Earnings Call Transcript - EPRT Q2 2023

Operator, Operator

Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust Second Quarter 2023 Earnings Conference Call. This conference call is being recorded. Additionally, there will be an audio webcast available on Essential Properties Realty Trust's website at www.essentialproperties.com. An archive of which will be available for 90 days. On the call this morning are Pete Mavoides, EPRT's President and Chief Executive Officer; and Mark Patten, EPRT's Executive Vice President and Chief Financial Officer. It's now my pleasure to turn the call over to Mark Patten.

Mark Patten, CFO

Thank you, operator. Good morning, everyone. And thank you for joining us today for the second quarter 2023 earnings conference call of Essential Properties Realty Trust. During this 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 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, I'll turn the call over to Pete.

Pete Mavoides, CEO

Thanks, Mark. And thank you to everyone who is joining us today for your interest in EPRT. As our second quarter earnings release indicates, we are pleased to report another quarter of strong results, driven by the strength and stability of our portfolio that continues to perform exceptionally well and impacted favorably by our strong investment activity. Our tenants continue to perform at a high level as reflected by our unit-level rent coverage that increased to 4.1x. Our same-store rent growth remained favorable at 1.5% with just 2 vacant properties. The overall health of our portfolio is a testament to our disciplined underwriting process, the quality of our operators, and the resiliency of our service-oriented and experience-based businesses. In the second quarter, we acquired 78 properties in 29 separate transactions that were 99% sale-leaseback transactions with 66% of those opportunities generated from existing relationships. The initial cap on our second quarter investments was 7.4%, and the average annual escalation in those leases was 1.9% on 19.3 years of weighted average lease term, which resulted in an average yield over the primary lease term of 8.7%. Our balance sheet remains conservatively positioned, and our liquidity remains strong, with quarter-end leverage of 4.3x and pro forma leverage of 4.2x when taking into account our unsettled forward equity, and liquidity of approximately $634 million. As we've said, we're committed to maintaining a conservative balance sheet. Based on our second quarter results, the visibility of our third quarter investment pipeline, and our anticipated capital markets activity, we have increased our guidance for 2023 AFFO per share to a range of $1.62 to $1.65. Turning to the portfolio, we ended the quarter with 1,742 properties in our portfolio that were 99.9% leased to 360 tenants operating in 16 industries. Our weighted average lease term stood at 14 years with only 5.2% of our ABR expiring through 2027. From a tenant health perspective, our unit-level rent coverage ratio at quarter end was 4.1x, and the percentage of our ABR that had less than 1x rent coverage level remained relatively consistent in 2023, totaling just 3.1% at quarter end. Regarding our second quarter investments, we invested $277 million in 29 separate transactions and properties representing 12 of our 16 targeted industries. With approximately 77% of those investments in properties operated in the carwash, equipment rental, casual dining restaurants, grocery, entertainment, and medical industries. The weighted average lease term of our investments this quarter was 19.3 years. As I mentioned earlier, the weighted average annual rent escalation remains strong at 1.9%. The weighted average unit-level rent coverage of tenants at these properties was 3.9x, and our average investment per property was $3.4 million. In the quarter, 99% of our investments were originated through direct sale-leaseback transactions, completed on our lease form with ongoing financial reporting requirements. In addition, 57% of our investments were in a master lease structure. Looking ahead to the third quarter, we remain active, and our pipeline should support investment levels relatively consistent with our recent activity. From an industry perspective, at quarter end, carwashes were our largest industry at 15.6% of ABR, followed by early childhood education at 12%, quick service restaurants at 10.8%, and medical dental offices at 10.6%. From a diversity perspective, our largest tenant, EquipmentShare, represented 3.6% of ABR at quarter end, and our top 10 tenants continue to demonstrate the diversity in our portfolio, accounting for 17.5% of ABR. As we've consistently stated, tenant diversity is an important risk mitigation tool for us and a product of our differentiated investment strategy. A direct benefit of our focus on non-credit rated tenants and middle-market operators offers an expansive opportunity set and, in our view, generates superior risk-adjusted returns. In terms of dispositions, we sold 16 properties this quarter for $41.7 million in net proceeds at a weighted average cash yield of 6.2%. The weighted average unit-level rent coverage ratio for the properties we sold was 2.2x. Owning fungible and liquid properties and capitalizing on that liquidity is an important aspect of our investment discipline, and it allows us to proactively manage our industries, tenants, and unit-level risks within our portfolio. For the remainder of 2023, we expect our level of quarterly investments to align with our 8-quarter average as we selectively take advantage of favorable market pricing to accretively recycle capital away from identifiable risks, reduce our industry concentrations, and, importantly, support our tenant relationships. With that, I'd like to turn the call over to Mark, who will take you through our operating results and the balance sheet for the second quarter and discuss our capital markets activity.

Mark Patten, CFO

Thanks, Pete. Echoing Pete's remarks, the second quarter of 2023 was certainly a strong quarter for us, evidenced by our reported results last night and represented by our increase in the top and bottom end of our guidance range for AFFO per share for the full year of 2023. Performance of our portfolio and our investment results for the quarter continue to reflect the high quality of our tenancy, consistent internal rent growth, and benefits of our differentiated investment platform. As I'll cover, our consistently conservative balance sheet and strong liquidity position continue to support our aspirations for external growth in 2023. Among the headlines last night was our AFFO per share for the second quarter, which on a fully diluted per share basis was $0.41. That's an increase of 8% versus Q2 of 2022. On a nominal basis, our AFFO totaled $61.9 million for the second quarter of 2023, which is up $11.3 million over the same period in 2022, an increase of 22% and up over 6% compared to the preceding first quarter of 2023. We also reported core FFO per share on a fully diluted basis of $0.44 for the second quarter, an increase of 7% versus Q2 of 2022. Total G&A was approximately $7.6 million in Q2 2023, and while recurring cash G&A, excluding approximately $360,000 of costs associated with the departure of one of our junior executives, totaled $5.3 million in Q2 2023. We adjusted our core AFFO by approximately $172,000, which reflects the impact of this non-recurring expense, net of the impact of stock compensation forfeitures. Importantly, our recurring cash basis G&A as a percentage of total revenue decreased to 6.1% in Q2 2023. We continue to have the expectation that our recurring cash G&A as a percentage of total revenue will rationalize quarterly and on a full-year basis. Turning to our balance sheet, I'll highlight the following. With our $236 million of net investments in 2Q 2023, our income-producing gross assets reached nearly $4.5 billion at quarter end. From a capital markets perspective, we had a solid quarter from an equity perspective. In mid-May, we settled the second half of our forward equity that we issued through an overnight offering in February of this year, which generated approximately $104.5 million in net proceeds. We also generated approximately $66 million of gross proceeds in the latter part of the second quarter from our ATM program, which was all on a forward basis. We settled approximately $45 million of those ATM sales prior to the close of the quarter. Turning to leverage, I'd like to personally announce that we have received commitments from our bank group for an unsecured $450 million term loan with a tenure including extension options of 5.5 years. This new term loan will have a 6-month delayed draw feature, and at closing, $200 million will be utilized to retire our $200 million term loan that's due to mature in April of 2024. Although the 2024 term loan will be paid off, we will retain the favorable swaps we have on that term loan through April of next year. As part of executing the new term loan, we are estimating that the impact of potential swaps on each of the draws and the April 2024 swap extension will be at a fixed rate ranging between 4.5% to 5%. We intend to close the new term loan in the third quarter of this year. Although, let me note that the closing of the new term loan is subject to customary closing conditions. We're very appreciative of the continued support of our bank group and very pleased to have the opportunity to address the near-term debt maturity and further bolster our balance sheet with attractively priced debt capital, which not only provides us with dry powder to address our near-term investment opportunities but also favorably impacts the interest costs, which we estimate for the remainder of 2023. Regarding our debt maturities, utilizing all the extension options and the new term loan resulted in a maturity date in 2029, which would result in us having no debt maturities until 2026. Specifically, regarding the second quarter 2023 results, our net debt to annualized adjusted EBITDAre was 4.3x at quarter end, when factoring in the proceeds that we'll generate by physically settling the remaining $20 million of the equity we issued on a forward basis in the second quarter that we have not yet settled. Our leverage at quarter end would equal 4.2x. Our total liquidity at the end of Q2 2023 totaled approximately $634 million. Our conservative leverage, strong balance sheet, and significant liquidity position continue to be supportive of our current investment pipeline and sufficient to fund our external growth plans for the remainder of 2023. Lastly, as our release indicated and Pete mentioned, we raised our AFFO per share guidance range for the full year of 2023 to $1.62 to $1.65 per share, which reflects not only our 2Q investment performance, our visibility into our investment pipeline, and our performance expectations for the core portfolio. But importantly, the strength of our middle market tenancy, which experienced no material credit losses in the first half of the year. The midpoint of our increased guidance range implies a year-over-year growth rate of nearly 7%. With that, I'll turn the call back over to Pete.

Pete Mavoides, CEO

Thanks, Mark. In our view, the current landscape for investing remains very positive as operators seeking to grow their businesses face the challenges of a constrained capital markets environment, which leads them to seek long-term capital by executing sale-leaseback transactions on the real estate. Additionally, the challenging market environment, particularly the availability and pricing of debt capital has curtailed the number of market participants that can meet the demand of these operators. We're excited about the opportunities we see to invest in the second half of the year. Operator, please open the call for questions.

Operator, Operator

Our first question comes from the line of Spenser Allaway with Green Street Advisors.

Spenser Allaway, Analyst

I was just wondering if you guys could provide some commentary on any cap rate trends you might have observed across the different industries in the second quarter.

Pete Mavoides, CEO

Yes. I would say, in general, cap rates were pretty static across the second quarter. Obviously, our cap rate on our investments was down 20 basis points, which is really a mix of a result of the industry mix. We did a number of restaurants and grocery deals that tend to trade at the tighter end of the cap rate range that we invest in and that brought that down. But generally, the market is pretty stable, and I would expect cap rates to kind of be in that mid-7% range in the back half of the year.

Spenser Allaway, Analyst

Okay. And I mean you kind of just alluded to what you're expecting for the back half of the year, but can you just provide any color on what you've observed thus far in terms of rates? Is it kind of static as you thought for the second quarter? Or any color there?

Pete Mavoides, CEO

Yes. It's static to slightly up. Our 3Q pipeline is a little higher than what we posted in the second quarter. But obviously, that can change depending upon what actually closes and future deals that come in. But overall, it's a pretty healthy investing market, and it's pretty stable. We haven't seen pricing pressures creep in and drive cap rates down. So it's been pretty consistent kind of throughout the year.

Operator, Operator

Our next question is from the line of Josh Dennerlein with Bank of America.

Josh Dennerlein, Analyst

Maybe a big picture question for you. Curious what your conversations have been like with tenants and how they're feeling about their expansion opportunities, just any pain points they're seeing? Just kind of curious what you're hearing?

Pete Mavoides, CEO

Yes. Listen, I would say overall transaction volumes are down as the capital markets and the availability of capital is somewhat constrained. That said, the operators who are transacting are finding good opportunities and leaning on relationships and their partners to continue to grow, really driving their underlying desire to grow from stable operations. I think you see that rippling through the portfolio's performance and lack of credit issues. So overall, the operators are feeling good about their prospects. There's always sort of transitional companies and growth aggregators that are driving investment volumes, and it feels pretty healthy.

Josh Dennerlein, Analyst

Appreciate that. Any particular segment that's more active in expansion mode?

Pete Mavoides, CEO

Yes. I mean, in the quarter, we invested in 12 of our 16 industries. So, we're really seeing investments across the spectrum. In the quarter, about one-third of our opportunities were in the car wash space, and you'll see that our car wash industry concentration has grown, and I would say there's a lot of consolidation and a lot of opportunities coming from that in the car wash space. We certainly have seen that over the last three or four quarters. The childcare space remains pretty robust for us with opportunities. Certainly, the restaurant space is a little more mature from that perspective. But overall, I would expect our portfolio to grow ratably.

Operator, Operator

Our next question comes from the line of Greg McGinniss with Scotiabank.

Greg McGinniss, Analyst

Thank you for the question. This is Elmer on with Greg. You touched on this in your remarks earlier a little bit, but how is buyer competition for the smaller asset size that you're requiring at $3 million to $5 million regarding private cash and leverage buyers and the cost of debt tracking slightly but still elevated, and regional banking turmoil subsiding? How has that changed in year-to-date acquisitions? And has that kept a normal course capital recycling opportunity still attractive in Q3 so far given that disposition volumes are up a little bit over 10% over Q2?

Pete Mavoides, CEO

Got you. First, I would say, by design, we do not compete with the $3 million to $5 million retail investor by doing sale leasebacks. The sale-leaseback transaction is a more sophisticated transaction with an operator that requires execution certainty that the retail investor generally can't provide, certainly the retail investor that is dependent on financing leverage bid. And I would say that leverage bid has become even more suspect in the current market. So that's not a segment of the market that we compete against on our investment. That said, as I said on the call, we do compete with larger leverage buyers who are struggling to get debt capital and on more organizational or portfolio basis that's allowed us to be a little more competitive and aggressive in our investments. In terms of the flip side of that coin, which is when we sell our assets, that market is investment volumes are down materially. It's a huge market, and we're able to sell into it because we're not as price-sensitive as many sellers. Given our basis and our ability to move some of the riskier assets out of our portfolio. So that market's dried up a bit, but it's still robust and allowing us to recycle capital and keep the portfolio.

Greg McGinniss, Analyst

Got it. And I guess as a follow-up, you mentioned last month seeing more potential field volumes that are meeting our investment criteria due to the attractive environment for sale-leaseback capital, of course, investment growing was up above the 8-quarter average. And I think you touched on it a little bit in your prepared remarks about G&A rationalizing a little bit. I think it was down quarter-over-quarter. Do you anticipate any headwinds on G&A in the balance of 2023, given the level of investment volume that you're seeing thus far?

Pete Mavoides, CEO

Yes. The short answer is no. We continue to staff in the organization. But generally, the vast majority of our staff and the executives are in their seats and trained and executing, and the investments we're making in G&A are really more for looking out next year. And so I wouldn't expect anything out of the normal on G&A. Mark, would you add anything on that?

Mark Patten, CFO

I think that's right. I think that trend and like you said, our headcount is pretty stable. So I wouldn't expect anything different.

Greg McGinniss, Analyst

Okay, thank you.

Mark Patten, CFO

Thank you.

Operator, Operator

Our next question comes from the line of Eric Wolfe from Citi. Please proceed.

Nick Joseph, Analyst

It's actually Nick Joseph here with Eric. We saw the upsurge of new relationships in terms of acquisition opportunities versus the recent quarters. Could you just walk through the typical cadence of the opportunity and how the conversations typically go in terms of growing these relationships from here?

Pete Mavoides, CEO

Yes. Listen, as we said in some of the prior quarters, we were really focusing our capital on servicing existing relationships that would bring us opportunities, and we generally like to lean into our relationships because when we have a relationship, it gives us an inherent competitive advantage because we've underwritten the credit, we have negotiated documents, and we're able to perform reliably against those opportunities. That said, we've always wanted to maintain a balance and strike relationships with new operators, and they become the growth engine down the road. And so in the quarter, we were able to strike some new relationships. There are some operators in the market doing deals, some of them in the market for the first time because the capital markets constraints and other alternative financing have driven them to sale-leasebacks, and some of the relationships were, quite frankly, transacting with other people, and those counterparties are no longer active. So they're sourcing to find a new counterparty. But we make it clear at the outset, we're in a relationship for the long term, and we want to help our operators grow their businesses, and the underwriting process is an investment that we make into those relationships such that we can continue to transact with these operators moving forward.

Nick Joseph, Analyst

Thanks. Appreciate that. And then just maybe on the other side in terms of sales, obviously, some dispositions in the quarter. How does that impact the relationship with the growth of those tenants where you have continuing assets with one that may be sold a handful of their properties?

Pete Mavoides, CEO

Yes. I think that is a process with some sensitivity to it. But as long as you're open and transparent, and making EquipmentShare is a great example, as we're able to sell those sites and really free up capital capacity to continue to invest with them and continue to help them grow their business. And so they recognize that it's mutually beneficial. And it's generally a collaborative process to kind of manage those relationships and manage those exposures.

Nick Joseph, Analyst

Thank you very much.

Pete Mavoides, CEO

Yeah. Thanks, Nick.

Operator, Operator

Our next question comes from Ki Bin Kim with Truist Securities. Please proceed.

Ki Bin Kim, Analyst

Thanks. Good morning. Mark, it seems like the bank debt market is a little more available for certain triple net REITs. Can you just discuss your refinancing plans? And what kind of pricing you're seeing? And if starting forward swaps is in the cards in the near future? Thank you.

Mark Patten, CFO

Yes. Thanks, Ki Bin. I mean, look, your note, a couple days ago, I think it was probably a pretty good analysis. For us, we are fortunate our bank group is very supportive. I think the way you sort of posed that dynamic in your piece was probably appropriate. But for us, the pricing really was pretty consistent with what we've seen before from the term loan side of things. In terms of the forward swaps, or frankly, just even swaps as we do the draws, you could do either. But certainly, the forward swap, I think I used in my remarks, which is kind of that 4.5% to 5% range. It all depends. So I think if you look at the renewal swap or the extension swap in April ‘24, that's probably a 4, 6 kind of number. If you look at when we do the draw, if we do more than just paying off the 2024 term loan, when we close that trench, the swap probably prices higher, but within the range I was mentioning. That's where I think the mix of the draws relative to doing a forward swap to match it, that's why that 4.5% to 5% is probably a pretty good range.

Ki Bin Kim, Analyst

Great. And in terms of your unit level coverage, there was a slight migration for some tenants moving below 1 times covered or below 1.5 times covered. And on the flip side, some actually improved. I'm not sure how much acquisition has changed that dynamic. But if you can just comment on high level, what type of tenants have maybe migrated south a little bit.

Pete Mavoides, CEO

Yes. Certainly. And I would start with only 2 big properties, a strong same-store sales number and growth in the portfolio and negligible or no credit loss. But the migration there, I think what you're seeing is some of the industries that are more sensitive to wage pressures and have lacked the ability to increase prices on a real-time basis, like the early childhood education guys. They can push prices, but you're not going to do it five or six times a year, and we've seen some decrease there. The restaurant sector has also seen some slight margin pressures with wages and cost of goods. But overall, nothing that's given us concern, and we would expect those operators to migrate back to a more healthy level.

Operator, Operator

And our next question comes from the line of Haendel St. Juste with Mizuho.

Unidentified Analyst, Analyst

This is Ravi on the line for Haendel. Just as the question, as we see the financing and liquidity in the banks, and we're starting to see more improvement there going forward. Do you feel that tenants will be incrementally less reliant on sale-leasebacks as a form of capital going forward? Or would you say that rates are still so high that you would still see that being an incremental versus capital?

Pete Mavoides, CEO

Yes. I would think it's more of the latter. If you think about a middle-market borrower borrowing unsecured in the 9%, 10%, 11% range, sale-leaseback capital is still accretive to that. And I think there's a long way to go in kind of normalizing that market before it reverts to a more normalized level that is inside of what sale-leaseback pricing they say, so I don't think that that's changed materially, and I think it's going to be a while before we see that.

Unidentified Analyst, Analyst

Okay. Just one more. What's your watchlist today as a percentage of ABR?

Pete Mavoides, CEO

Our watch list as a percent of ABR is 90 basis points, and just to refresh, we define that as the intersection level coverage of 1.5 or below and credit risk of single B or below, and that's currently 90 basis points, which is the level.

Unidentified Analyst, Analyst

Okay. I believe your theater closures are north of that. So, are those figures not included in most of those metrics?

Pete Mavoides, CEO

There'll be some theaters in those numbers, certainly. I think a couple of our theaters still remain below that 1.5 level. So of that 90 basis point figure, more than half is in our theaters.

Unidentified Analyst, Analyst

Got it. Great.

Pete Mavoides, CEO

Any more questions, operator?

Operator, Operator

No. This concludes the question-and-answer session. Pete, back to you.

Pete Mavoides, CEO

Awesome. Well, then that concludes the call. Thank you all for your time today. We appreciate it.

Operator, Operator

This concludes today's conference. Thank you for your participation. You may now disconnect your lines.