Earnings Call Transcript - EPRT Q3 2020

Operator, Operator

Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust Third Quarter 2020 Earnings Conference Call. This call is recorded, and a replay 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 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. 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. You may begin.

Daniel Donlan, Senior Vice President and Head of Capital Markets

Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties' third quarter conference call. Here with me today to discuss our third quarter and full year results are Pete Mavoides, our President and CEO; Gregg Seibert, our COO; and Mark Patten, our CFO. 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 these 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 yesterday's earnings press release. With that, Pete, please go ahead.

Peter Mavoides, President and CEO

Thank you, Dan, and thank you to everyone who is joining us today for your interest in Essential Properties. During the third quarter, we experienced a market improvement in rent collections as our tenants reopened their properties for business. In addition to this positive operating trend, we saw a stabilization in our cost of capital, and a constructive capital markets environment that was conducive towards maintaining a conservative balance sheet. As we stated on prior calls, we wanted to see these circumstances occur before deciding to resume our external growth plans. As such, we began looking for attractive investment opportunities early in the third quarter, which allowed us to invest $149 million this quarter and another $73 million to date in the fourth quarter. Looking at our third quarter investments, 92% were direct sale-leasebacks and 98% were transactions that involved an existing relationship. We believe these direct opportunities were a tangible output of the accommodative and relationship-based approach that we use to navigate the pandemic with our tenant base. While our short-term collections may have been higher, had we taken a more aggressive posture, our deliberate actions have strengthened our tenant relationships, which should benefit the company over the longer term. In order to maintain financial flexibility and appropriately fund our pipeline of opportunities, we raised $210 million of net equity in the quarter, including our overnight offering that raised $184 million of net proceeds in mid-September. We would like to thank those existing and new investors that demonstrated continued confidence in our company for supporting us. In terms of portfolio stabilization, approximately 99% of our portfolio as a percent of ABR is opened and operating today, which compares to 93% back in early August and just 66% in mid-April. In terms of rent collections, we collected approximately 90% of contractual cash rent owed to us in the third quarter, including 88% in July, 91% in August, and 91% in September. For October, we collected 91% of contractual cash rent and have another 3% attributable to recognized rental deferrals, which are scheduled to end after December. The remaining 6% of contractual cash rent is allocated as follows: 2.5% is non-recognized rent deferrals, which is mostly attributable to our 5 movie theaters that are leased to AMC theaters, 2.5% is unresolved, which is mostly attributable to Town Sports and Ruby Tuesdays. In the case of Town Sports, the tenant rejected our master lease on September 29. Our Ruby Tuesdays is currently in Chapter 11 bankruptcy proceedings. The remaining 1% is attributable to lost or temporarily abated rent. Turning to the portfolio. We ended the quarter with investments in 1,096 properties that were 99.4% leased to 214 tenants operating in 16 different industries. We had 7 vacant properties at quarter end, including the 3 fitness centers that were formerly leased to Town Sports International. As we have stated before, the value of our company does not reside in our leases. It resides in our properties and our ability to keep them consistently leased. Therefore, we see high and stable occupancy as a key indicator of that value. More specifically, we have seen solid demand for our vacant properties, and we expect to find replacement tenants or come to an agreement with the current tenants in the near term. Our weighted average lease term stood at 14.6 years at quarter's end with only 0.1% of our ABR expiring over the next year, and 3.5% expiring over the next 5 years. Our weighted average unit-level coverage ratio was 2.8x, which includes the full impact of second quarter tenant financials. We would expect our coverage ratio to continue to migrate lower, albeit at a moderating pace as the pandemic continues to have lingering impacts on certain industries. Turning to the balance sheet. We finished the quarter with leverage of 4x net debt to annualized adjusted EBITDAre and excellent liquidity of nearly $600 million. Looking forward, with the pandemic, causing a more negative impact on smaller tenants, many of our experienced middle market operators are seeing opportunities to purchase smaller operators and increase market share. This is generating an attractive opportunity set and growing investment pipeline for our company. While we are confident in our future prospects as we look to grow alongside these operators, we recognize that the pandemic is by no means behind us. As such, we remain diligent in our underwriting and highly focused on industries that have experienced minimal to no impact from the current pandemic. With that, I'd like to turn the call over to Mark Patten, our CFO, who will take you through the balance sheet and financials for the quarter. Mark?

Mark Patten, CFO

Thanks, Pete. Before I get into my prepared remarks, I'd like to say thank you to Pete and the Board for the opportunity to be a part of EPRT. It's a privilege to be a part of the terrific team Pete and Greg have assembled and to participate in the opportunity of helping to maximize value for our shareholders. As we reported in our earnings release last night, we're pleased with our third quarter results, particularly given the significant challenges presented by the ongoing pandemic. Our operating results for the third quarter of 2020 compared to the same period of 2019 included total revenue for Q3 2020 increased by approximately $6.6 million or 18.2%, totaling $42.9 million. We also saw our recurring Q3 G&A, as a percentage of total revenue, trend down sequentially to approximately 13.5%. This has improved from both Q2 2020 and Q3 of 2019. We recognized approximately $3.2 million in impairment charges in Q3, which was not associated with any impact from the pandemic but was related to our ongoing efforts to selectively recycle capital, including adjusting the basis of 8 investments we expect to monetize in the near term. Net income, as you can see from the release, was $12.3 million in the quarter. Our FFO was up $7.3 million, a 35% increase, totaling over $28 million, with our FFO per share reaching $0.30, up from $0.27 per share in the same period in 2019. Our core FFO was up $4.7 million. That's an increase of nearly 20%, totaling $28.6 million, which equates to $0.30 per share, a decrease of $0.01 per share compared to 2019. Our AFFO was up $3.6 million. That's a 16% increase, totaling approximately $26.3 million. With our AFFO per share equaling $0.28 per share, that's also down $0.01 per share compared to 2019. Our per share metrics for core FFO and AFFO were obviously impacted adversely by the adjustments we made to revenues in connection with the pandemic. In addition, the increase in our share count of approximately 10.1 million shares from our completed overnight offering in late September also had a marginal impact on these per share metrics, while the numerator in these calculations don't reflect the deployment of that capital in the yielding net lease investments. Picking up on Pete's remarks regarding our collection levels, I wanted to mention that we had no additional tenants move into non-accrual status in the third quarter, meaning no additional tenants are being accounted for on a cash basis. And importantly, we collected effectively 100% of the $1.3 million in deferred rent we were owed in the third quarter from those tenants we accounted for on an accrual basis. Regarding our balance sheet, I'll highlight just a few points. With the addition of the nearly $150 million of investments we completed during the quarter, our total assets at September 30 stood at nearly $2.5 billion. Our unrestricted cash totaled nearly $184 million. Our long-term debt remained consistent with the prior quarter, totaling approximately $804 million on a gross basis. In addition to our oversubscribed overnight offering that generated approximately $184 million of net proceeds, we also generated over $27 million of net proceeds from our ATM program, selling just over 1.5 million shares at a weighted average price of $17.88 per share. Our net debt to annualized adjusted EBITDAre, which, as Pete mentioned, was 4x at quarter end, continues to be well within our targeted range, providing ample runway for continued investment growth. We believe this provides us with a strategic advantage, especially given the challenging macroeconomic environment created by the pandemic. Our return to growth is supported by our significant liquidity position, which totaled approximately $580 million at quarter end, including $189 million of available cash and the $400 million of available capacity on our unsecured line of credit. That excludes the $200 million accordion feature that we have on the credit facility and an additional $70 million of borrowing capacity via an accordion feature on one of our 7-year unsecured term loans. With that, I'll turn the call over to Gregg Seibert, our COO.

Gregg Seibert, COO

Thanks, Mark. I want to start with the ongoing impact of the pandemic on our portfolio, which we have summarized on Pages 15 and 16 of our supplemental. As of late October, 87% of our portfolio ABR was open, 12% was open on a limited operating basis and 1% was closed, which is largely concentrated in our properties leased to entertainment and casual and family dining operators. In terms of rent deferrals, we have granted rent deferral requests to tenants, representing approximately $18 million in rent. As of the third quarter end, we had approximately $3.9 million of deferred rent remaining for future periods, of which we only expect to recognize $1.1 million in future revenues. So the vast majority of deferrals are behind us, and we have begun to collect repayment of these short-term concessions. Moving on to investments. During the third quarter, we invested $149 million into 19 transactions on 50 properties at a weighted average cash cap rate of 7.1%. These investments were made within 7 different industries, with over 85% of our activity coming from 4 industries: auto service at 36%, car washes at 28%, grocery at 10% and quick service restaurants at 10%. The weighted average lease term of our third quarter investments was 17.6 years. The weighted average annual rent escalation was 1.5%. The weighted average unit level coverage was 2.8x, and our average investment per property was $2.9 million. Consistent with our investment strategy, 92% of our third quarter investments were originated through direct sale-leasebacks, which are subject to our lease form with ongoing financial reporting requirements and 79% contained master lease provisions. From an industry perspective, quick service restaurants remain our largest industry at 14.1% of ABR followed by car washes at 13.3%, early childhood education at 13.3%, medical-dental at 10.7% and convenience stores at 9.8%. We continue to view these business segments as Tier 1 industries for essential properties. And going forward, we see our concentration of properties increasing in auto service, equipment rental and sales, pet care services, building materials and grocery. Conversely, we expect our concentration in the casual and family dining, home furnishings, health and fitness and movie theaters to continue to decline. In aggregate, these 5 industries now represent 17.3% of our ABR, which compares to 31.7% in the second quarter of 2018, which was our first quarter as a publicly traded REIT. From a tenant concentration perspective, no tenant represented more than 3% of our ABR at quarter end, with our top 10 representing 22.6% of ABR. In terms of dispositions this quarter, we sold 14 properties, including 3 vacant properties for $19.6 million in net proceeds. When excluding vacant properties and transaction costs, we achieved a 7% weighted average cash cap rate on our dispositions in the quarter. As we have mentioned in the past, owning properties that are highly liquid is an important aspect of our investment discipline as it allows us to proactively manage industries, tenants and unit-level risk within the portfolio. With that, I will turn it back to Pete for his concluding remarks.

Peter Mavoides, President and CEO

Thanks, Gregg. We're excited that the operating environment and capital markets have allowed us to pivot away from managing through the pandemic with our tenants and properties and move forward with capitalizing on our robust pipeline of accretive investment opportunities in order to drive earnings growth. We look forward to the balance of the year and continuing to put pandemic-related issues behind us as we continue to accretively build our portfolio of granular net lease properties. With that, operator, please open the call for questions.

Operator, Operator

Our first question comes from Haendel St. Juste with Mizuho. Could you provide insight on your portfolio? About a quarter of your revenue comes from travel centers, movies, gyms, and entertainment. I'm curious about your future direction in this area. In your prepared remarks, you mentioned reducing exposure to movies and gyms, but not childhood centers. Could you discuss these aspects further along with any potential portfolio shifts as we move past COVID and into a post-vaccine environment?

Peter Mavoides, President and CEO

Sure. And thanks for that. I think Gregg gave you some stats in the prepared remarks. We have been very deliberately focusing our investments in industries that we saw as durable and had real estate characteristics that we liked. And you saw that trend really since pre-pandemic, taking those 5 industries down from 37% to 17% was material. Quite frankly, we haven't invested in the movie theater since coming public. Our gyms have been growing at a much slower rate as has our casual and family dining. We've been lightening up both through growth as well as disposition. Notably, our generic retail exposure has been coming down dramatically as well, which is largely concentrated in furniture. We've had a very deliberate shift in our industry mix. The one outlier to that, that you pointed to, is childcare. We like childcare. We think that industry has a good place in our portfolio and has good operating fundamentals. Obviously, it was impacted significantly by the pandemic, but our operators in that space have been recovering nicely and performing well. You should expect to see us continue to invest in childcare. We have not been investing in a material way in any of those other industries, and you should expect to see that continue.

Haendel St. Juste, Analyst

That's helpful. Can you discuss a bit more about the investments in the quarter? Cap rates are currently in the low 7s. We've heard some of our peers talking about higher cap rates and noticed some investment yields exceeding 8%. Could you elaborate on the pricing trends you're observing in the assets that interest you? Should we anticipate this low 7% rate to persist in the near term? Also, is the $150 million in acquisitions from the quarter a reasonable figure to consider for the near term?

Mark Patten, CFO

Sure. In terms of volume and cap rate, generally, our discussion around that has been pointing to our trailing quarterly average, which is pretty consistent with this quarter. I think that's a good indicator of where we're set up to transact. In terms of cap rates, we generally have been telling people to expect us to transact in kind of the low to mid-7s range. This quarter at 7.1% is towards the low end of that range. What you see there is we are deliberately focusing on industries that had relatively minimal impact from the pandemic, notably auto service, quick-service restaurants, and car washes, and really staying away from some of the higher cap industries that were adversely impacted, such as movie theaters and gyms. Driving that cap rate down a little bit is the industry mix and the selection of tenants we did during the quarter. From a going-forward perspective, you should continue to see us transact in the low to mid-7s range at a pace that's relatively consistent with our past practice.

Operator, Operator

Our next question comes from the line of Nathan Crossett with Berenberg. I just wanted to get your thoughts on if we went back into a potential lockdown, how that may affect your pipeline? And also, was there any kind of elevated deal activity from people trying to get things done before the election?

Peter Mavoides, President and CEO

Sure. I would say there's elevated deal activity really from what we saw as a backlog of 6 months' worth of deals. A lot of our relationships and operators put M&A and development and other expansion on hold while they focused on grappling with the pandemic. As we come out of the backside, I think they've restarted those growth plans, which has created a backlog of opportunity. We have not seen a lot of election-related sales, and there may be some here late in the fourth quarter, but we have not seen that to date. In terms of shutdowns and a potential impact on the pipeline, I would say we're making 20-year investments in industries that we think to be durable and lasting. I think temporary shutdowns really aren't going to weigh heavily on that. In our view, shutdowns would be very localized and temporary and shouldn't have a massive impact on our pipeline. It may have some impact on the portfolio. But we'll monitor that and obviously, continue to work with our tenants as we navigate through this pandemic.

Nathan Crossett, Analyst

Okay. And then I was just going to ask one on the theater assets. I know you only have 5 AMCs. But for your property specifically, are there any potential other use cases, I guess, in a worst-case scenario for them?

Peter Mavoides, President and CEO

Yes, we have six theaters, five of which are with AMC. Typically, these are around 50,000 square feet each, with a rental agreement of approximately $14 to $15 per square foot. They consist of generic real estate. In the event that one of our operators were to close down, our first action would be to find another theater operator to lease the space. We strongly believe that theaters will persist and continue to have their place. If we needed to renovate them for alternative uses, at the end of the day, they still represent 50,000 square foot spaces with reasonable rent costs.

Operator, Operator

Our next question comes from the line of Sheila McGrath with Evercore. Pete, I was wondering if you could comment if there's any evidence that your target tenant base may be more prone to seek out raising capital via sale leaseback, given the pressure from COVID that might bode well for more acquisition opportunities as you look ahead into 2021?

Peter Mavoides, President and CEO

We haven't observed that, Sheila. Typically, our middle market tenant base is part of our portfolio because they recognize the advantages of sale-leaseback transactions and find our weighted average cost of capital more favorable compared to their own. The pandemic hasn't changed that perspective. However, as alternative sources of capital become more expensive, we may see some shifts. On the other hand, interest rates are low, and borrowing remains inexpensive for those who qualify. The group that can access traditional bank financing has likely become somewhat more restricted due to the pandemic. So, to summarize, we haven't seen a significant trend yet, but we anticipate some changes at the margins. Regardless, we still have numerous opportunities and a strong pipeline.

Sheila McGrath, Analyst

Okay, great. One more thing. I missed your comment on Town Sports. They rejected the lease, but did you mention that you already have a tenant?

Peter Mavoides, President and CEO

I did not. In the past, I've mentioned that we anticipated the bankruptcy for quite some time, and we've been actively looking for tenants in the market. There is strong demand for those properties and gyms. We expect to relet them quickly. There are ongoing discussions, and we hope to see positive results soon.

Sheila McGrath, Analyst

Okay. Great. And one last quick one on Ruby Tuesdays. How many units do you have there? And do you have any visibility on their path forward? Do you expect to get those buildings back vacant? Or what is your expectation?

Peter Mavoides, President and CEO

Yes. This is an ongoing negotiation with that tenant. We have seven sites leased to them under a master lease. Generally, we are confident in the value of our assets and their potential for reuse. If we do not reach a favorable agreement with Ruby Tuesdays, similar to our experience with Town Sports, we are confident another tenant will come along that will pay comparable rent at those locations.

Operator, Operator

Our next question comes from the line of Katy McConnell with Citigroup. Based on the occupancy fallout that you've already seen to date, can you elaborate on the demand that you're seeing to really set vacant space today? And based on any progress you've made so far, what are your expected spreads?

Peter Mavoides, President and CEO

Listen, I would argue that we haven't seen a vacancy fallout. At quarter end, we were over 99% leased, and we had 7 vacant properties, 3 of which came to us on the last day of the quarter. I think, as we tried to say in our prepared remarks, there's good demand for our properties, and we have a very robust ability to keep these properties leased and occupied, as evidenced by our very high occupancy. It's an important part of our underwriting to have fungible assets that have ready reuses and have the ability to re-tenant sites when they do become vacant. I think our team has done an excellent job of maintaining a very high occupancy in our properties.

Katy McConnell, Analyst

Okay. And then can you provide some more color on your strategic plans for the 15% of tenant exposure where you expect a slower recovery? And for those categories, how much of the uncollected 3Q rent have you deferred at this point versus have left unresolved where we could potentially see fallout down the line?

Peter Mavoides, President and CEO

Sure. The slower recovery industries, like casual dining, health and fitness, and entertainment, I would say the gyms are open, operating and returning to profitability. Our entertainment sector has seen them rebound and return to profitability. Our restaurants are doing well in both the casual and dining segments. The slowest recovery at 2.5% of our ABR really is in the movie theaters. It seems like recovery is not necessarily pandemic-related, but more related to the release of content, and it seems like that is on the horizon. We have very little left to be deferred. I think it's about $3 million and only $1 million of that will be recognized into revenue. The vast majority of the balance is largely attributable to our theaters, which is AMC.

Operator, Operator

Our next question comes from the line of Greg McGinniss with Scotiabank. Gregg, just to make sure I heard correctly, collections have held consistent 91% for the last few months. It sounds like deferrals are starting to be repaid. So does that mean we could see collections number tick up closer to 94% in November, given those repayments?

Gregg Seibert, COO

The repayments are not part of the adjusted base rates. They are prior period rent that was recognized but not collected, mainly reflecting cash flow. The increase from 90% to 94% will come from the reduction of recognized deferrals, which is 3%, and that will take place. I believe most of those deferrals will extend through the end of the year. Consequently, our return to 94% will be gradual due to those deferrals. However, we are recognizing the revenue, we believe it’s solid, and those tenants will fulfill their obligations as agreed. The difference between the 91% and the 94% regarding those 3% recognized deferrals is not significant.

Greg McGinniss, Analyst

Right. Okay. So it's basically just reflecting different deferral agreements that were maybe in place for Q2, but not Q3 and vice versa? That's why we're seeing that.

Gregg Seibert, COO

Yes, they're the same deferral agreements that were in place, they just span through the end of the year.

Peter Mavoides, President and CEO

Yes. Listen, you're right. We got started in the quarter late, largely as a result of wanting to see sustained collections and stabilization in the cost of capital. If you look at the $149 million in the quarter, it is right on our trailing 8-quarter run rate, pretty indicative of our ability to scale the pipeline. We feel good about the pipeline. If you look at the Q that we filed last night, subsequent to quarter end, we've closed about $75 million. We feel good looking at the back half of the year.

Operator, Operator

Our next question comes from the line of Alexander Pernokas with Bank of America. Sorry if I missed this, but how much quarterly revenue is on a cash basis? And is Town Sports included in that?

Daniel Donlan, Senior Vice President and Head of Capital Markets

Yes. Town Sports is on a non-accrual basis. So you should look at the disclosure on Page 15. You should assume that everybody and their non-recognized unresolved lost abated bucket. The 6%, give or take, is all on non-accrual status.

Mark Patten, CFO

So they're all on cash accounting.

Alexander Pernokas, Analyst

Okay. Great. And then could you just give your outlook for bankruptcies over the next 12 months? And how has your tenant watch list changed over the course of the pandemic?

Peter Mavoides, President and CEO

At the onset of the pandemic, our tenant watch list was comprised of all of our tenants and really focused on the industries and the sectors that we felt to be most impacted. I think we gave good disclosure around that on Page 16. As we sit here today, our main focus is on the 6% that are on cash accrual. These are tenants that are either not paying us rent that they owe us or there's a deferral that we're not sure we're going to get down the road. That really is where our focus is. As you would imagine, that is really in the sectors that have been most impacted and are the slowest to recover. We see a path to most of those operators and will continue to monitor them and work with them as we put this pandemic behind us.

Operator, Operator

Our next question comes from the line of John Massocca with Ladenburg Thalmann. Sorry if I missed this earlier, but what drove the big decline in industrial same-store rents?

Daniel Donlan, Senior Vice President and Head of Capital Markets

John, this is Dan. That was a typo. That's my fault. You should just switch around the retail and the industrial; it was updated on the website. So that's really the retail that is actually down that amount related to Loves Furniture.

John Massocca, Analyst

Okay. That makes sense. And then as we think about dispositions, there kind of appears to be a strong bid out there for restaurant properties. Could that drive an acceleration in capital recycling on your end? Assuming you are seeing that kind of same strong bid, are you seeing it extend to casual and family dining assets as well as QSR?

Peter Mavoides, President and CEO

Yes. Listen, the QSRs are clearly seeing a stronger bid. Our disposition activity has been focused on de-risking the portfolio, largely concentrated in the casual and family dining sectors. We feel pretty good about our QSR exposure and our tenants there. We don't feel the need to sell to recycle capital. We have a great capital position and good access to capital. Our sales of assets will be moving risk out of the portfolio, which will be in the casual and family dining sectors.

John Massocca, Analyst

Okay. But those would be potentially part of a thesis on how you want a portfolio, maybe over time could be something that comes out of the portfolio via dispositions or partially out of the portfolio via dispositions?

Peter Mavoides, President and CEO

Yes. That's been a thesis since day one. You've seen regular disposition activity, and we disclose where the industries are we're selling. Gregg gave you the commentary bringing down those 5 industries from 37% to 17%. A lot of that is through strategic asset dispositions. A very important part of our portfolio construction is having asset-level liquidity and owning assets that are granular in bite size and where there exists a good bid on an individual asset basis. For the most part, the majority of our assets have strong bids. That allows us to sell and manage industry exposures where we think it is appropriate.

John Massocca, Analyst

And I guess just generally, what is the spread in the bid out there? I know it's a little bit generic, so it's kind of tough to know of an asset, but the spread out there between casual and family dining vs. QSR?

Peter Mavoides, President and CEO

I believe new deals for quick service restaurants could range from 5.5 to 6.5, while casual dining could be between 7 and 8, albeit with some no bids. This demonstrates a considerable range. The demand for casual dining is quite low, and many of the bankruptcies are occurring in that sector. Conversely, the quick service restaurant segment is performing well. For instance, Carrols was among our top 10 last quarter, and we have a favorable view of them as a quick service operator. However, they have dropped out this quarter, being replaced by a Zaxby's franchisee, which is another strong operator in the quick service category, showing a trend of replacing names like Perkins and Ruby Tuesdays that has been ongoing for a while.

Operator, Operator

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

Peter Mavoides, President and CEO

Great. Thank you all for your time today. Hopefully, this has been helpful, and we look forward to engaging with you all at the coming NAREIT conference. Thank you. Have a great day.

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.