Four Corners Property Trust - Q3 2023

Transcript

Operator (participant)

Hello, and welcome to the FCPT third quarter 2023 financial results conference call. My name is Lauren, and I'll be coordinating your call today. There'll be an opportunity for questions at the end of the presentation. If you would like to ask a question, then please press star followed by one on your telephone keypad. I'll now hand you over to your host, Gerry, to begin. Gerry, please go ahead.

Gerry Morgan (CFO)

Thank you, Lauren. During the course of this call, we will make forward-looking statements which are based on our beliefs and assumptions. Actual results will be affected by known and unknown factors that are beyond our control or ability to predict. Our assumptions are not a guarantee of future performance, and some will prove to be inaccurate. For a more detailed description of some potential risks, please see our SEC filings, which can be found at fcpt.com. All the information presented on this call is current as of today, November 2nd. In addition, reconciliations to non-GAAP financial measures presented on this call, such as FFO and AFFO, can be found in the company's supplemental report. With that, I'll turn it over to Bill.

Bill Lenehan (President and CEO)

Good morning. Thank you for joining us to discuss our third quarter results. I'm going to make introductory remarks. Patrick and Josh will comment further on the acquisition market, and then Gerry will discuss our financial results and capital position. We reported third quarter AFFO of $0.42 per share, which is up $0.01 from our Q3 last year and in line with expectation. Our existing portfolio is performing exceptionally well, with 99.9% rent collections for the quarter and 99.8% occupancy at quarter end. FCPT has had a record acquisition year already, with $322 million of capital deployed year to date. That is up 13% from the full year of 2022, which was also a record acquisition year. We continue to see benefits of our investments in our people and the platform's capacity.

These transactions were funded with equity raised in late 2022 and early 2023, at an average price above $27 per share, and with our June debt offering, where we benefited from hedge gains to lock in a 5.4% yield to maturity. Year-over-year sales for the restaurant sector as a whole remained positive in the third quarter in the 3% range, according to Baird Research. Although the casual dining sector is seeing small declines off of a strong 2022. Darden was a standout from that trend, reporting same-store sales growth of 6.1% and 8.1% for Olive Garden and LongHorn, respectively. Chili's saw same-store sales rise 6%. As highlighted last quarter, restaurant margins are also improving as commodity and other labor inflation eases.

Our EBITDA to rent coverage in the third quarter was 4.8 times for the significant majority of our portfolio that reports this figure. This remains among the strongest coverage within the net lease industry and is a reflection of our underwriting standards. Turning to capital sources, which Gerry will discuss in more detail, we issued $100 million of private notes in July and did not issue equity during the quarter. We now start the fourth quarter with $220 million of availability on our revolver and no near-term debt maturities and very attractive properties to sell to 1031 buyers, if we choose to access this liquidity source. As we look ahead, the current capital market environment is making it challenging to deploy capital creatively. In this environment, we remain disciplined allocators of capital. Let me say that again.

In this environment, we remain disciplined allocators of capital. Since our inception in 2015, we have established mental models and structured our team's incentives that discourages us from deploying capital just to grow the company's size without an increase in per share metrics of earnings or intrinsic value. Our compensation is not tied to acquisition volumes, and we have never given acquisition or earnings guidance. Finally, we benefit from low, absolute, and relative overhead costs and can be nimble and modulate investment activities up and down without negatively impacting the organization or employee morale. We believe that we are prepared to operate successfully in today's environment and expect to ratchet up activity when it is accretive to do so. With that, I will turn it over to Patrick to further discuss the investment environment.

Patrick Wernig (Managing Director of Investments)

Thanks, Bill. We had a busy quarter, closing on $130.2 million across 31 properties. For 2023 year to date, we have acquired 90 properties for $322 million at a 6.7% cap rate, which is a record-high volume for us. Year to date, our acquisitions have been roughly split between restaurant at 38% volume, medical retail at 37%, and auto service at 23%. We expect the mix to remain balanced based on the pipeline over the remainder of the year. We remind ourselves often that our business is relatively simple. We do not focus on long-term covered land plays or trophy properties that come to market every 10-20 years. Our investment decisions are based on a consistently applied scoring model and yield spread.

If a tire store or a restaurant does not pencil, we can be patient, pass on it, and wait for the next one to come along that does. The industry story remains similar to recent quarters, where we're seeing the effects of the tightening lending market, mainly reduced private equity competition, fewer 1031 buyers and sellers, who are much more accommodating on compressed closing schedules and other non-price deal terms. Both developers and operators are more willing to engage with FCPT on portfolio opportunities than in prior years. We've also seen cap rates improve a great deal over the past several months as a reaction to the higher interest rate environment. There are opportunities for some really interesting portfolios that would have been priced 100+ basis points tighter a year ago.

Pricing has not moved enough in our view, but pressure is building on sellers as institutional net lease investors are largely holding the line and passing at current cap rates. We expect cap rates to move up over the short term in the absence of meaningful interest rate movement.

We've been asked recently by some investors, what is the most interesting acquisition opportunity for Four Corners right now? The answer is the same: down the middle of the fairway deals we've been doing for years, but at more attractive pricing and even stronger tenant credit than previously available in our cap rate range. Josh, I'll turn it over to you to discuss dispositions and re-leasing.

Joshua Zhang (Director of Investments and Head of the Acquisitions Team)

Thank you, Patrick. We sold three Red Lobster properties in September and early October that were underperforming versus brand average for $15 million, representing a small gain. We had these dispositions in the works for several months, and it was just happenstance that they lined up with the right buyers at similar closing timelines. These stores were underperforming relative to others in our portfolio, and we are maintaining our discipline of proactive portfolio management housekeeping to sell them at an attractive exit price, particularly when we have ample opportunities to redeploy the proceeds to further diversification at a positive spread. Turning to leasing, since inception and through the end of the third quarter, we've had 81 leases reach term expiration.

Of these, 72 leases, or almost 90%, were renewed by the existing tenants, and another seven, over 8%, were re-leased to new tenants, many of which had a positive rent spread and/or credit upgrade. Of the 81, only two remain vacant. The existing tenant is often the best candidate to continue on at a site, but in certain cases where there's a higher and better use or rents are well below market, we've been able to capture that positive rent spread and create meaningful value. We have no lease expirations in the portfolio for the remainder of 2023, and less than 2% of the rent stream is maturing in 2024. Gerry, I'll turn it over back to you.

Gerry Morgan (CFO)

Thanks, Josh. For the third quarter, our cash rental revenues grew 12.3% on a year-over-year basis, including the benefit of rental increases and $439 million of acquisitions in the last 12 months. We reported $56.1 million of cash rental income in the third quarter, after excluding $1.2 million of straight line and other non-cash rent adjustments. On a run rate basis, our current annual cash base rent for leases in place as of quarter end is $215.3 million, and our weighted average five-year annual cash rent escalator remains at 1.4%. We collected 99.9% of base rent for the third quarter, and there are no material changes in our collectibility or credit reserves, nor any balance sheet impairments.

Cash G&A expense, excluding stock-based compensation, was $4 million, representing 7.2% of cash rental income for the quarter. We continue to expect cash G&A will be approximately $16 million for the year. As a reminder, we take a very conservative approach to G&A and expense 100% of the costs associated with our internal investment program. We generated AFFO of $0.42 per share. Results were in line with expectation, but were impacted by higher interest expense on the $80 million of term loans that are unhedged and on the revolver balance. We also experienced a slight uptick in non-reimbursed property expenses from higher abandoned deal costs as we adjusted our deal pipeline to the rapid increase in Treasury rates.

With respect to the balance sheet at quarter end, we held $6 million of unrestricted cash, $11 million of 1031 proceeds available to redeploy, and have $220 million of undrawn revolver capacity. In total, that gives us $237 million of available capacity at the quarter, as the fourth quarter begins. In the third quarter, we funded the $130 million of acquisitions with cash on hand, the $100 million private note offering that funded in July, and $15 million of net revolver borrowings. On overall leverage, our net debt to Adjusted EBITDA in the third quarter was 5.6 times, and our fixed charge coverage ratio is a healthy 4.7 times. We've remained focused on maintaining a conservative balance sheet and extending and layering our debt maturities.

Our only debt maturity before November 2025 is a $50 million private note due in June 2024, and otherwise, our next debt obligation is $150 million of term debt due in November 2025. And with that, we'll turn it back over to Lauren for investor Q&A.

Operator (participant)

Thank you. If you would like to ask a question, then please press star followed by one on your telephone keypad. To withdraw your question, please press star followed by two. Please also ensure that your phone is unmuted locally. As a reminder, that is star followed by one to ask a question. Our first question comes from Rob Stevenson, from Janney Montgomery Scott. Rob, please go ahead.

Rob Stevenson (Managing Director and Head of Real Estate Research)

Good morning, guys. Can you talk about what you're seeing in terms of the differential, if any, between cap rates for restaurant assets that you'd want to own and add to the portfolio and the non-restaurant, medical, and auto assets? Any real gap there?

Gerry Morgan (CFO)

Not really. It's, I think, really being driven by rates and availability of credit, and that affects, you know, not just all net lease, but all real estate generally.

Rob Stevenson (Managing Director and Head of Real Estate Research)

Okay. So if those are on top of one another, how are you thinking about it today in terms of, you know, at the same return, whether or not you do the incremental restaurant asset or non-restaurant asset to diversify the portfolio, given the scarcity of capital these days?

Bill Lenehan (President and CEO)

Yeah, it's really about scoring the assets, Rob, which is a process and, you know, model that we've had in place now for years. And so, you know, we really look at properties, and we're thinking more of this one's an 80 and this one's a 74, and the model really builds in our preferences for different building types. And not to get too into the weeds, but there tends to be more prevalence for double net buildings or double net leases in auto service. So, if anything, maybe a little bit of preference to stay away from that or ensure that we've got a brand-new roof.

Rob Stevenson (Managing Director and Head of Real Estate Research)

Okay. And then, Gerry, anything that we need to be thinking about in terms of FFO going from third quarter to fourth quarter beyond acquisitions and dispositions, the impact of higher rates and any capital raising you do? Anything sticking out as abnormal between either the third or fourth quarter that we need to take into consideration?

Gerry Morgan (CFO)

No, not really. I think as you highlighted the one item that's variable, and that is, what is the interest rate on the unhedged portion of our debt, which is $80 million of term loans and whatever the revolver balance is. Otherwise, typically, the fourth quarter is a fairly normal quarter, quote, unquote, from a G&A perspective. We don't have big proxy costs or other things like that, and generally nothing that we see on the horizon with respect to property expenses that would be larger in the fourth quarter.

Rob Stevenson (Managing Director and Head of Real Estate Research)

Okay. Thanks, guys. Appreciate it.

Gerry Morgan (CFO)

Yep, of course.

Operator (participant)

Thank you. Our next question comes from Anthony Paolone, from J.P. Morgan. Anthony, please go ahead.

Anthony Paolone (Executive Director)

Yeah, thank you. Maybe I'd like to start with just how you're thinking about where spreads need to be compared to your weighted average cost of capital. Because I know, you know, cap rates are expected to go up, your capital costs have gone up, but just trying to understand, like, if you're looking at this in terms of a target spread or just what would get you to do something or make sense?

Bill Lenehan (President and CEO)

Yeah, you know, we don't have a specific number that, you know, is in the bullpen of our acquisition group that they know specifically. You know, we, we're looking-- we're calculating our cost of capital, which really today is our cost of equity, frankly, because the debt markets are so dislocated. And then comparing how we think about the quality of our portfolio versus what we're buying. So, we don't get into specifics for competitive reasons, but I think our view is, you know, we have this mental model that we've taken most people through, of sort of the green zone, yellow zone, and red zone. Our stock is right now, you know, right at the bottom of the yellow zone. It's gone up a little bit in the last couple of days, so, you know, we're pretty cautious.

And that's a mental model we've had, again, since inception. You know, in preparing for this call, I went back and read transcripts from 2016, our first handful of conference calls, and what I would say is our thought process about this business is remarkably similar to where it was then.

Anthony Paolone (Executive Director)

Got it. But I mean, and so just to kind of push a little, just to understand your capital costs and how you're thinking about it, when you say your, your equity, are you, should we be looking at just the inverse of your multiple, like a longer-term number, implied cap rate? Like, like, what's most important to you on that front?

Bill Lenehan (President and CEO)

Yeah, we triangulate different methods. You know, we typically look at the inverse of the multiple, adjusted for some cost to raise money. Unfortunately, raising money has some minor costs associated with it, even if you use the ATM. So that would be a good way to look at it. Gut check that with cap rate would be probably even better.

Anthony Paolone (Executive Director)

Okay. And then in terms of, you know, thinking about the balance sheet capacity, up in the high fives right now, any appetite to push a bit above that, or you really need to wait and see where cap rates settle?

Bill Lenehan (President and CEO)

Yeah, I would say it's a different analysis than when, you know, you're borrowing, your revolver was 3% or 2%. Now, borrowing on your revolver is expensive, and so unless you have some crystal ball that says rates are gonna dramatically decline in the future... And frankly, if we had that crystal ball, we wouldn't be buying buildings for a living, we'd be trading derivatives. Is that borrowing on your revolver to buy buildings isn't the sort of artificially accretive game plan that REITs had in the past. So, I think the way to look at it is cost to equity.

Gerry Morgan (CFO)

And I would just add, I think we-

Anthony Paolone (Executive Director)

Okay.

Gerry Morgan (CFO)

... we have been pretty consistent, Tony, that we want to keep our leverage below six times, and that doesn't mean that it can't go up periodically above six times for good reasons. I think what Bill's highlighting is right now, I'm not sure there's good reasons to go above six times this leverage.

Anthony Paolone (Executive Director)

Okay, got it. And just, if I can get one last one in here, just to follow up on Rob's questions. And you mentioned just no real difference between restaurant returns and some of the other product types. There's a lot of discussion around GLP-1 drugs and restaurants. Like, if they're about the same, like, do you find it's still worth taking the tail risk there, or how do you think about that, if at all, at this point?

Bill Lenehan (President and CEO)

Yeah, you know, I'm certainly not an expert on the GLP-1 drugs, but we've been doing our homework on the implications. You know, our current view is that the semaglutide drugs may lead to some minor behavioral trend changes, might have some minor effect on our tenants' businesses. But that's why we have conservatism in our underwriting model. You know, I don't think it's a major concern. You know, we're buying buildings with very long-term leases. It allows our tenants to adapt their business if there is some sort of behavioral shift. And, you know, I think we're gonna own these buildings for decades, so we wanna look long term and not be knee-jerk in our reactions based upon you know, what's sort of trending. So we're not dismissive.

I think it's a great question. You know, we really put our head down on this issue. We've actually brought in experts to advise us on this, and at the current moment, even sort of adjusting for what will certainly be a lower cost, probably consumable versus injectable, probably with lower side effects in the future, we don't think it's a major concern. But we're monitoring.

Anthony Paolone (Executive Director)

Great. Thank you.

Bill Lenehan (President and CEO)

Thanks.

Operator (participant)

Thank you. Our next question comes from James Kammert from Evercore. James, please go ahead.

James Kammert (Managing Director)

Good morning. Thank you. I was noodling on your medical retail deck you put out this week, and I was just curious, as a general rule, obviously, emergency rooms, urgent care, you know, have higher per square foot investments and rents, but how much of that improvements in those types of assets would Four Corners be paying for versus the tenant? I just wanna understand how that's split, if possible.

Bill Lenehan (President and CEO)

Yeah, it's a mixed bag. I would say we reject the basic premise that some market participants, you know, hang their hat on, which is the tenant should be able to get out the entirety of their construction costs in a sale leaseback. That's sort of a rule of thumb that some people follow, that we don't. But I would reiterate what you said, which is that these are real costs. So these are improved buildings. They are expensive to improve. It's something that we watch closely. I would say, you know, the higher construction costs come back to us as rents, and we have a demonstrated track record of being very rent sensitive.

Our model is 25%-30% rent-related factors, and it's something that we're in particular focused on in medical. So I don't have a precise number because it's all across the board. Everything from ground leases, where you have none of the construction costs, to some of the larger facilities that are brand new, where you're bearing you know a majority of the construction costs, but not all. But it's something that we focus on in our underwriting. I would draw a distinction of medical retail to some other forms of net lease, where you're in at a substantial premium to any reuse scenario, and sometimes you know maybe double what any reuse would be. Those are the kinds of transactions we've really stayed away from.

And maybe to circle back to Rob's question about the distinction between restaurant and other forms of net lease we look at, what I would say is where we've seen the most cap rate move is in the kinds of buildings that we were not buying before. Experiential retail, new concepts, brand spanking new brands with no track record, highly specialized use buildings, things of that nature.

James Kammert (Managing Director)

Okay, very good. Thank you. And just circling back, a cleanup on the Red Lobsters, are you pretty much done on that, sort of culling? And can you remind me, aren't the remaining assets largely under a master lease?

Bill Lenehan (President and CEO)

They are, and the ones that aren't, are very well covered. We have a couple of properties still on the market, but I don't think it's a major item. We had success selling what we wanted to sell. There's a couple more out there, but again, what remains is a very high quality and mostly in a master lease. And Red Lobster is doing better.

Operator (participant)

Thank you. Our next question comes from Connor Siversky from Wells Fargo. Connor, please go ahead.

Connor Siversky (Director and Senior Equity Research Analyst)

Good morning out there. Thanks for the time. Maybe just another one on the medical retail presentation. Appreciate the detail in that presentation. So, you know, you described the scoring criteria you use for restaurant and other net lease assets. You know, I'm wondering if you applied this same kind of scoring system to these assets, which might be a little more esoteric in nature. And then with that scoring system in play, is this potentially where you think you could find maybe higher yields on acquisition that would screen more favorably against the cost of capital as it sits today?

Bill Lenehan (President and CEO)

Yeah, great question. So I would say that our scoring model for restaurants has a north of 80% overlap with how we think about medical lease term credit, rent per sq ft, rent growth, is the lease truly triple net, et cetera, et cetera. Those, those are, very similar between the different property types. The locations are similar, between the property types. As far as finding higher yield, you know, we're really not, focused on thinking about the world that way.

We are trying to find high-quality properties at a yield that pencils, not, "Here's our cost of capital today, and Pat and Josh, go find things that are north of that, and we'll convince ourselves that the risk is acceptable." So we really look at the world a different way, which is focusing on quality and making sure that what we buy, we're very happy with, 'cause we're gonna live with it for a long time.

Connor Siversky (Director and Senior Equity Research Analyst)

Got it, understood. I know it was touched on earlier, you know, again, in the context of the cost of capital as it sits today, but you know, at the margin for any acquisition, how should we be looking at that funding mix or modeling that funding mix?

Bill Lenehan (President and CEO)

Well, I think for now, equity would be the primary. We have 1031 exchange proceeds, as Gerry mentioned, sitting on our books, so those need to be used. We've obviously considered that and made appropriate, you know, high quality acquisitions in our pipeline. But what I would say is, as Patrick alluded to, this is the most target-rich acquisition environment that we've had since inception. There's very good stuff to do. Pricing is coming our way. It's just not there yet with the stock price that we have. So to the extent that you see our stock price rebound, you will see us aggressively torque the business to take advantage of very attractive acquisitions.

But today, if we acquired assets at our stock price, we would be buying buildings for practice, and we've bought 700 buildings since inception. We don't need to practice.

Connor Siversky (Director and Senior Equity Research Analyst)

Understood. Appreciate the color. Thank you.

Bill Lenehan (President and CEO)

Great.

Operator (participant)

Thank you. Our next question comes from Alex Fagan from Baird. Alex, please go ahead.

Alex Fagan (Equity Research Analyst)

Hi, thank you for taking my question today. The first one is, what's the baked-in earnings growth for 2024 if Four Corners does nothing on the external front?

Bill Lenehan (President and CEO)

Well, we don't give earnings guidance, but what I would say is that the primary factor in driving earnings growth in our business is the annualization of assets purchased in the year prior. We have 1.5% rent bumps, 1.4% rent bumps. We're you know, pretty conservative on G&A. We have a little bit of floating rate debt, but most of it's fixed. So the primary driver is the timing of acquisitions throughout the year. So we've tended to be back-end loaded. This year, we are front-end loaded, but the primary is annualization. We don't give guidance. We try to stay away from that because it sets perverse incentives, but it's pretty easy to calculate where we stand.

And what I would also say is, given our disclosure regime of announcing every property bought or sold the day it occurs, you can follow in almost real time what that progress looks like.

Alex Fagan (Equity Research Analyst)

Okay, helpful. Thank you. Second one, kind of two parts, but will you look to sell more assets over the near term? And is the spread between where you guys can buy and sell either widening or contracting?

Bill Lenehan (President and CEO)

Well, I would say it's probably widening a little bit because our existing portfolio is largely investment-grade, very high-quality properties. That's what's financiable in the world today, if anything's financiable. And so, you know... And we have properties in 47 states, so we get to meet the 1031 exchange buyer where he or she lives. We have sold assets in the past. It's never been a large portion of our business. I don't think today it's a huge focus of ours, but if approached, we always are thoughtful in responding, and to the extent that we wanna do some culling, as you've seen with some of the Red Lobsters, we've been able to do that at pricing higher than what we purchased the properties for.

Alex Fagan (Equity Research Analyst)

And the last one for me, you mentioned Red Lobster is doing better. Are there any other tenants on the watchlist, and has it changed much since the beginning of the year?

Bill Lenehan (President and CEO)

Nope.

Alex Fagan (Equity Research Analyst)

Cool. Thank you, guys.

Bill Lenehan (President and CEO)

Yep, of course.

Operator (participant)

Thank you. As a reminder to ask any questions, please press star followed by one on your telephone keypad. Okay, we have no further questions, so I'll now hand back over to Bill for closing remarks.

Bill Lenehan (President and CEO)

Great, thank you, Lauren. Thanks for the robust questions. Specifically, thank you for being interested in our medical research report. A lot of good work went into that. If you have follow-up questions, please reach out. We'd love to continue the dialogue. Thank you.

Operator (participant)

This concludes today's call. Thank you for joining. You may now disconnect your lines.