Earnings Call Transcript - MDV Q3 2022

Operator, Operator

Good day, and welcome to Modiv's Third Quarter 2022 Earnings Conference Call and Webcast. All participants will be in a listen-only mode. On today's call, management will provide prepared remarks and then we will open up the call for your questions. Participants may also ask a question by emailing ir@modiv.com. And please note that this event is being recorded. I would now like to turn the conference over to Margaret Boyce, Investor Relations for Modiv. Thank you. Please go ahead, ma'am.

Margaret Boyce, Investor Relations

Thank you, operator, and thank you all for joining us today to discuss Modiv's third quarter 2022 financial results. We issued our earnings release and investor supplements before the market open this morning. These documents are available in the Investor Relations section of our website at modiv.com. I'm here today with Aaron Halfacre, Chief Executive Officer of Modiv; and Ray Pacini, Chief Financial Officer. On today's call, management will provide prepared remarks and then we'll open up the call for your questions. Before we begin, I would like to remind you that today's comments will include forward-looking statements under the federal securities laws. Forward-looking statements are identified by words such as will, be, intends, believe, expect, anticipate, or other comparable words and phrases. Statements that are not historical facts, such as statements about our expected acquisitions or disposition, are also forward-looking statements. Our actual financial condition and results of operations may vary materially from those contemplated by such forward-looking statements. Discussion of the factors that could cause our results to differ materially from these forward-looking statements are contained in our SEC filings, including a report on Form 10-Q. With that, I'd now like to turn the call over to Aaron. Aaron, please go ahead.

Aaron Halfacre, CEO

Thank you, Margaret. Hello, everyone, and thank you for joining our third quarter earnings call. Joining me today is Ray Pacini, our CFO, who will cover our financial results in detail following my opening remarks. I'll then close with a few more thoughts on the market before we open the line for Q&A. The major theme for the third quarter was steady disciplined execution. We completed two core acquisitions and two non-core asset dispositions as part of our continued long-term growth plan and strategic portfolio repositioning. We have been intently focused on price discovery as we evaluate both potential portfolio acquisitions and select industrial manufacturing investments. As part of our focus on identifying investment opportunities that could offer Modiv greater enterprise scale, we successfully expanded the capacity of our credit facility by $150 million. As most of you know, the markets remained volatile during the quarter with large swings in interest rates creating disruption in the real estate markets. An environment like this requires patience and an experienced management team to navigate the uncertainty, and we have been in no hurry to sign deals unless they can create long-term value for our shareholders. That said, third quarter revenue increased 17% year-over-year, excluding the one-time early termination revenue reported in the prior year quarter, reflecting strong portfolio performance. Due to market conditions, we exercised patience this quarter, and our reported transaction activity was lighter than the second quarter. That said, our pipeline is robust, and we see significant opportunities on the horizon. We are especially focused on the emerging trend of U.S. industrials reassuring their manufacturing operations. Based on our experience in providing the vital infrastructure needed for critical manufacturing facilities, Modiv is well qualified to partner with key manufacturers making this transition. As I'm sure you are aware, reassuring is gaining momentum primarily due to both global supply chain and geopolitical issues. We think that industrial manufacturing real estate will prove to be a bright spot for investors looking to capitalize on this long-term economic trend. As we continue to scale our portfolio in conjunction with this reassuring resurgence, we believe this can create strong, sustainable, and differentiated value for our shareholders. We are already making good headway in transitioning our portfolio into industrial manufacturing properties. In the past 12 months, our team has completed over $100 million in industrial manufacturing acquisitions at greater than an 8.5% blended weighted average cap rate while also completing multiple non-core dispositions for total proceeds of over $83 million. And now, some observations on the overall market. Over the quarter, we witnessed accelerated upward cap rate momentum as buyers began to sit on the sidelines searching for a modicum of price stability. Even so, we continue to find highly compelling opportunities in the industrial manufacturing sector; specifically, we are actively identifying properties where demand is consistent and relatively defensive in nature, such as those that can be equipped to produce manufacture goods like infrastructure and component products. The Valtir and Producto acquisitions we completed in the beginning of the third quarter reflect this strategy. While market volatility remains high, we are very optimistic about the opportunities in front of us. Modiv provides much needed liquidity to companies that want to monetize their industrial real estate assets and invest in the growth of their manufacturing businesses, ranging anywhere from highway guardrails to indoor farming. Even in a rising interest rate environment, the need for capital does not go away, and the commercial real estate market will eventually find pricing equilibrium with some sectors adjusting more quickly than others. Right now we are seeing volatility in cap rates along with the volatility in treasuries. That said, we believe most of the bad news is out and is increasingly being priced into the market as transactions get printed. To state the obvious, the broader market volatility has not only impacted property transactions, but also public company stock prices. On September 30, the last day of the quarter that insiders were eligible to acquire more shares, I purchased additional Modiv shares at $14.86, a price that was comfortably below the $17 share price range seen in mid-September. Since then, throughout October and into November, our share prices traded at an even lower level that quite candidly defies rational investment behavior. Considering that our last reported NAV per share was greater than $28, the research analyst consensus target price is $20, and even our depreciated GAAP book value is greater than $18 per share. No matter which number you choose to focus on, we are trading at a steep and valuable discount. At present, it appears our stock is suffering the vagaries of small scale day traders able to induce daily price volatility with minuscule share transactions. Meanwhile, these short-term profit seekers fail to realize that investors can collect a double-digit dividend yield with full knowledge that the company is currently trading for less than some of its parts. We see no logical long-term reason for this price dislocation to continue, and as such, remain adeptly focused on our long-term growth plans and strategic portfolio repositioning. I'll now turn the call over to Ray.

Ray Pacini, CFO

Thank you, Aaron. Good morning, everyone. I will now discuss our operating results for the third quarter and first nine months of 2022, provide an update on our portfolio, and cover our balance sheet and liquidity. Third quarter AFFO was $3.1 million or $0.31 per diluted share compared with AFFO of $3.8 million or $0.44 per diluted share in the third quarter of 2021. The primary drivers of the decrease in AFFO per share relate to one, an increase in dividends on our preferred stock as the third quarter of last year only had 14 days of dividends payable on the preferred stock, which we issued on September 17, 2021; and secondly, an increase in the fully diluted share count, primarily due to the issuance of $1.3 million Class C units in January 2022 in connection with our acquisition of the Kia auto dealership property. AFFO for the first nine months of 2022 increased 8% to $9.7 million or $0.95 per diluted share from AFFO of $9.1 million or $1.04 per diluted share in the first nine months of 2021. AFFO per share benefited from our acquisition activity and rent bumps offset by the increase in preferred stock dividends and the higher share count that I just mentioned. After excluding early termination fee revenue of $1.5 million in the prior year quarter, third quarter revenue of $10.2 million increased by $1.5 million or 17.2% reflecting rental income contribution from our acquisition of 16 properties during the first seven months of 2022. The increased rental income from these recent acquisitions was partially offset by decreases in rental income from the sale of eight non-core properties over the last 12 months. The early termination fee related to a Texas property, which was leased to Dana Incorporated and sold during July 2021. Total revenue for the first nine months of the year increased to $30.2 million from $28.3 million for the first nine months of 2021. Excluding the early termination fee revenue of $1.5 million in the prior year period that I just described, revenue increased 12.9%, primarily reflecting rental income from our 18 acquisitions over the last 15 months, partially offset by the decrease in rental income from the sale of 12 non-core properties over the last 21 months. On the expense side, G&A costs were $1.8 million in the third quarter down from $2.9 million in the third quarter of last year, reflecting our focus on maximizing efficiency in our operations and undertaking process improvements. G&A costs were $5.6 million for the first nine months of the year, down from $7.5 million in the prior year period, reflecting reductions in personnel and technology costs following our exit from the crowdfunding business in the first quarter of 2022. Property expenses were $2.1 million in the third quarter, an increase from $1.7 million in the prior year period and were $6.8 million for the first nine months, up from $5.3 million in the prior year period, reflecting the previously announced one-time write-off associated with our decision not to pursue a large Walgreens portfolio acquisition prior to our NYSE listing along with higher property taxes and property management fees due to growth in our portfolio. Property expenses for the first nine months of both 2022 and 2021 were 1.6% and 1.5% of average real estate assets during their respective periods after excluding the one-time write-off I just mentioned. Most of these property expenses are reimbursed by tenants, with at least 82% reimbursed each year. Adjusted EBITDA for the third quarter of $6.7 million increased $655,000 over the prior year quarter, primarily reflecting the decrease in G&A expense partially offset by an increase in our interest expense. On the other hand, adjusted EBITDA declined by $503,000 compared with the second quarter of 2022 due to write-offs of straight-line rent receivable related to the sale of Williams Sonoma during the third quarter and higher G&A due to the timing of our annual meeting and tax compliance. We expect adjusted EBITDA to increase in the fourth quarter, primarily reflecting increases in revenue from our acquisitions along with lower G&A expense. Now turning to our portfolio, as Aaron stated in his remarks, we continue to focus on acquisitions primarily in the industrial manufacturing sector as we expect the trend of onshoring manufacturing to remain strong, and we continue to execute on our long-term strategic plan to reduce our office exposure. During the third quarter, we completed two industrial manufacturing acquisitions in sale and leaseback transactions with Producto Holdings, LLC and Valtir, LLC, which was formerly known as Trinity Highway Products, for a total purchase price of $28.7 million and a blended weighted average cap rate of 7.61%. The Producto acquisition comprised two properties in Upstate New York, and the Valtir acquisition included four properties located in South Carolina, Texas, Utah, and Ohio. The Producto acquisition is a 20-year lease term and annual lease escalations of 2%. The Valtir acquisition includes a 25-year lease term for the South Carolina and Ohio properties with 15-year lease terms for the Texas and Utah properties and annual rent escalations of 2.25%. Including these transactions, our year-to-date acquisition activity totals $162 million at a weighted average cap rate of 8.2%. We have a strong pipeline of potential acquisitions under review, and we will continue to patiently pursue accretive opportunities that make sense for our portfolio and our shareholders. Now I’ll provide some color on our portfolio management activities, which are also key components of our ability to generate long-term returns for our shareholders. During the third quarter, we sold two office properties for $22.2 million at an exit cap rate of 7.4%. On a year-to-date basis, we have sold six office properties and one flex property, which generated total gains on sale of $13.1 million, as we execute on our plan to reduce non-core assets in our portfolio. Over the last 21 months, as part of our portfolio transition strategy, we have sold 12 non-core assets, primarily office properties. Over the same period and partially funded by these dispositions, we have acquired 18 properties with a primary focus on industrial manufacturing. As of today's date, our portfolio consists of 47 properties located in 17 states. The portfolio is comprised of 26 industrial properties, which represent approximately 54% of the portfolio based on annual base rent, 13 retail properties representing approximately 19% of the portfolio, and eight office properties representing approximately 27% of the portfolio. We expect to continue to opportunistically sell office properties from the portfolio but will remain patient and disciplined in this process. Now turning to our balance sheet and capital markets activities. As of September 30, 2022, we had total cash and cash equivalents of $5.7 million, and as of both September 30 and October 31, we had $201.4 million of outstanding indebtedness consisting of $44.6 million of mortgages and $156.8 million outstanding under our credit facility, including $6.8 million on the revolver. On October 21, we announced that we exercised the accordion feature of our credit facility increasing it to $400 million. It is now comprised of a $150 million revolving credit facility and a $250 million term loan, of which only $150 million is currently drawn on the term loan. The credit facility includes an updated accordion option that allows us to request additional revolver and term loan commitments up to a total of $750 million. The maturities for our revolver and term loan remain unchanged, with the revolver's maturity in January 2026 with options to extend for a total of 12 months and the term loan's maturity in January 2027. I would like to acknowledge and thank our banking partners who participated in the expansion of our credit facility, KeyBank, Truist, the Huntington National Bank, and First Financial Bank for their support and efficient execution in what has been a challenging financing market. On October 26, 2022, we purchased a five-year swap to fix SOFR at 3.44% on an additional $100 million of our term loan that will result in a fixed interest rate of 5.04% on additional draws under the expanded term loan when our leverage ratio is less than or equal to 40%. As part of the swap transaction, we sold a one-time option to terminate the swap on December 31, 2024, which reduced the swap rate. Under the credit facility, the interest rate will continue to vary based on our leverage ratio. The credit facility is priced on a leverage-based grid that fluctuates based on the company's actual leverage ratio at the end of the prior quarter. In accordance with the terms of our KeyBank credit facility, we define leverage ratio as debt as a percentage of the aggregate fair value of our real estate properties plus our cash and cash equivalents. Based on our leverage ratio of 38% as of the quarter ended September 30, 2022, the interest rate for the revolver is SOFR plus 155 basis points plus a 10 basis points SOFR index adjustment, and the interest rate on the revolver was 4.7125% on October 31, 2022. Based on the current balance sheet, approximately 90% of the company's indebtedness holds a fixed interest rate. The weighted average interest rate on the company's total debt outstanding of $201.4 million as of October 31, 2022, is 4.08%, based on the company's leverage ratio of 38% as of September 30, 2022. As previously announced, our Board of Directors declared dividends for common shares of approximately $9.06 for the months of October, November, and December, representing an annualized dividend rate of $1.15 per share of common stock. Based on the recent closing price of our stock, this dividend equates to an 11% annual dividend yield. As Aaron mentioned, we affirmed our 2022 annual AFFO guidance in the range of $1.26 to $1.36 per diluted share. I will now turn the call back over to Aaron.

Aaron Halfacre, CEO

Thank you, Ray. Before we turn to Q&A, I'd like to share some final thoughts. Volatile times in the marketplace can be true tests for our company's strategy, management team, and Board of Directors. And I'm proud to say that for Modiv, our strategy is battleship strong, and our management and Board remain not only confident but optimistic. We are more convinced than ever in our long-term value creation strategy and believe that our story is unique and compelling. Our commitment to providing our investors with an attractive, stable monthly dividend is unwavering, and the quality, resilience, and long-term earnings power of our portfolio continues to improve. With that, I'd like to thank everyone for joining us today, as well as wishing you and yours a happy holiday season. Now, I'll turn the call over to the operator for questions.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. And our first question comes from the line of Gaurav Mehta with EF Hutton. Please proceed with your question.

Gaurav Mehta, Analyst

Thanks. Good morning. You guys talked about having a strong pipeline of acquisitions. I was hoping if you could maybe provide some more color on what you have in the pipeline between portfolio-level acquisitions and individual properties?

Aaron Halfacre, CEO

We were quite active in the third quarter, despite being cautious. We haven't made any public announcements yet. However, we've evaluated four portfolios, three focused on industrial manufacturing and one that is diversified but primarily industrial. I personally visited 30 properties with our Chief Investment Officer, Bill Broms. We've been diligent in our analysis, as every decision at this scale needs careful consideration. During this time, we noticed significant changes in deals and cap rates, alongside market sell-offs and treasury influences, so we opted for a cautious approach. I've reviewed the performance of other REITs, many of which reported cap rates for the third quarter in the range of 6.5 to 7.2. While we see indications of widening cap rates, it's unclear at which levels they are closing. We've chosen to remain patient and have had opportunities to proceed but are focusing on being thoughtful about our decisions. Our concern isn't about deploying capital; rather, we want to ensure we understand key leases as best as possible. Despite the uncertainty, we are considering what the first quarter may present in terms of opportunities.

Gaurav Mehta, Analyst

Okay. Maybe one on your guidance, can you maybe talk about the $0.10 variance between the lower end and upper end? What are you underwriting to get to the upper end of the guidance versus lower end?

Aaron Halfacre, CEO

Yes. Ray can provide more specifics, but the difference in our guidance is primarily influenced by two factors: asset sales and acquisitions. Generally, I prefer not to discuss these activities until we have certainty about the transactions. For example, if you're in negotiations and the deal isn't finalized, we don't disclose those details. To reach the upper end of our guidance range, we would likely need to refrain from selling assets and increase our acquisitions, if I'm not mistaken.

Ray Pacini, CFO

Right.

Aaron Halfacre, CEO

Our original guidance was for $50 million in acquisitions at a 6.25% cap rate. However, I'm not seeing any opportunities at that cap rate. Additionally, we did sell some assets but did not make any acquisitions.

Ray Pacini, CFO

Correct.

Gaurav Mehta, Analyst

Okay. Maybe the last one.

Aaron Halfacre, CEO

Maybe acquisitions were $28 million I think.

Gaurav Mehta, Analyst

No, I'm sorry. Maybe last one on your portfolio allocation. You obviously talked about your focus on growing industrial manufacturing and then knowing it's closer to office. I was curious to maybe learn more about how you are viewing retail as a part of your portfolio.

Aaron Halfacre, CEO

Yes. I would love nothing more than to be a pure-play or not today. Our focus on asset sales has primarily been on the office sector, and that will continue to be our main focus. The retail assets we hold are quite standard and easy to sell; we could sell them tomorrow if we chose to. However, we are being careful about the timing of any sales. Long-term, we aim to reduce our retail holdings.

Operator, Operator

Thank you. And our next question comes from the line of Rob Stevenson with Janney. Please proceed with your question.

Rob Stevenson, Analyst

Good morning, everyone. Aaron, how are you approaching property sales in the current market situation? Are you waiting for conditions to stabilize? Is the difference between your selling and buying prices appealing enough to proceed? How should we view your plans for property disposition in the coming quarters?

Aaron Halfacre, CEO

Yes. We are marketing some office assets for sale. Earlier in the quarter, we received unsolicited bids for certain properties that we considered to have decent cap rates and went under contract. However, following the Fed's actions, interest seemed to wane, resulting in some buyers coming back to renegotiate, which we found unacceptable. Currently, transaction activity feels subdued compared to other times. When selling office properties, potential buyers must secure financing ahead of time, which has been challenging for them. We are cautious and don’t want to make hasty decisions. These properties are generating AFFO, and we are actively negotiating lease renewals. We understand the need to sell these assets but are not in a hurry to do so without a plan for reinvestment. We must balance selling quickly and maintaining our AFFO levels while managing leverage. Patience in this market is advantageous, and we believe we are benefitting from it.

Rob Stevenson, Analyst

Okay. How are your discussions with tenants regarding annual increases going? You completed a deal at 2.3% with Valtir, but most recent agreements have been at 2% increases. Is there general consensus in the market that 2% remains appropriate, or are future leases likely to shift towards 2.5% or even 3%, considering the strong inflation? Or is a rapid change in the market unlikely?

Aaron Halfacre, CEO

I believe that 2% is the lowest we can expect. Brokers have come to realize that 2% is no longer favorable. We've noticed a trend towards 2.5%, and we are currently under a letter of intent for a property, which is non-binding and may not materialize. This potential deal isn’t included in our guidance numbers. While it’s a modest transaction, it has an 8.25% cap rate with 4% increments. We are observing some movement in the market. I’ve spoken with some industry peers, and while they are taking a different approach, they are securing some uncapped CPI deals. Personally, I have not encountered that; instead, I’ve noticed some capped CPI agreements and others with collar ranges tied to CPI. However, the majority of the transactions we are encountering right now are at around 2.5%.

Rob Stevenson, Analyst

Okay. For my last question, Ray, how significant is the rate adjustment? If you exceed 40% leverage or if you acquire more than you sell in the near term, how does that affect you and what kind of impact does it have?

Ray Pacini, CFO

So for every 5% up to 50, it goes up 10 bps. And then north of 55 or north of 50, it goes up 15 bps. So it would top out at 210 bps on the term loan and 215 bps on the revolver.

Operator, Operator

And our next question comes from the line of James Allen Villard with Ladenburg Thalmann. Please proceed with your question.

James Allen Villard, Analyst

So did you repurchase any stock post 2Q earnings call? And if so, I mean, kind of how were you thinking about that utilization of that program going forward?

Ray Pacini, CFO

Post Q2, we purchased year-to-date, I know we bought 211,000 shares at an average of just under 17. During Q3, I don't remember the exact number of shares, but we bought them at an average of around 15. It's disclosed in our 10-Q; I just don't have the number.

Aaron Halfacre, CEO

I think we stopped.

Ray Pacini, CFO

Yes. We stopped. It just did not work.

Aaron Halfacre, CEO

Yes. So look, we still have it available. We turned it off. We only do sort of a 10b5-1, so we set and forget kind of thing. We're not trying to micromanage that process. We still have capacity available. I would tell you it's a balanced reaction to these things, but at these prices, I would probably participate in the buyback. We are just trying to manage that process a little bit. But yes, it's a tool we have. It's not a panacea. We don't expect it to move the needle for us. So I'd say it's a tool we have right now, looking at where we're at today. It's a tool that I could potentially use.

Ray Pacini, CFO

I just picked up the number from the 10-Q, which is going to get filed in a little bit. In July and August, we bought a total of 45,715 shares for a total of about $704,000. The average cost is $15.40 a share.

James Allen Villard, Analyst

Yes. That's helpful. Another follow-up question is can you provide us any more color on what's under PSA, what's under LOI?

Aaron Halfacre, CEO

No.

Ray Pacini, CFO

No.

Aaron Halfacre, CEO

I can't share specific details, but I generally prefer to know that it's confirmed because the market has been quite unpredictable. I don't want to be going in circles, and I don't want you all to do that either. Thank you, operator. Thank you to everyone for joining the call. The quarter was steady and disciplined, though not particularly exciting. We don't aim to be thrilling every quarter; instead, we want to be very deliberate in our approach. As we transition from a small to a microcap company, we need to carefully consider our decisions regarding leverage, growth, share price, and execution. It's crucial to be thoughtful rather than impulsive. In the past, many small-cap companies have harmed themselves through rash decisions. Every choice we make can lead to subsequent consequences, so we are being deliberate and attentive to our surroundings. I have assembled this team to function similarly to a hedge fund or private equity team, comprising various experts in a small group of 12 people. We are focused on gathering data, contemplating the situation, and consistently refining our processes while challenging our assumptions. This is vital in the current market environment. If we act indiscriminately, relying on a one-size-fits-all approach, the outcomes can vary greatly depending on market conditions. Currently, there seems to be a lot of uncertainty in the market, with shifts from risk-on to risk-off sentiments almost daily. Therefore, we are executing our plans while being mindful of the timing of that execution, which is essential. Ray and I will be heading to Nari in San Francisco shortly after this to meet with investors, as we continue to seek greater transparency and stability in the broader markets. This will help the entire sector avoid net retreats, which has been a concern for some time. I believe we are in a strong position to continue executing and to engage in the marketplace. Thank you all for your time, and I wish you a wonderful holiday season.

Operator, Operator

Thank you, everyone. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.