Essential Properties Realty Trust, Inc. (NYSE:EPRT) Q4 2023 Earnings Call Transcript

Essential Properties Realty Trust, Inc. (NYSE:EPRT) Q4 2023 Earnings Call Transcript February 15, 2024

Essential Properties Realty Trust, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning, ladies and gentlemen, and welcome to the Essential Properties Realty Trust Fourth Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [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 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 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.

Rob Salisbury: Thank you, operator. Good morning, everyone, and thank you for joining us today for Essential Properties fourth quarter 2023 earnings conference call. During this conference 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 the yesterday’s earnings press release. With that, I’ll turn the call over to Pete.

Pete Mavoides: Thank you, Rob, and thank you to everyone joining us today for your interest in Essential Properties. We finished 2023 with a strong $315 million of investments in the fourth quarter and just over a $1 billion invested for the full-year. This translated to AFFO per share growth of 8% in 2023, which we are proud of given the industry backdrop of heightened volatility in the capital markets and wider bid-ask spreads in the transaction markets, serving as a testament to the resilience of our differentiated investment strategy and variable portfolio. As the fourth quarter results indicate, our portfolio continues to perform at a high level with unit level rent coverage of 3.8x, occupancy of 99.8 and same-store rent growth of 1.5%.

The overall health of our portfolio is a result of 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. By underwriting and focusing on all three risk factors associated with net real estate investing, corporate credit, unit level performance and lease risk and real estate basis, we are able to construct and own an exceptionally durable portfolio of properties. Regarding our strong and consistent year of investments, we remained active in support of our longstanding tenant relationships as they increasingly turn to us as a valued and reliably consistent capital provider to grow their businesses given the limited funding availability in the bank market and the continued dislocation in the credit markets and the diminished level of competition from other net lease investors.

With quarter end pro forma leverage of 4.0x and liquidity of nearly $800 million, our balance sheet continues to be well capitalized for continued investment activity. As we look to aggressively capitalize on these trends that are creating the opportunity to generate historically wide risk adjusted returns. We are affirming our 2024 AFFO per share guidance of $1.71 to $1.75, which implies year-over-year growth of 5% at the midpoint. Turning to the portfolio. We ended the quarter with investments in 1,873 properties that were 99.8% leased to 374 tenants operating in 16 industries. Our weighted average lease terms stood at 14 years at year end, which is consistent year-over-year with only 4.7% of our ABR expiring through 2028. From a tenant health perspective, our weighted average unit level rent coverage ratio was 3.8x this quarter down slightly from last quarter, driven in large part by investment activity.

Our same-store rent growth in the fourth quarter was 1.5%, an improvement from 1.2% in the third quarter, driven primarily by positive leasing results and asset management activities, including a gym operator that we discussed in our last earnings call. During the fourth quarter, we invested $315 million through 43 separate transactions at a weighted average cash yield of 7.9%, representing a continued increase in pricing power for sale leasebacks. As we noted on the last earnings call, our investment activity in the quarter was broad based across most of our industries with no notable departures from our well-defined investment strategies. The weighted average lease term of our investments this quarter was 17.6 years, and the weighted average annual risk escalation was 1.9%, generating an average GAAP yield of 9.1%.

Our investments this quarter had a weighted average unit level rent coverage of 3.3x, and the average investment per property was $3.0 million consistent with a key tenant of our investment strategy, 97% of our quarterly investments were originated through direct sale leaseback transactions, which are subject to our lease form with ongoing financial reporting requirements, 72% contained master lease provisions and 96% were generated from existing relationships. Looking ahead to the first quarter of 2024, we have closed $40.9 million of investments to date at an cash yield of slightly above eight, and our pipeline remains robust as an increasing number of middle market companies are seeking sale leaseback capital as a financing alternative, as other sources of the capital have become unavailable or uneconomic.

While we have capitalized on the dislocation in private credit markets generating heightened pricing power with favorable lease terms, we are cognizant of the potential for easing in the monetary policy over the course of 2024, which could alleviate financial conditions bringing with it a lower cap rate environment. Should our pricing power diminish later this year, we would hope benefit from a commensurate reduction in our cost of debt capital such that our net investment spread is maintained. As a value added capital provider, we are able to dynamically price our sale leaseback transactions, which over time has afforded us the ability to generate investment returns in excess of market pricing. That being said, our current pipeline today suggests that our investment cap rates should be stable in the near-term.

From a tenant concentration perspective, our largest tenant represents 3.8% of ABR at quarter end, and our top 10 tenants now account for only 18.1% of ABR. Tenant diversity is an important risk mitigation tool and a differentiator for us, and it is a direct benefit of our focus on unrated tenants and middle market operators, which offers an expansive opportunity set. In terms of dispositions, we sold nine properties this quarter for $30.6 million in net proceeds at a 6.6% weighted average cash yield with a weighted average unit level coverage ratio of 3.5x. As we have mentioned in the past, owning fungible and liquid properties is an important aspect of our investment discipline as it allows us to proactively manage industry tenant unit level risks within the portfolio.

Going forward, we expect our disposition activity over the near-term to remain relatively in line with our trailing eight quarter average, driven by opportunistic asset sales and ongoing portfolio management activity. With that, I’d like to turn the call over to Mark Patten, our CFO. Mark?

Mark Patten: Thanks, Pete, and good morning, everyone. As Pete noted, we had a great fourth quarter, which was punctuated by a strong level of $315 million of investments at a 7.9% cash cap rate. Among the headlines from the quarter was our AFFO per share, which reached $0.42. That’s an increase of 8% versus Q4 of 2022. On a nominal basis, our AFFO totaled $67 million for the quarter. That’s up $11.1 million over the same period in 2022, an increase of nearly 20%. This AFFO performance was in line with our expectations when we updated our guidance last quarter. For the full-year ended December 31, 2023 our AFFO per share totaled $1.65 per share, which is an increase of 8% over 2022. On a nominal basis, our full-year 2023 AFFO increased by 21% over 2022, totaling $253.4 million.

Total G&A was $7.3 million in Q4 of 2023 versus $6.5 million for the same period in 2022. With the majority of the increase relating to an increase in compensation expense, our recurring cash G&A as a percentage of total revenue was 5.2% for the quarter and 5.9% for the full-year of 2023, which compares favorably to the 5.8% and 7% respectively for the quarter and full-year of 2022. We continue to expect that on an annual basis, our cash G&A as a percentage of total revenue will decline in 2024 as our platform generates operating leverage over a scaling asset base. Turning to our balance sheet, I’ll highlight the following: With our $315 million of investments in Q4 of 2023, our income producing gross assets reached $4.9 billion at year end.

From a capital markets perspective in the fourth quarter, we completed the sale of approximately $47.9 million of stock all on a forward basis on our ATM program. Additionally, during the quarter, we settled $190.6 million of the forward equity we raised in September. At year end, our balance of unsettled forward equity totaled $130.6 million. Our pro forma net debt to annualized adjusted EBITDAre adjusted for unsettled forward equity was 4.0x at year end. We are committed to maintaining a conservative balance sheet with best-in-class leverage and liquidity. At year-end, our total liquidity stood at nearly $800 million. Our conservative leverage, robust balance sheet and significant liquidity positions the company well to fund our growth plans for 2024 based on the pipeline we see today.

Finally, the strong performance to end the year in 2023 are conservatively capitalized balance sheet and the investment pipeline we are seeing, all support our previously issued 2024 AFFO per share guidance range of a $1.71 to a $1.75, which implies a 5% growth rate at the midpoint. It’s also important to note that with the ATM equity issues achieved this quarter, we do not require additional external equity capital to achieve our 2024 guidance. With that, I’ll turn the call back over to Pete.

Pete Mavoides: Thanks, Mark. In summary, we are quite pleased with our fourth quarter and full-year results and remain excited about the prospects for the business. Operator, please open the call for questions.

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Q&A Session

Operator: We’ll now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Connor Siversky with Wells Fargo. Please ask your question.

Connor Siversky: Good morning out there and thank you for the time. Quick question on the liquidity profile. Understanding that a chunk of that $800 million and liquidity is really predicated on the revolver. I’m curious with the robust pipeline, you mentioned, how comfortable would you be letting leverage run towards the end of this year? And then what is the desired funding mix for each incremental acquisition between free cash flow capacity on the forward and the revolver?

Pete Mavoides: Mark, would you tackle that one?

Mark Patten: You got it. All right a couple things. In terms of just kind of funding mix, generally speaking, we had been largely probably 60, 40 in terms of equity and debt. But now with almost a $100 million of free cash flow, that’s probably more like 60 equity, 30 debt and 10 is kind of your free cash flow. So that’s kind of how we think about looking at liquidity. In terms of running leverage up, I guess what I say is, we’ve said pretty consistently that consistently if we were to choose a range that we thought was reasonable in terms of leverage it would be 4.5x to 5.5x. So if you think about that and we’re sitting at 4x now, we’ve got a fair amount of runway to go before we ever even kind of step into that range.

Pete Mavoides: Next question, operator. Hold on, hold on, operator. Connor, were you good?

Connor Siversky: Yes. No, I’m good. I think the line cut out for a second, but I’ll leave it there for now. Thank you.

Pete Mavoides: All right. Next question please, operator.

Operator: Okay. Our next question comes from Josh Dennerlein with Bank of America. Please proceed with your question.

Carole Greenough: Hi. Good morning. This is Carole Greenough on behalf of Josh. My first question, I wanted to ask if you can go into a little bit more detail on the unit level rent coverage and the slight downtick or how that was attributed to recent acquisitions?

Pete Mavoides: Yes. I mean, listen, we provide pretty granular detail supplemental on the unit level rent coverage. Clearly, the headline number decreasing from down 20 basis points, some of that is attributable to the acquisitions in the fourth quarter as well as the acquisitions in the third quarter, both of which were at 3.3x. And there’s always some ebbs and flows with different operators and different reporting periods and the like. But overall, the portfolio is in a great spot and we’re not seeing any concerns that give us pause.

Carole Greenough: Great. And I guess on the flip side of that, the increase in your same-store rent growth. Is this being driven off of either different lease terms, higher escalators or what type of driver that’s going into that?

Pete Mavoides: Yes. I mean that’s just going to be the rent escalations built into our contracts, generally they range from anywhere between one and a quarter on up to two, on average it’s 17 I believe. There’s different compounding periods and clearly at 15 that represents a pretty solid flow through of those escalations for us. And that’s going to kind of ebb and flow as we’ve disclosed.

Carole Greenough: Okay, great. Thank you so much.

Pete Mavoides: Thank you.

Operator: Our next question comes from [indiscernible] with Citi. Please proceed with your question.

Unidentified Analyst: Hi. Thank you. I just wanted to ask you a little bit, you talked about some of the more traditional sources of capital, either not available or just becoming too expensive. But are you seeing other kind of competitors come to the market or do you have sort of a relative advantage at this point as you look for new acquisition opportunities in this environment?

Pete Mavoides: Yes. Thanks. And I think that’s a great question. I appreciate you asking it. We have a relative advantage to alternative sources of capital currently like the bank market and the high yield market and leverage loans and private credit. A lot of those traditional sources of capital have been priced inside of sale leaseback capital in the current environment. We’re able to compete pretty competitively with those sources. And then secondarily, the traditional sale leaseback market participants are somewhat limited particularly from the private buyers who are more reliant on debt financing and accessing the ABS market. A lot of those guys are a little more conservative in the current environment. So both from an alternative capital perspective and from a competitor perspective, we’re finding nice opportunity to put capital to work.

Unidentified Analyst: Okay. And then just – you mentioned you have a lot of room to draw on the – or you have to revolver. But if you were going to just issue kind of 10-year unsecured debt today, can you just give us a sense of where you think it would price?

Pete Mavoides: Yes. I think the best mark would be our current bonds, which are out there trading and they’re kind of in the mid sixes. I would think that hopefully a new [issuance] out the yield curve, good price inside of that, so call it low to mid-6.

Unidentified Analyst: All right. Thank you. Appreciate it.

Pete Mavoides: Thank you.

Operator: Our next question comes from Eric Borden with BMO Capital Markets. Please proceed with your question.

Eric Borden: Hey. Good morning out there. Just understand that the majority of the acquisitions completed in the fourth quarter was heavily driven by existing relationships. But looking ahead and given the limited access to the bank markets for some of your potential tenants are you seeing an uptick in new potential partners in the pipeline?

Pete Mavoides: That’s a great question. I generally tell people we’d like to see a 80%, 20% or 75%, 25% mix where we’re 75% existing relationships, 25% new relationships because it’s important for us to continually source new relationships because eventually some relationships outgrow us. Clearly, in the fourth quarter at 96, it’s more skewed towards existing relationships. In the current environment, we try to maintain our most profitable relationships and service the relationships that generate the best risk adjusted returns and take care of the good clients and reliable clients. And that’s kind of what we’re doing. I think in a more normalized environment, we would head back down to that 75%, 25% or 80%, 20%. But clearly partnering with long-term relationships is, is bringing value to us and we’re bringing value to them. And it’s a dynamic market that we’re happy to have those relationships.

Eric Borden: Okay. That’s helpful. And then maybe on the disposition front, just given the potential for lower yields in the back half of the year, is there potential for that, that quantum of total dispositions to rise above your four quarter trailing average just given the benefits there?

Pete Mavoides: Yes. I think the expectation should be it’s going to be more towards our eight quarter average. Clearly, the current market for dispositions is a bit challenged. We have a very granular and fungible portfolio. But the lack of financing out there is making it a little more difficult to sell assets than in a normalized environment. And we will focus on kind of managing individual tenant and industry exposures and getting out of any risky assets that we see. But I would expect it to be closer to the a quarter average. And really, we don’t see the need to lean into dispositions to generate the accretive capital given where we are from a balance sheet perspective.

Eric Borden: That sounds great. I’ll leave it there. Thanks guys.

Pete Mavoides: Great. Thank you very much.

Operator: Next question comes from Nate Crossett with BNP Paribas Asset Management. Please proceed with your question.

Nate Crossett: [Indiscernible]

Pete Mavoides: Nate, I got to tell you, you came through broken up. I didn’t catch that question. I don’t know if you’re on a handset or not.

Mark Patten: He might come back in. Why don’t we just…

Pete Mavoides: Operator?

Mark Patten: Yes, please.

Operator: Next question comes from Greg McGinniss from Scotiabank. Please proceed with your question.

Elmer Chang: Hi, good morning. This is Elmer Chang on with Greg. Just on tenants, is there more conservatism on bad debt expense or credit losses baked into 2024 guidance versus the say, 25 to 40 basis points you’ve experienced historically given concerns with the consumer? And then how much of that is tied to experiential operators feeling demand pressures from consumers either returning to work or still feeling the effects of inflation?

Mark Patten: Hey, listen, we have conservative rent loss assumption and credit loss assumptions built into our guidance as we always do. We take a very good close look at our portfolio and look at individual exposures to include the credits, unit level coverage and our rent basis to try to anticipate where we might take any rent loss. And there’s a wide range of assumptions baked into guidance around that. As we’ve said in the past, generally when you see us raising guidance throughout the year, it tends to be partially driven by the fact that those credit losses aren’t really coming to play. So the 40 basis points to 50 basis points, we don’t give specific guidance on the numbers in there. But it’s certainly were the range of guidance has a range around that I think is fair to say.

We really don’t have specific concerns about the consumer and specifically as it relates to the service and experience based industries that we’re in. Our experiential tenants are doing great and continue to – we continue to see good sales trends there and coverage improvements. And our credit loss assumptions are going to be much more specific to individual situations and investments. But that that’s baked into guidance and we feel good about what the guidance that we’ve reiterated today.

Elmer Chang: Okay. Thank you. And then you mentioned those experiential consumers not being concerned about them. But within the portfolio of early childhood and casual dining operators, how would you characterize their ability to pass through higher costs to consumers? Now that it seems inflation has been easing a bit and you’ve – and given you’ve talked about these types of businesses not being able to raise rates in the past several quarters?

Pete Mavoides: Yes, listen. I think early child who is going to be much different than casual dining or our early childhood education providers have done a good job of passing through increases. It tends to be lumpy around semesters and new students. But we’ve seen increasing trends there. I think the casual dining sector is the price, is a little more a) competitive, b) less discretionary and certainly those guys are going to have less ability to drive through inflationary pressures and we are seeing some margin compression there. But ultimately on both in all those industries, those end up being equity owner risk and not landlord risks. And we don’t see any outsized losses flowing through the portfolio in general and then in specific in either one of those industries.