Netstreit Corp

NYSE:NTST

Earnings Call Analysis

Strategic Focus on AFFO Growth and Capital Deployment

The company announced a modest upward revision in the AFFO per share guidance to $1.21 to $1.23, representing a 5% year-over-year growth at the midpoint. *add period* Liquidity remained strong at $564.6 million, with a fully hedged term loan interest rate fixed at 4.99%. *add period* Leverage stood at a healthy 4.2x against a target of 4.5 to 5.5x. *add period* Executives highlighted a buyer's market with significantly reduced competition, but cautioned against deploying capital without adequate spread, referencing current low acquisitions in the fourth quarter with plans to reserve liquidity for potential higher cap rates expected in early 2024.

Robust Liquidity and Prudent Leverage Management

The company concluded the quarter with a healthy liquidity position of $564.6 million, supported by various sources including $7.9 million in cash, credit facilities, and term loans. Notably, they managed to secure an all-in fixed rate of 4.99% for their hedged $250 million term loan until January 2029. This positions the company securely for future financial maneuvers. They maintained a net debt to annualized adjusted EBITDA rate of 4.2x, which comfortably sits below their target range of 4.5x to 5.5x, underlining both conservative leverage and financial flexibility.

Dividend Payout and Adjusted Funds From Operations (AFFO)

The Board has declared a steady quarterly cash dividend of $0.205 per share, reflecting a solid AFFO payout ratio of 66% for the third quarter. In terms of profitability guidance, AFFO per share is expected to range between $1.21 to $1.23, slightly increased from the prior $1.20 to $1.23 estimate. This adjustment suggests a 5% growth at the midpoint, marking a positive outlook on financial performance for the investors.

Investment Activity and Yield Prospects

The company is actively capitalizing on market dynamics to enhance yields. They've observed an advantageous spread of about 50 to 100 basis points between disposition and acquisition cap rates. Expectations are set to see investment yields continue to improve, with cap rates moving higher than the 7% achieved in the recent quarter, projecting possibly more than 20 basis points increment in the following period. Their strategy is clear — seek higher yielding investments and optimize their portfolio for growth, which echoes their planned $450 million net investment activity.

Looking Ahead: Financial Growth Expectations

The company has laid out a conservative projection, indicating potential low single-digit AFFO growth for the coming year. They anticipate achieving this through a combination of internal rent growth, credit loss management, and reinvesting free cash flow after dividends. Although the economic environment presents challenges, the company's strategic planning and existing pipeline of investments align them for continued, albeit modest, growth.

Earnings Call Transcript 2023-Q3

[Operator]

Greetings, and welcome to NETSTREIT Corp Third Quarter 2023 Earnings Call. [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Amy An, Director of Investor Relations. Thank you. You may begin.

[Amy An, executive]

Greetings, and welcome. We thank you for joining us for NETSTREIT's third quarter 2023 earnings conference call. In addition to the press release distributed yesterday after market close, we posted a supplemental package and an updated investor presentation. Both can be found in the Investor Relations section of the company's website at www.netstreit.com.

On today's call, management's remarks and answers to your questions may contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements address matters that are subject to risks and uncertainties that may cause actual results to differ from those discussed today.

For more information about these risk factors, we encourage you to review our Form 10-K for the year ended December 31, 2022, and our other SEC filings. All forward-looking statements are made as of the date hereof, and Net Street assumes no obligation to update any forward-looking statements in the future.

In addition, certain financial information presented on this call includes non-GAAP financial measures. Please refer to our earnings release and supplemental package for definitions of our non-GAAP measures, reconciliations to the most comparable GAAP measure and an explanation of why we believe such non-GAAP financial measures are useful to investors.

Today's conference call is hosted by Net Street's Chief Executive Officer, Mark Manheimer; and Chief Financial Officer, Dan Donlan. We will make some prepared remarks, and then we will open the call for your questions. Now I'll turn the call over to Mark.

Mark?

[Mark Manheimer, executive]

Good morning, everyone, and thank you for joining us today for our third quarter conference call. With the recent changes in the capital markets and subsequently the property markets, I want to begin with how NETSTREIT is positioned for what we foresee as an increasingly challenging landscape for the consumer and by extension certain retailers.

We will also discuss, where we see opportunities and how we plan to operate in this environment. The challenges we expect to occur for many retailers center around a consumer that is unlikely to spend at the same level that they have in years past, especially when it comes to purchases by lower income consumers on more discretionary type items.

While a small handful of our tenants have a diversified product mix that includes some exposure to discretionary items that may come under some pressure, the portfolio is built around necessity retailers, off-price value merchants and resilient service providers. We believe this defensive industry focus, coupled with our tenants' strong balance sheets and ready access to capital, position our portfolio to deliver predictable cash flow generation over the long term.

While there may be some headline risk associated with top line performance and gross margin pressures for some of our investment-grade tenants, we do not see these pressures threatening their ability to meet their financial obligations, including paying rent. We continue to be vigilant in monitoring our portfolio and where we have seen risk, we have actively recycled and redeployed capital into less challenged assets at generally higher going-in cash yields.

Turning to credit. Our watch list consists of just one tenant Big Lots, which now represents 1.9% of ABR versus 2.4% last quarter. While we may look to further decrease this exposure over the coming quarters, we do want to highlight the -- that the 9 infill assets that we now own have solid demographics, below market rents and excellent foot traffic.

More specifically, our remaining locations have an average 5-mile population density of over 100,000 people and an average household income of approximately $80,000, which is attractive for most retailers, when looking for expansion markets. Additionally, we believe our average rent per square foot of $6.90 is well below market. Lastly, when using Placer AI to track store-level foot traffic, our Big Lots rank in the top 75 percentile of the entire chain on average.

Again, while we may continue decreasing our closure to Big Lots, we do not believe that there is long-term economic risk to these assets given the positive underlying fundamentals of the real state, which is a testament to how we have underwritten our portfolio since inception. The other area of risk that we see developing across the retail space resides in tenants that have a high exposure to floating rate debt and/or low cost debt that is maturing soon.

Given the financial transparency we received from our tenants each quarter, we are able to quantify our attendance exposure to the aforementioned. Specifically, less than 9% of our tenancy as measured by ABR, has debt coming due between now and year-end 2025, and the majority of this concentration, or 7.5%, is with Walgreens, who has exceptional access to capital.

With that in mind, based on our limited exposure to retailers that are reliant on discretionary spend from low-income consumers, our tenant base having little to no refinance risk over the next few years and only 2.3% of our ABR expiring through 2025 year-end.

We continue to expect our portfolio to generate consistent cash flow as we navigate a potentially choppy macro environment. Turning to the portfolio. As of September 30, we had 547 investments that were leased to 85 tenants that operate within 26 retail industries across 45 states.

The annualized base rent for our portfolio was $124.3 million, 83.3% of which is leased to tenants with investment-grade ratings or investment-grade profiles. Our occupancy remains at 100%, and our weighted average remaining lease term was 9.3 years.

Moving on to external growth. We closed on $117.5 million of investments this quarter at a blended cash yield of 7%. The weighted average lease term remaining on these investments was 10 years and 97.2% of these investments were leased to investment-grade or investment-grade profile tenants.

Turning to quarterly disposition activity and loan payoffs. We divested of 6 properties for gross proceeds of $13.5 million at a blended cash yield of 6.9%, continuing to demonstrate our ability to accretively recycle capital while improving the quality and risk profile of our portfolio. All told, we completed $103.9 million of net investment activity in the third quarter, which brings our year-to-date net investment activity to $327.9 million.

While we are seeing significantly more opportunity for acquisitions in the fourth quarter at higher cap rates than what we have seen in 2023, we are also seeing plenty of opportunities to sell assets at stubbornly low cap rates to trade buyers and thus plan to ramp up our selling efforts to take advantage of the spread. Before I hand the call off to Dan, I want to provide additional commentary on our strategy and expectations as we finish 2023 and head into 2024.

Since our inception and IPO several years ago, we have exercised diligence in creating one of the highest credit quality net lease portfolios in the freestanding retail space by partnering with the strongest retailers in the country. We have had no rent interruptions to date even through a global pandemic and have experienced 0 vacancies.

With the current narrative being dominated by headlines discussing looming recessionary concerns, higher for longer interest rates and rising delinquencies and consumer credit, we believe the underwriting discipline we have exercised, since inception have positioned our portfolio to outperform during a time of heightened macro uncertainty. With that, I'll let Dan go over our third quarter financial results balance sheet and 2023 guidance update.

[Daniel Donlan, executive]

Thank you, Mark, and thank you, everyone, for joining our call today. Turning to our third quarter earnings release yesterday after the market closed, we reported net income of $4.2 million or $0.06 per diluted share.

Core FFO totaled $21.2 million for the quarter or $0.31 per diluted share. AFFO totaled $21.4 million for the quarter or 31% -- $0.31 per diluted share, a 3% increase from the prior year period. Total G&A expense, excluding onetime items, was $5.1 million, which represented 14.9% of total units. This compares favorably to last quarter and the prior year quarter, when G&A as a percentage of revenues was 16% and 18.2%, respectively.

As we look out to next year, our G&A should continue to rationalize relative to our asset base and total revenues as the company has reached the proper scale to effectively operate our business on a go-forward basis.

Moving on to the balance sheet. Total net debt was $567.5 million at quarter end, and our weighted average interest rate was 3.57%. In addition, when including the impact of extension items, which are solely at our discretion, we have no debt maturing until January 2027.

Turning to capital markets activities. We reraised $126 million of equity through our ATM during the quarter, which was primarily completed on a forward basis. As of quarter end, we had $98.7 million of ATM equity that remained unsettled. As previously announced on July 3, we closed a new $250 million senior unsecured term loan with a delayed draw option, which has a fully extended maturity date of January 2029.

The term loan includes an according future that allows the company to increase the total loan amount to $400 million. At closing, we drew $150 million and plan to draw the remaining $100 million in the first quarter of 2024. We fully hedged to $250 million term loan at an all-in fixed rate of 4.99% through January 2029. At quarter end, our liquidity was $564.6 million, which is comprised of $7.9 million of cash on hand; $358 million available on our revolving credit facility; $98.7 million of available forward equity; and the $100 million of remaining available principal on our 2029 term loan.

From a leverage perspective and adjusting for the forward equity, our net debt to annualized adjusted EBITDA rate was 4.2x at quarter end, which remains completely below our long -- the low end of our target leverage range of 4.5 to 5.5x.

Moving to guidance. We are updating our AFFO per share guidance range to $1.21 to $1.23 from $1.20 to $1.23, which impedes year-over-year growth of 5% at the midpoint. On the external growth front, we now expect to close around $450 million of net investment activity.

Lastly, turning to our dividend. On October 24, the Board declared a quarterly cash dividend of $0.205 per share. The dividend will be payable on December 15 to shareholders of record as of December 1. Based on the dividend amount, our AFFO payout ratio for the third quarter was 66%. With that, operator, we will now open the line for questions.

[Operator]

[Operator Instructions] Our first question comes from Todd Thomas with KeyBanc Capital Markets.

[Todd Thomas, analyst]

Mark, first question, you mentioned that you're seeing attractive capital still available as you look at recycling capital. What's the spread look like today between disposition and acquisition cap rates that you're seeing?

[Mark Manheimer, executive]

Yes, sure. So I mean, we're focused on really trying to find the trade buyer in 1031 exchanges, so in kind of one-off type situations. We're selling assets anywhere from, call it, a 5 cap to a 7 cap depending on the lease term and where we think we can redeploy that capital always hesitant to kind of to give a real concrete number on where we're going to go with dispositions just because we're relying on other parties to complete the transaction, and that's out of our control. So the mix could be -- could really swing that one way or the other. But for like-kind types of assets, we think we're picking up anywhere from typically 50 to 100 basis points.

[Todd Thomas, analyst]

Okay. And then it sounds like you're starting to see investment yields improve a little bit on new deals that you're looking at. Can you just describe a little bit more about what you're seeing there in terms of price trends, I guess, sort of vis-a-vis the sort of 2023 cash yields that you've achieved and sort of the 7% in the third quarter?

[Mark Manheimer, executive]

Yes, sure. No, absolutely, we are seeing cap rates move up. And so we -- at one point, we're acquiring assets in kind of the low-6s, and that kind of trended up to mid-6s end of year last year and early this year, up into the high-6s and now at 7 cap in the most recent quarter. We would expect the fourth quarter to be even higher than that. We're certainly not looking to transact really anything in the 6s.

So I would expect to see 20-plus basis points in the fourth quarter. Some of that's really just going to be dragged down by some developments that we had signed up in the past that we're already funding. I think on new transactions that are likely to close more in the first quarter, we are likely to pick up even another 20, 30 basis points beyond that.

[Todd Thomas, analyst]

Okay. And then just last question, I guess. I realize conditions are sort of fluid here, but I was just wondering if you can maybe provide a little bit of insight around how you're thinking about investments and maybe dispositions as well. So net investments really heading into 2024, just given the current environment today?

[Mark Manheimer, executive]

Yes, sure. I mean I think with where we're seeing the acquisition market, while it's getting better, it's really -- I don't think we're getting enough spread to go out in a hand raise equity and deploy capital, where we see it today. We do see opportunities like we mentioned on the disposition and then redeploying through capital recycling and see some pretty attractive opportunities there, but we'd really need to see a material improvement in our stock price or see cap rates really move into the 8s for us to consider turning on the spigot of acquiring assets and raising equity.

[Operator]

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

[Farrell Granath, analyst]

This is Farrell Granath on behalf of Josh. Just a quick question about -- as you had mentioned, the headlines of pharmacy specifically. I was curious about with your current acquisitions, are you seeing a change in competition for the assets that you're going after, kind of like the higher credit quality assets?

[Mark Manheimer, executive]

Yes. I mean I think we've really kind of seen this most of the year in probably even more so today, where the private buyer is more or less gone. The opportunity standpoint has really never been better in my entire career. That being said, the cost of capital is also a challenge. So we need to kind of balance that. But really developers and tenants trying to grow, even sale leasebacks certainly seeing a lot of opportunity there.

It's really gone from a full-blown seller market to a full-blown buyer market. With no bids and it's really in the private market other than the occasional 1031 buyer, which we're trying to take advantage of on the disposition market. And so it's really looking at the overall transaction market is likely down 70%, 80%, but competition is down really 90%, 95%.

[Operator]

Our next question comes from Eric Wolff with Citi.

[Nicholas Joseph, analyst]

Nick Joseph here with Eric. Just back to sourcing of investments. Just kind of curious your thoughts on kind of the rationale of issuing equity in the mid-16s, given kind of NAV -- [indiscernible] NAVs in the '19s and where you've talked about investment spreads and transaction cap rates historically. So just trying to understand the thought process there and kind of the value creation calculation.

[Daniel Donlan, executive]

Yes Nick, it's Dan Donlan. When you think about that price and you include the deminimis net price of that and you think about, where we raised the recent term loan, and then the impact of free cash flow, we got to basically a 100 basis point spread relative to where we saw our pipeline shaping up into the fourth quarter. So that's really kind of we focus on earnings growth. We obviously look at implied cap rate as well. And it was probably marginally dilutive to implied cap rate by 10 basis points or so. So that's the way we looked at it. And it certainly was accretive to our AFFO per share.

[Nicholas Joseph, analyst]

Yes. I guess one of the advantages that you have is that you're smaller and so you can kind of grow off of that base. And so how do you think about a 100 basis point investment spread off of that and kind of taking away some of that advantage versus putting pencils down and waiting for a better opportunity?

[Daniel Donlan, executive]

Yes, sure. I mean, yes, we'd like to get back to more normalized spreads, which I think we've said before is kind of in the 150 to 175 basis point spread. But we feel like 100 basis points is adequate and provide some growth and their scaling into the G&A is also something that we view is helpful.

[Nicholas Joseph, analyst]

And maybe just finally, if you did put pencils down that did no deals kind of going forward or beyond what's in the pipeline today, what would that imply for growth in 2024?

[Mark Manheimer, executive]

Yes. Nick, it would basically imply kind of low single-digit year-over-year AFFO growth. The building blocks of that is internal rent growth of about 1%. Credit losses of around 30 basis points. Reinvestment of our free cash flow after dividends, let's call it, $32 million of free cash flow after dividends.

Obviously, the full year impact of 2023's investments and leverage in and around the midpoint of our range. What I'd say is if we fixed our $175 million 2024 term loan to be push it out to 2027, had we not done that, we probably would be looking at more mid-single-digit AFFO growth year-over-year, but we thought it was prudent, given the environment we were in, in May and June to push out that term loan and swap it to a fixed rate. So we're -- we're glad we did it.

[Operator]

Our next question comes from Greg McGinniss with Scotiabank.

[Greg McGinniss, analyst]

So obviously, it takes time for sellers direct a nice reality and for cap rates to increase. So how are you weighing deploying capital today at these 7, low-7 cap rates versus holding back, potentially collecting some cash interest income and investing in a few quarters once cap rates move higher. Based on our math, long run IRR tends to really appreciate another 25 to 50 basis points of investment yield?

[Mark Manheimer, executive]

Yes, no, sure. And that's a good question. We're really, for the fourth quarter, largely done with the acquisitions. We -- the guidance, I think, the slight tweak there really relates to -- we've got some properties that we're looking at selling and we're relying on other buyers to come through.

So if they don't come through, then that number might be a little bit higher than $450 million. If they all come through, then it might be a little bit less. But that's somewhat out of our control. But yes, and we have some time to deploy the capital from the most recent equity raise, and we do feel like cap rates are likely to be higher early 2024 than where they are today. How much higher they go? Little bit difficult to say, but we certainly want to reserve some dry powder for early next year.

[Greg McGinniss, analyst]

Fair enough. And then year-to-date, you've had $189,000 of earned development interest, which has been offset by the near $700,000 of capitalized interest expense through AFFO. Is it possible for that current AFFO headwind to turn into positive or a tailwind into 2024?

[Daniel Donlan, executive]

Yes. I mean it should continue to grow. That's really the interest we received from developers as we're funding their development. So you should see it start to tick up over time. I don't think of it's ever going to eclipse the capitalized interest.

[Greg McGinniss, analyst]

Were those -- is that part of maybe some of the headwinds on deals that you agreed to perhaps before cost of capital increased this much?

[Daniel Donlan, executive]

Yes. Look, I mean some of the developments that we entered into were in the first and second quarter. And the yields on those are kind of low-7s, high-6s. I would note that they had much longer lease terms than what has historically been achieved with those retailers as well as annual bumps, which has not also been historically recognized as well.

[Greg McGinniss, analyst]

Yes. I can appreciate how you guys were able to change to some of those lease terms that we haven't seen in the past, which definitely is a positive for those. But in thinking about here going forward, have those same retailers been open to further increasing potential yields on those investments?

[Mark Manheimer, executive]

Yes. I mean I think some of the retailers that are really pressed to grow their store count, they really need institutional capital to come in. They can't rely on the 1031 market like they had in the past through their developer network. So hard to say exactly, where all those negotiations go as they're ongoing, but I think if you need institutional capital, most institutions like us, like to have annual increases in the leases. So I would expect that to continue on the margin.

[Operator]

Our next question comes from Haendel St. Juste with Mizuho.

[Ravi Vaidya, analyst]

This is Ravi Vaidya on the line for Haendel. I hope you guys are doing well. During the quarter, you issued equity when the stock was at [ $16.50. ] Can we consider this a watermark as to when you'd consider issuing the equity again?

[Mark Manheimer, executive]

Where you raise equity is highly dependent upon the opportunities that you see. Right now, the opportunities that we see relative to where our cost of equity is, it's -- there's no adequate spread there. So we're not going to ever put a number on where we would raise capital or not raise capital. It's ultimately going to depend upon the opportunity set where that's priced and where we trade relative to that opportunity set.

[Ravi Vaidya, analyst]

Got it. And you ended the quarter with the leverage at 4.2% and inclusive of the forward, what are you willing to let leverage tick up to in order to execute on your capital deployment goals?

[Mark Manheimer, executive]

So our stated leverage range is 4.5x to 5.5x, and I think you should expect us to operate within that range in 2024 and beyond. Obviously, they were -- we're mindful of the range. And I think you'll probably likely see us shade closer to the midpoint of that range if over time.

[Operator]

[Operator Instructions] Our next question comes from Alec Feygin with Baird.

[Alec Feygin, analyst]

Quick question just on dispositions, saw a slight uptick in that. Do you guys plan on continuing to dispose of some properties in the portfolio? And what's the opportunities out there?

[Mark Manheimer, executive]

Yes, we do. I would expect the dispositions to ramp up a little bit here in the fourth quarter and potentially beyond the fourth quarter. We do see a pretty attractive opportunity to not only accretively recycle capital, but also extend that lease terms by placing those assets with longer lease term assets with better rental increases and potentially better properties, and we believe we can do that accretively.

[Operator]

Our next question comes from Linda Tsai with Jefferies.

[Linda Yu Tsai, analyst]

Last quarter, you didn't have any shares outstanding under your forward equity program, but then this quarter, you have about 6 million?

[Mark Manheimer, executive]

Yes. Yes, that's correct.

[Linda Yu Tsai, analyst]

Just wondering what happened during the quarter?

[Mark Manheimer, executive]

Yes. We sold their shares during the quarter through a forward block.

[Linda Yu Tsai, analyst]

Okay. Got it. And then just on big lots. Are there any updates there on -- I know they're on your watch list, but just any overall view on what's happening with them?

[Mark Manheimer, executive]

Yes, sure. I mean obviously, they've had a less than great run over the past several quarters, but they are making some efforts to try to improve their free cash flow, which was neutral last quarter, but that was really driven by cost of their working capital, when you really can't do that for several quarters in a row. So we're really kind of trying to look to see them improve their operations and get the positive EBITDA after CapEx to start to feel better about their tenant health, but we are expecting to see some improvement in the gross margin here in a month, when they announce earnings. So we'll be looking forward to that.

[Operator]

Our next question comes from Ki Bin Kim with Truist Securities.

[Ki Bin Kim, analyst]

If you had to go raise new debt in the bank markets today, what are you getting quoted?

[Mark Manheimer, executive]

We're getting quoted in the mid-5s. But to be frank, we've already -- we have $100 million basically of unsettled equity. We have $100 million that we'd get to draw down on the existing term loan. There really is any need right now to pull down any type of -- to do any incremental long-term debt issuance, if you can even call term loan debt, long-term debt.

[Ki Bin Kim, analyst]

Okay. And in terms on drug stores, if you look at the closure plans that have come out recently, any kind of broader common themes that you're seeing? Or is it just overall coverage? And when you overlay that with your tenant exposures, any kind of impact that you might see longer term?

[Mark Manheimer, executive]

Yes. We don't think we're going to have any impact with the locations that we have. We've got a very good relationship, both with CVS and Walgreens. We do not have any [indiscernible] exposure. And so we talked to them before we're acquiring assets and really get updates as we see news like this and call them up.

And fortunately, they've been very open with us and telling us that the stores that we have are not on any closure list. But yes, as it relates to the ones that they are closing, and some of those are leases that are rolling over where they already have a presence in some of those markets. They've grown through some mergers over the years and really have multiple stores in the same markets, and they feel like they don't really need that number of stores in those markets. And so -- and then there are, obviously, some locations that just don't generate positive cash flow. So those are the ones that they've looked to close.

[Operator]

We have reached the end of our question-and-answer session. I would now like to turn the floor back over to Mark Manheimer for closing comments.

[Mark Manheimer, executive]

Thanks, everybody, for joining us today. We look forward to seeing you in the next few weeks at the conferences and appreciate everybody's time. Thanks.

[Operator]

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.