Earnings Call Transcript - FCPT Q1 2023

Operator, Operator

Ladies and gentlemen, welcome to the FCPT First Quarter 2023 Financial Results Conference Call. My name is Glenn, and I will be the moderator for today’s call. I will now hand you over to your host, Gerald Morgan, CFO of FCPT. Gerald, please go ahead.

Gerald Morgan, CFO

Thank you, Glenn. During the course of this call, we will make forward-looking statements, which are based on beliefs and assumptions made by us. Our actual results will be affected by known and unknown 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 some potential risks, please refer to our SEC filings, which can be found at fcpt.com. All the information presented on this call is current as of today, May 2, 2023. 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 also available on our website. With that, I'll turn the call over to Bill.

Bill Lenehan, CEO

Good morning. Thank you for joining us to discuss our first quarter results. I'm going to make introductory remarks. Patrick will make further comments on acquisitions and the pipeline, and then Gerry will discuss the financial and capital raising results. The existing portfolio continued to perform exceptionally well with 99.9% collections for the quarter and occupancy also at 99.9%. This is going to be an interesting year overall for the commercial real estate sector with transaction volume predicted to be down 50% or more, some REIT sectors unable to raise capital accretively and specific sectors like office definitely out of favor. We contrast that with what FCPT, we believe, will be a year of business as usual. By that, I mean that we expect our portfolio to continue to perform well and benefit from the high tenant coverage our low rent levels allow. First quarter acquisition volumes were lower, which was in line with the overall market slowdown in our typical deal timing. However, we are currently working on very interesting investment opportunities in our pipeline, many of which are deals that may not have come our way in the past. We believe that 2023 will be a very healthy growth year. Of course, capital costs have gone up too, and we remain vigilant on comparing our investment yields against the cost of capital used to fund those acquisitions. In the quarter, we raised $52 million of equity at an average price of $27.73, and we began the second quarter with pricing locked on over $185 million of combined equity forwards and treasury locks to fund acquisitions at accretive rates. We reported first-quarter AFFO of $0.41 per share. EBITDA grew 9% on a year-over-year basis. AFFO was flat prior quarter and year-over-year. This is due to the effects of higher interest rates on both our cost of debt and cost of equity. Cash rental revenues grew 12.2% on a year-over-year basis, including the benefit of rental increases and $263 million of acquisitions in the last 12 months. This included the acquisition of 10 properties in the first quarter for $20 million at an initial cash yield of 6.9%, reflecting rents in place as of March 31. Patrick will discuss the current investment environment in more detail. But just speaking at a high level, the first quarter continued to see attractive acquisition pricing with cap rates above historical levels, especially after the Silicon Valley Bank and Signature Bank collapses. The Q1 acquisitions average cap rate reflected that dynamic, improving 30 to 60 basis points versus the 6.6% and 6.3% in Q4 and Q3 of last year. Of course, the news of the First Republic Bank is still being processed by the market. We anticipate investment opportunities for FCPT will emerge from the continued tightening of lending standards. Moving on to our tenants' performance. Restaurant operators continue to have strong sales results in the first quarter with Baird estimating restaurants are operating at approximately 105% of 2022 weekly sales levels according to their survey on April 24. Restaurant operators are seeing a moderation of cost increases in food and labor, but are still expecting some levels of margin pressure. We continue to view the industry sales trend as a helpful data point, but we also want to call out the very strong recent performance of our two largest tenants, Darden and Brinker. Darden, the parent company of Olive Garden and LongHorn, saw its brand same-store sales rise 12% and 11% for the most recent quarter. Olive Garden's margins rose 390 basis points from the prior quarter to 22.5%. LongHorn also showed significant improvement, rising 310 basis points from the prior quarter to 17.4%. Brinker, the parent company of Chili's, saw brand same-store sales rise by 8% and restaurant margins improved by 450 basis points to 10.3%. All three of our anchor brands are benefiting from moderating labor and commodity costs while continuing to leverage rising sales volumes. Our estimated EBITDA rent coverage was 4.6% for the 72% of our portfolio that reported the statistic, driven mainly by large improvements in margins in Darden's last quarter. This remains among the strongest coverage within the net lease industry and provides a cushion versus inflationary impacts on input prices and moderating consumer demand. One item that we've been tracking is how much Darden brand sales have risen since the FCPT spin-off in 2015 versus how much rents have risen. Olive Garden and LongHorn same-store sales have risen 23% and 45%, respectively, over the past 7 years, while rent has only risen 11%. With that, I'll turn it over to Patrick.

Patrick Wernig, CIO

Thanks, Bill. I'd like to pick up on the comments you made around the shift in cap rates. After years of being in a seller's market, we're seeing significantly more opportunities for well-capitalized investors to acquire high-quality real estate net leased to strong operators. The cap rate improvement is a direct result of less competition and tighter lending standards. Specifically, we attribute the current buyers market to four factors, which are somewhat circularly impacted by one another. First, less institutional competition with fewer private equity sponsors pursuing retail net lease. Second, tighter bank lending standards have raised borrowing rates and lower loan leverage as a percentage of property value. As Bill mentioned, this shift has been particularly acute following recent turmoil in the banking sector. Third, reduced 1031 exchange transactions. For example, in recent years, the tight valuations of multifamily apartment buildings have driven property sales and subsequent 1031 exchanges into retail net lease. The valuation is down, there's less motivation for owners to exchange into net lease today. And finally, net lease and sale leaseback transactions are more attractive on a relative basis for operators evaluating the financing options than in recent years, even as cap rates rise. Shifting to the pipeline, we expect more new or newly constructed properties in our Q2 acquisitions and for the rest of the year. We've largely been outpriced for developer projects in prior years. But in 2023, we have been more successful in engaging with developers. They have been more eager to sell their completed inventory or to arrange forward commitment to purchase properties that are yet to be completed. Those same developers were selling properties 100 basis points inside of our pricing a year ago. Regarding the property mix, our Q1 acquisitions were more heavily anchored to medical retail than typical. 71% of our property is leased to medical tenants, 24% to auto service and 5% to casual dining. Looking at the forward pipeline, we'd expect the mix to even out over the course of the year; the medical retail may comprise a higher percentage of full year volume than in prior years. We've been very focused on building out our pipeline and capabilities in that sector and expect it to be a core part of our portfolio in the future. As we stated in the past, Q1 is typically our lowest deal volume quarter for the year. For example, in 2021 and 2022, Q1 was 15% of acquisition volume for the year. This year, we saw a slow start to sourcing in January and February, which we attribute to market volatility. That said, after February, our closings have picked up speed. We closed over $25 million of volume in the month of April, outpacing all of Q1. Looking at our pipeline, we expect to have a robust Q2 and Q3. We expect to continue recycling capital opportunistically into new acquisitions, particularly where we can also improve portfolio quality. In the quarter, we sold three properties for a sales price of $12.1 million, representing a combined gain of $1.6 million. These were two Red Lobsters and one Burger King, and the sales were previously disclosed. These stores were specifically selected as disposition candidates based on relative underperformance versus their respective brands.

Gerald Morgan, CFO

We generated $51.4 million in cash rental income for the first quarter after excluding $0.8 million of straight line and other noncash rental adjustments. We collected 99.9% of base rent for the quarter. There were no material changes to our collectibility or credit reserves nor any balance sheet impairments in the quarter. On a run rate basis, our current annual cash base rent for leases in place as of March 31 is $195.7 million, and our weighted average 5-year annual cash rent escalator remained at 1.4%. Cash G&A expense for the quarter was $4.3 million, representing 8.3% of cash rental income for the quarter. We continue to expect cash G&A will be approximately $16 million for the year, although we trended slightly higher in the quarter due to higher payroll taxes given the timing of prior year stock grants that vested in January. Turning to the balance sheet. As Bill highlighted, we are well capitalized to fund growth. On March 31, we held $31 million of cash and 4.1 million shares under forward sales agreements with anticipated net proceeds of $111 million upon settlement. Including our undrawn revolver of $250 million, we start the quarter with $392 million of available liquidity. Our results this quarter were impacted by higher short-term borrowing rates. 92% of our $1 billion of debt is fixed, currently at a rate of 3.44%. However, the interest rate on the remaining 8% of our debt is variable and pricing increased on average by approximately 90 basis points versus the fourth quarter. A reminder to investors that we think a 90% fixed, 10% variable rate debt mix is appropriate for our business; it benefits us in some quarters and impacts us in others. Our current all-in cash interest rate at quarter end is 3.64%. With respect to overall leverage, our net debt to adjusted EBITDA in the quarter was 5.6x. Our fixed charge coverage ratio is a healthy 4.6x. Pro forma for settling and deploying the remaining equity, we estimate our leverage is approximately 5.3x, well below our target of 6x leverage. As of March, we also have $75 million of forward starting swaps in place, effectively fixing the 10-year treasury base rate at 2.6% for our next long-term private note issuance later this year. And with that, I'll turn it back over to Glenn to open up for investor Q&A.

Operator, Operator

Our first question comes from Wes Golladay from Baird.

Wes Golladay, Analyst

Maybe I'll just start with Gerry, since he just finished up. How should we think about settling the forwards or issuing the debt, any priority there?

Gerald Morgan, CFO

Yes. The forwards are already issued. So I think they get priority. But as mentioned, we'll also look to access the debt markets at some point this year and obviously, use the revolver as needed to smooth out between. The great news is in the current capital markets, we have options, both with the equity forwards and with delayed funding on private notes to time the issuance of our capital to meet acquisitions.

Wes Golladay, Analyst

Okay. Bill, you mentioned seeing more types of deals recently due to the bank turmoil. Were you referring specifically to the developments you discussed in your prepared remarks, or are you also talking about more sale leasebacks or other types of deals?

Bill Lenehan, CEO

I think it's across the board, Wes. We've seen opportunities from regional banks that owned net lease properties, restaurant properties; their balance sheets are shrinking, and they're looking for liquidity. We've seen developers who historically would have been selling properties one by one at very high prices to the 1031 exchange market, look to us to buy forward their pipeline really across the board. And if you look at the relative attractiveness of net lease versus high yield versus JV equity versus preferred versus bank debt, I think net lease now is the most attractive. It's been on a relative basis versus other kinds of capital since our inception.

Wes Golladay, Analyst

Yes. So am I to read that correctly, you may have a little bit more chunky portfolios, maybe small portfolios? And would you get a discount on that?

Bill Lenehan, CEO

Yes, I think that's a fair read. Pricing is one part of it, and there are circumstances where we feel like we're getting better pricing. Other factors might be getting longer lease terms, not having such high premium investment-grade properties. But certainly, pricing is one of the many factors.

Operator, Operator

We have our next question comes from Jim Cambridge from Epical.

Unidentified Analyst, Analyst

Building off the developer commentary, are you sort of looking towards building more of a relationship type or programmatic acquisition pipeline with these folks? Or still too early for that?

Bill Lenehan, CEO

It really is evolving in real time; if you look at even yesterday and today, what's happening in the capital markets. But I would say our ICSC schedule, if this is a proxy, is far more weighted towards developers than it has any other year. And we've made a real concerted effort to explore that avenue for acquisitions. And it's just historically, there was such a strong bid from folks who sold their apartment building for a 4 cap and wanted to turn around and buy properties that didn't have any landlord responsibilities. Because their proceeds were so tax advantaged and that they sold their down leg property for such a high value, they were willing to pay up for net lease, especially the kind of high-quality net lease that we buy. And with the sales of apartments down so substantially and banks are not very willing, local banks are not very willing to extend credit, I think we are in a really good situation.

Unidentified Analyst, Analyst

Thank you for your insightful comments about the less competitive environment. Do you have any thoughts on the decreased presence of institutional capital? Given your experience in the industry, do you think that those investors were merely short-term participants, or are they currently facing challenges with their cost of capital? Do you anticipate they will return in larger numbers in the future? I'm interested in your views on the persistence and stability of institutional funds and private equity.

Bill Lenehan, CEO

Yes. Let me just maybe take the question more broadly. You had, on one hand, a buyer, 1031 exchange buyer who wasn't super sophisticated, was buying locally. But it's unusual that as a $3 billion company, we were competing against, in many cases, literally individuals. They were less focused on pricing, used more leverage than we were willing to use. And then on the other hand, you had an influx of private equity funds and private equity funds on behalf of insurance captives. Now they were less interested in buying the $2 million buildings, $3 million buildings that we are often buying, but they provided liquidity in other places. They have largely exited the market. So it's both the individual and the private equity funds. I think the private equity funds really had few other alternatives when high yield was 4% or 5%, bank loans were only a couple of percent and net lease seemed at a moment in time to be more attractive. So we think that there's less competition across the board. I'd also make a quick comment that it's unusual that in times of dislocation like we're in now, it's very typical for real estate opportunity funds, Blackstone, KKR, TPG, Carlyle, that sort of thing, to be very active. And those funds, right now, while they are flush with liquidity and investable cash, have been less active than in other environments, and the kinds of buildings that they very often would buy office in particular are particularly out of favor.

Operator, Operator

We have our next question comes from John Massocca from Ladenburg Thalmann.

John Massocca, Analyst

So maybe as you look at the pipeline, particularly kind of near term for the rest of 2Q and 3Q, what are you seeing in terms of cap rate trends? The cap rate expansion we've seen over the last couple of quarters starting to moderate? Or is it kind of continuing at pace?

Bill Lenehan, CEO

I think we were a little early, or certainly earlier than some of our peers, in talking about a 50 to 75 basis point cap rate increase. I think that's probably because we look at a lot of individual properties, and we're not waiting for portfolios. That pricing has been wide. We can be quite active at a 7 cap or above today. But I also would remind people that pricing is only just one of the variables. And to the extent that we find long-term investment grade, high credit quality portfolios, we certainly are willing to pay more for that. But we'll see. I think that the turmoil over the last couple of days in the lending market and the focus on real estate, on regional banks' balance sheets bodes well for us competitively.

John Massocca, Analyst

Okay. And then given it made up such a big portion of 1Q acquisition activity, how are you thinking about the underwriting for the specialty medical properties, urgent care properties? And how does that underwriting maybe differ versus some of your traditional restaurant property investments?

Bill Lenehan, CEO

Sure. It's important to remember that specialty medical involves significant investment, including specialty HVAC units and various water fixtures in each room. The underwriting factors are similar, as aspects like location leverage, lease term, and rent growth are crucial. Additionally, it's essential to consider your investment basis and ensure alignment with creditworthy tenants. The medical space is quite diverse, and we've conducted substantial research on it over the past couple of years. I estimate there's about an 85% overlap with the other types of net lease properties we invest in.

John Massocca, Analyst

Is there any difference in how you have to view the credit versus in the restaurant space, either because of fungibility or the types of credits that tend to be backing these operations?

Bill Lenehan, CEO

Not really. I mean, there's very similar dynamics: private equity involvement, people executing roll-up strategies, benefits of scale, some very similar dynamics at the high level. But obviously, every credit underwriting we do has a component that's top down, which is how is the industry, what are the demographics; and then bottoms up, which is what's the balance sheet of the guarantor and the lease, what are their sources of funds, how are they performing. So there are both components. But I would say, overall, relatively similar, and a subsector that's long-term trends are pretty positive with the aging of America. And to the extent that we're going to bend the cost curve in health care, I feel pretty strongly it's going to happen outside the hospital.

Operator, Operator

We have a follow-up question from Wes Golladay from Baird.

Wes Golladay, Analyst

You guys have been more active with Cooper's Hawk, which I see as being a little bit weaker credit than you normally go after. So how are you getting comfortable with these deals?

Bill Lenehan, CEO

Cooper's Hawk may not meet the median standards we typically consider, and the build-out costs can be quite substantial. We have evaluated several locations and completed one transaction. It's an intriguing brand with additional revenue from its popular wine club in the Midwest. We assessed multiple options and felt confident with the one we chose. Generally, we tend to avoid brands that require significant investments for build-out. However, we are exploring various opportunities. This particular case stands out as we were assured that the local market is robust, the construction is brand new, and even though the cost was higher than what we usually pay, it remains below the average for Cooper's Hawk.

Operator, Operator

We have no further questions on the line.

Bill Lenehan, CEO

Okay. Great. Well, thank you, everyone, for joining the call. Again, a much more interesting environment to be a buyer of real estate. We have ample capital to execute our business plan. Our team is as strong as ever, and we're really looking forward to the next few quarters. With that, we'll adjourn the call. But anyone who would like to meet at NAREIT, please reach out to Drake and look forward to seeing you in New York. Thanks.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines.