National Retail Properties, Inc. (NYSE:NNN) Q1 2023 Earnings Call Transcript

National Retail Properties, Inc. (NYSE:NNN) Q1 2023 Earnings Call Transcript May 2, 2023

Operator: Greetings, and welcome to the NNN REIT First Quarter 2023 Earnings Call. At this time all participants are in a listen-only mode, and a question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, Mr. Steve Horn, CEO of NNN REIT. Sir, you may begin.

Steve Horn: Thanks, Ali. Good morning, and welcome to the inaugural NNN REIT First Quarter 2023 Earnings Call. Joining me on this call is Chief Financial Officer, Kevin Habicht. As this morning’s press release reflects NNN’s performance in the first quarter produced 3.9% core FFO growth along with acquisitions, slightly over $155 million with a 7% initial cash yield. In addition, our portfolio retained a high occupancy of 99.4%, which I attribute to the upfront due diligence on property acquisitions and the continuous portfolio management that NNN does every day. But before we continue with the operational performance, I want to address the name change, which I’m excited about. First, as I stated in the press release, the change does not signal a strategy shift with acquisitions, balance sheet management with deliberate and consistent NNN.

We felt it was time to take advantage of the NNN brand. The reality is NNN is what we are called with our circle of investors, peers, clients every day. In addition, our website and emails use the NNN REIT brand. Therefore, the change is making NNN even more consistent within our sector. Turning to the highlights of the first quarter financial results. Our portfolio of 3,449 freestanding, single-tenant retail properties continue to perform exceedingly well. As I stated earlier, occupancy ended at 99.4% for the quarter, which is above our long-term average of 98%. Occupancy remained flat from year-end. At the quarter-end, NNN only had 20 vacant assets, which is one less than the year-end, which is a product of our leasing department enjoying a high level of interest by a number of strong national and regional tenants in our vacancies.

In addition, 91% of our leases that were up for renewal during the quarter exercised an extension. I’m sure we’ll cover more of the credit watch list in the Q&A, but I just want to get a little bit more color. There were some large names that filed bankruptcy, and our portfolio is still performing at high levels. And we expect that trend to continue. One of the recent filings of Bed Bath & Beyond, which NNN currently owns three of their assets with an average rent of $13 per square foot. We’ve been getting a lot of inbound interest on the assets because of the quality of real estate. So I expect when the time comes to release the assets, we’ll have superior recovery rate in a timely manner. Remember, as I stated earlier, the average occupancy from NNN since 2003 is 98%.

So the portfolio has stood the test of time through GFC and COVID. Turning to acquisitions. We’ll continue to be prudent in our underwriting, and NNN is afforded the luxury to continue to be selective. We acquired 43 new properties in the quarter for approximately $155 million, the initial cap rate of 7% with an average lease duration of 19 years. Almost all of our acquisitions this past quarter were sale-leaseback transactions. That is a result of the calling effort of our NNN acquisitions department. NNN prides itself on maintaining the relationship business model, which we do repeat programmatic business. With regard to the acquisition pricing environment, the last quarter of initial cap rate of 7% is approximately 40 basis points wider than the fourth quarter of 2022.

As I mentioned during the February call, we were seeing cap rates steadily increase. But now as we sit here at the beginning of May, the cap rate increases are starting to plateau some. What I mean, the rate of increase is definitely slowing down. So, I’m not expecting another 40 basis points for the second quarter of 2023. This is resulting in NNN seeing that cap rates are starting to hit the glass ceiling, assuming the macroeconomic environment settles down. During the quarter, we also sold 6 properties that generated nearly $12 million of proceeds to be reinvested in new acquisitions. The dispositions consisted of 3 vacant assets and 3 income-producing assets at a 6.6% rate. I do expect disposition activity to be greater in the second quarter, and we are keeping our disposition guidance unchanged for the year.

As I finish up and to remain consistent as past calls, Kevin and his team keep the balance sheet rock solid. We ended the first quarter with $209 million out on our $1.1 billion line of credit, no material debt maturities until 2024. Thus, NNN is in a terrific position to fund the remaining of our 2023 acquisition guidance. In summary, the occupancy rate, leasing activity, the relationship-based sale leaseback acquisition volume, we believe once again validated our consistent long-term strategy of acquiring well-located parcels, leased to strong regional and national operators at reasonable rent, while maintaining a strong and flexible balance sheet. As I stated earlier, NNN is in solid footing as we are a quarter into 2023. With that, let me turn the call over to Kevin for more color in detail on our quarterly numbers.

Kevin Habicht: Okay. Steve, thank you. And as usual, I’ll start with the cautionary statement. We will make certain statements that may be considered to be 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 these 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 this morning’s press release. Okay. With that out of the way, headlines from this morning’s press release report quarterly core FFO results of $0.80 per share for the first quarter of 2023, and that’s up $0.03 or 3.9% over year ago results of $0.77 per share, and that was flat with prior fourth quarter results.

Today, we also reported that AFFO per share was $0.82 per share for the first quarter, and that’s also up $0.03 per share or 3.8% over Q1 2022 results. As can be seen in the footnote on page 1 of the press release as well as the detailed deferred rent repayment schedule on page 13, the accrual basis, deferred rent repayments have now been virtually fully repaid and will not create any real noise in our AFFO number going forward. The scheduled cash basis deferred rent repayments continue to taper off materially in 2023 as can be seen again in the details provided on page 13 of the press release. And that slowdown produces about a $5.8 million or $0.03 per share headwind for the full year which we obviously — previously, I should say, noted and is baked into our 2023 guidance.

One last note on first quarter results. We did receive $1.7 million of lease termination income and that’s higher than normal and compares with $1.0 million in Q1 of 2022. But, overall, a good quarter, in line with our expectations. Moving on, our AFFO dividend payout ratio for the first quarter of ‘23 was approximately 67%. That created approximately $49 million of free cash flow, that’s after the payment of all expenses and dividends for the quarter. This free cash flow funded 31% of our total acquisitions in the first quarter, and that’s about half of the equity needed for those acquisitions, assuming we run a balance sheet at roughly 60% equity and 40% debt on a gross book value basis. Occupancy was 99.4%, as Steve mentioned, at quarter end, and that’s flat with year-end of 2022.

G&A expense was $12.25 million for the quarter, and that represents about 6% of revenues, but our midpoint guidance for this line item is still $44 million for the full year 2023, which would put G&A closer to about 5.5% of revenues for the year. We ended the quarter with $782 million of annual base rent in place for all leases as of March 31, 2023. Today, we did not change our 2023 guidance, which we introduced in February. First quarter results might suggest we have the opportunity to be at the higher end of the guidance range, but we will revisit any guidance changes when we report second quarter results. The 2023 guidance and the key supporting assumptions are on page 7 of today’s press release. Switching over to the balance sheet, we maintain a good leverage and liquidity profile of roughly $900 million of liquidity.

The first quarter was fairly quiet in terms of capital markets activity. We issued $17 million of equity in the first quarter, executing trades around $46 per share level. After a few years of nearly no usage of our $1.1 billion bank line of credit, we did begin to use it a bit in 2023, and that was a part of our plan to navigate this rockier interest rate and capital market environment. Our weighted average debt maturity is about 13 years, including that bank line. All of our debt outstanding is fixed rate with the exception of that — the $209 million on our bank line, which represents about 5% of our total debt. A couple of metrics. Net debt to gross book assets was 40.4%, which is flat with year-end. Net debt-to-EBITDA was 5.3 times at March 31st.

Interest coverage and fixed charge coverage was 4.7 times for the first quarter of ‘23. So, we’re in very good shape to navigate the elevated economic and capital market uncertainties and to continue to grow per share results, which we view as the primary measure of success. And with that, we will open it up to any questions. Ali?

Q&A Session

Operator: Thank you. Our first question is coming from Spenser Allaway with Green Street.

Spenser Allaway: You mentioned in your prepared remarks that the rate of cap rate increases has slowed. But can you just comment broadly on the different retail industries, or are there any segments that stand out as continuing to have a wider bid-ask spread. So, cap rates haven’t moved just quickly. And then to the contrary, any industries that have seen cap rates move faster?

Steve Horn: Yes. The cap rates through the second half of last year, you saw slowly — you’re increasing at a pretty good clip. And what we’re finding is the acquisitions in the second quarter. And now you specifically asked what segments. Just think of whatever our portfolio is, that’s the segment I’m really speaking of, if it’s QSR, convenience store, auto service, typically where we’ve done the most volume recently and the large regional operators, non-investment-grade tenants. But yes, we’re seeing a little bit of a plateau in the cap rates, they’re acceptable cap rates. But we picked up that 40 basis points. I’m kind of thinking more in the range of 20, 30 basis points for the second quarter. And then, as we move out in the third quarter, it’s a little bit too early on the pricing. But assuming the economy stays where it is, I think we’re kind of getting near the top of it right now currently.

Spenser Allaway: Okay. That’s helpful. And then, the cap rate on the dispositions. Those are pretty low for the second quarter in a row. Is there anything unique here driving that lower than prior quarters? And is there any reason to think that that could continue on future dispositions this year?

Steve Horn: The dispositions, we’re not changing our guidance for 2023. I’m expecting to hit that guidance range. It was a — more of a timing issue, lower in the fourth quarter and the first quarter, but the stars are starting to align where I’m expecting the second quarter to pick up pace a little bit. As far as our dispositions this quarter, again, the 3 vacancies and the 6.6% cap rate was a result of really two defensive sales, meaning one was a rent asset we sold and the other was an obsolete, I’ll call it a gas station, not a convenience store. And then the third one was an opportunistic sale where somebody liked the property more than we did.

Operator: Our next question is coming from Joshua Dennerlein with Bank of America.

Joshua Dennerlein: Could you remind us what the bad debt amount is assumed in guidance and how the Bed Bath & Beyond BK falls within that range?

Kevin Habicht: Yes. Sure. This is Kevin. Yes. So we assumed in our guidance as we have for a number of years, 100 basis points of rent loss in our guidance and didn’t really use any of that in the first quarter. And as it specifically relates to Bed Bath & Beyond, we — our stores have not been closed or on the rejection list. And so, we anticipate they will continue to pay rent up until that changes, if and when that changes. So at the moment, we’re not experiencing any notable level of bad debt at this point.

Joshua Dennerlein: Okay. Interesting. So, they’re not on the closure list or…

Kevin Habicht: Correct. Yes. They’ve announced, I think, 480 total stores, 360 Bed Bath, 120 buybuy BABY, and our stores are not on that list.

Joshua Dennerlein: Okay. Okay. Good color. And then I think just reading the 10-Q that came out this morning, there’s another tenant in bankruptcy. I guess, could you update us on that tenant, the assets and maybe what the trends are compared to the market?

Kevin Habicht: Yes. So we really only have two in bankruptcy. One is Bed Bath, which we talked about in the other is Regal Cinema, which we’ve talked about in the past, which is just one property and we’ll see where that goes. They’re still paying rent, but we’ll negotiate that. That goes along, whether that survives or does not survival, time will tell, but very small in the scheme of things.

Operator: Our next question comes from Eric Roth with Citi.

Eric Roth: Thanks. Good morning. Just starting with the guidance question, what takes you sort from that current run rate of $0.82 in the first quarter down to $0.80 for the rest of the year. I think, you got a lease termination income, but it would seem like there is something off that gets you down there other than the lease termination income.

Kevin Habicht: Yes, nothing really — I mean I think as I noted in my prepared remarks, we’re clearly tracking for the high end of our guidance range, and it was a little bit of a discussion or thought process here internally, whether we would think about revisiting our guidance. But we’re just kind of measured and delivered kind of people. And so, we deferred that to the second quarter. I did note, like I say, to your point, there’s $0.01 of unusual onetime kind of income, lease term income in the first quarter that help the results. And so we’re not expecting that to continue. But yes, we’re — we like where we stand, and hopefully, with time, we’ll be able to let the guidance drift higher, which is — has occurred from time to time over the years. But yes, that’s just the way we went at it this time.

Eric Roth: Okay. And then you mentioned that cap rate — you’re hitting the glass ceiling around 7%, although I think you said that might expand about 20, 30 basis points further. But just curious at that level, sort of, call it, the low-7 type cap rate. How are you feeling about your ability to create value at that level, given your cost of capital? I noticed that you didn’t raise much on your ATM in the first quarter, but maybe that was just more timing related.

Steve Horn: Yes. I’ll take that one, the first part of the — talking about the cap rates hitting the glass ceiling. Yes. No, we’re expecting the second quarter expand off our 7% cap rate and kind of what I said in the opening remarks. Third quarter is a little bit too early. But we’re going to — we’ll deploy money at that 7.25%, 7.3% range. And Kevin can talk about kind of — as it relates to our cost of capital.

Kevin Habicht: Yes. I mean — and we’ve talked about this over the years, how we think about our cost of capital. I won’t go into all the details at the moment, but it’s in our pitch book. And we try to burden our cost of equity today at around 8.5% kind of cost. For purposes of deploying capital, that’s the kind of return hurdle we’ve set up internally as we think about deploying capital into new investments. So what that ends up producing is a weighted average cost of capital, including that in the low 7s. And so, we feel like today, that’s what we need to earn to generate the sufficient and appropriate return for NNN shareholders. And so — and other people take different views around their cost of equity and all that kind of thing.

But like I said, I won’t go into all the details there. But the good news is for us — and that’s why I kind of highlighted our free cash flow funded half of our equity need, if you will, in the first quarter just from operations. And so, we really have a — in terms of raising additional capital, and that’s before property dispositions, which would be another 10%, 15% of our acquisition fund — equity funding for acquisitions. And so at the end of the day, we need precious little new equity capital on a cash flow basis to kind of run the — or achieve the guidance — acquisition guidance, we’re thinking of for the years. Having said that, the free cash flow we generated, the property disposition proceeds in our minds we continue — we burdened that at a 8.5% cost as well.

It’s not free cash flow, cost 8.5%. And if we can’t earn that kind of return on equity, then we probably are doing a disservice in our opinion, to shareholders, and we might should send it back to shareholders if we don’t think it has a sufficient kind of cost to it. So, that’s just the way we think about it. Like I say, it’s a little different than I think a lot of folks, but I think it’s helped us being a little more disciplined over the years, and we like that approach.

Operator: Thank you. Our next question is coming from Rob Stevenson with Janney.

Rob Stevenson: Good morning, guys. Steve, back to the cap rate commentary that you were making before. How much does that defer the movement between sale leasebacks versus the one-off and small portfolios that maybe more sensitive to all these issues with the banks these days?

Steve Horn: Hey Rob, good question. I mean, you know we don’t play in, like we call it 1031 market where there’s the one-off. I mean, we have a dedicated acquisition guy that’s always trying to find the diamond in the rough. But as day-to-day operations, we do the sale leaseback. The sale leaseback market, the sophisticated clients have understood the capital markets or just the overall lending environment is a little more difficult for the middle market. So it’s being migrated to the sale leasebacks. And they’ve allowed for the cap rate expansion. The 1031 market, where there’s even more competition, if it’s doing the 1031 exchanges or just there’s more cash buyers, so they’re not as sensitive to the bank lending market currently.

So, those cap rates haven’t moved quite as much. Now, all that being said, if you played in the investment grade market and you’re buying those deals that you are buying at high-4s, low-5s, you’ve seen a significant cap rate movement because they started off so low, historically the last couple of years. But the sale leaseback market, we’re still seeing an increase for the second quarter, just not as fast of a rate.

Rob Stevenson: Okay. And how deep is that buyer pool today? I mean, if the seller doesn’t like the price that you give them — they have 25 guys behind you willing to do that price, or is that buyer pool for those sale-leaseback transactions sort of thinned out as well, given rates and other issues?

Steve Horn: Kind of the same story line. I’ve been in the business here at NNN REIT for 20 years. And we’ve been highly competitive market from day one. Just the names have changed over the course of the years. Yes, there’s a few less buyers in the market currently that relied on the kind of the secured loans but it’s still highly competitive. Nobody is stealing assets. It’s market pricing currently. If somebody doesn’t like my pricing, there’s somebody right behind me that’s willing to do it.

Rob Stevenson: Okay. That’s helpful. And then, Kevin, given all that’s gone on with the bank term loan market as well as interest rate hedge pricing, where is your best debt access today? And what is that costing you today?

Kevin Habicht: Rob, it’s funny, today, everything pretty much cost the same roughly or at least in the scheme of things. And so, bank lines are close to 5.5%, 10-year debt is close to 5. 5% and 30-year debt is not a whole lot more than that. And so today, it’s really any decision around the term of debt you might be using or issuing is a bit of a bet on where rates will be 2 years or 4 years from now. And so like I said, we chopped a lot of wood on long-term debt in prior years, particularly in 2021 and pushed our weighted average debt maturity pretty far out, and for the last several years, really have not used our bank line. So we — our approach has been to pivot somewhat to use our bank line, which has been virtually unused.

We have the flexibility to do that and let this interest rate cycle play out a bit and see where rates go, call it, a year from now and make maybe a longer term bet on interest rate direction. So, that’s the way we’re kind of playing it at the moment. And having said that, I’ll say, a, I — we don’t typically — we don’t give guidance on our capital markets activity, and b, I reserve the right to change my mind. And so hopefully, I’ve been sufficiently elusive. So…

Operator: Our next question is coming from Wes Golladay with Baird.

Wes Golladay: Are you seeing any signs that the tenants will pause expansion due to the macro uncertainty?

Steve Horn: You kind of broke up.

Wes Golladay: Yes. Are you seeing any signs of — at your current tenant roster, the ones that you’re growing with will pause their expansion plans due to the macro uncertainty?

Steve Horn: I think, what we’re seeing out there right now, our development pipeline is really high compared to historical basis. So, we’re not seeing a slowdown as far as them picking and choosing expansion as far as individual sites. What we’re seeing is — and it’s more not really the economic uncertainty of their customer. It’s more of the debt lending side of things, that the M&A activity we’re seeing slowdown. There’s not many doubles or home runs in the M&A market that we’re seeing that our tenants are picking up. It’s kind of more base hits where they’re doing 1 or 2 site bolt-on acquisitions. Now, we’re afforded the luxury is that we don’t need the home run here at NNN, that the pool that we are shopping at is plenty big for us to hit our targets.

Wes Golladay: Okay. And then, Kevin, I want to go back to your comments about the — how you view your weighted average cost of capital. I think you said it was in the low-7s and you’re — currently where you’re buying, have you historically tried to target a spread over that, or do you just view that, hey, we’re buying better quality and the overall quality mix is being transacted at our weighted average cost of capital…

Kevin Habicht: Yes. And I know I’m swimming upstream on this because that’s the vernacular of our industry to think about a spread above your cost of capital. But I think the way a lot of folks get to a spread above their cost of capital is they just take a low view as to what they — what kind of return on equity hurdle that they need to meet. So — and so in our pitch book, we use that example. If you think your cost of equity is 5.5%, to pick a number, then you come out on the weighted average cost of capital day close to 5.5% because that’s not far from that. And so, you think your cost of capital is very cheap. Again, this is not — we divorce sourcing capital from deploying capital. And look, I understand those two things get connected eventually.

But we try to layer on a level of extra discipline, if you will, of burdening our cost of equity for purposes of deploying capital at about 8.5% cost. And if you fully burden your cost of equity, you don’t really need a spread above that because you’re earning enough. You’re justifying — that’s what the hurdle rate’s there for is to say what do we need to earn to sufficiently compensate NNN shareholders. And so, — to your answer your question, we typically have not had a big spread above our cost of capital, but it’s been that way because we burden our equity at a higher rate than most other companies do. And we’ve set that hurdle there. And I think it leads to the better outcomes in the long run. In the past, call it, two years ago when the world was awash with money, we burdened our cost of equity at about an 8% return, and our cost of debt was a whole lot lower and our weighted average cost of capital in our minds was about a 6% level.

That’s what we said was the return requirement for NNN shareholder then. And so you didn’t see us do virtually any sub-6 cap rate deals, call it, two years ago. And now, the world’s changed. Interest rates are up. We’ve raised our return on equity hurdle. And so now we’re targeting kind of a low-7s kind of return. And we think that fully and sufficiently compensates our shareholders. And again, this is for purposes of deploying capital. When it comes to sourcing capital, we really take a little bit different view and we try to get capital when it’s available and well priced, almost irrespective of need. We know we’ll use it eventually. But that’s just the approach we take. And like I say, it — and we’ve been doing this for kind of consistently for a long time, but we do go about it a little differently.

And so, we never really get into the vernacular of a spread over our cost of capital because we really — we put extra burden on our equity return hurdles that I think compensates for that. So, anyway, sorry, that was a long-winded answer to your question.

Wes Golladay: No, I appreciate it. Thanks for the detailed answer, Kevin.

Operator: Our next question is coming from John Massocca with Ladenburg Thalmann.

John Massocca: Maybe building a little on Wes’ first question. As you kind of think about what your tenants are using, new dollars you’re investing with them for? Is it — what’s kind of the broad breakdown between expansion and maybe refinancing?

Steve Horn: It’s definitely skewed towards expansion currently. Our tenants haven’t — it’s still early on over a year into it that we’re not seeing our tenants having to refinance debt. Most of our tenants, it’s a business model decision to do sale-leaseback financing. They believe in not owning real estate because they understand they can take that equity, put it into operations and make a higher margin selling a service or a good that they’re selling opposed to the increased value of real estate. So, we don’t do a lot of refinancing. Historically, we’ve done a lot of M&A financing and bolt-on acquisitions and new store development is the vast majority of where we deploy capital.

John Massocca: Okay. And then, you talked about it a little bit in terms of Bed Bath & Beyond, but maybe more generally, what’s the demand like out there for vacant assets, vacant boxes, et cetera?

Steve Horn: So, out of the 20 current vacant assets that we have, we have about activity around a little over half of those assets right now, which — it’s a little bit nice surprise, John, how much activity we’ve had. Because typically, when it’s a vacant asset, it’s not our best real estate in the portfolio. We don’t get that back. But yes, those are definitely some movement of the smaller regional or even the mom-pop operators taking our vacant assets.

John Massocca: And I guess maybe how does that activity number compared to pre pandemic or earlier years?

Steve Horn: It’s definitely elevated right now that we’re seeing more activity with our vacant. First and foremost, we always try to re-lease our vacant. But after a certain amount of time, it’s not realistic to hold on the vacancies. You could get the overhead drag and we’d rather just sell them, even though it might not be top dollar and then redeploy that money accretively into acquisitions.

Operator: Thank you. Here is we have reached the end of our question-and-answer session. So I will now turn the call back over to Mr. Horn for closing remarks.

Steve Horn: Thank you, Ali. NNN’s in a great position here heading into the second quarter. I look forward to it. Thanks for joining us this morning. And we look forward to seeing many of you in person in the upcoming conference season, specifically ICSC and NAREIT. Thanks for joining.

Operator: Thank you. This does conclude today’s conference, and you may disconnect your lines at this time, and we thank you for your participation.

Steve Horn: Thanks, Ali.