Spirit Realty Capital, Inc. (NYSE:SRC) Q4 2022 Earnings Call Transcript

Spirit Realty Capital, Inc. (NYSE:SRC) Q4 2022 Earnings Call Transcript February 28, 2023

Operator: Good day and welcome to The Spirit Realty Capital Fourth Quarter 2022 Earnings Conference Call. . Please note that this event is being recorded. I’d now like to turn the conference over to Pierre Revol, Senior Vice President of Corporate Finance and Investor Relations. Please go ahead.

Pierre Revol: Thank you, operator and thanks everyone for joining us for Spirit’s fourth quarter 2022 earnings call. Presenting today’s call will be President and Chief Executive Officer, Jackson Hsieh; and Chief Financial Officer, Michael Hughes. In addition, our Chief Investment Officer, Ken Heimlich, will be available for Q&A. Before we start, I want to remind everyone that this presentation contains forward-looking statements. Although we believe these forward-looking statements are based on reasonable assumptions, they are subject to known and unknown risks and uncertainties that can cause actual results to differ materially from those currently anticipated due to several factors. I refer you to the Safe Harbor statements in our most recent filings with the SEC for a detailed discussion of the risk factors relating to these forward-looking statements.

This presentation also contains specific non-GAAP measures. Reconciliation of non-GAAP financial measures to most directly comparable GAAP measures are included in the exhibits furnished to the SEC under Form 8-K, which include our earnings release and supplemental investor presentation. These materials are also available on the Investor Relations page of our website. For our prepared remarks, I am now pleased to introduce Jackson Hsieh. Jackson?

Jackson Hsieh: Thanks, Pierre, and good morning. We’re pleased to report strong results for 2022, which exceeded the targets we announced in 2019. We achieved AFFO per share of $3.56, surpassing the midpoint of our 2019 Investor Day range by $0.14. We also increased our total ABR to $681 million, while increasing our industrial exposure to 23% with both hurdles exceeding our Investor Day targets. Furthermore, we maintain high occupancy, low lost rent, and stable unreimbursed property costs across our portfolio of 2115 properties. These results reflect our prudent underwriting approach and well diversified portfolio leased to sophisticated operators in durable industries. During the quarter, we invested $312.4 million in 24 properties at a 7.27% cash capitalization rate.

88.4% of these investments were in industrial assets, including distribution, light manufacturing, and industrial outdoor storage, with 90.2% of the investments originated through sale leaseback transactions. We also invested $38.5 million in development and revenue producing capital expenditures, almost half of which was related to our $67 million investment in $125 million cutting-edge facility for SunOpta, a leading plant-based food manufacturer. This facility opened for operations in December. Our disposition program also produced great results in the fourth quarter, we sold 21 occupied properties for $110.2 million at a 6.22% weighted average cash capitalization rate, representing a positive 93 basis point spread for a capital deployment cap rate and resulting in a $33.3 million gain.

The occupied mix included 42% retail, and 47% medical and only 4% of the sold properties were leased to investment grade tenants. For the year, we sold 278 million of leased assets at a weighted average cash capitalization rate of 5.47%, representing a 118 basis points spread for capital deployment cap rate and generating a $94.2 million gain. Only 24% of the sold properties were leased to investment grade tenants. Our capital recycling program, which started early in 2022, has been very successful. It has allowed us to further reshape the portfolio and accretively redeploy capital into asset classes and industries that we find attractive today. We expect continued success with dispositions this year, in total through acquisitions and dispositions, Spirit has successfully completed more than 150 transactions in 2022, which is a testament to our people and the robust processes we have established.

As I previously discussed, the majority of our fourth quarter acquisitions were in industrial assets, which continues to be a strategic focus for us. Given our growing exposure, we have featured notable achievements in this sector in our supplemental investor presentation. On Page 13, we spotlight the sales of Shiloh, Sunny Delight, BE Aerospace and Mac Papers Properties. These were industrial properties that we purchased and later sold, realizing 85% gain and capturing 312 basis points of cap rate compression, since we acquired these assets. On Page 14, we highlight the fourth quarter acquisition of a manufacturing facility leased to Way Interglobal, a top RV appliance manufacturer and supplier. In November, shortly after we closed on our sale leaseback Way Interglobal was acquired by LCI Industries, a much larger public company, and a major credit upgrade for Spirit.

On the same page, we feature the development of the 270,000 square foot, state-of-the-art SunOpta facility, illustrating how Spirit can partner with industrial tenants to build mission critical facilities. Finally, on Page 15, we highlight select industrial acquisitions completed in the fourth quarter, including one, distribution and two, industrial outdoor storage facilities. We find these investments appealing because they’re mission critical assets leads to strong operators with low in place rents. And while the acquisition yields are very attractive for us today, we anticipate that these facilities just like the industrial dispositions featured on Page 13 will appreciate in value over time. One of our earlier investments within the industrial sector was the 129 million sale leaseback transaction for a distribution center and two manufacturing facilities leased to Party City that we completed in 2019.

We highlighted this investment at our Investor Day and provided an update on Page 16 of the supplemental investor presentation. What’s important to note is that despite Party City’s ongoing bankruptcy, we expect a positive outcome for Spirit given Party City’s dominant position in the party goods sector, and the assets high quality and mission critical nature. 85% of our investment is in the 900,000 square foot distribution center in Chester, New York, which is located in Orange County. This property serves as Party City’s primary distribution center, running at full capacity and handling over 45,000 SKUs for clients across the globe. Given its critical role in the company’s operations, this facility epitomizes the concept of mission critical.

In addition, market rents for distribution centers in Orange County stand at $11 per square foot and are projected to increase by 6% this year. This is significantly higher than our current rental rate of $8.05 per square foot, which grows contractually at 2% per year. Our investment in this facility is well below replacement costs and should we ever have the opportunity to re-let the asset, there is significant upside in this property due to the high tenant demand for distribution centers, the lack of others of this size and the difficulty of doing ground up development in this market. The two other facilities are smaller in terms of investment, but also have great stories. The Eden Prairie site is a manufacturing facility, responsible for production of 60% of the world’s Mylar Balloons.

This building is in a strong sub-market and is vital to the anagram business, the manufacturing arm of Party City. Like Chester, it is an example of a mission critical asset. The Los Lunes facility is a high-quality asset in an excellent location. Notably, there’s already been sub-leased to Cupertino Electric at the same rental rate that Party City was paying, showing the versatility and quality of the light manufacturing assets we pursue. As a reminder, our approach to underwriting is based on analyzing industry duration, and our tenants position within it, examining tenant credit worthiness and evaluating the real estate residual value underpinning the facility. While it is important to get all three right, when you enter into a sale leaseback, we know that credits can change to the positive or negative for a variety of reasons.

So the industry and real estate are paramount. In the case of Party City, the credit deteriorated. But we remain confident in the industry and Party City’s position as the dominant party goods supplier and manufacturer and believe the real estate is extremely valuable. We therefore expect a positive outcome for Spirit’s investment and believe this will be a good proof of concept for underwriting approach. As we think about the current year, we remain committed to taking actions that will create the most value for shareholders. We have set forth a fully financed capital deployment plan, utilizing free cash flow, asset dispositions and in-place debt to produce positive investment spreads in a volatile capital markets environment. Our focus for the upcoming year is to showcase our portfolio strength and highlight our platforms effectiveness, which we expect to result in steady cash flows and dividends for our shareholders.

With that, I’ll turn it over to Mike to discuss the quarter and our 2023 guidance.

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Mike Hughes: Thank you, Jackson. Good morning, everyone. Once again, our operations continued to perform at a very high level during the fourth quarter. We achieved a slight increase in occupancy a 0.1% to reach 90.9%. Our lost rent improved from 0.3% in the third quarter to only 0.1%. Our weighted average lease term remained stable at 10.4 years. Our unreimbursed property costs remained steady at 1.4%. Our ABR increased by 19.9 million, reaching 680.9 million. The increase was driven by net acquisitions at 15.1 million, organic rent growth of 4.8 million. Our forward same-store sales growth stabilized at 1.6% as the majority of the movie theaters re-tenanted during COVID, which were driving a slightly higher growth have largely returned to paying full base rent rather than variable rent.

AFFO per share was $0.88 compared to $0.90 in the third quarter. The $0.02 decrease was primarily attributable to a reduction of 1.7 million in non-tenant income, an increase of 1.8 million in cash interest expense, reflecting a full quarters impact of the 800 million term loan borrowings, which we swapped to a fixed rate of 3.5% in August. Turning to our balance sheet, we issued 1.6 million shares during the quarter under our ATM program, generating net proceeds of 63.9 million. We ended the year at 5.2x leverage with liquidity of 1.7 billion comprised of cash and cash equivalents, restricted cash and availability under our credit facility and delay draw term loans. We expect to draw on the term loan towards the middle of the year. In addition, our deferred rent balance declined by 7.4 million during 2022 to 7.9 million at year-end and should decline to 3.5 million by the end of 2023.

As a reminder, our deferred rent has already been recognized in earnings, therefore the repayment of deferred rent only impacts our balance sheet. Now for 2023 guidance, our AFO per share range is $3.53 to $3.59, the capital requirement of 700 million to 900 million, and dispositions of 225 million to 275 million. To better understand our guidance, we have provided a walk from Q4 2020 annualized AFFO per share to the midpoint of our 2023 AFFO per share on Page 4 of our supplemental investor presentation. As we noted on Page four, we believe that annualized fourth quarter 2022 AFFO per share, equating to $3.52 is the right run rate for analyzing and understanding our 2023 guidance, as the fourth quarter includes the full impact of the aforementioned $800 million of term loans and minimal non-tenant income.

Walking forward with $3.52 per share, we expect about $0.04 from organic tenant growth, $0.06 from our 2023 net capital deployment, plus $0.05 from last rent reserves, which equal 1% of our AVR and less another $0.01 for inflationary G&A increases. Keep in mind that as is usually the case at this point during the year, the last rent reserve is an assumption is not specific to a particular tenant. As Jackson mentioned, our capital deployment plan is entirely funded through free cash flow, dispositions and our existing debt capacity with no reliance on the capital markets. Should the capital markets turn more favorable, or we find compelling risk adjusted return opportunities, we will certainly consider taking advantage of those situations. But for now, we remain cautiously optimistic and disciplined in our approach to the year.

With that, I will turn the call back to the operator to open it up for Q&A. Operator?

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Q&A Session

Operator: Thank you. We will now begin the question-and-answer session. . Our first question comes from Wes Golladay with Baird. Please go ahead.

Wes Golladay: Just quick point on the net investment activity. What type of spread are you looking at for investments this year? I think last year, you said you were around 118 basis points.

Mike Hughes: Hi, Wes. This is Mike. Yes, I mean, given the way we size it and the way we’re going to use capital to acquire we’re looking at about 200 basis points of spread.

Wes Golladay: Okay, fantastic. And then, you do have that 500 million delayed draw a term loan? Do you have to draw the whole thing? Can you do a partial on that? And what do you think about timing and putting on swaps? Or do you already have a swap to that?

Mike Hughes: Yes. We haven’t swapped that yet. That’s something we’ll continue to evaluate and be optimistic about as far as timing, contractually, we need to draw that by middle of the year at July 1, although there is some flexibility that we can use to negotiate longer term extensions on some of that if we need to.

Wes Golladay: Okay. Can you do the whole thing, or can you do partial?

Mike Hughes: Yes. You can do partial up until July 1. So you do partial and then by July 1, you need to draw the whole thing unless we could actually get an extension.

Operator: Our next question comes from Haendel St. Juste with Mizuho.

Haendel St. Juste: I guess first question is, you guys backed up 3.2 million of deal pursuit costs in the quarter? I know you had a little bit last quarter, 470,000, I think, curious if there’s any comments or anything you’d like to share on what drove that big increase? Or was anything? Well, any comments you can make probably on that. Thanks.

Jackson Hsieh: Sure. Hey, Haendel. Good morning. It’s Jackson. That was kind of a one-off situation. It was a large transaction that we were looking to acquire. We spent quite a bit of time on last year. We also had obviously a large number of transactions that we completed. We closed over 100 separate transactions and U.S. cap rates were moving up throughout the year. We dropped a lot of transactions, if tenants were either delaying or if environmental due diligence or lease terms didn’t come back the way we had initially underwrote the transaction and committed to it. We walked away. I’d say it’s a combination of more transactions, more terminated transactions and a large acquisition that we were looking at potentially acquiring last year.

Haendel St. Juste: Okay. Fair enough. Appreciate that color. And maybe just a follow-up on the $0.05 of reserves embedded in the guide here. I know you guys don’t want to get into a conversation around specific tenants, but maybe can you talk a bit broadly about the watchlist year exposure to kind of the at known risk categories? And then, specifically, Party City, you mentioned that you don’t anticipate any rent disruption during or after emergence of bankruptcy. So just curious what scenario is broken, so guide for that as well?

Jackson Hsieh: Yes. Maybe I’ll start first, and handover. We typically use a 1% reserve, it’s just a normal loss rent reserve that’s been historically what we’ve done, last year was slightly less. From what we see today, obviously, Party City is going through a restructuring right now, and we feel, as I talked about in my comments, we’re highly confident in that asset in the cash flows. And if those cash flows change and we’re wrong. We think there’s actually upside in those cash flows given the real estate and things I talked about in the prepared remarks. As it relates to watchlist, yes, we’re looking at more things. There’s more things, obviously, just given the environment that we’re sitting in. I can actually tell you today that the realized active things that we’re looking at in terms of lost rent are not here right now.