Earnings Call Transcript - EPRT Q4 2020

Operator, Operator

Greetings, and welcome to the Essential Properties Realty Trust, Inc. Fourth Quarter 2020 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Dan Donlan, Senior Vice President of Capital Markets. Thank you. You may begin.

Daniel Donlan, Senior Vice President of Capital Markets

Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties Fourth Quarter 2020 Conference Call. With me today to discuss our fourth quarter and full year results are Pete Mavoides, our President and CEO; Gregg Seibert, our COO; and Mark Patten, our CFO.

Peter Mavoides, President and CEO

Thank you, Dan. And thank you to everyone who is joining us today for your interest in Essential Properties. We are excited to report our fourth quarter and full year results and, more importantly, turn the calendar to a new year. While the COVID-19 pandemic is still very much with us, our tenants have adapted their businesses to profitably operate in the current environment. Most importantly, they pay rent reliably and timely. I want to take a moment to acknowledge all of our employees at Essential Properties and their incredible efforts over this unprecedented year. Our team members rose to the challenges presented by the pandemic by effectively managing tenant relationships, negotiating, structuring, and documenting the appropriate tenant accommodations; working through necessary lease restructurings and asset repositionings; and then seamlessly shifting back to growth when the conditions warranted in the second half of 2020. These actions have stabilized the portfolio with high occupancy and sustained rent collections, and we are firmly on track to deliver attractive earnings growth in 2021 and beyond. Turning to the fourth quarter, we saw continued improvement in our rent collections and an increase to our occupancy as we relet properties and restructured leases for a handful of larger tenants. In addition to these positive operating trends, our cost of capital has continued to improve, and the capital markets remain conducive towards investing in external growth opportunities and maintaining a conservative balance sheet to support that growth. As such, with pent-up demand from our existing relationships and renewed M&A activity from various growth-oriented tenants, we invested $244 million at a 7.1% initial cash yield in the fourth quarter, which was a record level of activity for us. Consistent with our investment strategy, 88% of our investments were direct sale-leasebacks and 90% were transactions that involved an existing relationship, which speaks to the quality of our market relationships and the predictability of our investment platform from both a sourcing and underwriting perspective. All of these combined factors gave us the visibility in late January to provide 2021 AFFO guidance of $1.22 to $1.26 per share.

Gregg Seibert, COO

Thanks, Pete. During the fourth quarter, we invested $244 million into 108 properties through 33 separate transactions at a weighted average cash cap rate of 7.1%. These investments were made within 11 different industries with over 80% of our activity coming from 5 industries: quick service restaurants, equipment rental and sales, auto service, medical dental, and car washes. The weighted average lease term of our quarterly investments was 16.3 years. The weighted average annual rent escalation was 1.4%. The weighted average unit level coverage was 3.6x, and our average investment per property was $2.2 million. Consistent with our investment strategy, 88% of our fourth quarter investments were originated through direct sale-leasebacks, which are subject to our lease form with ongoing financial reporting requirements, and 89% contain master lease provisions. From an industry perspective, car washes are our largest industry at 15.5% of cash ABR, followed by quick service restaurants at 13.9%, early childhood education at 12.3%, and medical dental at 10.6%. We view these 4 business segments as Tier 1 industries for Essential Properties. Going forward, we see our industry concentration increasing in auto service, equipment rental and sales, pet care services, building materials, and grocery.

Mark Patten, CFO

Thanks, Gregg. As we reported in our earnings release last night, we were pleased with our fourth quarter results, particularly the initial impact of our strong investment activity that kicked off in the latter part of the third quarter. Our operating results for the fourth quarter of 2020 compared to the same period in 2019 included total revenue of $41.1 million for the fourth quarter, an increase of approximately $1.9 million or nearly 5%. This was impacted by having to write off nearly $1.5 million in revenues, including nearly $1 million of straight-line revenues previously recognized that mostly stemmed from the Chapter 11 bankruptcy filings of 2 tenants during the quarter. We also recognized an additional COVID related adjustment in the quarter, as we picked up nearly $1 million in property-level expenses, specifically property taxes associated with the previously mentioned tenants that have filed for bankruptcy, as well as other vacancies that were resolved in the quarter.

Peter Mavoides, President and CEO

Thanks, Mark. We are 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. 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 in the future. With that, operator, let's please open the call for questions.

Operator, Operator

Our first question comes from the line of Nate Crossett with Berenberg.

Nate Crossett, Analyst

Obviously, acquisition volumes have been ramping. So I was just curious to know what kind of the run rate is baked into your guidance here? And then also, just based on the current size of your team, is there kind of an upward bound limit that we should be thinking about?

Peter Mavoides, President and CEO

Sure. Thanks, Nate. The fourth quarter was a really big quarter for us, and we're happy with the results there. But as has been our tradition, we don't provide acquisition guidance. We provide very specific detail on our trailing 8 quarters average and guide people to that as an indicator of where we're likely to transact. Our team, when we came public, was staffed and remains staffed to transact at that level. As you look out in 2021, certainly, our guidance has a range of assumptions built into it, but a good baseline is looking at the trailing average.

Nate Crossett, Analyst

Okay. That's fair. What about just your comments on pricing? It seems like, for the year, it was pretty stable, just above 7%. Is that kind of your expectation for this year as well?

Peter Mavoides, President and CEO

Yes. The cap rates over the last 8 quarters have really ranged from 7.1% to 7.5%. I'd say that there are really two factors going into that: one being the industry mix; and two being the overall competitive environment. Our industry mix has been gravitating towards the more secure industries we invest in and away from some of the more risky industries, which has impacted our cap rate downward. And it's very competitive out there right now; a lot of people have a lot of capital to put to work in the space. We're really trying to get the best risk-adjusted returns. Generally, my guidance there has been low to mid-7s; low 7s would still be the guidance.

Nate Crossett, Analyst

Okay. Just quickly on the cost of capital side. Do you guys think that you're getting closer to a potential investment-grade rating at some point, just given that you're growing pretty quickly?

Peter Mavoides, President and CEO

Well, sure. I would remind you, we have an investment-grade rating from Fitch. We certainly have maintained an investment-grade quality balance sheet since coming public. We hadn't really pursued a second investment-grade rating because we hadn't needed to support our debt activity, but I think that may be on the calendar here for 2021.

Operator, Operator

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

Haendel St. Juste, Analyst

Hope everyone's well. So my first question, I was hoping you guys could talk about the two bankruptcies in the fourth quarter, Loves and Ruby Tuesday. It sounds like in your comments that you've made some real progress there. Maybe you can share some color? Have you re-leased all of the former boxes? What do the recoveries look like?

Peter Mavoides, President and CEO

I would like to start by noting that our guidance includes the resolution of those situations. The recoveries are dynamic and certainly complex. This is especially true for Ruby Tuesday, where we sold assets at significant gains over our investments and repositioned some assets while taking others back that were vacant. We won't disclose a specific recovery number for either of those investments. Typically, we provide detailed numbers on our recoveries in our supplemental materials, usually around the 90% range. My expectation for both scenarios is that, ultimately, we would align closely with that figure.

Haendel St. Juste, Analyst

Okay. Maybe differently. It sounds like you're further along with Ruby than with Loves. I'm curious about the demand for the Loves' furniture boxes, what type of market is there? And maybe some color on what the rent levels broadly in the market offer for those types of space?

Peter Mavoides, President and CEO

Yes. We only had 4 Loves, 4 former Art Van sites. We don't have a broad sample set. Recoveries can be as low as $6 a square foot or as high as $18 a square foot, really depending on the specific sites. As we sit today, we have 1 remaining Loves' furniture, and we have worked to reposition two of them to another furniture operator. The recoveries and the assets are decent and fungible.

Haendel St. Juste, Analyst

I appreciate that. I have a question about the collection set on Page 15 of the supplement. Could you explain some of the figures and the reasons behind the sequential changes from January compared to the fourth quarter? You mentioned that overall collections increased to 97% in January from 96% in the fourth quarter. Additionally, cash collections rose from 91% last quarter to 95%, while deferrals decreased from 5% in the fourth quarter to 2% in January. Could you elaborate on these sequential changes?

Peter Mavoides, President and CEO

That's a lot of questions there, Haendel. The biggest change in collections of cash rent was certainly the expirations of deferrals. We had some new deferrals that crept in late in the fourth quarter. The cash rents improved significantly, and we really end up talking about the 3%, with a good chunk of that remaining from our 5 theaters leased to AMC, which continue to struggle. That remains a good chunk of the 3% that we're not collecting.

Haendel St. Juste, Analyst

And if I could follow up on, you mentioned that there were some deferrals that crept in late in the quarter. I'm curious, it sounds like those might have been COVID restriction-related. So some color on the tenant industry? What makes you think that those are deferrals?

Peter Mavoides, President and CEO

It was COVID-related and the reinstitution of shutdowns. Largely, the sectors that remain challenged are the entertainment and fitness centers. What gives me comfort in recognizing those deferrals is that those tenants have remained current and creditworthy.

Operator, Operator

Our next question comes from the line of Katy McConnell with Citi.

Katy McConnell, Analyst

Can you touch on the timing of 4Q acquisitions and whether an acceleration of closings before year-end might be the reason for the lighter volumes year-to-date?

Peter Mavoides, President and CEO

Yes. Generally, in this business, the acquisitions tend to be quarter-end loaded. And this fourth quarter was no different. The trend is particularly acute in the fourth quarter where you have some more activity that's more tax driven. That year-end crush tends to result in a January lull that we all in the industry fight. We feel good about our pipeline and are excited for a big March.

Katy McConnell, Analyst

Can you provide more background on what drove the tax adjustment burden to fall on you in the fourth quarter? Could that be a risk for any other bankruptcy tenants that you have exposure to?

Peter Mavoides, President and CEO

Yes. When we kick out a tenant and terminate a lease, we become liable for those taxes to the extent that a bankrupt tenant isn't paying. That's what happened. We certainly bear the risk of taxes as landlords. We pass those risks through to our tenants, but if a tenant becomes uncreditworthy, we become liable.

Operator, Operator

Our next question comes from the line of Sheila McGrath with Evercore.

Sheila McGrath, Analyst

With the benefit of hindsight, are tenants or Essential Properties, as a landlord, requiring any new lease language surrounding a shutdown, like providing more clarity on what a short-term deferral might look like?

Peter Mavoides, President and CEO

That hasn't crept into our lease negotiations. I wouldn't be surprised if tenants start looking to share that risk of state-mandated shutdowns. Currently, the tenants bear those risks and are required to pay rent regardless of mandated shutdowns.

Sheila McGrath, Analyst

You had more dispositions in the fourth quarter than typical. What were the drivers there? Do you expect larger disposition volume in 2021 as you reduce casual dining and exposure to gyms?

Peter Mavoides, President and CEO

No. Those industries are rightsized where they are. We had one large tenant buyback that happened in the fourth quarter, and quite frankly, that tenant wasn't performing as we would have expected. So we were happy to transact and move those assets back and reinvest that capital into better-performing operators.

Operator, Operator

Our next question comes from the line of Ki Bin Kim with Truist.

Ki Bin Kim, Analyst

So given how some of these troubled tenants have been released like Town Sports, Ruby Tuesday, or Loves Furniture, I'm curious how much ABR is on the come and not in the fourth quarter run rate.

Daniel Donlan, Senior Vice President of Capital Markets

Yes. The key factor is Town Sports. They paid us rent in December, which is significant. The tenants who are not on accrual but are paying us in cash also offer potential upside to our revenue run rate.

Peter Mavoides, President and CEO

The fourth quarter is certainly depressed from a run rate perspective, and we have good momentum in the first quarter, which is reflected in our guidance.

Ki Bin Kim, Analyst

So is it $1.5 million-plus? What other dollars should we be modeling going forward?

Peter Mavoides, President and CEO

Part of it is the $1.5 million is the catch-up recognized over several quarters. It's not going to be a one-quarter shot.

Ki Bin Kim, Analyst

How much rent are you currently collecting from AMC? Has there been any dialogue with your tenant?

Peter Mavoides, President and CEO

Yes. I'd stop short of disclosing exactly what we're collecting from AMC. We put them on a percentage rent deferral through the end of the year, depending on their level of revenue.

Ki Bin Kim, Analyst

What kind of G&A run rate should we expect in 2021?

Peter Mavoides, President and CEO

I think where we settled out in Q4 will probably tick up a little bit because of compensation-related incentives. Total G&A will probably tick up a little bit from that $24.4 million we had for the full year.

Operator, Operator

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

Greg McGinniss, Analyst

EPRT has had a fairly concentrated approach to target industries for acquisitions. I'm curious about what the other services category encompasses and whether or not you're starting to look into other industries for transactions?

Peter Mavoides, President and CEO

We've always had another services bucket. We're open to other industries as long as they meet our criteria for fungibility and granularity. The services are pretty self-explanatory, and we remain open to evaluating opportunities in the investment universe.

Greg McGinniss, Analyst

Are there specific tenants in the portfolio that might be rent-paying, but you have concerns about?

Peter Mavoides, President and CEO

Yes. We have 237 tenants, and some are on our watch list. We're working to rightsizing those investments, as you see in our disposition activity. Two-thirds of the non-recognized is AMC, and the other is a bunch of smaller tenants.

Operator, Operator

Our next question comes from the line of Caitlin Burrows with Goldman Sachs.

Caitlin Burrows, Analyst

What additional credit events, if any, are assumed in the guidance range? Does that bankruptcy impact the debt levels compared to 2020 or 2019 actual results?

Peter Mavoides, President and CEO

The high level of restructurings we experienced in 2020 is largely in the rearview mirror. As we look to 2021, we expect a much more normalized level of credit events. Guidance incorporates all those scenarios.

Caitlin Burrows, Analyst

Does guidance assume an increase in recognized rent levels as the year progresses?

Peter Mavoides, President and CEO

Yes. We expect the deferrals to burn off. We expect those who aren't paying to either start paying or we have the ability to kick them out and put people in who will pay.

Caitlin Burrows, Analyst

On the unit level rent coverage, it looks like that was the same in 4Q '20 and 4Q '19 at 2.9x, but the distribution of tenants has shifted. Can you discuss how that distribution has changed?

Peter Mavoides, President and CEO

The pandemic really impacted that disclosure because the majority of our tenants were offline. We feel that number will stabilize after the effects of the pandemic pass.

Caitlin Burrows, Analyst

Would you say that the shifts we've seen are temporary?

Peter Mavoides, President and CEO

Yes, I believe so. If we were to evaluate all those sites for the deferrals that were granted, it would probably align more closely with pre-pandemic levels.

Operator, Operator

Ladies and gentlemen, I apologize for the delay. We're going to go ahead and resume our conference. Our next question is from the line of Sam Choe with Crédit Suisse.

Sam Choe, Analyst

I think most of my questions have been answered. I'm seeing that Mavis Discount Tire entered your top 10 tenants. Am I correct to assume that this was an example of you guys expanding on a pre-existing relationship?

Peter Mavoides, President and CEO

Yes, Sam. We did some investments with them earlier in the year and were able to do some add-on investments. They're a great tenant, a great company.

Sam Choe, Analyst

In your prepared remarks, you mentioned that most of the growth, around 80-90%, has been pre-existing relationships. So could building on these relationships increase top 10 tenant exposure? Or should that remain relatively flat?

Peter Mavoides, President and CEO

We manage our top 10 concentration and individual concentrations carefully. The majority of our investments will be outside of our top 10.

Sam Choe, Analyst

One more from me. Your strategy of reducing exposure to more challenged segments makes sense, but I noticed you added some health and fitness assets during the quarter. What did you like about those assets?

Peter Mavoides, President and CEO

What you're seeing was the re-tenanting and repositioning of our Town Sports that was in bankruptcy. We like gyms that are well positioned from membership and revenue perspectives.

Operator, Operator

We'll move on to our next question, which is coming from the line of R.J. Milligan with Raymond James.

R.J. Milligan, Analyst

With the recent spike in the 10-year, has that had any impact on your business? At what point does the 10-year start to have an effect?

Peter Mavoides, President and CEO

The recent spike has not had any material impact on our business. A 30-day movement isn't going to impact those transactions significantly. We think a move in the rate would help us by making alternative capital sources for our tenants more expensive.

R.J. Milligan, Analyst

As you think about non-rated or below investment-grade tenants, has there been any change? Is there interest in increasing investment-grade exposure?

Peter Mavoides, President and CEO

Our middle market strategy is governed by our desire to be a sale-leaseback provider of choice. We feel pretty good about our portfolio's quality. We think our investment thesis has been validated through this pandemic.

R.J. Milligan, Analyst

As you're structuring new leasebacks, are there any changes contemplated in the shape or form of escalators going forward?

Peter Mavoides, President and CEO

Lease escalations are always intensely negotiated. We like being below 2% because higher escalations can create a scenario where your rents may grow faster than the tenant's profitability.

Operator, Operator

Our next question comes from the line of John Massocca with Ladenburg Thalmann.

John Massocca, Analyst

You mentioned cap rate compression that you were seeing out in the marketplace. What are some alternative financing sources driving this compression?

Peter Mavoides, President and CEO

Most of the competition is coming from other net lease capital investors, whether it's public REITs or private investors discovering the technology of ABS financing. The stickiness of the cap rates remains.

John Massocca, Analyst

How sustainable do you think the high leverage, ABS-backed investment in the space is?

Peter Mavoides, President and CEO

It's a very efficient market, and I would suspect it will continue to be here as a competitive factor moving forward.

Operator, Operator

I’m not seeing any additional questions coming in at this time. So I’d like to pass the floor back over to management for any additional closing comments.

Peter Mavoides, President and CEO

Thank you, operator. We apologize for the dropped host and appreciate your time today. We're excited about the fourth quarter, but more importantly, we're excited about 2021 and our ability to continue investing and growing. We look forward to meeting with many of you investors at the Citigroup Conference upcoming. Thank you.

Operator, Operator

Ladies and gentlemen, we thank you for your participation on today's conference. You may disconnect your lines at this time.