Essential Properties Realty Trust, Inc. Q1 FY2021 Earnings Call

Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust First Quarter 2021 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. This conference is being recorded and a replay of the call will be available 2 hours after completion of the call for the next two weeks. The dial-in details for the replay can be found in today'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.

Thank you, operator, and good morning everyone. We appreciate you joining us today for Essential Properties first quarter 2021 conference call. Here with today to discuss our first quarter are Peter Mavoides, our President and CEO; Gregg Seibert, our COO; and Mark Patten, our CFO. During this conference call, we will make certain statements that may be considered forward-looking statements under federal securities laws. 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 release. With that, Pete, please go ahead.

Thank you, Dan. And thank you to everyone who is joining us today for your interest in Essential Properties. The first quarter was solid for us on all fronts. In terms of the portfolio, our portfolio demonstrated great stability and durability as our tenants largely put the impacts of COVID-19 behind them and emerged from the pandemic as stronger operators. While the pandemic continues to affect businesses, these burdens are now more manageable with the vast majority of our tenants no longer needing support from us in the form of deferred rents. Additionally, in the fourth quarter and into the first quarter, we largely completed the repositioning of properties formerly leased to tenants that needed to restructure as a result of the pandemic. In terms of the investments, our industry relationships, which were strengthened during the pandemic, are driving investment activity as tenants continue to turn to us as a capital partner of choice for their real estate capital needs. As a result, the record level of activity that we experienced in the fourth quarter continued into the first quarter with another strong performance on the investment front. During the quarter, we invested $198 million into 74 properties at a 7.0% initial cash yield with over 16 years of lease terms. More importantly, 81% of these deals were repeat/relationship transactions and 80% were direct sale leasebacks on our lease form.

Thanks, Pete. During the first quarter, we invested $198 million in 74 properties through 200 separate transactions at a weighted average cash yield of 7%. These investments were made within 9 different industries, with over 95% of our activity coming from 4 industries: quick service restaurants, auto service, medical, and dental, and early childhood education. The weighted average lease term of our quarterly investments was 16.1 years. The weighted average annual rent escalation was 1.8%, the weighted average unit level coverage was 3 times, and our investment per property was $2.7 million.

Thanks, Gregg. As both Pete and Gregg noted in their remarks and as was evident in our release last night, we had a great first quarter, highlighted by strong revenue growth and our FFO and AFFO results, which on a per share basis were $0.30. Some notable elements in our reported operating results for the first quarter of 2021 include the following: Total revenue reached $48.6 million for Q1, an increase of $7.1 million or 17% over last year, which reflects the full quarter impact of our record level of investments of $244 million in Q4 2020 and more broadly our total 2020 investment activity of $603 million at a weighted average cash yield of 7.1%. For the first time since the onset of the pandemic, our results did not have notable adjustments directly related to COVID. That said, we did incur approximately $300,000 of property level expenses associated with property taxes and maintenance for a vacant property that was sold in April 2020, as well as a few properties that were re-let intra-quarter, so those should be non-recurring going forward. We recognized approximately $5.7 million in impairment charges during the quarter, with $3.8 million of this charge related to a single furniture property. We also recognized $3.8 million in gains on asset dispositions that Gregg mentioned during the quarter. Total GAAP G&A was $6.4 million in Q1 2021 versus $7.5 million in the same period last year. That's a 15% improvement, which reflected reduced costs for professional services, such as audit and legal, as well as certain outsourced services. We expect that these particular cost elements in our G&A will continue to trend favorably during 2021. We saw our recurring cash basis G&A for Q1 2021 decrease to approximately $4.8 million versus $5.6 million in Q1 last year, and notably, as a percentage of total revenue, our Q1 2021 cash G&A was just over 10%, a favorable level compared to Q1 2020, which was nearly 13% of revenue.

Great. Thanks, Gregg and Mark. With that, operator, please open the call for questions.

Thank you. We will now be conducting a question-and-answer session. Our first question comes from the line of Sam Choe with Credit Suisse. Please proceed with your question.

Hi, guys. Good morning. I was just looking at your investment activity and seeing that March was especially strong. I just wanted a reminder of how long investments typically take for you to complete once under PSAs or LOIs. I know much of it is relationship-based, which helps with the timing standpoint, but I'm curious if there have been any changes since the pandemic on that front?

Yes. Thanks, Sam. Generally, as we’ve said in the past, we have about a 60 to 90-day transaction cycle; 30 days to negotiate a contract and then 30 days to perform due diligence, and that may vary. We've closed deals as quickly as three weeks, and we've had deals that lag for many months, given that we’re predominantly sale leasebacks. A lot of our deals are driven by an underlying M&A transaction that often becomes the gating item for closing, where another operator is buying a competitor and conducting due diligence, and that business deal drives the timing. But generally, you should assume we have about a 60 to 90-day cycle on our pipeline.

Got it. Are you able to disclose how much investments are under PSA or LOI subsequent to the quarter?

Generally, we don't. In the context of our overnight offering that we did in April, we disclosed our forward pipeline in that context, which was about $250 million. My broad commentary would be that we have a full pipeline, and we're working hard to close the quality opportunities that we see and drive investments.

Thank you so much, guys.

Thank you, Sam.

Thank you. Our next question comes from the line of Sheila McGrath with Evercore ISI. Please proceed with your question.

Yes, good morning. Pete, in the supplemental on the leasing page, the retail line item looks to have some lease restructurings with a lower recovery rate. I was just wondering if you could provide a bit of detail on that?

Yes, Sheila. I would first start off by saying we generally don't have a lot of generic retail, and certainly the numbers that had a million one to 569 would support that. What you're seeing there is largely the impact of some of our Art Van restructuring leases.

Okay, great. And then I think Gregg mentioned that in the pipeline, there are more entertainment assets, but you're not focusing on cinemas. So what would that - what kind of tenants would that include and are cap rates any higher on entertainment assets now since the pandemic?

Yes. So I think what Gregg said is we're seeing some in our pipeline, and we're open to investing in both entertainment assets as well as casual dining, as those sectors have rebounded. That includes family entertainment centers, bowling alleys, trampoline parks, and other miscellaneous type uses while keeping discipline to have our granular and fungible properties; it wouldn’t encompass some special-use assets. Generally, that industry is going to be at the wider end of our cap rate range, but for high-quality operators and fungible assets, it's not going to be substantially wider than our average. I would consider that sector to be in the low 7 range.

Okay, thank you.

Thank you.

Thank you. Our next question comes from the line of Nate Crossett with Berenberg. Please proceed with your question.

Hey, good morning. So maybe just to follow up on Sheila's question a bit. The pipeline that's in place now, the pricing you're kind of anticipating is in the low sevens, is that correct? And then just your comments on competition and pricing overall given the recent trends?

Yes, I would say you should certainly expect to see us continue to transact in that low seven range, and the current pipeline is supportive of that. We've seen increased competition in the first half of the year as competitors have restarted their investment activities and new competitors have come into the space. This competition has not really abated as a result of rates sort of spiking up. But we think we have a great set of relationships, and people continue to choose to transact with us. We certainly have a full pipeline, and despite that competition, we expect to continue to invest in that kind of low seven range.

Okay, that's helpful. And then just one on the funding side, I think you have one investment-grade rating with Fitch, and I think last quarter you mentioned you may pursue another this year. Where does that stand?

Yes. If there were an update on that, we would have provided it. We're in dialogue with the agencies, and when we get somewhere, we'll let you know. But that's an ongoing discussion we’re having.

Okay. I mean, is there a material difference if you were to price then I’ll say 10-year money today, if you had to be investment-grade versus what you have right now?

It then gives you more granularity on it, but it certainly depends on which market you're pricing into. And I think the more validation of your credit that you have, the more expensive the universe of investors that you can approach. Given where the markets are today and what we're hearing is that there wouldn't be a material difference.

And I would say, Nate, with the recent equity raise and paying down our revolver and sitting on cash, we’re not in a position where we need any debt capital, but we're certainly preparing ourselves for the time when we do.

Okay, thank you.

Thank you.

Thank you. Our next question comes from the line of Haendel St. Juste with Mizuho. Please proceed with your question.

Hey, thank you for taking my question. Good morning.

Good morning.

I guess starting first on the auto service tenant issue in first quarter that drove the occupancy dip. It seemed like there were some prior concerns. I think the tenant was already on cash basis accounting. So what changed in the first quarter and is there any reason for us to be concerned about the sub-sector at all given this tenant issue, or is this more of a one-off in your perspective?

Yes, it was - I would say it shouldn't certainly give you any concern. The automotive service sector is doing fine and is one of the least impacted industries that we invest in from a COVID-related perspective. The occupancy dip is really not terribly material at all; if you think we're still at over 99%. We gave some commentary on the call, where we've worked through those assets. I would say broadly, given the COVID backdrop, we gave tenants more leeway than we normally would, really giving them the benefit of the doubt as the pandemic played out and impacted their business, trying to discern whether the operator was impacted truly from the pandemic or was just a bad operator. It took us a little longer to come to the conclusion that this was just a bad operator, and we needed to put better operators in place, and that's why we decided to do.

Got it, got it. Can you talk a bit more about maybe the timeline for re-letting those seven assets and how we should think about the new rents versus old and the recoveries you're underwriting?

Yes. Separate from the specific tenant, generally the mandate to our asset management team is to find the market for the asset. Finding the market means running an organized process and disciplined negotiations to find a replacement tenant or to sell. That process should not be any longer than 90 days. An orderly marketing and negotiation process might experience some fallout, which could prolong that, but it shouldn't go on for six months. To the extent that we have a vacant asset longer than six months, it is simply because we're not meeting the market. My expectation around timing is that we provide, in my view, really good disclosure on our re-let history. As we said on the call, we would expect the outcome on the specific situation to be consistent with our past experience.

Okay, fair enough. Any tenants began paying rents in first quarter, or did you recognize any prior period rent? What are you thinking about the prospects for some of the tenants on cash basis accounting, as well as the potential for reversing and recognizing some of the accruals? Thanks.

There is a lot going on in that question, Haendel. We repositioned many tenants throughout the fourth and into the first. A lot of assets are coming back online. There are many variables in our revenue and our tenant base, and I would say all of those variables are baked into our guidance. Generally, we're feeling good about our tenants and their payments. But Dan, you or Mark, please add anything to that.

I think what I'd add is on the deferral front. We had said all along that on the deferrals, the payback was anywhere from 12 to 18 months. We're probably 35% of the way into the deferral payments, and we're collecting substantially all of them, so we're in pretty good shape on the deferral front regarding what we agreed to defer.

Okay. And on non-accrual?

Yes, I mean, Haendel, I think you should expect the non-accrual bucket to continue to increase in terms of their collections throughout the year. In terms of the non-recognized deferrals, which we did not recognize in revenues, there is an opportunity for that to come into the earnings stream, but that wouldn't be until 2022 or beyond.

Yes. Whenever they pay us either in cash or we catch up, which would mostly be when we are caught up.

Got you, got you. I appreciate that, and I'll probably follow up with you guys offline to get a bit more color. Thank you.

Great. Thank you, Haendel.

Thank you. Our next question comes from the line of John Massocca with Ladenburg Thalmann. Please proceed with your question.

Good morning.

Good morning, Massocca.

As you start looking at investments in the entertainment sector, in particular, has there been any change to how you are structuring leases with potential new tenants post-pandemic, such as insurance requirements, deposits, or any kind of force majeure language, etc.?

No, not really. We have very durable leases and generally we're doing a lot of repeat business. In fact, some of the tenants in that sector that we're dealing with have leases already in place, and we’re just adding new properties to them. We haven't broadly seen changes in our leases as a result of the pandemic. Both investors and operators recognize that this is a hopefully once-in-a-lifetime event and shouldn't change the nature of an underlying 20 to 40-year agreement.

Okay. And then the other side of it, kind of considering how things are tightening, how are you thinking about underwriting in the casual dining space? Is it tough to get a feel for the segment given the balance of some of the reopening versus some of the headwinds that existed pre-pandemic and maybe some operating pricing pressures?

Yes, I think as we typically do through sale-leasebacks, we’re looking at 3 or 4 years of operating history and performance and understanding how that site has performed, both in a stabilized and challenged environment, and how that site has recovered. We're certainly digging into P&Ls and understanding kind of the sources of revenue, both on-premises and off-premises, and the like. Our discipline in terms of underwriting assets really hasn't changed. We certainly have more data to look at but ensuring that we're getting in at the right basis while buying units that are healthy and stabilized is what we're looking to do.

Okay, that's it from me. Thank you very much.

Thanks, John. Appreciate it.

Thank you. Our next question comes from the line of Chris Lucas with Capital One Securities. Please proceed with your question.

Hey, good morning, guys. Just Pete, a quick one on the early childhood education line of business. I'm curious about how that business performed over the last several quarters. And then I'm also curious if you have any thoughts on what the president's proposal on pre-K funding may do either as a tailwind or a headwind to that business?

Yes. The early childhood education space was severely impacted by the COVID pandemic, as we disclosed, and our collections in that sector kind of lagged in terms of recovery. As we sit today, those operators are open, operating, and paying, and occupancy, which was shut in the second quarter, rebounded from maybe 40% to 60% in the third quarter, and it's now around 60% to 80% almost full occupancy here in the fourth and into the first. So those operators are doing well, open, and operating. In terms of government initiatives for subsidized early childhood education, most of our operators are for-profit and not businesses that are driven or significantly supported by subsidies. Globally, to the extent that there is more demand for childcare, I think it will benefit operators and their ability to fill up the real estate that we own and they operate. We think it'll be a plus. But clearly, it's not something that our operators needed; it would simply be a nice tailwind.

Great, thank you. That's all I had.

Thank you, Chris.

Thank you. That does conclude today's question-and-answer session. I’d like to turn the floor back over to management for closing comments.

Great. Well, thank you all very much. We look forward to engaging with you over the next several weeks as we have a couple of non-deal roadshows coming up, and we're excited to continue executing here in the second quarter. Thank you all.

This concludes today's teleconference. You may disconnect your lines now. Thank you for your participation and have a wonderful day.