Essential Properties Realty Trust - Q2 2023
July 27, 2023
Transcript
Operator (participant)
Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust's second quarter 2023 earnings conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. If anyone should require operator assistance, please press star zero on your telephone keypad. 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 two 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 Essential Properties Realty Trust's 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, and Mark Patten, EPRT's Executive Vice President and Chief Financial Officer.
It's now my pleasure to turn the call over to Mark Patten.
Mark Patten (EVP and CFO)
Thank you, operator. Good morning, everyone, and thank you for joining us today for the second quarter of 2023 earnings conference call of 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.
Pete Mavoides (President and CEO)
Thanks, Mark, and thank you to everyone who is joining us today for your interest in EPRT. As our second 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 exceptionally well and impacted favorably by our strong investment activity. Our tenants continue to perform at a high level, as reflected by our unit-level rent coverage that increased to 4.1x. Our same-store rent growth, which remained favorable at 1.5%, and just two vacant properties. The overall health of our portfolio is a testament to our disciplined underwriting process, the quality of our operators, and the resiliency of our service-oriented and experience-based businesses.
In the second quarter, we acquired 78 properties in 29 separate transactions that were 99% sale-leaseback transactions, with 66% of those opportunities generated from existing relationships. The initial cap rate on our second quarter investments was 7.4%, and the average annual escalation in those leases was 1.9% on 19.3 years of weighted average lease term, which results in an average yield over the primary lease term of 8.7%. Our balance sheet remains conservatively positioned, and our liquidity remains strong, with quarter-end leverage of 4.3x and pro forma leverage of 4.2x when taking into account our unsettled forward equity and liquidity of approximately $634 million. As we've said, we are committed to maintaining a conservative balance sheet.
Based on our second quarter results, the visibility of our third quarter investment pipeline, and our anticipated capital markets activity, we have increased our guidance for 2023 AFFO per share to a range of $1.62-$1.65. Turning to the portfolio. We ended the quarter with 1,742 properties in our portfolio that were 99.9% leased to 360 tenants operating in 16 industries. Our weighted average lease term stood at 14 years, with only 5.2% of our ABR expiring through 2027.
From a tenant health perspective, our unit-level rent coverage ratio at quarter end was 4.1x, the percentage of our ABR that had less than 1x rent coverage level remained relatively consistent this quarter of 2023, totaling just 3.1% at quarter end. Regarding our second quarter investments, we invested $277 million in 29 separate transactions in properties representing 12 of our 16 targeted industries, with approximately 77% of those investments in properties operated in the car wash, equipment rental, casual-dining restaurants, grocery, entertainment, and medical industries. The weighted average lease term of our investments this quarter was 19.3 years, as I mentioned earlier, the weighted average annual rent escalation remained strong at 1.9%.
The weighted average unit-level rent coverage of tenants at these properties was 3.9x, and our average investment per property was $3.4 million. In the quarter, 99% of our investments were originated through direct sale-leaseback transactions completed on our lease form with ongoing financial reporting requirements. In addition, 57% of our investments were in a master lease structure. Looking ahead to the third quarter, we remain active and our pipeline should support investment levels relatively consistent with our recent activity. From an industry perspective, at quarter end, car washes was our largest industry at 15.6% of ABR, followed by early childhood education at 12%, quick-service restaurants at 10.8%, and medical-dental office at 10.6%.
From a diversity perspective, our largest tenant, EquipmentShare, represented 3.6% of ABR at quarter end, and our top 10 tenants continue to demonstrate the diversity in our portfolio, accounting for 17.5% of ABR. As we've consistently stated, tenant diversity is an important risk mitigation tool for us and a product of our differentiated investment strategy, a direct benefit of our focus on non-credit-rated tenants and middle-market operators, which offers an expansive opportunity sets, and in our view, generates superior risk-adjusted returns. In terms of dispositions, we sold 16 properties this quarter for $41.7 million in net proceeds at a weighted average cash yield of 6.2%. The weighted average unit-level rent coverage ratio for the properties we sold was 2.2x.
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 industries, tenants, and unit-level risks within our portfolio. For the remainder of 2023, we expect our level of quarterly investments to align with our eight-quarter average as we 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 our operating results and the balance sheet for the second quarter and discuss our capital markets activity. Mark?
Mark Patten (EVP and CFO)
Thanks, Pete. Echoing Pete's remarks, the second quarter of 2023 was certainly a strong quarter for us, evidenced by our reported results last night and represented by our increase in the top and bottom end of our guidance range for AFFO per share for the full year of 2023. Performance of our portfolio and our investment results for the quarter continue to reflect the high quality of our tenancy, consistent internal rent growth, and 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. Among the headlines last night was our AFFO per share for the second quarter, which on a fully diluted per share basis, was $0.41. That's an increase of 8% versus Q2 of 2022.
On a nominal basis, our AFFO totaled $61.9 million for the second quarter of 2023. That's up $11.3 million over the same period in 2022, an increase of 22%, and up over 6% compared to the preceding first quarter of 2023. We also reported Core FFO per share on a fully diluted per share basis of $0.44 for the second quarter, an increase of 7% versus Q2 of 2022. Total G&A was approximately $7.6 million in Q2 2023, while recurring cash G&A, excluding approximately $360,000 of costs associated with the departure of one of our junior executives, totaled $5.3 million in Q2 2023.
We adjusted our Core FFO by approximately $172,000, which reflects the impact of this nonrecurring expense, net of the impact of stock compensation forfeitures. Importantly, our recurring cash basis G&A, as a percentage of total revenue, decreased to 6.1% in Q2 2023. We continue to have the expectation that our recurring cash G&A, as a percentage of total revenue, will continue to rationalize quarterly and on a full year basis. Turning to our balance sheet, I'll highlight the following. With our $236 million of net investments in 2Q 2023, our income-producing gross assets reached nearly $4.5 billion at quarter end. From a capital markets perspective, we had a solid quarter from an equity perspective.
In mid-May, we settled the second half of our forward equity that we issued through an overnight offering in February of this year. That generated approximately $104.5 million in net proceeds. We also generated approximately $66 million of gross proceeds in the latter part of the second quarter from our ATM program. That was all on a forward basis. We settled approximately $45 million of those ATM sales prior to the close of the quarter. Turning to leverage, I'd like to first announce that we have received commitments from our bank group for an unsecured $450 million term loan, with a tenor, including extension options of five and a half years.
The new term loan will have a six-month delayed draw feature. At closing, $200 million will be utilized to retire our $200 million term loan that's due to mature in April of 2024. Although the 2024 term loan will be paid off, we will retain the favorable swaps we have on that term loan through April of next year. As part of executing the new term loan, we are estimating that the impact of potential swaps on each of the draws and the April 2024 swap extension will be at a fixed rate ranging between 4.5%-5%. We intend to close the new term loan in the third quarter of this year, although let me note that closing of the new term loan is subject to customary closing conditions.
We're very appreciative of the continued support of our bank group, and very pleased to have the opportunity to address a near-term debt maturity and further bolster our balance sheet with attractively priced debt capital, which not only provides us with dry powder to address our near-term investment opportunities, but also favorably impacts the interest costs we estimated for the remainder of 2023. Regarding our debt maturities, utilizing all the extension options in the new term loan would result in a maturity date in 2029, which would result in us having no debt maturities until 2026. Specifically regarding the second quarter 2023 results, our net debt to Annualized Adjusted EBITDAre was 4.3 times at quarter end.
When factoring in the proceeds that we'll generate by physically settling the remaining $20 million of the equity we issued on a forward basis in the second quarter that we have not yet settled, our leverage at quarter end would equal 4.2x. Our total liquidity at the end of Q2 2023 totaled approximately $634 million. 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 2023.
Lastly, as our release indicated and Pete mentioned, we raised our AFFO per share guidance range for the full year of 2023 to $1.62-$1.65 per share, which reflects not only our 2Q investment performance, our visibility into our investment pipeline, and our performance expectations for the core portfolio, but importantly, the strength of our middle-market tenancy, which experienced no material credit losses in the first half of the year. The midpoint of our increased guidance range implies a year-over-year growth rate of nearly 7%. With that, I'll turn the call back over to Pete.
Pete Mavoides (President and CEO)
Thanks, Mark. In our view, the current landscape for investing remains very positive, as operators seeking to grow their businesses face the challenges of a constrained capital markets environment, which leads them to seek long-term capital by executing sale-leaseback transactions on the real estate. The challenging market environment, particularly the availability and pricing of debt capital, has curtailed the number of market participants that can fill the demand of these operators. We're excited about the opportunities we see to invest in the second half of the year. Operator, please open the call for questions.
Operator (participant)
Thank you. Ladies and gentlemen, if you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we pull for questions. Our first question comes from the line of Spenser Allaway with Green Street Advisors. Please proceed.
Spenser Allaway (Senior Analyst)
Thank you. I was just wondering if you guys could provide some commentary just on any cap rate trends you might have observed across the different industries in the second quarter.
Pete Mavoides (President and CEO)
I would say in general, cap rates were pretty static across the second quarter. Obviously, our the cap rate on our investments was down 20 basis points, which is really a mix of a result of the industry mix. You know, we did a number of restaurants and grocery deals that tend to trade at the tighter end of the cap rate range that we invest that brought that down. Generally, the market's pretty stable, and I would expect cap rates to kind of be in that mid-seven range in the back half of the year.
Spenser Allaway (Senior Analyst)
Okay. I mean, you kind of just alluded to what you're kind of expecting for the back half of the year, but can you just provide any color on what you've observed thus far in 3Q in terms of cap rates? Is it kind of static as you saw through the second quarter, or any color there?
Pete Mavoides (President and CEO)
Yeah, it's static to slightly up. Our 3Q pipeline is currently a little higher than what we posted in the second Q, second quarter, but obviously, that can change depending upon what actually closes and future deals that come in. Overall, it's a pretty healthy investing market, and it's pretty stable. We haven't seen, you know, pricing pressures, creep in and driving cap rates down. It's been pretty consistent, you know, kind of throughout the year.
Spenser Allaway (Senior Analyst)
Okay. Thank you very much.
Pete Mavoides (President and CEO)
Thank you, Spenser.
Operator (participant)
Our next question comes from the line of Josh Dennerlein with Bank of America. Please proceed.
Josh Dennerlein (Senior Equity Research Analyst)
Yeah. Hey, guys. Thanks for the time. Maybe a big-picture question for you. Just kind of curious what your conversations like have been with tenants and kind of how they're feeling about their expansion opportunities, just maybe any pain points they're seeing. Just kind of curious what you're hearing?
Pete Mavoides (President and CEO)
Yeah, you know, listen, I would say, overall transaction volumes are down, you know, as the capital markets and the availability of capital has, you know, somewhat constrained. That said, the guys who are transacting are finding good opportunities and, you know, leaning on relationships and their partners to continue to grow. You know, really driving the underlying desire to grow is, you know, stable operations, and I think you see that, rippling through the portfolio's performance and, you know, lack of credit issues. Overall, the operators are feeling good about their prospects. You know, there's always sort of, you know, transitional companies and growth aggregators that are driving investment volumes, and, you know, it feels pretty healthy.
Josh Dennerlein (Senior Equity Research Analyst)
... appreciate that. Any particular segment that's more active in expansion mode?
Pete Mavoides (President and CEO)
Yeah, I mean, you know, in the quarter, we invested in, you know, I think 12 of our 16 industries, so we're really seeing investments across the spectrum. You know, in the quarter, about a third of our opportunities were in the car wash space, and you'll see that our car wash industry concentration has grown. I would say there's a lot of consolidation and a lot of opportunities coming from that in the car wash space. You know, we certainly have seen that over the last, you know, kind of three, four quarters. The childcare space remains pretty robust for us with opportunities. You know, certainly the restaurant space is a little more mature from that perspective.
Overall, I would expect our portfolio to grow ratably.
Josh Dennerlein (Senior Equity Research Analyst)
Thank you.
Pete Mavoides (President and CEO)
You got it, Josh. Thank you.
Mark Patten (EVP and CFO)
Thanks.
Operator (participant)
Our next question comes from the line of Greg McGinniss with Scotiabank. Please proceed.
Elmer Chang (Equity Research Associate)
Hi, thanks for the question. This is Elmer Ismaili on with Greg. You touched on this in your remarks earlier a little bit, how is buyer competition for the smaller asset size that you're acquiring at $3 million-$5 million regarding private cash and leveraged buyers and cost of debt retracting slightly, but still elevated and regional banking turmoil subsiding? How has that changed in year-to-date acquisitions? Has that kept normal course capital cycling opportunities still attractive in Q3 so far, given disposition volume was up a little bit over 10% over Q2?
Pete Mavoides (President and CEO)
Gotcha. That was a long question.
Elmer Chang (Equity Research Associate)
You got that?
Pete Mavoides (President and CEO)
I'll dig into it. First, I would say, you know, by design, We do not compete with the $3 million-$5 million retail investor, you know, by doing sale-leasebacks. A sale-leaseback transaction is a more sophisticated transaction with an operator that requires execution certainty that the retail investor generally can't provide. Certainly, the retail investor that is dependent on financing or a leverage bid, and, you know, I would say that leverage bid has become even more suspect in the current market. You know, we, that's not a segment of the market that we compete against on our investment.
That said, as I said on the call, we do compete with larger leverage buyers who are, you know, struggling to get debt capital and on more organizational, more portfolio basis, that's allowed us to be a little more competitive and aggressive in our investments. In turn, in terms of the flip side of that coin, which is when we sell our assets, you know, into those markets and the leverage that our buyers get, you know, certainly that is a challenge.
And, you know, the, that market is, you know, to, investment volumes are down materially, but that's a huge market, and, and we're able to sell into it because we're not as price sensitive as many sellers, given, you know, our basis and our ability to move, you know, some of the riskier assets out of our portfolio. That market's dried up a bit, but it's still robust and, and allowing us to, you know, recycle capital and, and keep the portfolio fresh.
Elmer Chang (Equity Research Associate)
Got it. Thank you. I guess as a follow-up, you mentioned last month, seeing more potential deal volume that are meeting your investment criteria, right, due to the attractive environment for sale-leaseback capital. Investment volume was up above the eight-quarter average, and I think you touched on it a little bit in your prepared remarks about G&A rationalizing a little bit. I think it was down quarter-over-quarter. Do you anticipate any headwinds on G&A in the balance of 2023, given the level of investment volume that you're seeing thus far?
Pete Mavoides (President and CEO)
Yeah, you know, we, the short answer is no. You know, we continue to staff at, you know, in the organization, but generally, the vast majority of our staff and then executives are in their seats and trained and executing, and, you know, investments we're making in G&A are really as, you know, more for like, as we look at next year. I wouldn't expect anything out of the norm on G&A. Mark, would you add anything on that?
Mark Patten (EVP and CFO)
I think that's right. I think, that trend is, like you said, our headcount is pretty stable, I wouldn't expect anything different.
Elmer Chang (Equity Research Associate)
Okay. Thank you. Thanks for the time.
Pete Mavoides (President and CEO)
You got it.
Mark Patten (EVP and CFO)
Thanks. Thank you.
Operator (participant)
Our next question comes from the line of Eric Wolfe from Citi. Please proceed.
Nick Joseph (Head of US Real Estate and Lodging Research Team)
Thanks. It's actually, Nick Joseph here with Eric. We saw the uptick in new relationships, in terms of acquisition opportunities, versus the recent quarters. Can you just walk through the typical cadence of the opportunity and how the conversations typically go, in terms of growing these relationships from here?
Pete Mavoides (President and CEO)
Yeah, you know, listen, and as we said in some of the prior quarters, we were really focusing our capital on servicing existing relationships that were bringing us opportunities. You know, we generally like to lean into our relationships because when we have a relationships, it gives us, you know, an inherent competitive advantage because we've underwritten the credit, we have negotiated documents, and we're able to perform reliably against those opportunities. That said, you know, we've always wanted to maintain a balance and, you know, strike relationships with new operators and they become, you know, the growth engine down the road. In the quarter, we were able to strike some new relationships. There's some guys who are in the market doing deals.
Some of them are in the market for the first time, because of the capital markets, constraints and other alternative financing has, have drove them to sale-leasebacks. Some of the, the relationships were, you know, quite frankly, transacting with other people, and those, those counterparties are no longer active, and so they're, you know, sourced to find a new counterparty. You know, we make it clear at the outset, you know, we're in a relationship for a long term, and we want to help our operators grow their businesses. You know, the underwriting process is an investment that we make into those relationships such that we can continue to transact with these guys, you know, kind of going forward.
Nick Joseph (Head of US Real Estate and Lodging Research Team)
Thanks. Appreciate that. Then just maybe on the other side, in terms of sales, obviously, some, some dispositions in the quarter. How, how does that impact, kind of the relationship or the growth with those tenants, where you have exist or where you have continued, assets with, with one that maybe, sold a handful of their, properties?
Pete Mavoides (President and CEO)
Yeah, I think, you know, that is a process that there is some sensitivity to, but as long as you're open and transparent and, you know, making, you know, EquipmentShare is a great example, is we're able to sell those sites and really free up, capital capacity to continue to invest with them and continue to help them grow their business. They recognize that it's, it's mutually beneficial and, you know, it's generally a collaborative process to kind of manage those relationships and manage those exposures.
Nick Joseph (Head of US Real Estate and Lodging Research Team)
Thank you very much.
Pete Mavoides (President and CEO)
You got it. Thanks, Nick.
Mark Patten (EVP and CFO)
Thanks, Nick.
Operator (participant)
Ladies and gentlemen, as a reminder, if you would like to ask a question, please press star one on your telephone keypad. Our next question comes from the line of Ki Bin Kim with Truist Securities. Please proceed.
Ki Bin Kim (Managing Director)
Thanks, good morning. Mark, you know, it seems like the bank debt market is a little bit more available for a certain triple net REIT. Can you just discuss your refinancing plans and what kind of pricing you're seeing, and if starting forward swaps is in the cards in the near future? Thank you.
Mark Patten (EVP and CFO)
Yeah, thanks, Ki Bin. I mean, look, your note, what, two days ago, I think, was probably a pretty good analysis. You know, for us, we are fortunate. Our bank group is very supportive. I think the way you sort of posed that dynamic in your piece was probably appropriate. For us, you know, the pricing really was, you know, pretty consistent with what we'd seen before from the term loan side of things. In terms of the forward swaps, or frankly, just even swaps as we do the draws, you could do either, but certainly, the forward swap, I think, is the used in my remarks, which is kind of that 4.5%-5% range. You know, it all depends.
I think if you, if you look at the, if you look at the renewal swap or the extension swap in April of 2024, that's probably, you know, a 4.6 kind of number. If you look at, you know, when we do the draw, if we do, you know, more than just paying off the 2024 term loan, when we close, that tranche, the swap probably prices higher, but within the range I was mentioning. You know, that's where I think, you know, the, the mix of the draws relative to doing a forward swap to match it, that's why that 4.5%-5% is probably a pretty good range.
Ki Bin Kim (Managing Director)
Great. In terms of your unit level coverage, you know, there was a slight migration for some tenants moving to the below 1x covered or below 1.5x covered. You know, on the flip side, some actually improved. I'm not sure if, you know, how much acquisition has changed that dynamic, but if you can just comment on high level, you know, what types of tenants have maybe migrated south a little bit?
Pete Mavoides (President and CEO)
Yeah, certainly. You know, I would start with, you know, only two vacant properties, a strong same-store sales number, and, you know, growth in the portfolio and de minimis to negligent to no credit loss. You know, the migration there, I think what you're seeing is, some of the industries that are more sensitive to wage pressures and have lacked the ability to increase price on a, a real-time basis, you know, like the early childhood education guys. They can push price, but, you know, you're not going to do it, you know, kind of, five, six times a year. So we've seen some, decrease there.
The restaurants have also seen some slight margin pressures with wages and cost of goods. Overall, nothing that's given us a concern. We would expect those guys to migrate back to a more healthy level.
Ki Bin Kim (Managing Director)
Okay. Thank you.
Pete Mavoides (President and CEO)
You got it.
Mark Patten (EVP and CFO)
Thanks, Ki Bin. Thanks.
Operator (participant)
Our next question comes from the line of Haendel St. Juste with Mizuho. Please proceed.
Ravi Vaidya (VP of Equity Research)
Hi, good morning. This is Ravi Vaidya on the line for Haendel. Just as a question, as we see that the financing and liquidity in the banks, we're starting to, I feel like we're starting to see more of an improvement there going forward. Do you feel that tenants will be incrementally less reliant on the sale-leaseback as a form of capital going forward? Would you say that since rates are still so high, that you would still see that being an incremental source of capital? Thanks.
Pete Mavoides (President and CEO)
I, I would think it's more the latter. If you think about a middle-market borrower and, and borrowing unsecured in the, you know, 9%, 10%, 11% range, you know, sale-leaseback capital is, is still accretive to that. I think there's a long way to go in, in kind of normalizing of that market before it becomes, you know, reverts to a more normalized level that is, you know, inside of what sale-leaseback pricing that they see. I, I don't think that that's changed materially, and, you know, I, I think it's gonna be a while before we see that.
Ravi Vaidya (VP of Equity Research)
Okay. just one more. What's your watch list today as a percentage of ABR?
Pete Mavoides (President and CEO)
Our watch list as a percent of ABR is 90 basis points.
Mark Patten (EVP and CFO)
Yeah.
Pete Mavoides (President and CEO)
Just to refresh, we define that as the intersection of unit-level coverage risk of 1.5x or below, and credit risk of single-B or below. That's currently 90 basis points, which is the level.
Ravi Vaidya (VP of Equity Research)
Okay. Because I believe your theater exposure is north of that. Are theaters not included in those metrics?
Pete Mavoides (President and CEO)
There'll be some theaters in those numbers, certainly. I think a couple of our theaters are still kind of below that 1.5x level. Yeah.
Ravi Vaidya (VP of Equity Research)
Okay.
Pete Mavoides (President and CEO)
Of that.
Ravi Vaidya (VP of Equity Research)
Thank you.
Pete Mavoides (President and CEO)
90 basis, more than half is in our theaters.
Ravi Vaidya (VP of Equity Research)
Got it. Thank you again.
Pete Mavoides (President and CEO)
Thank you, guys.
Mark Patten (EVP and CFO)
Yeah, thanks.
Pete Mavoides (President and CEO)
Great. Any more questions, operator?
Operator (participant)
Nope. This concludes question and answer session. Pete, back to you.
Pete Mavoides (President and CEO)
Awesome. Well, that concludes the call. Thank you all for your time today. I really appreciate it.
Operator (participant)
This concludes today's conference. Thank you for your participation. You may now disconnect your lines.