Earnings Call Transcript - EPRT Q2 2021

Operator, Operator

Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust's Second Quarter 2021 Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. This conference is being recorded and a replay of the call will be available two hours after the completion of the call for the next two weeks. The dial-in details for the replay can be found in 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.

Operator, Operator

Thank you, operator, and good morning everyone. We appreciate you joining us today for Essential Properties' Second Quarter 2021 Conference Call. Here with me today to discuss our operating results are Pete Mavoides, our President, CEO; Gregg Seibert, our COO; and Mark Patten, our CFO. During this conference call, we'll make certain statements that may be considered forward-looking statements under federal securities law. The company's actual future results may differ significantly from the matters discussed in these forward-looking statements, and we may not release revisions to those forward-looking statements to reflect changes after the statements are made. Factors and risks that could cause actual results to differ materially from our 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.

Pete Mavoides, CEO

Thank you, Dan, and thank you to everyone who is joining us today for your interest in Essential Properties. The second quarter was another strong quarter for us on all fronts. Starting with the portfolio. With collections at 99% in the second quarter and July collections at 100%, our portfolio has returned to pre-pandemic levels. While we continue to monitor how COVID could potentially impact our portfolio, our tenants have largely adapted to the current realities of the pandemic and emerged as stronger operators. With just two vacant properties at quarter end and one vacant property as of today, we have effectively repositioned all properties previously leased to tenants that did not survive the pandemic. With that in mind, over the trailing 12 months ended June 30th, we experienced recoveries of 87% on all re-leasing activity which is a strong indicator of not only the quality of our real estate, but our disciplined focus on owning fungible single-tenant properties at an appropriate basis. In terms of investments, our industry relationships which we work to cultivate and strengthen during the pandemic drove the bulk of our growth this quarter, as 98% of our investments being relationship business and we continue to deploy capital at high levels relative to our historical pace. During the quarter we invested $223 million into 94 properties at a weighted average cash cap rate of 7.1% with 88% of investments being originated through direct sale-leasebacks and 83% containing master lease provisions.

Gregg Seibert, COO

Thanks Pete. During the second quarter, we invested $223 million into 94 properties through 34 separate transactions at a weighted average cash cap rate of 7.1%. These investments were made in 11 different industries with over 65% of our activity coming from quick-service restaurants, medical dental, early childhood education, and casual dining. The weighted average lease term of our investments this quarter was 13.5 years. The weighted average annual rent escalation was 1.4%. The weighted average unit level coverage was 2.7 times, with the average investment per property being $2.4 million. Consistent with our investment strategy, 88% of our second quarter investments were originated through direct sale-leasebacks, which are subject to our lease form with ongoing financial reporting requirements and 83% contain master lease provisions. Looking ahead, we are seeing increased competition from existing and new market participants as there is a growing appreciation for the durability of our focused industries at middle market tenancy. As a result, we are experiencing cap rate compression as we seek to protect and service our relationships. From an industry perspective, quick-service restaurants are our largest industry at nearly 14% of ABR, closely followed by car washes at 13.8%, early childhood education at 13.6%, and medical dental at 12.5%. We continue to view these four business segments as Tier 1 industries for Essential Properties and therefore, they are likely to remain our highest concentration industries for the foreseeable future. Of note while much of our investment activity over the last 12 months has been focused on more pandemic-resistant industries, we have started to selectively invest in proven operators of profitable locations in both the entertainment and casual dining industries, which continue to experience strong rebounds in revenues and profits. From a tenant concentration perspective, no tenant represented more than 2.5% of our ABR at quarter end and our top 10 tenants account for just 19.5% of ABR, which was down 70 basis points versus last quarter. Increasing tenant diversity is an important risk mitigation tool and a differentiator for Essential Properties and it is a direct benefit of our middle market focus which offers a significantly more expansive opportunity set that is strategy concentrated on publicly traded companies and investment-grade rated credits. In terms of dispositions, we sold nine properties this quarter for $19.6 million in net proceeds. When excluding vacant properties and transaction costs, we achieved a 7.1% weighted average cash yield on these dispositions which had a weighted average unit coverage ratio of 1.8 times.

Mark Patten, CFO

Thanks Gregg and good morning everyone. We certainly did have a strong second quarter. The notable elements of our reported operating results for the second quarter of 2021 are as follows; total revenue was up $18.6 million or 48.2% versus the same period in 2020, totaling $57.1 million for Q2 2021, which reflects the benefits of a full quarter of our $198 million of investments in Q1 2021. More broadly, our total investment activity since we restarted our external growth in Q3 2020, which totaled $814 million at a weighted average cash cap rate of 7.1%. In addition our total revenues reflected approximately $3.1 million in revenue from our determination to move the number of tenants back to an accrual basis. The one-time adjustment, which was largely related to our five properties leased to AMC, resulted in the recognition of approximately $2.1 million of base rent revenue that was owed but not recognized in prior periods as well as another $1 million of related straight-line rent. In total, this adjustment added nearly $0.03 per share to FFO and just under $0.02 per share to AFFO. I'll note that this adjustment was based on our assessment regarding the probability of each tenant's performance pursuant to their lease both current and future rent payments including any deferral arrangements and was further supported by our evaluation of the tenant's operations and financial condition as of quarter end and an assessment of operating dynamics in their industries. Total G&A was $6.5 million in Q2 2021 versus $6.3 million for the same period in 2020. That's a 3.5% increase, which was largely due to an increase in non-cash stock compensation expense, offset by increased efficiencies related to cash components of G&A including amounts incurred for professional services as well as certain outsourced services. More importantly, our G&A continues to scale as our cash basis G&A as a percentage of total revenue was 11% for Q2 2021 versus 15% for Q2 2020. Net income was $23.4 million in the quarter, that's up 124% from Q2 2020. Our FFO totaled $37.2 million for the quarter or $0.32 per fully diluted share, a 23% increase over the same period in 2020. Our AFFO was up $14.6 million or $0.34 per fully diluted share, that's an increase of 26% versus Q2 2020.

Pete Mavoides, CEO

Thanks, Mark. We're excited that the operating environment and capital markets have allowed us to return to pre-pandemic levels and move forward with capitalizing on our robust pipeline of accretive investment opportunities in order to drive attractive earnings growth. More importantly, we believe our disciplined and differentiated investment strategy has created an incredibly resilient net lease portfolio that should continue to generate attractive risk-adjusted returns as we grow into the future. With that operator, let's please open the call for questions.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. Our first question comes from the line of Nate Crossett with Berenberg. Please proceed with your question.

Nate Crossett, Analyst

Hey, good morning. Thanks for taking the question. Just on the pipeline, I was wondering if you could characterize the deal flow a bit. You mentioned heightened competition. How should we be viewing this in terms of the amount of deal flow you can execute on? What's the size of the pipeline right now? And what's kind of the outlook that we should be baking in for pricing, kind of, going into the back half of the year? Are we still looking at over 7%, or where do you kind of see that trending?

Pete Mavoides, CEO

Thank you, Nate, for your question and good morning. Typically, we have visibility into our forward pipeline for about 90 days, as our transactions generally follow that cycle. However, we had a strong quarter and feel optimistic about our outlook for the third quarter. The pipeline is still strong. We usually don’t provide specific investment guidance but refer to our historical averages as a guideline for what we might expect. Historically, we’ve been fairly consistent, and recently we’ve seen many good opportunities to transact. Regarding cap rates, we generally transact between a low of 6 and a high of 7.50, and the actual rates in any quarter depend on the selection of deals, industries, credit sizes, and various factors. We’ve been guiding expectations in the low 7s, and I don’t anticipate a significant deviation from that.

Nate Crossett, Analyst

Okay. That's helpful. What about just the lease escalation that you're able to underwrite in these sale-leasebacks and acquisitions? Is the heightened competition making it harder to get higher escalation in those contracts? Or how do you see that kind of playing out over time?

Pete Mavoides, CEO

Yes. The escalations are really just one part of the economics of the investments and that - to the extent that we're having competition, it's impacting the overall economics, which flows into the initial cap rate as well as the bumps in the out years. We still expect to kind of be in that, call it, 1.4, 1.6, so I think that's pretty center mass of market. But again, that's going to vary, given the selection of deals and the nature of deals in any given quarter. But we get bumps in the majority of the deals we do and we will work hard to get the best bonds that we can.

Nate Crossett, Analyst

Okay. Thanks, guys.

Pete Mavoides, CEO

Thanks, Nate. Appreciate the questions.

Operator, Operator

Thank you. Our next question comes from the line of Katy McConnell with Citi. Please proceed with your question.

Parker Decraene, Analyst

Hey, guys. This is Parker Decraene actually on for Katy. Just a couple of quick ones from me. First off, I think last quarter you guys discussed seven auto service vacancies that came off or that came back to you through termination. I was just wondering, at this point, I think you leased eight or nine assets this quarter. Were all of those seven assets included in that nine and just maybe, you can give some color on sort of the resolution of that?

Pete Mavoides, CEO

Yes. Listen, we give plenty of color on the resolutions of our re-tenanting activity in our re-leasing stats at 87%. The one vacancy we have is not related to an auto service operator. So you can infer that we got all of those sites re-leased. And given that, we've re-leased nine and seven of them were related to that 10 and I think that's pretty clear on what happened there.

Parker Decraene, Analyst

Okay. And then, secondly, I guess, I just want to understand from, sort of, the cash accounting basis, if there's any other tenants that you guys still have under a cash accounting kind of revenue basis and what the total accrued rent balance might be for some of those in aggregate?

Pete Mavoides, CEO

Mark, why don't you answer that?

Mark Patten, CFO

Yes. I appreciate that question. It's just a handful of tenants. It represents maybe a little bit more than $0.01 of AFFO recognized, deferred not recognized, that has the potential to be reversed sometime in the future.

Parker Decraene, Analyst

Okay. Thanks. That’s all for me.

Pete Mavoides, CEO

Thank you.

Operator, Operator

Thank you. Our next question comes from the line of Greg McGinniss with Scotiabank. Please proceed with your question.

Greg McGinniss, Analyst

Hey, good morning. So, Gregg, you're now averaging, looks like, $200 million of acquisitions a quarter for the last year. Does that feel like a sustainable level? And then, also does the increased market participation impact volumes, or should we just maybe cap rates to compress a bit? How should we think about that?

Pete Mavoides, CEO

Yes. As I've mentioned, we often refer to the trailing eight-quarter average as a gauge for what to anticipate. I hesitate to set a firm expectation that we'll reach $800 million in transactions per year, as that figure is quite high. We have indicated that we are focusing on acquisitions given the current market conditions, but I won't affirm that as our goal moving forward. Increased competition does not automatically generate deal flow for us; rather, deal flow is influenced by the overall economic landscape and the M&A climate, as well as the growth in our relationships. However, this competition does impact cap rates. You may have noticed that our cap rates have been declining over the past few years, and we are actively working to halt that decline. Fortunately, our cost of capital has improved in tandem, making the spreads we are investing in quite appealing.

Greg McGinniss, Analyst

Okay. Thanks. And then on the acquisitions, how much of what was closed for last quarter or the last year were driven by prior relationships versus new tenants?

Pete Mavoides, CEO

Listen, we provide that on a quarterly basis. And generally, just looking at page 8 of our sub, we define prior relationships as people that we've done deals with in the past and that tends to be in the mid to high 80s.

Greg McGinniss, Analyst

Okay. Yeah, I recall, you guys used to provide it. I guess, I just missed it this time around. But thank you.

Pete Mavoides, CEO

I think that's in our investor presentation.

Greg McGinniss, Analyst

Yeah, I am sorry.

Pete Mavoides, CEO

But anyhow listen, in this quarter, it was 98%. And so it remains a main driver of our investment activity our relationships and our ability to kind of work with those guys reliably.

Greg McGinniss, Analyst

Okay. And just a quick follow-up on that point. It looks like new top tenants got Spare Time and Harps looks, like you own about 20% of their total stores. I'm just curious, how that 20% number maybe compares to the average tenant in your portfolio? Just to try and get some sense for how much more you can mine those relationships or if it's really just based on the growth of those tenants having new stores?

Pete Mavoides, CEO

Yeah. Listen, it's – I would say, the percent of stores we own from any one tenant, it can range from 5% to 100%. And I'll stop short of giving you an average there. As it relates to Spare Time and Harps, we've – they've been existing relationships with ours, and we've been able to add units over time and populate them into our top 10. But obviously, it's a consideration as we manage our overall exposure both with individual names and our top 10, where, unfortunately, at times we become full with tenants. That tends to get offset by a growing denominator that allows us to do deals down the road. But when you're doing 98% of your business with people you've transacted with in the past that – you want to continue to serve those relationships and take advantage of being the embedded capital provider because that provides synergies, cost-effectiveness and ultimately better economics both for us and the tenant.

Greg McGinniss, Analyst

All right. Okay. Thanks so much, Pete.

Pete Mavoides, CEO

You got it. Thank you.

Operator, Operator

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

Sheila McGrath, Analyst

Yes. Good morning. G&A as a percent of revenue was just over 11% as you highlighted, that's the best read since the IPO. Just what is your target for that metric? Is the second quarter G&A a good run rate or do you envision having to add meaningfully to personnel?

Mark Patten, CFO

Yeah. Thanks, Sheila. I guess, what I'd say is we've achieved some pretty good efficiencies in our cash G&A. The back half of the year, though as conferences and travel starts to pick up, we might see a slight increase in the back half on the cash G&A. But I think as a percentage of revenue it's going to continue to trend down. But I think in terms of headcount, I think we're pretty well-staffed for handling the business that we see ahead of us.

Sheila McGrath, Analyst

Okay. Great. And then you guys have the benefit of looking at rent coverage metrics for your tenants. Just – are there any businesses worth noting that have already returned to pre-pandemic levels? Which sectors have had the quickest recovery and which sectors have been kind of the laggards?

Operator, Operator

Yeah, Sheila, I'll tackle that. There's certainly – some of our sectors were barely impacted by the pandemic. I would say, our quick service operators, our car washes, auto service, convenience stores probably had the lowest level of impact. The greatest level of impact and the most extended level impact, I would say, clearly, in the movie theaters which everyone knows and understands. But also the gyms have been slow, but have recovered. And then the early childhood education guys are still kind of ramping back up to pre-pandemic levels as the country isn't at a full return to work status, which we hope to see in September. So certainly, there's been a wide dispersion of performance, but we feel good that collecting our cents on the dollar and they're all open and operating.

Sheila McGrath, Analyst

Okay, great. Last question. On AFFO guidance you moved it higher. Can you remind us your thoughts on the dividend? Are you managing to a certain payout ratio? Just your thoughts on the dividend outlook?

Pete Mavoides, CEO

We aim to maintain a payout ratio in the 70% range. Historically, we've been growing the dividend in line with our AFFO per share growth, and the Board reviews this every quarter, which we will continue to do.

Sheila McGrath, Analyst

Thanks a lot.

Pete Mavoides, CEO

Sure. Thank you.

Operator, Operator

Thank you. Our next question comes from the line of Caitlin Burrows with Goldman Sachs. Please proceed with your question.

Caitlin Burrows, Analyst

Hi, good morning. I was wondering maybe if we could talk about the watch list. It seems like the portion of the portfolio under one-time coverage is larger than it's been in the past but the total coverage is actually higher than in the past over three times now. So could you go through what this means for your watch list? And how much is the end of 2020 still dragging down those coverage levels? Have you already seen some improvement in the first half of 2021? Or are those tenants that may continue to struggle?

Pete Mavoides, CEO

Sure. As we mentioned during the call, those statistics have been significantly affected by COVID, especially since the second quarter of last year involved shutdowns for many of our tenants. The numbers presented do not account for any rent deferrals. Therefore, the trailing 12 months reflect a quarter with virtually no revenue while still requiring full rent payments. We anticipate that these figures will materially improve as time progresses. Additionally, our watch list is more refined than merely focusing on coverage; we assess these tenants on a quarter-over-quarter basis as well as in terms of capitalization within our real estate portfolio. Overall, our watch list is in a very positive position, and we are optimistic about the status of our tenants, viewing these statistics as largely a remnant of the COVID pandemic.

Caitlin Burrows, Analyst

Got it. And just to clarify, it seems that with the overall coverage level of 3.2 times, there are others that are performing very well. Is that fair?

Pete Mavoides, CEO

There are others that are performing very well, and there is significant investment activity contributing to those statistics, which is influenced by the selection of industries we focus on. However, there are companies that have emerged from the pandemic as strong operators.

Caitlin Burrows, Analyst

It seems that the line for interest income on loans and direct financing leases has been increasing, likely due to the growth of the loan receivable portfolio. Could you provide some details about that? Is it related to specific acquisitions and investments that cause them to be classified differently from regular NOI, or is this interest income additional to NOI?

Pete Mavoides, CEO

The interest income contributes additionally to NOI. There are situations where we may provide loans. We lend against assets we prefer to have in our portfolio, but due to reasons like seller motivation, tax issues, or structuring challenges, we can't achieve full ownership. In such cases, we make a loan, which tends to be a favorable investment for us, with a loan-to-value ratio that is lower than our standard sale-leaseback deals, yet with generally similar financial terms. The loan book has been a small component of our investment activities and is expected to remain that way. Fortunately, we have encountered good opportunities to issue loans over the past year and have pursued them.

Caitlin Burrows, Analyst

Got it. Okay, thanks.

Pete Mavoides, CEO

Thank you.

Operator, Operator

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

John Massocca, Analyst

Good morning.

Pete Mavoides, CEO

Hi John.

John Massocca, Analyst

Maybe just going back to the two new additions to the top tenant list. I mean specifically with Spare Time, can you maybe give a little color on the underwriting for that tenant? What got you comfortable with more bowling alley-focused, family entertainment center and how they've bounced back given similar companies were hit pretty hard by the initial wave of the pandemic?

Pete Mavoides, CEO

Sure. Listen John, I think our underwriting for that individual tenant is going to be consistent with our underwriting for any tenant, which is taking a look at the corporate credit, taking a look at the operations, taking a look at the units, how they perform and valuing the real estate at a point that we think is fair. Spare Time is a great tenant. It's a great company, a great family-owned company that we've been doing business with for a while and have great comfort in their ability as an operator. The sites that we own and the sites that we invested in during the quarter have rebounded and are doing really well and really benefiting from some pent-up demand for people wanting to get out and be entertained and do things. We like the family entertainment business and we think Spare Time is a great operator in that space.

John Massocca, Analyst

You had maybe Spare Time assets in the portfolio pre-pandemic though is that a fair assumption based on what you said?

Pete Mavoides, CEO

I think I said that, yes.

John Massocca, Analyst

And then with Harps, maybe just any color there, I guess, given just what's kind of the financial outlook for them kind of the financial backing for that tenant particularly given kind of the competitiveness of the grocery space?

Pete Mavoides, CEO

Yes. So Harps is, I believe, like a 112 unit regional grocer that is well capitalized with a strong balance sheet. The sites we purchased are well-located sites with strong sales and strong profitability. I know it's a competitive industry, but when you're doing a sale-leaseback you're buying sites that are existing and have long track records that we can underwrite and that was the case with the sites we bought with Harps.

John Massocca, Analyst

Okay. Those questions I had that's been covered. So thanks very much for the time.

Pete Mavoides, CEO

Thank you, John. Appreciate the questions.

Operator, Operator

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

Chris Lucas, Analyst

Hi, Pete. Hi, guys. Just following up on a couple of questions. Maybe if we could go back to the less than one-time unit level coverage. Pete I appreciate the sort of trailing 12-month issue. I guess if you looked at it on an annualized most recent quarter basis, do you guys have that number as to what it looks like less than one-time? Just kind of trying to figure out what the sort of current status really is.

Pete Mavoides, CEO

Yes. We do and that's not a number we disclosed or not a number we're going to disclose. It's largely varied across industries, I gave some commentary on how those industries are performing. But as we said, we think that will trend back to a normalized level and it's not something concerning to us. The fact that everyone's paying currently gives us good comfort that the sites are recovered and the tenants are committed to the sites that we own.

Chris Lucas, Analyst

Okay. And then as it relates to sort of the transactions that you have completed, I'm kind of curious as to whether or not you have insight into what I would call the source of that? In other words, is it related to M&A that the tenant has gone through that is creating an opportunity? Or is it more just sort of their organic unit growth or legacy portfolio that they are disposing of and entering into sale-leasebacks? And how does that compare to sort of the pre-pandemic?

Pete Mavoides, CEO

I would say both the organic growth is not a significant driver of investment activity for us, as it tends to consist of one or two units over time. The two main sources of business for us are mergers and acquisitions, where an operator is either acquiring a competitor or consolidating, which significantly drives our business. The other source is when an operator is monetizing assets on their balance sheet, such as through sale-leaseback transactions or liquidating real estate assets to address other capital needs. I haven't analyzed the sources or motivations behind the recent quarter's activity yet, but it seems to be approximately 60% towards M&A.

Chris Lucas, Analyst

Okay. Thank you. That's all I have this morning.

Pete Mavoides, CEO

Great. Thank you very much, Chris. Appreciate it.

Operator, Operator

Thank you. There are no further questions at this time. I'd like to turn the floor back over to Pete for closing comments.

Pete Mavoides, CEO

Great. Well, we're really excited to report this quarter. It was a strong quarter for us and we have great momentum going into the third. So thank you all for your participation today and your questions. Have a great day. Thank you.

Operator, Operator

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