Earnings Call Transcript - FCPT Q4 2023

Operator, Operator

Hello, and welcome to the FCPT Fourth Quarter 2023 Financial Results Conference Call. My name is Elliott, and I'll be coordinating your call today. I'd now like to hand over to Gerry Morgan. The floor is yours. Please go ahead.

Gerry Morgan, Speaker

Thank you, Elliott. During the course of this call, we will make forward-looking statements, which are based on our beliefs and assumptions. Actual results will be affected by factors that are beyond our control or ability to predict. Our assumptions are not a guarantee of future performance, and some will prove to be incorrect. For a more detailed description of potential risks, please refer to our SEC filings, which can be found on our website. All of the information presented on this call is current as of today, February 15, 2024. In addition, reconciliation to non-GAAP financial measures presented on this call such as FFO and AFFO can be found in the Company's supplemental report. And with that, I'll turn the call over to Bill.

Bill Lenehan, CEO

Thank you, Gerry. Good morning. Thank you for joining us to discuss our fourth quarter results. I will make introductory remarks. Patrick and Josh will comment further on the acquisition market, and Gerry will conclude with the discussion of our financial results and capital position. We reported fourth quarter AFFO of $0.43 per share, which is up $0.02 or 4.9% from Q4 last year. Our existing portfolio is performing exceptionally well with 99.8% rent collections for the quarter and 99.8% occupancy at quarter end. FCPT had a record acquisition year with $333 million of capital deployed in 2023. That was up 16% from our full year 2022, which was also a previous record acquisition year. We are benefiting from establishing verticals in medical retail, auto services, and other retail in addition to restaurants, our historical core area of focus. These transactions were primarily funded with equity raised in late 2022 and early '23 at an average price of about $27 per share and with our June debt offering where we benefited from hedge gains to lock in a 5.4% yield to maturity. After utilizing these funds, we slowed down acquisition activity in the second half of the year to reflect the impact of higher interest rates on equity and debt sources of capital. I would also highlight that the impact of purposely slowing down acquisition activities in 2023 was an elevated level of broken deal costs, which increased property expenses by approximately $250,000 versus the 2022 level. While these had an impact on 2023 AFFO, it was the right decision to terminate transactions if they were no longer accretive. Year-over-year, the restaurant sector as a whole remained positive in the fourth quarter in the 4% range according to Baird research. Although the casual dining sector is seeing small declines off the strong levels in the prior year period. Darden was a standout from that trend, reporting same-store sales growth of 4.1% and 4.9% for Olive Garden and LongHorn, respectively, for their quarters ending November 26. Chili's saw same-store sales rise 5% for the most recent quarter ended December 27. All three brands saw margins expand as well as commodity and labor inflation easing. Our EBITDAR to rent coverage in the fourth quarter was 4.9x for the significant majority of our portfolio that reports this figure. This remains amongst the strongest coverage within the net lease industry. Turning to capital sources, we issued $25.4 million of equity in the fourth quarter at an average price of $25.34. We started the first quarter of 2024 with $234 million of available capacity on our revolving credit facility, very minimal near-term debt maturities, and highly attractive properties to sell to 1031 buyers if we choose to access that source of liquidity. As we look ahead, the current capital market environment is making it challenging to deploy capital accretively. I want to restate something I said last quarter. In this environment, we remain disciplined allocators of capital. Since our inception in 2015, we have established mental models and structured our team incentives to discourage deploying capital just to grow the Company's overall size without also increasing per share metrics of earnings or intrinsic value. Our investment team does not work on commission, and their goal is not tied to acquisition volumes as we have never given acquisition or earnings guidance. Finally, we benefit from low absolute and relative overhead and can be nimble and modulate our investment activities up and down without negatively impacting the organization or employee morale. All that said, the team is laser-focused on building an accretive pipeline while minimizing risk. Cap rates have widened, and we have found interesting investment opportunities that Pat will elaborate on. We believe that we are prepared to operate successfully in today's environment and expect to ratchet up activity when we believe it is accretive to do so. With that, I'll turn it over to Patrick to further discuss the investment environment.

Patrick Wernig, Speaker

Thanks, Bill. As Bill mentioned, our cost of capital rose in 2023. And while market cap rates did improve, the shift was not commensurate with the movement in interest rates. As such, we moderated our acquisitions volume down in Q4 despite the last few months historically being our busiest time of the year. In total, we closed on $12.8 million across six properties for the quarter. We spent years building on our platform and team. And our continued progress in outpacing prior year's volume reflects our growing capacity. Additionally, while it's not reflected directly in the numbers, the quality of these properties was also particularly strong in 2023 versus prior years, given the reduced number of active net lease buyers in the market, which allowed FCPT to be very selective. Our overall cap rate for the year was 20 bps higher than our previous year's acquisitions despite a large long-term investment-grade transaction with Darden as the tenant. We'd also like to note that our average initial lease term for the acquired properties this year was four years longer at 12 years compared to eight years last year. It's worth pointing out that the cap rates for Q4 were higher than our full year figure. And today, we're pricing acquisitions above a 7% cap rate. Most of 2023's volume was closed in Q2 and early Q3 of this year and priced two to three months prior to that. For the year, our acquisitions have been roughly split between restaurant at 39%, medical retail at 36%, and auto service at 23%. We continue to monitor the market and expect to have more favorable opportunities and more attractive pricing in 2024 compared to 2023. However, we note that the bid-ask spread between buyers and sellers, while converging, still exists. As mentioned earlier though, we believe that our team is entirely equipped to transact where it meets our underwriting criteria and is still accretive. The macro backdrop continues to be uncertain. We've focused on what we know: purchasing accretive and high-quality real estate leased to creditworthy tenants operating service-based retail businesses. Josh, I'll turn it over to you to discuss dispositions, re-leasing, and our portfolio.

Joshua Zhang, Speaker

Thanks, Patrick. We sold one Red Lobster property in October in the fourth quarter last year that was underperforming versus brand average for $3.8 million, representing a small gain. Over the course of the past 14 months, we have sold six of our weakest Red Lobster properties at a weighted average cap rate of 6.5% and have reduced our exposure from 2.9% of annual base rent last year down to less than 1.7% today. Currently, most of our Red Lobsters are master leased, and the ones that are not in the master lease are reporting rent coverage in line or better than the rest of our portfolio. We are fortunate that even our weakest performing stores are able to be sold at attractive cap rates and recycled into our investments accretively. It reminds us that even if the capital markets continue to be challenging, our portfolio has immense value that can be unlocked through selective dispositions. Turning to leasing, we had five leases that expired in Q4 with all five renewing above their current rent levels. This reinforces our confidence that rents are set at attractive levels for the tenants in our portfolio. Our portfolio today stands at 99.8% occupancy and remains well-positioned with only 1.3% and 2.2% of annual base rent maturing in 2024 and 2025, respectively. And with that, Gerry, I'll turn it back over to you.

Gerry Morgan, Speaker

Thanks, Josh. For the fourth quarter, our cash rental revenues grew 15.8% on a year-over-year basis, including the benefit of rental increases and the $333 million of acquisitions that were closed in the last 12 months. We reported $57 million of cash rental income for the fourth quarter after excluding $0.6 million of straight-line and other noncash rental adjustments. And on a run-rate basis, our current annual cash base rent for leases in place as of December 31 is $218.2 million. And our weighted average five-year annual cash rent escalator remains at 1.4%. As Bill mentioned, we collected 99.8% of base rent in the fourth quarter. And there were no material changes to our collectibility or credit reserves or any balance sheet impairments. Cash G&A expense excluding stock-based compensation was $4.1 million, representing 7.1% of cash rental income for the quarter, down compared to 8% for Q4 2022. For your modeling purposes, we expect cash G&A will be approximately $17 million for 2024. As a reminder, we take a conservative approach to G&A and expense 100% of costs associated with our internal investment team. With respect to the balance sheet, at quarter end, we had $259 million of liquidity, comprised of $60 million of unrestricted cash, $8 million of 1031 proceeds available to redeploy, and $236 million of undrawn revolver capacity. With respect to overall leverage, our net debt to adjusted EBITDA in the fourth quarter was 5.5x, and our fixed charge coverage ratio was a healthy 4.4x. Our only near-term debt maturity is a $50 million private note due in June of 2024. Otherwise, our next debt obligation is $150 million of bank term debt due in November of 2025. While we won't comment on specific timing or strategy, we expect to address this small maturity well prior to its expiration in June. And based on our strong credit profile and recent conversations with multiple banks in our lender group, we expect that the bank market remains open to us at an attractive cost of capital amongst the many options we have available when thinking about this maturity. We remain committed to layering and using conservatism in our debt maturity stacking. And with that, I'll turn it back over to Elliott for investor Q&A.

Operator, Operator

First question today comes from Anthony Paolone with JPMorgan.

Anthony Paolone, Analyst

Just wondering if you could talk, Bill, about just like what you think is a good deal today, whether it's just a higher yield or what's maybe the lease length or real estate basis, like how you're sizing up the things that you like versus not doing anything.

Bill Lenehan, CEO

I'd invert the question. I look at net lease more as having selection bias, excluding attributes. So we're now being very focused on having truly triple-net leases even in industries where it's not always the case like medical and auto service. It's being focused on having longer lease terms, higher credit tenants, and we're still getting pricing in the north of a seven cap. So we've always been quite selective. As Pat mentioned, the more recent environment allows us to be even more so. So it really is being able to very quickly ignore properties that we still see every once in a while that are priced very aggressively or have very high rents or have small, unproven tenants. That's the way I would look at it. You're seeing more investment-grade, triple-net, new construction medical retail in our pipeline would be one example.

Anthony Paolone, Analyst

You mentioned deals in the 7s, but the ones you've completed this year were around six or nine. Do you believe that is sufficient compared to your current capital costs? Should we expect some upward movement, or how should we consider this?

Bill Lenehan, CEO

I think the trend seems to be in our direction. Obviously, the recent Fed commentary has sent the market up and down seemingly on a daily basis. But I would say that the cap rates we're seeing good stuff to do in the low 7s. And that kind of works with our current cost of capital. It certainly would be a lot more obvious if we had a couple more dollars on our stock price.

Operator, Operator

We now turn to Connor Siversky with Wells Fargo.

Connor Siversky, Analyst

In the opening remarks, you mentioned the elevated level of broken deal costs that impacted acquisition volumes. I'm just curious maybe if you could extrapolate on that point a little bit. Is that just due to pricing dislocations between FCPT and the seller? Or are there any other factors to consider in those broken deals?

Bill Lenehan, CEO

Yes, I wanted to provide a bit more detail. We are not abandoning deposits; that’s not the case at all. When we are in discussions involving a Letter of Intent, there are legal expenses and sometimes we hire third-party experts to assess environmental factors or structural issues with the property. This has been a consistent aspect of our operations. If we plan to acquire over 100 buildings annually, there will be instances where we advance in negotiations only to discover issues that lead us to reconsider the purchase. However, given the current environment, we are being cautious to avoid becoming too attached to a property and making poor long-term decisions just to mitigate deal costs. This situation was particularly noticeable in 2023, unlike in previous years, and I thought it was important to mention.

Connor Siversky, Analyst

Okay. That's good color. I appreciate the context there. And then just quickly on the watch list. I mean I appreciate the work in getting out of some of those Red Lobster assets. Is there anything else in the portfolio that you have eyes on right now? Or maybe in the context of the choppy macro environment, are you considering changing any of the criteria to put something on a watch list?

Bill Lenehan, CEO

No. I think that's a definitive no. Maybe to add to my comments and segue this to Anthony's previous question, we are very happy that we didn't do novel net lease in the last handful of years. And what do I mean by novel net lease, like $9 million car washes, bowling alleys, things like that, that you could get higher yields, and we could certainly be doing those right now with an eight handle on it. But the credit is much more tenuous than what we've been doing. So one of the important factors of having a consistent model that errs on being conservative is when you have a choppy macro, your portfolio hangs in there better than your peers.

Operator, Operator

Now turn to Alex Fagan with Baird.

Unidentified Analyst, Analyst

First one is, what is the investment pipeline looking like? How likely will we see an even higher percentage of medical and auto service assets as part of that investment total in 2024?

Bill Lenehan, CEO

Hard to predict full year volumes because you'll still be sourcing deals for seven to eight more months before you know exactly what's going to happen in '24. I would imagine that the percentages absent a chunky portfolio will remain relatively consistent with what we've done in the past. The pipeline is quite decent. I would say that we look at the pipeline in a green, yellow, orange, and red color-coded way. Green being deals that we intend to close in the near term, yellow that we're negotiating LOIs, orange being on the radar, red being out there in the ether. We don't know whether they're going to happen, but they're certainly not close. I would say we've got a lot of things in the orange pipeline right now that if we had a little bit better cost of capital and could lean into, we think would have actually pretty sensible ROAs associated with them or unlevered IRRs, however you want to look at it. It's just funding with the current equity and debt capital markets makes it a little bit harder. So it's really as much a function of sources of capital as it is what we could deploy that capital for.

Unidentified Analyst, Analyst

Got it. And actually, on the potential for any big portfolio deals, are there any ones that are interesting that Four Corners is currently looking at?

Bill Lenehan, CEO

We're always evaluating deals of different sizes. Throughout our history, we've completed several transactions, from the original Chili's portfolio to the Cheddar's deal last summer and several large outparcel transactions. We are continuously engaged in various opportunities. However, as we mentioned earlier, the current market has buyers and sellers roughly 30 to 40 basis points apart in their pricing expectations, leading to an increase in situations where sellers withdraw their assets from the market compared to the past.

Operator, Operator

This concludes our Q&A. I'll now hand back to Bill Lenehan for final remarks.

Bill Lenehan, CEO

Thank you, Elliott. Well, pleased to have the call conclude in about the 20-minute mark as we were able to accomplish in our early days. Hopefully, we can get back to that. Thank you, everyone. And if you have questions, please don't hesitate to reach out. Thank you.

Operator, Operator

Ladies and gentlemen, today's call has now concluded. We'd like to thank you for your participation. You may now disconnect your lines.