Essential Properties Realty Trust, Inc. (NYSE:EPRT) Q3 2023 Earnings Call Transcript October 26, 2023
Operator: 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 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; 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’s now my pleasure to turn the call over to Rob Salisbury. Thank you, sir. You may begin.
Rob Salisbury: 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.
Pete Mavoides: 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 4.0 times. 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 in 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 an initial cash cap rate of 7.6%, 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 mid-point to mid-point. 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’s 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 and 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 mid-point 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 4.0 times, and the percentage of our ABR that had a less than 1 times 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 points 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 2.1 times. 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 3.3 times, and our average investment per property was $2.8 million. Looking ahead to the fourth quarter, we remain active and our pipeline 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, car washes 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 ten 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 non-credit rated tenants and middle market operators, which offers an expansive opportunity set and in our view generates 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 was 3.6 times. 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.
Mark Patten: 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 a $1.64 to a $1.65. 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 EBITDA RE was 4.5 times 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 3.7 times.
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.
Pete Mavoides: Thanks, Mark. Operator, please open the call for questions.
Operator: Thank you, sir. We will now be conducting a question-and-answer session. [Operator Instructions] And the first question comes from the line of Haendel St. Juste with Mizuho. Please proceed with your question.
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Q&A Session
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Ravi Vaidya: Hi, good morning. 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 2024 guide. What gives you the confidence to provide 2024 guide in the current environment? I know you guys have a strong liquidity position. Your balance sheet is a good shape, but how are you thinking about volume and spreads going forward, especially when we’re expecting slower volumes and shifting capital costs?
Pete Mavoides: Yes, 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 that’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 to provide guidance.
Ravi Vaidya: Got it. And if we just assume a worst case scenario and transaction markets are completely shut down, how much do you think you can grow FFO next year?
Pete Mavoides: Mark, why don’t you take that?
Mark Patten: How much we can grow AFFO next year at a baseline? So I think the way – 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 2023 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’d build into, like the headwinds around our swap that we’ve got forward starting, you’d probably be just under 4% growth.
Pete Mavoides: Yes. And listen, 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. And so we are no – 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.
Ravi Vaidya: Got it. Thank you. I appreciate it, guys.
Pete Mavoides: Thank you.
Mark Patten: Thanks.
Operator: And the next question comes from the line of Eric Wolfe from Citi. Please proceed with your question.
Nick Joseph: Thanks. 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?
Pete Mavoides: Yes, listen, as we generally do, we kind of pumped 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 high-7s and we assume that that persists and our ability to put capital to work at that level persists 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.
