Nnn REIT, Inc. Q4 FY2022 Earnings Call

Thank you, Jenny. Good morning and welcome to National Retail Properties’ fourth quarter 2022 earnings call. Joining me on the call is Chief Financial Officer, Kevin Habicht. As this morning’s press release reflects, NNN’s performance in 2022 produced 9.8% FFO growth along with an all-time high in acquisitions of nearly $850 million. In addition, the year concluded with high occupancy of 99.4% and an impressive rent collection of 99.7%, all driven by our best-in-class team here at NNN. The end of the year surge positions the company well headed into the uncertainty of 2023. A few highlights of 2022 that I am proud of what NNN accomplished. One, 33rd consecutive annual dividend increase, released its inaugural corporate responsibilities and sustainability report, positioned the Board of Directors for the foreseeable future, and 1 of only 13 REITs included in the 2023 Bloomberg Gender Equality Index. While there is a change at the helm in 2022, the building blocks to realize long-term value at below-average risk for our shareholders remain in the most simplistic form. Continue to execute our strategy using a bottom-up approach, continue to increase our annual dividend maintaining top-tier payout ratio, focused on growing FFO per share in the mid single digits over multiple years. We do this by setting our acquisition, disposition activity, and our balance sheet management to achieve that objective. As I stated earlier, NNN is on solid footing as we were a month into 2023. First, at year-end, NNN had $166 million drawn on our $1.1 billion line of credit after finishing the year with all-time high acquisitions. We have the option to keep leverage neutral while utilizing a reasonable amount of the availability of the credit facility, approximately $180 million of free cash flow, plus $110 million of dispositions to execute our 2023 strategy. Using those three sources, as I mentioned, leaves NNN with manageable equity requirements for the year. Secondly, NNN’s longstanding strategy of being selective while deploying capital and opportunistically raising capital over the years will not change for 2023. The sizable fourth quarter, which I will cover shortly, allows NNN to continue being opportunistic with acquisitions as the price discovery continues. The cap rates have been slowly increasing, evidenced by our fourth quarter initial cap rate being 30 to 40 basis points higher than our third quarter, and we are still seeing further expansion in the first quarter of 2023. Shifting to the highlights of the fourth quarter financial results, our portfolio of 3,411 freestanding single-tenant properties continues to perform exceedingly well, and we expect that trend to continue, maintaining high occupancy levels of 99.4% for two consecutive quarters, which remains above our long-term average of 98% plus or minus a fraction. We also collected 99.6% of rents for the fourth quarter. The recent headlines of certain retailers, such as Bed Bath, Party City, Regal, Red Lobster, etc., that are assumed to have filed bankruptcy in the near-term have minimal effect on NNN. NNN’s exposure is limited, if not zero, in some cases. Turning to acquisitions, during the quarter, we invested just over $260 million in 69 new properties at an initial cash cap rate of 6.6% and with an average lease duration of 16 years—a term you typically don’t associate with NNN. While we deviated from our historical trend this past quarter, typically, we source the majority of our deals from our relationships and don’t target investment-grade deals. But during the quarter, NNN was in a position to be opportunistic. As you noticed in the press release, our exposure to drug stores increased from 1.3% to 2.6% year-over-year. Over the years, NNN passed on drug store portfolios because we viewed these opportunities as not the best risk-adjusted return to deploy capital at that given time, based on market pricing, real estate metrics, and lease form. This particular portfolio was in line with our underwriting standards, the real estate, and the lease form. But more importantly, the transaction is an excellent real estate play, with well-performing assets and excellent locations for the long run. Currently, we are well into the price discovery period, where the bid-ask spread has continued to adjust, and we continue to maintain our thoughtful and disciplined underwriting approach. NNN continues to emphasize acquisition volume through sale-leaseback transactions. Our 2022 average lease duration was slightly over 16 years with our stable relationship with tenants, with long-duration net leases more landlord-friendly than a 10/31 market. During the quarter, we sold 5 properties at a 5.9% cap, plus 2 vacant assets, raising $16 million in proceeds. For the year, we raised $65 million from the sale of 17 properties at a 5.9% cap, plus 16 vacant assets. Although job one is always to release vacancies, we will continue to sell non-performing assets if we do not see a clear path to generating rental income within a reasonable timeframe. With that, let me turn the call over to Kevin for more color and detail on our quarterly numbers and updated guidance.

Thanks, Steve. And as usual, I will start with the cautionary statement that we will make certain statements that could be considered to be forward-looking statements under federal securities laws. 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 in this morning’s press release. With that out of the way, yes, headlines from this morning’s press release report quarterly core FFO results of $0.80 per share for the fourth quarter of 2022, that’s an increase of $0.05 or 6.7% over year-ago results of $0.75 per share, and full-year 2022 core FFO results were $3.14 per share, which is a strong 9.8% increase over year-ago results. Today, we also reported that AFFO per share was $0.81 for the fourth quarter, which is up $0.04 or 5.2% over 4Q 2021 results. As usual, we footnoted that fourth quarter AFFO included $681,000 of deferred rent repayment in our accrued rental income adjustment for the fourth quarter; without this, we would have produced AFFO of $0.80 per share for the quarter. Likewise, the full year of 2022 AFFO included $5.4 million of deferred rent repayments in our accrued rental income adjustment; without this, we would have produced AFFO of $3.18 per share for the full year, representing an 8.9% increase over the adjusted $2.92 per share results in 2021. These scheduled deferred rent repayments continue to taper off materially in 2023, as seen in the details provided on Page 13 of the press release, but the headline growth of 9.8% core FFO per share in 2022 is an excellent result for us and notably above our historical mid-single-digit growth rate. Admittedly, we did have some tailwinds in 2022, which likely contributed something in the $0.09 to $0.10 per share range for the annual results. These tailwinds included some of the refinancing we did in 2021, most notably redeeming our 5.2% preferred, which probably added $0.03 per share. We also experienced a $3.3 million increase in our cash basis deferred rent repayments in 2022. We resumed full rent from Chuck E. Cheese in 2022, adding about $3.3 million of rent at the beginning of the year. Additionally, we had one less executive position, which generated some G&A savings in ‘22. Of course, layered on all of that, we entered 2022 with $171 million of cash on the balance sheet, creating notable accretion once that was invested—a good year, indeed. The AFFO dividend payout ratio for the full year 2022 was approximately 67%, resulting in about $188 million of free cash flow after the payment of all expenses and dividends for the full year. As we see it, this free cash flow funded over 40% of the equity needed to fund our 2022 acquisitions. Occupancy was 99.4% at quarter-end, remaining flat with the prior quarter and up 40 basis points for the year. G&A expense came in at $10.8 million for the quarter, up from $9.9 million year-ago levels. More importantly, for the full year, G&A expense totaled $41.7 million, down 6.6% from 2021, representing approximately 5.4% of total revenues and 5.6% of NOI. We ended the year with $772 million of annual base rent in place for all leases as of December 31, 2022. Today, we also introduced 2023 guidance with a core FFO per share guidance range of $3.14 to $3.20 and an AFFO guidance range of $3.19 to $3.25 per share. Core FFO guidance suggests about 1% growth to the midpoint in 2023. The more modest growth in 2023 guidance reflects the high bar of last year’s 9.8% growth created and the lack of tailwinds that were helpful in 2022. A particular headwind in 2023 worth noting is the $5.8 million slowdown in cash basis deferred rent repayment. As detailed on Page 13 in the press release, tenants continue to repay these rent deferrals on time, but what is owed is slowing notably. As usual, we don’t provide guidance on any of our capital markets assumptions regarding our capital markets activity, except for the general assumptions that we intend to behave in a fairly leverage-neutral manner over the long run. We are hopeful to move our guidance higher through 2023, as we have done in most years. For now, this is where we feel comfortable.

Yes. Thank you. Good morning, everyone. You spoke a bit about the drug store deal. I’m curious if you’re seeing a narrower spread between investment-grade and sub-investment-grade deals that might push you up the credit quality spectrum or if that deal was just a one-off?

Yes, our strategy isn’t going to change in 2023. It was a one-off deal. We were in a great position, balance sheet-wise, whereas a lot of our competitors already had significant exposure to the drug store sector. NNN had laid low for about a decade in the drug store market. This deal was really attractive due to the above-average lease terms that the company was willing to offer, which is why we jumped in. The economics were good. We don’t disclose specific economics on deals, but the drug store deal was above our average, with an average cap rate of 6.6% for the quarter.

Yes. I mean that’s been perpetually on our list for the last couple of years, as well. A lot of folks, I guess, at this point. But yes, still current on rent; the liquidity to pay rent seems to suggest they have a little more runway left. We will see if they have the ability to continue to raise some more capital here in the coming quarters. But I don’t have a lot of news to share on that front. They represent 2.8% of our total rent and ABR.

Yes. Thank you. Just going back to the acquisition guidance, I know you mentioned you’re waiting to see how that bid-ask spread continues to adjust. But I’m curious how much of that conservatism on guidance is reflective of your current tenant base not wanting to grow right now versus perhaps conservatism on new prospective tenants?

Yes, Spenser. Yes, we’re always conservative in what we see in the pipeline. That being said, our pipeline is fairly robust as we sit here early February for 2023. We are comfortable with our first quarter numbers if everybody behaves appropriately and deals close. Our development pipeline for 2023, to answer your question, feels like our current relationships are growing, but our development pipeline is as robust as it’s been in 5 years. So, we are very comfortable with that. We’re seeing a slowdown in M&A activity with our relationships, but we feel confident they are still growing. Our acquisition guidance, as you know, will adjust throughout the year.

Yes. Hey guys. I just wanted to follow up on the drug store deal. Just curious, I think in the past you might have shied away from drug stores just because they didn’t really have much rent bumps built in. Just curious if this was different where there were rent bumps, or was it a marketed sale-leaseback deal?

Hey, Josh. The drug store deal, as I mentioned, was north of our average cap rate deal for the fourth quarter. But this was a real estate play. It was a sale leaseback; therefore, it wasn’t based on developer rent per square foot numbers, so we were comfortable that the tenant set the rents at very market-rent levels. More importantly, 85% of the properties are in hard corners, and about 90% have drive-through capability, making it a strong real estate play. The average lot size was 1.6 acres, so yes, we received above-average lease terms according to market standards for drug store deals with more landlord-friendly leases than usual, which is why we pursued this opportunity.

Sorry, I’m pitching up to you. In other income, what are you looking at?

No, on Page 15 of the sup, your top 20 lines of trade looks like you list other at 8.1% of the portfolio, which looks like it was up over the course of the year, just kind of curious what’s in that other category and if there are any noteworthy themes with that increase?

Yes. I mean, nothing notable. I can circle back to you and maybe provide a little more color on that.

Hey, just going back to the 100 basis points assumptions on the bad debt. Obviously, appreciate that historically, you’ve come in way below that. Just trying to get a sense of, is this year, is your expectation that just based on the watch list, based on what you’re hearing, could we be closer to that 100 basis points this year versus last year? Just trying to figure out how conservative that assumption is based on what you’re already seeing in the portfolio?

We don’t have visibility on any near-term concerns, so yes, the 100 basis points still feels fine. I share your sentiment that this seems like a year where retailers may struggle a bit more. The reserve might be utilized more than it has in the past, but as of now, there is nothing alarming on our near-term radar.

Great. And then just looking at the cash flow statement in the K, I think it looks like at least in ‘22, that was close to $200 million of excess cash after the dividend base. I think you mentioned a similar number earlier in your opening comments. But is that sort of a fair range for ‘23 as well, given the FFO guidance? Just making sure we’re not missing anything?

Yes. Good question. So, it was about $188 million, close to the number you’re talking about. It will probably be a touch lower in ‘23 as the rent deferral repayment slows down, so the expected number is about $180 million of free cash flow after all expenses, all dividends to fund acquisitions.

The deals that we started pricing near the end of the fourth quarter that are going to close in the first quarter are where we’re seeing that 30 to 40 basis points again. We’re also starting to see deals we’re pricing today, which will likely close in the second quarter, are starting to be accepted at higher cap rates. When I say market, I mean the sale-leaseback market, where they seem to be a little more sophisticated and understand our increased cost of debt. However, in the 10/31 market, it remains fairly robust, and we’re not seeing a significant increase unless you’re considering 5, 6, or 10-year leases.

Thanks. Maybe just on that last comment, what was kind of as the 10/31 market there and maybe compress some of that bid-ask spread that we are currently seeing?

We are always evaluating the 10/31 market, but it contributes a small portion of our deal flow, so I’m not sure what it would take to close that gap. If I had to speculate, assets in the $15 million to $25 million range would likely see a compression of the bid-ask spread. However, in the $2 million to $5 million market, cash remains abundant and doesn’t require financing. I don't foresee those cap rates moving significantly. For modeling purposes, John, I would just spread the $110 million midpoint evenly throughout the year.

Yes. We don’t have any real plans to issue long-term debt in the near-term, primarily because we have not heavily utilized our bank line. We have the luxury of leaning on that in this environment. We don’t have immediate plans to issue long-term debt and will evaluate the environment as the year progresses. We have a weighted average debt maturity of over 13 years, which gives us flexibility, so we are unlikely to need to issue long-term debt soon.

I just want to focus on the comments about the development pipeline being the most robust in 5 years, with $22 million under construction. What is the commitment for these projects, and how big could this pipeline get?

Historically, pre-COVID, we have had about a $100 million run rate for our pipeline, which is a good ballpark figure to consider. We don’t do long-term commitments; it’s more about purchasing land when it’s time to build, typically within a three-month window. No. We still have three Bed Baths because they are fabulous real estate. They were not on the initial list of Bed, Bath closures, but they are good real estate that we expect to replace easily. You are right; we lost one Regal in Chicago, but we are receiving good interest for that asset as well. We are maintaining a comfortable position with our underwriting model, emphasizing real estate first. While we understand the importance of tenant credit, if you purchase highly desirable real estate near market rent, cash flow replacement is possible. There is a self-selection process in our business model; tenants willing to sign long-term leases are more likely to favor lower rents.

We have not seen any notable changes in rent coverage ratios, which we track; however, we receive this data with a lag, meaning we may not have real-time data for evaluation. As of this point, there are no concerns causing alarm in any particular trade line.

Hi. Good morning. Considering the discussions around retailer credit and credit losses, are you doing anything differently in terms of underwriting or credit monitoring to ensure you make it through potential worst-case scenarios?

We are not changing our approach. NNN’s business model prioritizes real estate, and while we recognize tenant credit importance, our emphasis remains on good real estate purchases near market rent to ensure cash flow replacement. Our underwriting will remain the same; we have demonstrated our resilience during economic downturns, so we are comfortable with our current strategy.

[Operator Instructions] Your first question is coming from Brad Heffern of RBC Capital Markets. Brad, your line is live. [Operator Instructions] Thank you everybody. This does conclude today’s conference call. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation.