the way I'd answer that is if you take a look at what you might refer to kind of doing nothing else other than kind of the run rate activity in the fourth quarter, which is really going to have the most significant impact on 2024. So what we do in the fourth quarter of '23 is going to be the biggest component. Our embedded rent bumps would be the secondary element and then obviously, redeploying our retained capital, which Pete mentioned is nearing $100 million, which is a pretty significant milestone for us. So those three components and really just the other things you built into like the headwinds around our swap that we've got forward starting, you'd probably be just under 4% growth.
I would add, we see a great market to invest, and we've been driving cap rates up, and we are actively engaged with our relationships to deploy capital at accretive spreads. So by no means sitting on our hands and not taking advantage of the dislocation in the capital markets on the contrary, we see a great opportunity for us to put capital to work at accretive spreads.
The next question comes from the line of Eric Wolfe with Citi.
It's actually Nick Joseph here with Eric. Maybe just following up on that in terms of 2024 guidance assumptions. What's the investment spread assumption embedded there? What are you thinking in terms of cap rates to get to the midpoint of 2024 guidance?
Listen, one, as we generally do, we kind of punted on the specifics of that question and that there's a wide range of assumptions supporting guidance. Generally, what we're seeing today is investment cap rates in the high7s. And we assume that, that persists in our ability to put capital to work at that level persist through at least the first half of 2024. And as I said earlier, a large part of the capital that we're putting to work is already priced in the form of the term loan that we did and that we swapped, and we get the rates on that and the forward equity that's already priced in. And so I think you can do the math on those components, but that's kind of how we're thinking about it.
That's helpful. And then just going back, you mentioned kind of the desirability of sale leasebacks on some of these middle-market tenants. Can you talk about those conversations that are going on today, how they're thinking about doing those deals versus other capital sources that you may be looking at?
Yes. And this has been an evolving and improving theme for us over the last couple of quarters, but the bank market is one, costly and two, challenging to access. And so when you think about SOFR plus 4, 5, 6, you're talking about rates that are wide of what we're getting deals on a 20-year basis today, if you can even get that. And then you look at the unsecured sub-investment-grade market that's even wider. And so these middle market operators are struggling with capital alternatives and largely focused on long-term permanent capital against the real estate with equity from the owners to capitalize new investments and grow their businesses.
The next question comes from the line of Greg McGinniss with Scotiabank.
This is actually Elmer Chang on with Greg. So you've grown exposure to the carwash industry from 10% of ABR to 15% in the last 5 years, primarily due to, as you talked about the cash flow stability and growing credit quality they provide. With having to be more selective on these types of deals in recent quarters, what other types of businesses do you see you going with in the portfolio in the near term that offer similar attributes, but maybe don't require you to have to be as selective?
I would say our investment discipline is designed to be very selective and source an opportunity set that allows us to be selective amongst the mix of transactions that we're seeing. When you run a business that is focused on prior relationships and relying on those prior relationships such that 80% to 90% of your business is coming from those relationships, your incremental investment activity is going to look a whole lot like your portfolio. Generally, what we tell people is to expect our portfolio to grow ratably, which means we'll continue to invest in car washes, and that will be in that kind of 12% to 15% range.We'll continue to invest in early childhood education. That will be in that 12% to 15% range. Quick-serve restaurants, automotive service, casual dining. All these are industries with inherent real estate characteristics that we like. And as a result, we conduct our sourcing activity and have relationships to generate opportunities out of those industries.
And maybe if I can touch on your watch list. It seems it improved incrementally during the quarter or at least was stable. As you look ahead to next year, could you give us a sense of which tenants or industries you believe would be most impacted if there's a weaker consumer?
Not a lot of our industries are consumer discretionary by design. What we see and we've seen this through a number of cycles now as these industries tend to perform pretty stable through consumer stress. And I would say really the only area, and we usually see it the hardest and fastest is in casual dining, but it's never really that deep, but we would expect the portfolio to perform stable through a period of consumer distress.
The next question comes from the line of Sanket Agrawal with Evercore ISI.
I just wanted to understand, like, get some color around early childhood education exposure in the portfolio? Like how many different tenants represent that? And then what is the average ABR exposure there and then funding trends you're seeing from the PE side in that particular sector and also any particular credit issues percolating in that sector?
Generally, we currently own about 186 early childhood education centers. You can see in the quarter that Busy Bees came into our top 10. Actually, Busy Bees is the local brand. What's the name of the BrightPath Kids is the corporate, which is a large operator that purchased a smaller operator that we had already done a sale-leaseback with. Generally, we see good trends in that sector with improving coverage and PE continues to roll up a lot of the smaller localized and regional operators such that we see improving credit trends in our investments.
The next question comes from the line of Ki Bin Kim with Truist Securities.
When you talk about higher yields that you expect going into 2024, I was just curious if you're noticing that in a broad spectrum or is it more concentrated to a couple of key industries?
No. I think our ability to drive pricing is more a factor of the dislocation in the broad capital markets that is affecting all our industries equally. And so it's really across the board of our opportunity set.
And in terms of your 2024 guidance, what are you assuming for credit losses? I think in the past, you said 25 to 40 basis points is normal for the portfolio. Just curious how 2024 compares to that?
Yes. What we have said is that 25 to 40 basis points is a kind of historical loss experienced. Generally, when we build the guide, particularly this far in advance and in the market backdrop that we're seeing, we're a little bit more conservative than that as we go through and take a real deep dive into our individual exposures and tenants and what may happen there. So you can assume baked in the guide is a range of scenarios, that's probably a little wider than that. But historically, the tailwinds to our guidance throughout the year is the lack of manifestation of those losses.
[Operator Instructions] The next question comes from the line of Connor Siversky with Wells Fargo.
Susan for Connor this morning. In the context of weakening consumer metrics, how should we be thinking about tenant credit specifically here. So EPRT's portfolio exhibited resiliency during the COVID environment. How can we feel comfortable they expect the same kind of performance if consumer spending drops off?
It's hard to imagine a scenario where you see a larger drop-off in consumer spending than we saw during COVID. And if you start with the premise that the portfolio performed well through that period of time. I think you should assume that it should continue to perform going forward. I would say we are ultimately landlords to these businesses, and we are owning the cash flow assets that comprise these businesses and ultimately, a weakening consumer is going to have impact on the equity values of these companies but not the obligations to the landlords. And I think we very deliberately invest in a very specific set of industries and an investor can easily take a look at the sectors that we're in and understand that many of them are not really discretionary or subject to a weakening consumer.
I appreciate the color. Just a quick follow-up. If you had to choose one area, where do you think the highest risk to consumer behavior is within your portfolio?
Yes. As I said, the casual dining tends to get hit the earliest and hardest when you see a recession as consumers eat out less and will trade down to QSR options. That would probably be the biggest hit. That said, we have great coverage in that space and good assets such that I would not expect to have any material credit losses.
And the next question comes from the line of Josh Dennerlein with Bank of America.
This is Farrell Granite on behalf of Josh. I want to touch on again for 2024 capital sourcing, kind of with the assumption if acquisitions are expected to stay largely in line with historic trends. What is your maybe strategy and plans for capital sourcing and perhaps thought process on prefunding going into '24?
Yes. I mean capital sourcing, I think what we started with was really the bottom end of our range is utilizing the liquidity that we have available to us now. Otherwise, sourcing, as you move through kind of a range, the capital sourcing is, number one, the availability on our revolver. And that's really probably the biggest component of anything that we do relative to the 2024 guide.
And I would add, given our unsettled forwards, the term loan and the capacity that we have built into the balance sheet, we have almost $800 million to $1 billion of investable capital without exceeding our leverage targets.
The next question comes from the line of Spenser Allaway with Green Street Advisors.
Thank you, guys, for all the great color on '24 guidance. Maybe just one more as it relates to that. Can you just talk about how far acquisition spreads could compress before you ultimately decided to perhaps pump the brakes or just not grow next year?
I'd stop short of putting a hard number on that. We take a forward look. We expect markets to improve. I would more say you're unlikely to see us, it'd more come down to managing our balance sheet such that leverage gets out of whack, and we get into a spot where we're uncomfortable relative to the balance sheet and our ability to access capital. And historically, our behavior around leverage is pretty predictable. You've seen us crest 5% or 5x net debt to EBITDAre a couple of times. I think I would look at it that way, Spenser.
And I think, Spencer, the other thing I might mention is just depending on where you land on a weighted average cost of capital for us. Our net spread today is in a pretty good spot, and we grew incredibly favorable and underpinning compression in cap rates would probably be a market backdrop that would make our weighted average cost of capital to get favorable. I think that means our spreads stay constructive.
And then can you just remind us if you currently have a share buyback program in place? And if we did enter an environment where external growth was off the table, should that be expected to be like a use of capital?
We do not. We have not put one in place. And listen, I think if we got to that point, and we thought the best thing for shareholders was for us to invest in our shares, then the Board would consider that, but we do not have one in place as we sit today.
There are no further questions at this time. I'd now like to turn the floor back over to Pete Mavoides for any closing comments.
Well, I'd like to congratulate the team on a great quarter. As we said, we're pretty optimistic about what we're seeing going forward, and we're happy to have our 2024 guidance out there, and we look forward to meeting everyone in coming weeks at the conference schedules. Thank you, and have a great day.
This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.