Essential Properties Realty Trust, Inc. Q2 FY2022 Earnings Call

Good morning, ladies and gentlemen, and welcome to the Essential Properties Realty Trust Second Quarter 2022 Earnings Conference Call. This conference call is being recorded, and a replay of the call will be available 2 hours after the completion of the call for the next 2 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. It is now my pleasure to turn the call over to Dan Donlan, Senior Vice President and Head of Capital Markets at Essential Properties. Thank you. Please go ahead.

Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties' Second Quarter 2022 Conference Call. Here with me today to discuss our operating results are Pete Mavoides, our President and CEO; and Mark Patten, our CFO. 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 date 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, Pete, please go ahead.

Thank you, Dan. And thank you to everyone who is joining us today for your interest in Essential Properties. As our second quarter results indicate, our portfolio continues to perform at a high level with just 2 vacancies, same-store rent growth of 1.9% and unit-level rent coverage now at the highest level in our history. Additionally, with the recent data indicating a slowdown in demand for consumer discretionary goods, but continued strength in the demand for services, our portfolio remains well positioned in the current economic environment as over 93% of our ABR is derived from service-oriented and experience-based businesses. On the investment front, we remained active in support of our long-standing tenant relationships, but we did deliberately slow our investment pace to allow seller expectations to better reset to the rapid changes that occurred in the capital markets this quarter. Looking out to the back half of the year, we see our investment pace trending towards our trailing 8-quarter average at modestly higher cap rates, which, along with the recent closing of our $400 million unsecured term loan, supports our decision to increase our 2022 AFFO per share guidance to a range of $1.52 to $1.54 from a previous range of $1.50 to $1.53. Turning to the portfolio. We ended the quarter with investments in 1,561 properties that were 99.9% leased to 322 tenants operating in 16 industries. Our weighted average lease term stood at 13.8 years with only 4.3% of ABR expiring through 2026. Our weighted average unit-level coverage ratio improved to 4.0x from 3.8x last quarter. While our traditional credit statistics, which focus on implied credit ratings and unit-level coverage, experienced strong sequential improvement this quarter, these statistics are negatively skewed by, one, our trailing 12-month reporting convention, which lags our own reporting by 1 to 2 quarters; and two, the fact that various municipalities were still placing capacity restrictions on certain industries well into 2021. We continue to expect these statistics to improve sequentially, particularly at the low end of the coverage spectrum as demand for the services and experiences that our tenants provide largely improved throughout 2021 and into the first half of this year. During the second quarter, we invested $176 million through 23 separate transactions at a weighted average cash yield of 7%. These investments were made in 11 different industries with 70% of our activity coming from the quick service restaurant, car wash, and family entertainment industries. The weighted average lease term of our investments this quarter was 17.2 years. The weighted average annual escalation was 1.5%. The weighted average unit-level coverage was 2.7x, and the average investment per property was $3.9 million. Consistent with our investment strategy, 100% of our quarterly investments were originated through direct sale leasebacks, which are subject to our lease form with ongoing financial reporting requirements and 86% contained master lease provisions. From an industry perspective, early childhood education remains our largest industry at 13.7% of ABR, followed by quick service restaurants at 12.9%, car washes at 11.7%, and medical and dental at 11.3%. Of note, unit level coverage for our early childhood education portfolio is now above pre-pandemic levels as our operators have experienced strong pricing power due to a favorable supply-demand imbalance. From a tenant concentration perspective, our largest tenant represents only 3.2% of our ABR at quarter-end, and our top 10 tenants account for just 19% of ABR, which was down 20 basis points versus last quarter. Increased tenant diversity is an important risk mitigation tool and 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 8 properties this quarter for $26.1 million in net proceeds at a 6.2% weighted average cash yield with a weighted average unit-level coverage ratio of 1.1x. As we have mentioned in the past, owning liquid properties is an important aspect of our investment discipline as it allows us to proactively manage industries, tenants, and unit-level risks within the portfolio. We expect our level of dispositions to remain elevated in the back half of the year as cap rates for individual granular properties remain near historic lows. With that, I’d like to turn the call over to Mark Patten, our CFO, who will take you through the financials and balance sheet for the second quarter. Mark?

Thanks, Pete, and good morning, everyone. The second quarter was another strong quarter for us, which was certainly an output of the performance of our portfolio. The notable elements of our reported operating results for the second quarter of 2022 are as follows: Total revenue was up $14.4 million or 25.2% versus the same period in 2021, totaling $71.4 million for Q2 2022, which reflects the impact of our net investment activity and the performance of our tenant base. I'll mention that in contrast to last quarter, our investment activity this quarter was heavily weighted toward the back end of the quarter, while our asset dispositions occurred more at the beginning of the quarter. Total G&A was just over $7 million in Q2 2022 versus $6.5 million for the same period in 2021, which primarily was reflective of higher non-cash stock compensation expense. Our cash G&A moved lower sequentially from Q1 2022 by approximately $400,000, which included the impact of lower payroll-related costs, which, as I mentioned in our Q1 2022 conference call, were elevated in Q1 2022 and the adjustment to our incentive compensation accrual in Q2 2022. Our cash basis G&A continues to scale favorably as a percentage of total revenue, coming in at just 6.8% for Q2 2022 versus 8.1% for Q2 2021. Net income was $35.8 million in the quarter. Our FFO totaled $54 million for the quarter or $0.41 per fully diluted share, a 28% increase over the same period in 2021. Our nominal AFFO totaled $50.6 million for the quarter, up $10.7 million over the same period in 2021, which on a fully diluted per share basis was $0.38, an increase of 12% versus Q2 2021. Turning to our balance sheet, I'll highlight the following. With another solid quarter of investments, our income-producing gross assets reached $3.7 billion at quarter-end. From an equity perspective, we generated approximately $32 million of net proceeds during the second quarter on our ATM program. Our ATM activity was lighter than recent quarters, in part due to the challenging dynamics in the equity markets, but also as we generated liquidity through recycling capital from asset sales and loan repayments. Subsequent to quarter-end, we closed a $400 million 5.5-year term loan. We completed the term loan through an amendment of our $800 million credit facility. The rate on the term loan is floating at 1-month term SOFR plus 95 basis points. At closing, $250 million of the term loan was funded with the remaining $150 million available on a delayed draw basis. We greatly appreciate the support of our lender group in partnering with the company to get this fully prepayable term loan executed at attractive rates. Our net debt to annualized adjusted EBITDAre was 4.7x at quarter-end, and our total liquidity, including the remaining $150 million available to us on the term loan, is approximately $808 million. We utilized the $250 million funding from the term loan to effectively pay off the outstanding balance on our revolver. Our conservative leverage position, strong balance sheet, and significant liquidity position continue to be supportive of our investment pipeline and future growth plans. Lastly, I'll reiterate that our current investment pipeline, outlook for the core portfolio, and strong performance this quarter provided us with a basis to increase our 2022 AFFO per share guidance range to the $1.52 to $1.54 that Pete mentioned, which implies a 14% year-over-year growth rate at the midpoint. With that, I'll turn the call back over to Pete.

Great. Thanks, Mark. Operator, please open the call for questions.

The first question is coming from Greg McGinniss of Scotiabank.

Pete, you mentioned in the opening remarks that cap rates remain near historic lows. Just curious, what do you think may change that? Right? Could we potentially see expanding cap rates in the back half of the year? I mean, debt costs have obviously gone up. So just curious what you think is holding the cap rates and whether that might change?

Yes, Greg, thank you for that. I made that comment in relation to our activities in the market for individual assets, specifically properties being sold to retail investors and in the 1031 exchange market. That market is still quite constrained, and it seems to be influenced by factors that aren't completely linked to interest rates. It's more about the search for yield, tax deferrals, and other elements. I also mentioned our future pipeline. We closed our pipeline at a 7% cap rate, and we expect to see a slight increase in cap rates in the latter half of the year. The market is intriguing. One of the reasons we intentionally slowed down our pipeline this past quarter was to let asset pricing align with rate changes, and we anticipate that will become apparent in the latter half of the year.

Okay. And then in thinking about the current environment and whether or not we're in a recession right now, are you starting to see any impact to your tenants? I mean, the tenant credit metrics all look pretty strong and continue to improve on a trailing 12-month basis. But are you having to look at some of your tenants in terms of potential credit loss this year or those that might be going on your watch list?

No, we really haven't observed any signs of weakness. In fact, the coverage levels are at all-time highs and the portfolio is in excellent condition and performing well. One aspect that often goes unrecognized is the stress test these tenants experienced during COVID, which led to the right-sizing of their operations and their recovery from that period. Therefore, we are not seeing any issues, nor do we foresee any, and our tenants are managing their situations effectively.

Okay. And then just a comment, not a question, but the Chicken N Pickle concept looks amazing and I want one in New York.

Well, those guys are a great operator. They've got a great concept that's really resonating, and I don't know that we would want the basis that it would cost to put in New York, if you're talking about the city, but they are definitely expanding and that concept has some good legs to it.

The next question is coming from Nicholas Joseph of Citi.

It's Corey on with Nick Joseph. I actually have a question on the transaction pipeline. I'm just curious, with rising rates, are you seeing that impact demand? Could you just comment on how that buyer shift is looked at by market? Are some markets disproportionately impacted by buyers' commentary around ...

I had a tough time with that question. You really broke up. Did you catch it, Dan? No? Can you say it, can you repeat the question?

It feels like cap rates and ...

I can just repeat it. I'm just curious if you had any insight on occupied markets on rising rates to buyers?

Yes. In the retail investor and 1031 market that we operate in, which is a national market, we haven't noticed much of that impacting us. There is a significant variation in rates based on the asset class and the purchase price of the assets, but I haven't observed any substantial changes in that market, especially not by geography.

Got it. And then are there any changes to lease escalations in some of your newly signed deals, you know, with the impact of inflation or maybe a tougher macro backdrop? Has that impacted conversations around lease escalators?

It really hasn't. And if you think about how we operate our business, where 80-plus percent of what we're doing in any quarter is repeat business with guys where we already have a negotiated lease, it's really not creeping into the narrative. And so we're doing 20-year leases, and this recent spate of inflation for the first time in 30 years really hasn't changed that negotiating dynamic.

The next question is coming from Haendel St. Juste of Mizuho.

So Pete, I remember you had, I think, $330 million under contract or LOI. What portion of this, I guess, is still in the pipeline for the third quarter? I guess trying to understand what's in the pipeline, the type of deals – the volume for the second quarter is obviously a little bit below the historical trend. So I’m curious if these deals are now part of the pipeline for the second half as you’re looking at it? And maybe you can give us some color on what’s in that pipeline? Any new categories?

Yes. The pipeline is quite dynamic and typically reflects a 90-day outlook, though some deals may extend beyond that due to the nature of our investments in mergers and acquisitions, which often involve uncertain timing. Therefore, it's hard to pinpoint an exact percentage. The discussion during the call indicated we expect our investment levels to align with the average over the past eight quarters in the latter part of the year, suggesting a figure around 200. The pipeline supports this expectation. Regarding the pipeline's composition, there are no significant updates. It's important to note that since we derive 80% of our business from repeat and relationship-driven transactions, the deals will predominantly come from our previous portfolio and established relationships. Consequently, the pipeline will largely reflect our existing holdings, with only slight changes such as some expansion in cap rates.

Great. Maybe one on dispositions. I wanted to understand the cap rate there. A bit lower than we expected. The volume's a bit more – I understand it’s the incremental source of capital these days. But maybe you could talk about the level of cap rates, is that a level we should expect? And maybe the decision to sell assets so late in the quarter, did that influence what you sold in the cap rates at all?

Yes. Listen, I think the timing of dispositions is reflective of our decision to kind of lean into capital recycling as a result of the movements in rates that we saw during the quarter. That sales cycle just by design puts it towards the end of the quarter. And we anticipate staying on our front foot in terms of dispositions in the back half of the year. The cap rates on dispositions are going to vary wildly, and it’s not a material part of the financial picture. So I wouldn’t guide much lower than you saw printed, but I would expect that we would generally transact kind of around that 6% range or below. I did make the commentary that Citi asked about at the beginning that this market remains pretty robust, and it’s somewhat disconnected from movements in rate. And so there’s a real disconnect for us to sell into that and realize those rates despite the movements in cap rates and interest rates, as well as selling off kind of the assets that we don’t want to hold on a long-term basis. So the liquidity we built into the portfolio is an important risk mitigator for us and this is an important source of capital, and you should expect us to tap that as we look at the back half of the year.

The next question is coming from Sheila McGrath of Evercore.

Pete, borrowing costs are up, depending on the company, 50, 100 basis points or more. I just wonder, based on your experience, in the net lease sector, if you think that cap rates can move in lockstep with borrowing costs rise? Or do you expect a lag here?

There is definitely always a delay as we work through our pipeline, which typically spans about 90 days. This is one reason why our second quarter results of $176 million reflect a 7% cap rate, as these were largely deals we committed to before the rate changes. That's why we are projecting low 7s and higher for the latter half of the year. There is a delay in how cap rates respond to changes, and usually, cap rates do not move in tandem with interest rates. They do tend to move in the same direction, but it takes some time and tends to be somewhat muted.

Okay. And then the GAAP cap rate for acquisitions tweaked back to 8%. It hasn't been at that level for a couple of years. Just wondering, were you able to originate current product with higher annual escalations?

Yes, that's what that was indicating. It also aligns with our weighted average lease term being so long at 17.2 years. We were originating deals that were slightly longer as well.

The next question is coming from Josh Dennerlein of Bank of America.

This is Lizzy Doykan on for Josh. Back to the question on tenant credit quality. I was wondering if you could explain why the rent coverage ticked down to 2.7x from about 3.3x last quarter. If you could explain the trend in that?

I believe the key trend to focus on is the performance of our overall portfolio rather than our individual quarterly investments. The number we reported reflects the investments made during the quarter, which can fluctuate significantly based on the mix of industries and property types from one quarter to the next. The more significant trend is that our portfolio's overall coverage has grown to 4 times, the highest level we’ve seen. The 2.7 times figure represents a very small part of the entire portfolio and is largely affected by the specific deals we engage in.

Okay. And for my second question, I’m just wondering if you all have changed your thinking around underwriting new acquisitions. It seems to be on track, and you haven’t changed your outlook for that, for the 8-quarter trailing average. But given the conditions, has there been any change in how you’re thinking about underwriting?

There are really two aspects to consider here. The first is underwriting risk, and the second is managing and growing the business. Our approach to evaluating underwriting risk with our tenants has been developed over decades of investing in this asset class, and that approach remains consistent and is not likely to change. Regarding our acquisition pace, even though our cost of capital isn't as favorable as it has been, it is still attractive, with many opportunities available due to reduced competition, especially as current market volatility has eliminated much of that competition that we faced earlier this year. We have strong relationships that keep providing us with investment opportunities to expand our portfolio and enhance our earnings. Therefore, we are optimistic about what we see in the latter part of the year, and we plan to continue deploying capital in this direction.

The next question is coming from Ki Bin of Truist Securities.

Can you talk about the debt raise you guys just did? I believe it’s still floating – if you have any plans to swap it and what that cost could look like?

Yes. Thanks for that question. I'll start with saying what we've consistently said before that our philosophy is really to match fund our leverage to our long-dated leases, which we certainly plan to do. But it just strikes us that now is not an opportune time to lock in that long-term funding given the dislocation that we see in the public unsecured debt market. So not swapping the long 5-year term loan really sort of preserves our optionality around the prepayment capability. And that's really why we're there.

If you can just kind of help me – satisfy my curiosity though, what would the swap rate be if you did it in this type of market?

Go ahead, Dan, what do you get on that?

Yes. It's around 2.3% right now, Ki Bin, on a 5-year basis.

Okay. And as cap rates do tick up higher, I'm guessing it’s not going to be for all types of assets and all categories together, right? What do you think shakes loose first? And would those types of assets be things that you’d be interested in? So I guess I’m asking, for the sort of things that you’re typically looking to buy, would those cap rates move upwards as well?

Yes. The way we invest involves providing sale-leaseback capital to growing operators within our targeted 16 industries, primarily leaning on established relationships from past dealings. Our competition for these deals is influenced by two main factors: the level of competition and our rivalry with other capital sources. We typically face competition from various types of financing, whether unsecured or mortgage-related. When capital becomes more expensive or less accessible, our sellers, counterparties, and tenants tend to be less sensitive to pricing. Consequently, we are witnessing an opportunity to adjust cap rates across the full range of investments in all our industries. We continue to steer clear of highly competitive auction situations that tend to drive cap rates down, such as with investment-grade existing lease deals. Nonetheless, we are observing the potential to adjust cap rates across all our opportunity sets, albeit at a gradual pace.

The next question is coming from John Massocca of Ladenburg Thalmann.

Regarding the disposition front, it appears that much of the capital recycling has been influenced by loan receivable prepayments. I am interested in the prospects for additional tenant prepayments in the near to medium term, considering that we have seen significant amounts of this in two of the last three quarters.

Yes. I would start by mentioning that our loan book is relatively modest at around $200 million. Therefore, we don't have a large amount. I anticipate that we will continue to see some loan payoffs in the second half of the year, although they may not be as significant as what we experienced this quarter. However, we do not have control over this process; it ultimately hinges on when the borrower chooses to seek alternative funding or decides to repay. So, the timing of these payoffs is uncertain.

Okay. And then maybe bigger picture, kind of with recession and an economic pullback, at least in people's minds or kind of outlooks going forward. As you kind of look back in your experience in kind of the sale-leaseback market with the middle market credits, in prior cycles, maybe, and maybe as you look forward, if there is an economic slowdown, how correlated do you feel deal flow is to economic activity? Essentially, your tenants either aren’t confident or in a position to expand or consolidate? I mean how do you think that flows through to your transactions? Or do you think it’s kind of immune to that because you’re a reliable source of capital maybe?

Yes. I would say we are somewhat immune to that because our opportunity set is so large and our investment volumes are so modest relative to the opportunity set. And we go to market with a great cost of capital relative to a lot of alternatives. I would also point out that our 16 industries and our service and experience-based industry focus is one of the bright spots of the economy and really fighting the trend, and services and experiences are doing pretty well. And our tenants within those industries continue to do well. And so that’s one of the reasons why we’re maintaining our kind of guidance and raising our guidance despite what is not a completely sunny outlook.

The next question is coming from Chris Lucas of Capital One.

Pete, just kind of going back to the disposition pool that you guys are thinking about and just kind of reviewing the last trailing 8 quarters, there’s sort of a mix of what appears to be sort of risk mitigation in terms of low coverage-type assets being sold as well as maybe some more median credit issues. So I’m just curious as to when you guys think about the disposition pool that you’re looking at to sort of fund acquisitions, is it risk mitigation? Or is it relative value that drives what goes into that pool?

I would say it's not for show, but it's more about assessing risk and selling assets that don't align with our long-term investment goals. This process involves removing those assets from our portfolio. When we sell assets from the master lease, we set a specific rent on each asset, which impacts our overall position. Generally, this is about managing risk. Occasionally, we receive unsolicited offers for assets at prices that significantly exceed our value expectations, and we may accept those bids. However, primarily, it's about mitigating risk.

Okay. And then as it relates to – I guess I’m just trying to understand, we talk about interest rates and its impact on cap rates. I guess, I just want to make sure that – is there a specific rate benchmark that you’re looking at? Obviously, with the increased concerns about a recession, you’ve seen sort of a flight to the 10-year, it’s come down quite a bit just in the last couple of weeks. Just kind of curious when you think about what drives that potential move in cap rates? What rate are we really talking about?

I think the 10-year really becomes the best proxy given the long-dated nature of this asset class and just the liquid nature of the 10-year. Most investors in this space are looking to match fund and term debt similar to the underlying lease term. And so I think the 10-year becomes the best proxy.

Thank you. At this time, I'd like to turn the floor back over to Mr. Mavoides for closing comments.

Great. Well, thank you all for your participation today and your questions. We appreciate your interest in our company. And everyone, have a great summer. Thank you.

Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect your lines at this time, and enjoy the rest of your day.